On Thursday, the high-yielding mortgage REIT Annaly Capital Management, Inc. (NYSE:NLY) announced that it has "reached a definitive agreement with Crexus Investment Corp (NYSE:CXS) to acquire for $13.00 per share in cash ... all the shares of CreXus that Annaly does not currently own."
While Annaly's announcement went on to endorse the multiple purported benefits of the deal, shareholders in the mortgage REIT would be wise to consider what lurks beneath the surface.
The deal looks good -- at first On the surface, as I've discussed before, this looks like an extremely good deal for Annaly given the multiple operational synergies it appears to offer. Until now, CreXus operated within the Annaly family of companies, paying management fees to a wholly owned subsidiary of Annaly, FIDAC. With the acquisition, these will now be consumed under one roof.
Also, unlike Annaly, CreXus is entirely unleveraged. In fact, its third-quarter balance sheet contains absolutely no debt whatsoever. Annaly, on the other hand, has more than $100 billion in repurchase agreements alone (these are short-term debt instruments secured by collateral) compared to a mere $17 billion in shareholders' equity.
Finally, CreXus' portfolio of securities backed by commercial real estate yields significantly more than Annaly's portfolio of securities backed by residential mortgages. To give you some context, according to data from S&P's Capital IQ, CreXus' portfolio yields an impressive 14.3% while Annaly's yields a comparatively meager 2.5%.
The net effect, in turn, will be to lower Annaly's average cost of funds, increase its yield on earning assets, and therefore increase its pivotal interest rate spread. With respect to its cost of funds, Annaly paid an average of 1.5% to borrow money in the third quarter of last year. This was markedly higher than many of its competitors, including American Capital Agency Corp. (NASDAQ:AGNC) , which reported a 1.1% cost of funds, and ARMOUR Residential REIT, Inc. (NYSE:ARR) , which had a 0.9% cost of funds over the same time period.
Alternatively, with respect to its earning-asset yield, Annaly is also earning less on its portfolio of mortgage-backed securities than both of these companies. In the most recently announced quarter, as I just noted, Annaly's came in at 2.5%, American Capital Agency's at 2.6%, and ARMOUR Residential's at 2.7%. It follows, then, that the same relative disadvantage is holding true in terms of interest rate spreads, where the three companies line up at 1.02%, 1.42%, and 1.8%, respectively.
In other words, despite the fact that I neither like nor trust Annaly's management, there's legitimate reason to believe that the CreXus deal will indeed be "immediately accretive to both [...] taxable earnings and [...] dividends per share," as Annaly asserts in a press release it published this morning.