Annaly Capital Management: Two Ways Investors Could React To Reality

| About: Annaly Capital (NLY)
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Summary

The Fed hiked again, cementing my belief that Annaly Capital Management is facing serious headwinds.

Cost of funds will likely rise significantly in Q3 compared to Q1 as it will fully absorb the impact of the last two hikes.

Investors could push the stock to trade at a premium and then deal with a correction later.

The stock could also trade around book value, implying a steadily declining share price as dividends are paid.

I see no good reason to buy the stock.

As expected, the Fed raised rates last week, increasing the federal funds rate to 1-1.25%. Despite the assured path to higher interest rates, Annaly Capital Management's stock (NYSE:NLY) has not backed down. I believe that investors are being highly optimistic about the company's prospects in a tightening environment. While shifts in sentiments are difficult to predict, sooner or later, investors must face reality.

Cost Of Funds Will Rise

The second quarter is not over yet, but the two most recent rate hikes will fully impact Annaly Capital in the third quarter. The company was lucky in the first quarter as the March hike only impacted the tail of the quarter and the June hike obviously had not happened yet.

In the chart above we can see that the 3-month Libor rate has risen significantly since Q1.

At the end of Q1, the company had $62.7 billion of repurchase agreements, which accounted for 89% of all interest bearing liabilities ($70.1 billion). Because repo agreements tend to track Libor rates, the post-Q1 rise in Libor rates will have significant impact on the company's ability to earn a spread on its investments.

Two Paths Forward

Because generating economic income is essentially a fool's errand at this point (read Paying Yourself), I believe that book value will continue to fall as the company will likely continue to pay dividends. I believe that the management won't eliminate dividends because that's what has always been done in the past. To illustrate point, I'm going to borrow the chart I made from my other article:

Source: data from company filings

Despite a lack of real profits, which should have led to an increase in book value (or at the very minimum maintain it), the company has continued to pay a significant amount of dividends.

Based on the assumption that company will continue to pay dividends, I see two scenarios. In the first scenario, the book value will fall but the stock won't move as investors continue to focus on the dividend yield. In such a case, the stock will get more and more expensive until it trades at a substantial premium to book value, after which the stock will experience a big correction. In the second scenario, the stock will move in conjunction with the book value, leading to a steady decline in the stock price as dividends are paid out.

Neither of the above scenarios spell catastrophe for shareholders as the total return won't be extremely negative. In the first case, investors could actually make some money in the short-term on the back of unfounded optimism. However, such gains would require faith that market participants will remain irrational and allow the company to trade at a premium to book value. I don't know what every investor out there is thinking, but investing based on sentiment rather than fundamentals is certainly something that I do not recommend.

Conclusion

The most recent rate hike cements my belief that Annaly is facing significant macro headwinds that pose serious challenges to the company. Regardless of these challenges, the stock has continued to perform well. Taking this into account, I believe that investors could either push the stock to trade at a premium in the near-term and suffer the consequences down the road, or the stock will trade around book value, implying a steady decline in the share price as dividends are paid. For those reasons, my outlook remains negative for the stock despite its recent outperformance.

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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.