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Despite No Surprises Is Annaly Capital Management, Inc. (NLY) Still a Buy?

Annaly Capital (NLY)Annaly Capital Management, Inc. (NYSE:NLY) commenced operations in 1997 as a mortgage REIT with the objective of providing its shareholders elevated returns primarily through dividends. The company is self-managed and seeks to invest at least 75% of its total assets in high quality mortgage-backed securities and short term investments. The company’s charter allows the management to invest the remaining 25% of assets in unrated or less than high quality assets but that are at least investment grade. The company is currently invested in mortgage-backed securities backed by single-family residential mortgage loans as well as securities backed by loans on multi-family and commercial properties. At the end of the fourth quarter, around 93% of the securities that NLY held were fixed rate Agency MBS and debentures, while the remaining 7% was adjustable-rate Agency MBS and debentures. NLY entered in a contract to swap around 40% of the Agency MBS’s interest rates.

Earnings Review

Annaly Capital reported its performance for the fourth quarter of 2012 on Feb. 6, 2013. The reported bottom line of $700.5 million or $0.7 per common share for the quarter climbed 52% from a year ago, while it is over two-fold the bottom line of the linked quarter. Much of the sequential surge in the bottom line was a result of unrealized gains and losses on interest rate swaps Agency interest-only mortgage backed securities and net losses on extinguishment of Convertible Senior Notes.

Interest income has continued its downward journey since the second quarter of 2012. For the fourth quarter, interest income of $756.6 million fell 60 basis points over the linked quarter. Part of the reason for such a decline in interest income was the 4.3% decline in Agency mortgage-backed securities that NLY held. The weighted average yield on interest yielding assets declined 47 basis points over the same time period, causing the interest income to decline further.

Interest expense on the other hand surged. During the fourth quarter, NLY incurred $185.5 million in interest expense, compared to $181.9 million during the linked quarter. The rise in interest expense was a result of the higher cost of repurchase agreements, partially offset by a decline in the cost of Convertible Senior debt. The weighted average cost of funds during the fourth quarter dipped over the linked quarter from 1.6% to 1.55%.

As a result, net interest income of $571 million for the fourth quarter declined 1.4% over the linked quarter. Other income of $49.8 million declined 2% over the third quarter, largely due to lower net gains on disposal of investments, partially offset by higher net gains on trading assets. Unrealized gains on interest rate swaps produced $341.5 million against a loss of $104.2 million during the third quarter.

During the fourth quarter, NLY managed its general and administrative expenses well as they came down 36% sequentially to $40.1 million. Much of the improvement was a result of lower compensation expense, which still happens to be the largest contributor in expenses. The general and administrative expenses as a percentage of average assets declined to 0.12% from the linked quarter’s ratio of 0.19%.

Prepayment Speeds

Annaly reported 19% CPR for its MBS portfolio at the end of the fourth quarter. This is compared to 20% prepayment speed for its portfolio at the end of the third quarter. Lesser CPR means lower premium amortization cost. Therefore, net amortization of premiums and accretion of discounts for the fourth quarter were reported at $433.3 million, down 5% compared to the linked quarter.

Competition

Since Annaly is currently exclusively invested in Agency MBS, its closest competitors include American Capital Agency Corp. (NASDAQ:AGNC) and ARMOUR Residential REIT, Inc. (NYSE:ARR). While American Capital is largely invested in fixed rate securities, like NLY, Armour Residential has a relatively large proportion of adjustable-rate securities in its portfolio. Both American Capital Agency and Armour Residential are considered to have prepayment protected portfolio, which is why they reported lower CPRs for their MBS portfolio at the end of the third quarter of the prior year. American Capital and Armour Residential are currently yielding 15.9% and 13.4%, respectively. Both are currently trading at 13% and 9% premiums to their third quarter book values.

Conclusion

I believe Annaly Capital Management, which is currently yielding 12%, presents an excellent long term investment opportunity. The company might face short-term headwinds due to the Fed’s continuous meddling. However, the hike in mortgage rates since the beginning of this year signals that the situation is beginning to reverse. I believe if rates continue to increase, Annaly Capital could get some support for its interest rate spread.

The article Despite No Surprises Is Annaly Still a Buy? originally appeared on Fool.com and is written by Adnan Khan.

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