2023-04-27 07:50:56 ET
Summary
- 1Q23 earnings were mixed depending on which metric one looks at.
- Erratic behavior in capital markets seems to consistently hurt NLY.
- Valuation at this time is not compelling.
In light of recent earnings, we are updating analysis on Annaly Capital ( NLY ).
Let us begin with a review of the quarter and follow with our overall take on NLY as an investment.
1 st Quarter 2023
NLY reported decent first-quarter earnings on 4/26/23 of $0.81 which is a technical beat of $0.06. GAAP metrics look much worse with a loss of $1.79. For investors looking at this quarter it will be crucial to decipher whether GAAP or non-GAAP is correct given the magnitude of difference.
I think both metrics are relevant in some ways so I will provide both numbers as well as an explanation of why they are so different.
Starting off with GAAP numbers, Net Interest Margin or NIM looks rough at 0.09. Historically, with exception to 4Q22 NIM is usually between 1% and 3%. Making 9 basis points an ugly read.
The source of the weak NIM seems to be cost of interest bearing liabilities which comes in at 4.52% on a GAAP basis, making a negative 56 basis point spread against their yield on interest earning assets of 3.96%
NLY
Moving to non-GAAP numbers, NIM looks quite a bit better at 1.76%.
NLY
The big difference here is that NLY is saying the economic cost of interest bearing liabilities is 2.34% versus the GAAP cost of 4.52%.
Footnote 5 says the following.
“Average GAAP cost of interest bearing liabilities represents annualized interest expense divided by average interest bearing liabilities. Average interest bearing liabilities reflects the average balances during the period. Average economic cost of interest bearing liabilities represents annualized economic interest expense divided by average interest bearing liabilities. Economic interest expense is comprised of GAAP interest expense and the net interest component of interest rate swaps.”
Another key accounting election in Annaly’s report is the concept of PAA or Premium Amortization Adjustment. RMBS is often bought at a premium or discount to par value which arises as interest rates change after the security is initially issued. If, for example, the issue initially had a 7% coupon but RMBS today trades around 5.25% the issue would trade at a premium to par such that the YTM is 5.25%.
If Annaly bought at a premium to par that difference needs to be amortized over the expected life of the security. This is a non-cash expense, at least as it relates to the current period.
Thus, this excluding PAA accounting is useful for calculation of cash related things like dividend coverage. In the quarter, NLY generated earnings available for distribution of $0.81 which covers its $2.60 annual dividend.
However, as it relates to longer term profitability, amortization expense is very real.
Book Value
Book value declined slightly in the quarter to $20.77.
This, unfortunately, is a continuation of a long streak of book value erosion.
Annaly Investment thesis
Annaly appears to be rather cheap with a slight discount to book and very low EPS multiples.
However, agency RMBS has proven to be a consistently challenging industry in which to operate and I wouldn’t want to own it at a price to book above 80%.
Total return in such investments is a constant battle between impressively high dividend yields and a constantly eroding book value. Even if book continues to decline it is possible for investors to get a strong total return, but that requires an entry price that builds in a buffer with cushion in both payout ratio and discount to book.
As of the 1Q23 earnings release payout ratio appears to have a decent buffer, but there just isn’t enough of a discount to book at this time. Without the buffer the next unexpected change to interest rates or prepayment rates or cost of financing could send book value below entry price. At that point the investor’s nominal yield is no longer a true yield because declines in market price which follows book make total return significantly less than the going in yield.
Every mortgage REIT, Annaly included, tries its best to hedge risks involved in interest rate shifts. I find Annaly’s management to be intelligent and believe they are genuinely trying their best to mitigate risk, but time and time again the hedges just don’t work.
Consider the hedging strategy employed by many of the agency mREITs over the past few years in which hedges were put in place against the risk of rising interest rates.
Even though they were right that interest rates did indeed rise, these hedges only protected from the parallel shift and did not really work against the twist (inversion).
Beyond the twisting action at least partially invalidating certain hedging activity, hedges have failed to protect against spread widening.
On the AGNC 1Q23 earnings call Peter Federico details the widening activity
“Over the last two years, the fixed income markets experienced a significant repricing as the Fed tightened monetary policy at a historic pace. Agency MBS have been uniquely impacted with the spread between the current coupon MBS and the 10-year treasury, widening 135 basis points since April 2021.”
The spreads got even wider in 1Q23 as SVB and other regional banks dumped their RMBS to free up capital.
Federico - “Despite relatively common markets, the overhang of supply from the FDIC and related bank failures has driven Agency par coupon spreads 10 basis points wider since quarter-end to approximately 163 basis points to a blend of 5- and 10-year treasuries.”
Thus, even if mREIT managers were prescient enough to see the Fed action coming and see the yield curve inversion, they simply weren’t hedged for the spread widening.
One cannot see such movements coming because the movements aren’t rational.
RMBS, much like treasuries is backed by the U.S. credit, so it does not make sense for it to trade at 5.25% when equal duration Treasuries are yielding 3.5%, but that is what has happened.
In a steady financial environment where markets are orderly and efficient the agency RMBS REITs can maintain or even grow book value. They can sit there and collect spreads amplified by leverage.
Occasionally, such environments do exist, but the last 10 years have been back to back incidents of unforeseen chaos.
This chaos invariably invalidates hedges and seems to almost always result in book value destruction.
Thus, despite respecting Annaly’s capabilities, I don’t want to be invested in this sector unless there is a substantial discount to book and dividends are very well covered.
As of current market pricing, the cushion is not thick enough to protect from the next instance of chaos in capital markets.
Don’t be tempted by the juicy double-digit yield. Total return is likely to be significantly south of that.
What if you collect the dividend and just don’t sell?
I have heard many put forth the notion that a declining stock price doesn’t matter if they don’t sell the stock.
While I agree with the concept, the problem here is that the stock price declines are in parallel with real fundamental value declines.
The stock has not been selling down on market whims or fears. It is selling down to match book value. Book value measures the equity that NLY has to invest in RMBS and other assets.
If they have less assets to invest on a per share basis, their revenue generation ability is reduced. As such, book value declines lead to dividend cuts.
For now NLY’s dividend appears safe, but if book value keeps eroding there will be more cuts down the road.
While I am bearish on the sector and don’t think NLY is cheap enough to buy at current pricing, I do want to point out some cause for optimism.
Improving outlook
With how wide spreads are between RMBS yields and treasuries, I do believe the path of least resistance is a narrowing of spreads. Such a narrowing would produce a modest recovery in book value for NLY.
With market mortgage rates significantly higher than most existing mortgages prepayment rates should remain quite low which extends the duration of assets, allowing a longer runway of interest collection. This is particularly relevant for issues still trading at a premium to par.
The ideal scenario for NLY would be levering up on RMBS while spreads are still blown out and then spreads returning back to historical norms. I don’t know if this will happen, but it is plausible.
For further details see:
Annaly Capital Faces Continued Challenges