Annaly Capital Stock Is Up, But Remains Under Pressure

Source: Thinkstock

Source: Thinkstock

I have covered Annaly Capital Management (NYSE:NLY) in numerous pieces over the last few years. However, it has been some time since I covered the company after making a incredibly bold (and correct) call that Annaly’s stock had bottomed. Since that call, the stock is up 26 percent. In this article, I want to address why the stock is still under pressure despite its heroic comeback. First, as we know, the dividends had been sliced as the company’s earnings; however, it is on the rebound, just like the stock. Recall that common dividends declared for the quarters ended March 31, 2014, December 31, 2013, and March 31, 2013 were $0.30, $0.30, and $0.45 per common share, respectively. The bleeding in dividends has stopped. But what could cause the dividends to rise along with the share price?

Now, as you may know, the company distributes dividends based on its current estimate of taxable earnings per common share, not GAAP net income. The problem is Annaly often only reports GAAP to us, but not taxable income on a quarterly basis. But, taxable earnings and GAAP net income will typically differ due to items such as non-taxable unrealized and realized gains and losses, differences in premium amortization and discount accretion, and non-deductible general and administrative expenses. That said, the terrible performance for the company is starting to reverse course.

In its most recent report, we learned that Annaly’s GAAP net loss for the quarter ended March 31, 2014 was $203.4 million or $0.23 per average common share as compared to GAAP net income of $1.0 billion or $1.07 per average common share for the quarter ended December 31, 2013, and GAAP net income of $870.3 million or $0.90 per average common share for the quarter ended March 31, 2013.

Sure seems to be a terrible report — on the surface at least. But the decrease from both prior periods was largely attributable to higher unrealized losses on interest rate swaps and interest only agency mortgage-backed securities and a net loss on trading assets. In other words, the company has been rebalancing its portfolio significantly. Core earnings for were $239.7 million or $0.23 per average common share as compared to $350.1 million or $0.35 per average common share for the quarter ended December 31, 2013, and $296.4 million or $0.29 per average common share for the quarter ended March 31, 2013.

While the earnings numbers are definitely important, I like to be cognizant of how the entire portfolio is performing, including Annaly’s yield on assets and its interest rate spread. I want to start by saying book value came in at $12.30, and thus the stock is currently trading at a 5 percent discount to book. What determines book value? A number of things, but it can be impacted by the net interest spread which impacts earnings potential. For the quarter ended March 31, 2014, the annualized yield on average interest-earning assets was 3.21 percent and the annualized cost of funds on average interest-bearing liabilities, including the net interest payments on interest rate swaps, was 2.31 percent, which resulted in an average interest rate spread of 0.90 percent.

Why is this important? This spread is how the company makes its money. At 0.90 percent, this represents a 53 basis point decrease from the 1.43 percent average interest rate spread for the quarter ended December 31, 2013, but just a 1 basis point decrease from the 0.91 percent average interest rate spread for the quarter ended March 31, 2013. The company’s annualized yield on average interest-earning assets decreased for the quarter ended March 31, 2014 when compared to the quarter ended December 31, 2013, primarily due to higher amortization expense on its investment securities. Further, stability in prepayment speeds during the quarter resulted in more normalized amortization of investment premiums compared to prior quarter, which reflected lower amortization expense due to a sharp decline in prepayment speeds. Thus, the company’s annualized cost of funds on average interest-bearing liabilities increased for the quarter ended March 31, 2014 when compared to the quarter ended December 31, 2013 due to higher interest rate swap notional amounts during the period. Wellington J. Denahan, Chair and Chief Executive Officer of Annaly, stated:

We remain optimistic about the investment landscape in light of the markets reaction to the Federal Reserve’s ongoing reduction of bond purchases. We continue to be flexible with our capital deployment and feel comfortable in our ability to sustain attractive risk-adjusted returns in the quarters ahead.

Looking ahead, Annaly seems to be righting the ship. It has taken nearly a full year, and has required a lot of work to rebalance the portfolio. The dividend cuts have stopped, and recently interest rates have come down in the last two months, which should help quarterly performance for the present quarter. I would expect to see the dividend maintained, and am looking for positive news in the next report. This is a strong company to own for the long-term given the average 12 percent interest rate and the improving assets the company has. It will take time for the rebalancing to take hold, but so long as interest rates do not spike like they did in the spring of 2013, the stock should perform well.

Disclosure: Christopher F. Davis is long in Annaly Capital. He has a buy rating on the stock and a $13.00 price target.

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