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Annaly Capital: Is This REIT a Buy Amid the Downgrades?

Annaly Capital (NLY)Annaly Capital Management, Inc. (NYSE:NLY) is one of the most loved REITs, paying a dividend that yields 12.2% and boasting a market cap of $15 billion. Being an owner, manager and financer of various real estate related investments, Annaly has navigated the tough real estate market relatively well, being down only 9% since 2008, versus the S&P 500’s 3% decline over this time period.

However, Morgan Stanley recently downgraded Annaly and dropped its price target to $17, versus the stock’s current trading range of around $16.40. In addition to Morgan Stanley, JPMorgan downgraded the company and also placed its price target at $17. Macquarie downgraded Annaly and has a $15.50 price target and FBR Capital downgraded the company, placing a $16 price target on the shares. However, we still believe that REITs, Annaly included, is one of the best ways to play QE3.


Analysts have downgraded the company on concerns over the continued low interest rate environment which will impact the investment returns generated by Annaly, and only be partially offset by low short-term funding costs. The company experienced spread compression in its most recent quarter due to a decline in its asset yield by 19 basis points, but it was Annaly’s decision to sell $6.4 billion of MBS during the quarter that likely accelerated the decline in the asset yield.

Annaly’s conservative financial position has given the company the ability to expand its portfolio as investments become more attractive, which should help insulate the company some should rates begin to rise. Even with room to grow, Annaly should generate fees of about $88 million in 2012, up 10% from 2011, on $12.4 billion of net AUM. For 2Q, book value was up 0.3% to $16.23, only slightly below the company’s current trading range. The posted book value was a beat of estimates by $0.42, but the company is down 7% over the past month. We believe this could possibly pose a buying opportunity.

Top competitors of Annaly include many smaller REITs, all less than one-fifth the size of Annaly as measured by market cap, including Chimera Investment Corporation (NYSE:CIM), Two Harbors Investment Corp (NYSE:TWO), Capstead Mortgage Corporation (NYSE:CMO) and Hatteras Financial Corp. (NYSE:HTS). Also, all of these REITs pay a high dividend that yields more than 11%.

Chimera trades with one of the highest betas, 1.2, among the peers. The company recently announced the restatement of GAAP financial statements for 2008-2011 due to an accounting error on treatment of RMBS investments. However, the company does not expect cash flow or taxable income to be impacted on the reinstatement, and so Chimera is still on of our 5 monster dividend stocks. Given the stock trades below $3, it has managed to attract little fund interest, with only Appaloosa Management LP owning a fair number of shares at 4 million.

Two Harbors now trades above $12, well above its $9.94 book value. The company also saw a decline in asset yields and reported core EPS $0.04 below estimates. Management cited lower net spreads on recently acquired securities as reasoning for the miss, where Two Harbors had increased its MBS portfolio by more than 17% above estimates. This move was mainly done in an effort to seek pre-pay protected securities. The company is one of the strongest price performers year to date, up 30%, and may be outpacing itself as it now trades above the other REITs on a P/B basis.

Capstead is down almost 12% over the past month as the company has cut its dividend twice over the last two quarters, now paying a quarterly dividend of $0.36 versus $0.43 from the beginning of the year. With the price decline, the company currently trades around $12.70, while its book value is around $13.25, but we are still cautious more dividend cuts could come. Much like Chimera, Capstead has little fund interest, with big names owning the company, but only very modest positions, averaging 250,000 each. The biggest names include Jim Simons, Israel Englander and D.E. Shaw.

Hatteras is another one of our 5 monster dividend stocks, just like Chimera. Also, like the other REITs—other than Annaly—Hatteras has big names owning shares, but the positions are very small—Bill Miller and Israel Englander are a couple of managers who owned the stock at the end of June. Hatteras reported 2Q core EPS $0.07 lower than estimates and saw its 2012 full year estimates cut due to continued lower than expected net interest spread. The company is also under pressure due to having cut its dividend by over 11% for the most recent quarter, but Hatteras should likely be able to hold off on future cuts.

Fund interest for Annaly is much greater than any of the other REITs, and the company saw Jim Simons come in as a new shareholder during 2Q, and calls Bill Miller of Legg Mason as top fund owner with over 5 million shares at the end of 2Q. Also, since 2Q SAB Capital has increased its stake in the company to over 10%. Other fund managers with modest positions include D.E. Shaw, Chuck Royce and Ken Griffin.

We believe the company is still strongly positioned to continue to pay its high dividend and navigate the low-rate environment. Annaly trades in line with its peers on a P/B basis, but has the greatest wherewithal to navigate the real estate related markets as higher yielding opportunities given its lower than average debt to equity ratio of 6x.

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