Annaly Capital: Just Did Not See That Coming

| About: Annaly Capital (NLY)


NLY remains one of my longest and oldest holdings.

Q4 earnings are out and I discuss the key metrics honing in on performance related issues.

What about the dividend?

Annaly Capital (NYSE:NLY) remains one of my longest and oldest holdings. The mREIT sector began to rebound after three years of pain back in 2016, but in recent weeks has been hit hard. It has been a tough hold in this name, but over the last two years, the stock has mostly traded sideways, and for an income name, this is a good thing. You come out on top, banking that dividend. In a changing rate environment, the short-term could continue to be turbulent, but the longer-term looks bright. Higher rates bode well for the mREITs. Better performance could mean share appreciation. To me that is simply a bonus, because you are collecting a massive dividend and that is why we own a name like this. Provided the company is covering its dividend, growth is always welcome. Over the past few quarters Annaly has been very close to not covering its dividend. Is that still the case?

As we saw in the recently reported Q4 earnings, Annaly delivered a decent report that was better than I expected, and it was a bit above analyst estimates. I did not see this coming, especially after seeing reports of competitors. It saw GAAP net income of $1.8 billion or $1.70 per share, one of the strongest quarters in recent memories. However, we need to gauge dividend coverage and so the net GAAP income/loss doesn't tell us much in this regard. This is why I like to focus on is the core earnings. Annaly's core earnings, excluding any premium amortization adjustments, came in at $0.30 per share. This is perfect coverage of the $0.30 dividend. As I have said before, for the dividends to be secure moving forward, we need this core income to rise.

Given core earnings remain close to the dividend, and the fact that recent quarters saw minimal (or failing) coverage, I will tell you I still have some concerns, despite the dividend being maintained the last two years. However, I still see the dividend as being maintained. Failure to cover this quarter would have resulted in a cut being more likely than not. This performance helps allay concerns that I had, although we must still be cautious. Of course, Q4 performance will be the tell all, but for now we can rest easy. I suspect a bit of short-term pressure from rate hikes but longer-term these bode well for the company.

What we need to watch moving ahead are the key metrics. In Q4 the yield on interest earning assets rose sharply to 3.81% and the average cost of interest-bearing liabilities, including interest expense on interest rate swaps used to hedge cost of funds, was 1.53%, which resulted in a net interest spread widening significantly to 2.28%, up from 1.13% last quarter. This is an immense turnaround from the 0.8% in Q2. In fact this is the widest I have seen the spread in many quarters. Remember anything under 1% is exceptionally weak. That said, if we factor in the premium amortizations, using a slightly adjusted core spread, the core average yield on interest earning assets was 2.68%, which resulted in a core net interest spread of 1.15%. This is moving in the right direction, but is also impacted greatly by the constant prepayment rate.

The constant prepayment rate is the most critical indicator to watch, as it impacts all others. And as you know, I have been concerned about prepayments, and these have crushed earnings in the last two quarters. I have to say too, that the constant prepayment rate for Annaly Capital has been much higher than the sector average. In the last two quarters we saw the constant prepayment spike up to 15.9% in Q3 from 12.7% in Q2 2016. But here in Q4, the constant prepayment rate cooled slightly to 15.6%. This was another strong positive in a really strong quarter. Of course, Ideally, I would like to see 5-6% on this measure, but the entire sector is facing pressure here. The good news is that it did not pressure the spread, and subsequently net income. Though if the CPR was even lower, the spread would likely have been higher.

One metric that has been hit hard this earnings season has been book value. We have seen 10% plus drops in some mREITs in just one quarter. In general, book values have been falling sector wide for years. However, a few companies have started to turn the tides. Let's review Annaly's recent history of book value. Book value was $13.10 to start 2015, but fell to $12.88 as of the end of Q1 2015, dropped to $12.32 in Q2 2015, fell another 3% to $11.99 in Q3 and dropped to $11.73 in Q4. In Q1 2016, it fell another to $11.61 and in Q2 it fell another 1% to $11.50. In Q3 book value expanded, and expanded quite nicely. It grew 3% to $11.86. However, despite an overwhelmingly positive quarter, with the rise in rates in Q4, Annaly could not escape a hit to book value, which I expected. It rang in at $11.16, so it fell $0.70 or 5.9%. This is a substantial hit, just like the rest of the sector, but is actually a smaller hit than what I have seen from most competitors. Based on a share price of $10.40, the discount-to-book narrowed to $0.76 or 6.8%.

Looking ahead, we have seen insiders buying the stock again. That is a positive. I think insiders recognize the tide is turning. Rising rates create short-term pressure but are a positive for the long-term. Bottom line? This was a stellar quarter on most fronts, although the hit to book value hurts, even if it was sector wide. The discount-to-book is still attractive and with the dividend being maintained I am happy simply holding and reinvesting the dividends, waiting for the eventual strong turn around. I am holding at this point, but anytime this dips below $10, Annaly should be attractive for income investors.

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Disclosure: I am/we are long NLY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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