All Is Well For Annaly Capital

Mohsin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Annaly Capital (NYSE: NLY) finally announces agreement to acquire CreXus Investments (NYSE: CXS.DL) amid increasing long-term mortgage rates. Under the agreement, Annaly agreed to hike the November bid price of $12.5 for each share of CreXus to $13 a share. This way Annaly would pay $872 million for the remaining shares of the commercial mortgage REIT. I believe this diversification is a strategic step in the right direction under the prevailing scenario where the Fed is committed to keep the rates low. According to the terms of agreement, CreXus has until March 16 to receive and negotiate alternatives. Besides investing in government securities, Annaly has expanded into overseeing distressed-debt buyers and another securities firm. It has also started financing home lenders.

In times when Bernanke’s dissatisfaction might lead to the continuation of QE3 pace, diversification on the business model is the only way to survive. The Fed chairman has signaled today that he has no intentions on easing up on the $85 billion easing a month until the US labor markets show signs of significant improvement. This is amid the central bank’s balance sheet touches a record size of $3 trillion.  Armour Residential’s charter allows it to include non-Agency MBS into the asset portfolio. It is currently investing and managing Agency only paper. Any news of diversification from this mREIT will be a bullish sign for its investors.

Company Description

Annaly Capital is America’s largest debt real estate investment trust (REIT) with a market cap of $14.5 billion seeks to invest largely in Agency mortgage backed securities. However, the company’s charter allows its management to include assets other than Agency MBS up to 25% of its equity.

Dividends

The stock offers a dividend yield of 12%, while the 10-year Treasuries offer only 2.03%. Annaly’s offered dividend yield is above the yield offered by junk bonds with CCC ratings. During the second week on January, junk bonds with CCC ratings dipped below 10% yield. Therefore, on a risk-adjusted basis, Annaly Capital is a lucrative investment opportunity for investors looking for regular income.

The company was forced to cut its quarterly dividend twice during the prior year, 10% cut being the most recent. However, I believe the diversification and hike in mortgage rates will reverse this. Both diversification and increase in mortgage rates since will support the net interest income of the company during the first quarter of 2013. CreXus Investment reported a net interest spread of 10.37% when leveraged 2 times means a spread of 20.8%. This is compared to 1.02% spread for Annaly at the end of the third quarter of the prior year. CreXus Investment’s additional spread would expand Annaly’s net interest spread. Therefore, investors can expect this quarterly dividend distribution to continue in the near future.

Valuations

The most appropriate matrix for valuing mortgage REITs is their price to book value. Book values are marked to market, which is why they are considered appropriate. Currently, Annaly Capital is trading at 0.9 times its recent quarter’s book value, while American Capital and Armour Residential trade at 0.98 times and 0.9 times their respective book values. The relative valuations also make Annaly Capital an attractive investment as it is trading at cheap multiples compared to its closest peers.

Conclusion

I am bullish on Annaly Capital despite Fed’s dissatisfaction at the current growth and its commitment not to slow down its record easing. Diversification will provide support to the company’s net interest income and the dividend distribution. Besides, the company is trading at cheap multiples. These reasons make me bullish on Annaly Capital.


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