Annaly Capital And Chimera: If It Is Too Good To Be True...

Includes: CIM, NLY
by: Takeover Analyst

After the subprime mortgage crisis, many investors are naturally wary of real estate investments. But with staggering dividend yields and low PE multiples, investors should not be so quick to pass off REITs and other financials. Annaly Capital Management (NYSE:NLY) and Chimera Investment (NYSE:CIM) offer dividend yields of 14.8% and 18.4%, respectively, paying out returns through this method.

This, however, comes at the risk of holding those oh-so-dreaded CDOs and CMOs - even debentures of Fannie Mae and Freddie Mac. Chimera was spun off from Annaly Capital around four years ago and is still managed by stellar partners at Annaly Capital; but, as Jim Cramer is fond of mentioning, the experts are not always right. The firms are essentially betting on how and when interest rates will change and random walks are, of course, objective to past success.

The greater the spread between investment returns and interest rates, the more profit both firms generate. The latter is at an all time low, but how far into the future will this continue? The idea is simple enough for rational markets to quickly factor in a reasonable outlook. In addition, there are concerns over housing stagnation, margin calls, higher mortgage prepayments, and onerous regulations. In the third quarter, Annaly Capital had CPR increased from 11 to 18, in large part due to the reduction in LTV cap.

From a multiples perspective, both nevertheless are cheap. Annaly Capital trades at a respective 8.5x and 7x past and forward earnings; Chimera at a respective 4.9x and 5.6x past and forward earnings - well below book value. Annaly Capital trades at a significant premium to peers, which, in my view, is largely due to the trust in management's seemingly precognitive power. At the same time, it trades at only 1.01x book value, well below the historical average of 1.24x.

At the third quarter earnings call, Annaly Capital Management's renowned Chairman & CEO, Michael Farrell, used a conceit that compared the global financial system to a patient of overly aggressive policy makers:

Subprime wasn't the only problem, it was just the external agent that activated the dormant virus of overleveraged, falling asset values, including the oversupply of homes in the U.S. and structural fiscal and current account imbalances. As the patient seems to be stabilizing, the realization that the conditions are not bacteria but rather viral have gotten lost in the treatment. Delaying the inevitable elements of the worst-case scenario through increasingly aggressive and desperate policymaking is simply reopening the wounds of 2008, market-by-market, country-by-country and consumer-by-consumer.

While in some sense I agree with Farrell, I would have appreciated greater discussion about specific actions that management is taking to address "aggressive and desperate policymaking". Investors want a greater understanding of how Annaly Capital's investments justify the large premium to competitors and the CEO's speech might be seen as a sort of whitewashing the subprime mortgage mess. Although the CEO states that "[s]ubprime wasn't the only problem", it was, to most economists, the main problem that resulted in the financial crisis.

The rally in the Treasury market has also decreased Annaly Capital's swap book value to $1.55 per share. Although the firm has strong cash holdings to justify the dividend, reforms and unemployment pose risks by driving instability in mortgage prepayments. My view is that the current premium to competitors will be more sensitive to underperformance in free cash flow generation than in strong performance. In that extent, I believe that the stock is risky.

Consensus estimates for EPS are that it will increase by 7.3% to $2.50 in 2011, decrease by 7.6% in 2012, and then increase by 1.3% in 2013. Of the 18 revisions to EPS, 16 have gone down. Assuming a multiple of 8x - still the highest among all reasonably similar companies - and a conservative 2012 EPS of $2.25, the rough intrinsic value of the stock is $18. While an overly simplistic calculation, this implies a limited margin of safety that does not traditionally meet the threshold considered to be a value play. Analysts nevertheless currently rate the shares a "buy".

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.