INVESTMENT THESIS
We are launching coverage of mortgage REIT Annaly Capital Management Inc. (NYSE: NLY) with a BUY rating and a target price of $9. NLY invests in U.S. agency mortgage securities on a leveraged basis, funding the assets through repurchase agreements (repos). As of September 30, NLY’s investment portfolio was $96.3 billion. The company generates income from the interest earned on securities less hedging and borrowing costs, and from net realized gains and losses on its investment portfolio. The company’s leverage was 6.2-times as of September 30, 2020.
We believe that recent Federal Reserve programs will ensure liquidity and less volatility in the MBS markets for the foreseeable future. Fed intervention in the repo markets and extended MBS purchases should allow market participants to continue to operate in markets that had seized up in March.
NLY pays an annualized dividend of $0.88 per share for a yield of about 10.6%. The high yield is generated via leverage in the repo and term funding markets. Our price target of $9, along with the dividend, implies a potential total return of 19% from current levels.
RECENT DEVELOPMENTS
NLY shares have underperformed the broad market over the past year, falling 11.9% while the S&P 500 has risen 18.0%. However, we note that the main driver of the stock is the dividend yield, currently at 10.6%. NLY has a relatively low beta of 1.19. The company accounts for about 17% of the Mortgage Real Estate ETF REM.
On October 28, the company reported 3Q20 EPS of $0.32, slightly above consensus. Book value rose to $8.70 per share at the end of 3Q20, up 3.7% from the end of 2Q20.
NLY reported a 3Q conditional prepayment rate (CPR) of 22.9%, and projects a 17.1% long-term CPR for its existing portfolio. The CPR is the percentage of a mortgage security or pool that is expected to be prepaid in a year, and the higher the CPR, the lower the return on the investment. Conversely, a lower CPR boosts returns and benefits earnings. We expect a lower-than-average CPR for the NLY portfolio due to the company’s purchases of prepayment-protected securities.
On July 1, the company completed the acquisition of its external manager Annaly Management Company. This finalized the transition from an externally managed REIT to an internally managed REIT.
On October 8, NLY published its first corporate responsibility report, outlining its ESG goals and commitments.
EARNINGS & GROWTH ANALYSIS
NLY primarily invests in agency mortgage-backed securities collateralized by residential mortgages. Its $96.3 billion investment portfolio includes $76.1 billion in securities, along with assets transferred or pledged to securitization vehicles and loans. Income is generated through the spread between the yield on its investments and the cost of borrowing and hedging activities.
The company also has three other smaller business segments. Annaly Residential Credit Group, with $1.9 billion in assets, invests in non-agency residential mortgage assets; Annaly Commercial Real Estate Group, with $2.5 billion in assets, originates and invests in commercial loans, securities, and other commercial debt and equity investments; and Annaly Middle Market Lending Group, with assets of $2.1 billion, finances private equity-backed middle-market businesses. These three ‘riskier’ businesses are the primary reason that NLY has a higher yield than many peers.
NLY’s investment portfolio had relatively flat performance in 3Q20. The company funds its mortgage-backed securities via the repo market, allowing it to leverage its MBS portfolio in order to pay its dividend. (Its leverage ratio fell from 6.4 to 6.2 in 3Q20). NLY sees growth in times of economic stability, when U.S. interest rates and MBS rate spreads are steady, as it takes advantage of the spread between the yield of the acquired securities and its hedging costs. We note that NLY and other REITs are required to pay out 90% of their income to shareholders.
Based on the company’s recent results and investment trends, we are setting EPS forecasts of $1.08 for 2020 and $1.13 for 2021.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating on NLY is Medium. The company scores well above average on our three main measures of financial strength: leverage based on debt/cap, profitability, and interest coverage.
The company pays a quarterly dividend of $0.22 per share, or $0.88 annually, for a yield of about 10.6%. Our dividend estimates are $0.91 for 2020 and $0.88 for 2021.
Anally has a stock buyback program. It has repurchased $209 million of its stock thus far in 2020.
MANAGEMENT & RISKS
Founded in 1996 and based in New York, Annaly is managed by Annaly Management Company LLC. David Finkelstein became the company’s CEO and chief investment officer in March 2020. Prior to joining Annaly in 2013, Mr. Finkelstein served as an officer in the markets group of the Federal Reserve Bank of New York. Serena Wolfe is the CFO.
Investors in NLY shares face numerous risks. On a macro level, the company is dependent on a stable housing environment. Investments in agency MBSs are very interest rate-sensitive, especially in a declining rate environment. As mortgage prepayments increase, the value of the securities falls. Liquidity risks are also significant, as NLY must be able to fund its securities through repurchase agreements. Recent Federal Reserve actions in the repo market have diminished fears that the market could again seize up, though rising prepayments could negatively impact the portfolio. The company also faces regulatory risks at both the national and state level. Additionally, NLY is subject to risks related to the COVID-19 pandemic.
COMPANY DESCRIPTION
Annaly Capital Management is a leading diversified capital manager. It is a publicly traded REIT that invests in and finances residential and commercial assets. The company has four different types of businesses: Agency, Middle Market Lending, Commercial Real Estate, and Residential Credit. The company’s primary investment portfolio consists of agency mortgage-backed securities (MBS), managed on a leveraged basis. The company uses an actively managed portfolio and hedging strategies with the goal of preserving net asset value in different interest rate scenarios.
VALUATION
We think that NLY shares are attractively valued at recent prices near $8, above the midpoint of their 52-week range of $4.02-$10.50. On the fundamentals, the stock is currently trading below its September 30 tangible net book value of $8.70 per share, which we view as favorable. We also expect further growth in book value. We believe that NLY will continue to trade slightly below book value due to the price volatility in the three non agency business segments. Interest rates across the curve have been relatively stable, enabling mortgage REITs to manage their books in a more favorable manner. Fed intervention in the repo markets and increased MBS purchases should also allow market participants to continue to operate in markets that had seized up in March.
Our price target of $9, combined with the dividend, implies a potential total return of 19% from current levels.
On December 8, BUY-rated NLY closed at $8.32, up $0.60.
Source: Argus
