Annaly: Wait For Margins To Contract, Lower Price Levels

| About: Annaly Capital (NLY)
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Annaly Capital Management (NYSE:NLY) has a business model which raises capital through short term loans (usually 30 days) and invests that money into government sponsored mortgage-backed securities. This gives the company's assets an added measure of security because the assets are backed by the United States government and are understood to be risk free, similar to Treasury bonds. This differentiates the company from other real estate investment trusts that invest in physical real estate with the added measure of risk.

The most important variable in determining the company's profits are the interest rate costs incurred in borrowing the capital it needs. The other is the return it receives on the securities it purchases. I think this second variable is causing the company some concern at the moment, which I will discuss in detail below. The margin or the profit Annaly Capital makes is the difference between these two variables which is generally called the yield curve. The company profits when the return on its investment exceeds the interest it pays on the money it borrows. This is a very low risk business model, in my opinion, and by definition of low risk - expected returns are generally not that substantial.

The company also makes money thorough its Fixed Income Discount Advisory Company - the asset management division of Annaly Capital Management. This division makes profits by receiving fees from third parties to apply the company's business model with external capital. In effect adding revenue without risking any shareholder capital. This division has a publicly listed closed end mutual fund with First Trust (NYSE:FHY). The Fixed Income Discount Advisory Company also collects a fee by advising Chimera Investment Corporation (NYSE:CIM). I think this division diversifies the company somewhat and is the main source of the company's future growth. The company's main line of business is limited in its growth potential as it is required to pay out most of its profits to shareholders to retain its tax status.

Annaly Capital Management currently pays out a dividend of $2.28 per share, which amounts to a dividend yield of 13.8%. The company also has a five year expected PEG ratio of 2.82 which makes the stock somewhat expensive compared to its pears, in my opinion. The five year earnings forecast on the stock is only 2% which is significantly less than any of its main competitors. Equity Residential (NYSE:EQR) is the company's closest competitor in this market and it pays out a dividend of $2.27 per share that brings in a dividend yield of 3.9%. Equity Residential also has a five year expected PEG ratio of 2.07 with a five year earnings growth forecast of 7%. Another one of Annaly Capital's competition is Boston Properties (NYSE:BXP) and it pays a dividend of $2.20 per share with a dividend yield of 2.1%. Boston Properties also has a five year expected PEG ratio of 3.71 with a five year earnings growth forecast of 5.2%.

Simon Property Group Inc. (NYSE:SPG), another contender in this market, pays a dividend of $3.80 per share with a dividend yield of 2.8%. Simon Property Group also has a five year expected PEG ratio of 2.51 with a five year earnings growth forecast of 5.8%. The last competitor in this group is Vornado Realty Trust (NYSE:VNO) and it pays a dividend of $2.76 per share that amounts to a dividend yield of 3.4%. Vornado Realty Trust has a five year expected PEG ratio of 1.19 with a five year earnings growth forecast of 5.5%. At least using these metrics Annaly Capital Management is not doing that great fundamentally in relation to its nearest competitors, in my opinion. Not only is it more expensive in terms of growth, the estimated growth going forward doesn't even come close to any of the competition.

Although Annaly Capital Management benefited from the subprime meltdown to a degree, in the form of lower interest rates and its lack of exposure to the subprime market - the company is starting to feel the effects of lower interest rates. The company did quite well during the crisis as it could borrow money much more cheaply and the assets it was holding were mostly fixed rate mortgages at a higher rate of interest. At this point in time, the company's higher rate mortgage securities are being paid off and the capital is being reinvested in lower yield securities or lower rate mortgages. This is reducing the company's margins and requiring it to lower its dividend. With the company's current business model there is really nothing it can do about the situation except wait for interest rates to start to rise again, in my opinion. Of course the company will then be paying more to borrow but eventually the spread between short term credit and long term mortgage loans will widen and the company's margins will improve.

If you own the stock now for the long term my best advice is to hold on to it and wait it out, perhaps picking up more if the price falls. If you are considering buying the stock now is probably not the best time. A strategy you might consider is to wait for the company's margins to contract further sending the stock price down and gradually buying in through the trough at timed intervals. I believe the risk to Annaly Capital Management is to the downside at the moment.

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