Annaly Capital Management: Explaining 45% Drop In Core EPS

| About: Annaly Capital (NLY)

Summary

Recently, the management changed the definition of Core EPS.

Core EPS no longer excludes the impact of premium amortization adjustment.

PAA is non-cash but does affect the stock's underlying, in my view.

Q4 2016's unadjusted Core EPS was inflated by PAA, but the benefit was real.

The new Core EPS will be significantly more volatile and less comparable, which accurately reflects the inherent risk of the business model.

After a regulatory push by the SEC, Annaly Capital Management (NYSE:NLY) finally revised its definition of Core EPS back in Q4 to include PAA (premium amortization adjustment).

Source: Extract from 8-K released on February 15th, 2017

With the inclusion of PAA, the Core EPS will fluctuate a lot more as interest rates change, but it will reflect a much better view of how much value was created or destroyed over the reporting period, in my view.

A quick note for new investors in Annaly: Mortgage REITs generally disclose some form of adjusted earnings as opposed to FFO, because the underlying assets are financial in nature. A conventional REIT adds back depreciation because it can be said that this non-cash expense doesn't reflect underlying economics; real estate tends to appreciate over time, whereas depreciation implies loss of value over time. As I will discuss below, purchase amortization adjustment is not the equivalent to the typical add-backs of a conventional REIT.

Non-Cash, But Real

For many companies adding back a non-cash expense or benefit does make sense since a one-time write-down of goodwill isn't going to impact future cash flow, but for a financial company like Annaly Capital, I believe that PAA does matter. PAA tells us how much CPR influenced the life of Annaly's investments. Because Annaly's investments are financial, a significant step-up or step-down in PAA translates to very real gains or losses over time. For example, if CPR goes up, PAA should rise significantly as the life of the asset goes down, hence any premiums must be amortized over a shorter life. Yes, the expense is still non-cash, but it essentially means that the company had paid more for less cash flow, and this change is reflected retroactively through PAA.

To give a very simple example, suppose that Annaly purchases a five-year bond that yields 3% at $110. The $10 premium gets amortized over the five years (the technical accounting is more complicated, but that's the idea) to show that each year the company is making $1 net of this premium ($3-$10/5). However, if this five-year bond suddenly becomes a one-year bond, then the $10 premium should be amortized over one year instead of five years. This means that the company actually made a loss on this purchase, and this is indeed something that investors need to care about!

Example in Q1 2017

In Q1, the Core EPS dropped by 45% from $0.53 in Q4 2016 to $0.29 in Q1 2017. While the company is facing significant headwinds (read Market Shuts Out Annaly), the cash earnings should not have been this dramatic. When we account for the impact of PAA, we can see that the adjusted Core EPS actually increased quarter over quarter. PAA added $0.23 in Q4 and subtracted $0.02 in Q1, so adjusting for PAA, adjusted Core EPS actually increased from $0.30 to $0.31. Now, this doesn't mean the quarters are equal. The PAA benefit in Q4 reflected the significant rise in interest rates after the election and the corresponding decrease in CPR, so while there was no immediate cash benefit, Annaly can now collect interest on investments for a longer period of time. Now, there are a ton of other things that go into Core EPS - hedges are a big one - but that's a topic for another time.

Confusing, But Rightly So

I believe that for the average investor, the new disclosure of Core EPS will just add more confusion. Not saying that the old measure of Core EPS was accurate nor particularly reflective of value creation or destruction, but the new version of Core EPS will be significantly more volatile, which is just the nature of the business. As much as investors like a safe dividend and prefer to see stable income, it is my opinion that with the exception of certain insurance companies, financial companies are anything but stable. This is especially true for mortgage REIT stocks, whose sustainability of dividends depend on spreads. Unfortunately, spreads are out of the management's control. It doesn't mean you can't make money, but investors should understand the inherent risk in the business model.

In conclusion, the new Core EPS may not be easy to understand, but it does better illustrate the underlying volatility of Annaly's business.

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

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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