Annaly: We Just Got Diluted

| About: Annaly Capital (NLY)

Summary

NLY is raising capital

I discuss why the company chose today to chase down funding from a secondary offering

Key metrics are tight and we need to watch the per share core income figures going forward

NLY is among the best in the game

Annaly Capital (NYSE:NLY) is out with some just announced news that has this investor in pain, with the company taking advantage of its recent premium valuation to raise some serious capital. In turn, we as shareholders are about to experience some massive dilution. Shares are already reacting after hours, falling 3% at the time of this writing. So what is the deal here?

I cannot blame management for raising the capital, but this is no tiny offering. This deal is no joke with the company issuing a public offering of 60,000,000 shares of common stock. That is 60 MILLION more shares. Oh, and in customary fashion, there could be more. That is right. In connection with the offering, as is so often done, Annaly intends to grant the underwriters of the public offering a thirty-day option to purchase up to an additional 9,000,000 shares of common stock. Talk about massive dilution. There is about 1.02 billion shares outstanding, which means this is about a roughly 6% dilution. Some may claim this is not a huge watering down, but its enough to cause concerns over future dividends, concerns over earnings per share, and a hit to share price.

Why take the funding? It may be crass to say this, but frankly “because they can.” Annaly Capital Management is finally trading above trailing book value, so it can issue shares at a premium. Of course the company intends to use any proceeds of this offering to acquire new assets such as further Agency backed assets, in addition to other residential, commercial and corporate credit assets. So just about anything Annaly has its hands in already the money can be used to pick up more of. In a changing rate environment, this new influx of cash is a strong advantage, but it definitely is going to hit shares and earnings have to become an issue we are concerned with. While Annaly will pay down liabilities and fund other working capital items, we were already skating close to being unable to cover dividends here.

Remember what we just saw in the recently reported Q1 earnings. Annaly was above analyst estimates in terms of interest income. Annaly saw GAAP net income of $440 million or $0.41 per share, which was down heavily from the sequential quarter's $1.70 in earnings, which was one of the strongest quarters in recent memory. However, we need to gauge dividend coverage, and this is why I like to focus on core earnings. Annaly's core earnings came in at $0.29 per share, meaning this was below coverage of the $0.30 dividend. That hurts. Unless the investments made with this money give an equal boost to core income, the per share coverage becomes at risk.

Key metrics have been an issue. Volatility in borrowing and financing conditions resulted in the all-important net interest spread narrowing significantly from 2.28%, to 1.15% last quarter. We must keep an eye on this spread. One of the items impacting the yield on assets is the constant prepayment rate. While Annaly’s CPR fell heavily to 11.5% last quarter, keep in mind that a healthy prepayment rate is under 10%. Further I still would like to see no more than 5% on this measure.

The need for more cash and flexibility with asset purchasing, coupled with the premium-to-book value the company enjoys, is why this capital raise is happening now. In general, book values have been falling sector wide for years. However, a few companies have started to turn the tides. Here in Q1 2017, book value saw a small 0.7% bump to $11.23. We will take it. Based on a share price of $12.26, the stock is trading at a premium-to-book of 9.2%. This premium is why I had a hold rating on the name. Now we are about to get shellacked by this raise. But you should not be surprised. At all. These offerings happen all the time. So this is no surprise. To keep the ball rolling, fresh funds are needed. That is the danger of the mREIT business. To fund those dividends, borrowing and dilution is common. Annaly just happens to be among the best at the game.

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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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