Why This Dividend Darling Is Too Good To Be True

By Ryan Guenette - August 28, 2012 | Tickers: NLY, CIM, CYS, HTS, TWO | 0 Comments

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The search for reliable income has become extreme. Despite the recent rally in the overall market, fear continues to overpower optimism. Unemployment in the United States is once again on the rise. Fears of the European Union falling into a hopeless spiral downward have been confirmed by the numerous reports depicting a continent falling together. China’s magnificent growth is slowing, prompting officials to prepare for a projected “soft landing”. While the market has been on an absolute tear for the majority of this year, many believed it is a rally for all the wrong reasons. The global economic picture is slowly dimming, which has led to frenzies in stocks that offer reliable income. One commonly pursued name is Annaly Capital Management (NYSE: NLY).

Annaly offers a dividend that yields 12.93%, an astonishing number. Over the past year Annaly has declined 4.36%, over a period in which the S&P 500 has rallied 26.03%. So is this real estate investment trust (REIT) a dream for income investors, or is it a one-trick pony?

Deteriorating Fundamentals

In 2009, Annaly reported earnings per share of $3.52. In 2014, the average analyst consensus believes the company will derive $1.69 from its business operations. This represents a decrease of 51.99% over just 5 short years. Based on these statistics, Annaly's compound annual growth rate (CAGR) is -13.65%, a troubling number. Over this time period, operating and net margins significantly worsen, leading to a steep drop-off in earnings. Unfortunately, earning is not the only deteriorating item on Annaly’s balance sheets. Currently, Annaly pays out an annual dividend of $2.20, which at the current price, puts the company’s dividend as yielding 12.93%. By 2014, the street projects that the company’s dividend will drop to $1.75 annually, which at the current price would put Annaly’s dividend as yielding 10.30%. The severe projected dwindling in Annaly’s earnings and dividend over the coming years is troubling, but in 2014 the company’s dividend is still expected to be above 10%. From this we can see Annaly’s worsening financial picture, yet its continued large dividend is incredible.

The chart below displays Annaly's sales, operating profit, net income, net margin, operating margin, earnings per share, dividend, and rate of dividend (the percentage of net income that is paid out in the dividend) over the foreseeable future.

A Substantial Threat to the Annaly Business Model

Annaly is a mortgage real estate investment trust. The company borrows at historically low short-term interest rates and heavily invests in portfolios of mortgages backed by Freddie Mac and Fannie Mae at long-term rates that are higher. The margin between the mortgage rate and borrowing cost is Annaly’s profit. However, with the current refinancing rates at historical lows, more and more people are finding the motivation to refinance their remaining debt. The holders of the original mortgage, Annaly or other REITs in many cases, lose out on many years of high yielding returns due to the person paying of the mortgage in advance. The historically low mortgage rates are killing Annaly’s margins, forcing them to receive payment for their mortgages earlier and with less interest paid on them. Annaly will not be able to sustain its massive dividend without improving mortgage rates. If mortgage rates are able to recover, Annaly’s margins would improve, profits would rise, and the massive dividends would continue to be doled out.

The chart displays the 30 year fixed mortgage rate, sitting at all-time lows.          

What REIT Is Superior?

Compared to some of Annaly’s most prominent competitors, such as: Chimera (NYSE: CIM), CYS Investments  (NYSE: CYS), Two Harbors  (NYSE: TWO), and Hatteras (NYSE: HTS), Annaly compares relatively favorably.

In terms of growth, Cimera leads the industry as the only company to grow over the period. All companies in the sector pay out colossal dividends yielding in the double digit, yet all are declining except for CYS’ dividend. In the fundamental ratio comparison, Annaly stands out as trading at a hefty premium, while the rest trade at more modest single digit multiples. When growth is taken into account, Two Harbors looks attractive, while Annaly again appears to be pricy. In the net profit margin comparison, CYS stands out to the upside, while Annaly stands out to the downside.

The Foolish Bottom Line

The double digit yielding stocks can be tempting to buy. Annaly has underperformed the market over the past couple of years, but trounces the market when dividends are considered. Annaly’s financial breakdown reveals the disturbing truth of a company with worsening margins, declining profits, and weakening dividends. The historically low interest rates are like poison to Annaly’s business model, but if they rebound, Annaly will rally. Buying a stock just for the dividend is not my favorite strategy, but can be considered when the dividend is as big as Annaly’s is. In conclusion, currently the only upside to Annaly Capital Management is its massive dividend, and is not a stock I would recommend until mortgage rates rebound.    

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