2023-07-27 07:27:00 ET
Summary
- Annaly Capital Management's Q2 earnings were acceptable given the challenging market environment, with a non-GAAP EPS of $0.72, slightly missing earnings consensus by $0.02 per share.
- NLY's total portfolio value decreased by 7.7% from the previous quarter to $78.9 billion, as it reduced its agency portfolio in preparation for FDIC sales and debt ceiling negotiations.
- Despite a challenging market, Annaly's business model could benefit from potentially lower long-term interest rates in the coming months, making it an attractive investment for those expecting interest rates to peak.
Annaly Capital Management ( NLY ) released its Q2 earnings, which were acceptable considering the tough market environment for the company, and the company seems to be a good play right now on potential lower long-term rates head.
As I've covered in a previous article , Annaly's investment case is quite reliant on its high-dividend yield and upside potential at the time seem limited as the company's business model does not work well in a rising interest rate environment. Despite that, its shares have performed better than I was expecting over the past three months, with a total return of about 11.5%, slightly better than the overall stock market.
Article Performance (Seeking Alpha)
As shown in the previous graph, my recommendation at the time was 'Hold', and considering that it has released its Q2 earnings, I think it's now a good time to revisit its investment case and see if Annaly offers now a better risk-reward proposition or not.
Annaly Capital Q2 2023 Earnings Review
Annaly has released its Q2 2023 earnings , reporting a non-GAAP EPS of $0.72, missing slightly earnings consensus (by $0.02 per share), and declined from $0.81 per share in the previous quarter. This represented a decline of $0.09 from the previous quarter, as the company was affected by capital markets volatility, and also from a lower total portfolio value.
Indeed, at the end of last June, Annaly's total portfolio was valued at $78.9 billion, a decline of 7.7% from the previous quarter, as the company decided to reduce its agency portfolio to prepare for FDIC sales and debt ceiling negotiations. Despite that, its portfolio composition was not much changed at the end of Q2, with agency MBS representing the vast majority of its assets.
Portfolio (Annaly)
Due to a lower portfolio value and unchanged shareholders' equity value, its economic leveraged decreased in the quarter, which is a positive development in the current uncertain market environment and can also be considered good for its dividend distribution, as balance sheet leverage reduced significantly during the quarter.
Leverage (Annaly)
Its hedged portfolio also declined in-line with the decline in total assets, representing some $73 billion, or 92.5% of total assets, down from more than $80 billion in the previous quarter. This shows that Annaly has adapted its portfolio to the current rising interest rate environment, and its exposure to interest rates is currently quite reduced, with the rest of its asset being considered liquidity, consisting of cash and unencumbered agency MBS.
This is not surprising given that Annaly has historically managed its exposure to interest rate risk considering its outlook for rates, and the fact that Annaly was almost fully hedged at the end of Q2 means that it's not expecting long-term rates to decline in the short term.
By being hedged, Annaly is also taking a defensive approach to its balance sheet in the current market environment, which can also be seen by its stable book value compared to the previous quarter. Indeed, its book value was $20.73 at the end of Q2, a decline of only 0.2% from Q1. Considering that long-term rates continued to increase in the quarter and volatility remained somewhat elevated, Annaly's small book value decline is quite good and shows that Annaly's management actions are bearing fruit.
30-Y Rate (Investing.com)
However, as I've previously said, its business model does not perform well in a rising interest rate environment and the company cannot fully hedge interest rate risk, which explains why its annual decline in book value is much more significant (-12% YoY).
In Q2, its net interest margin excluding PAA was 1.66%, a decline of 10 basis points (bps) compared to Q1, and a decline of 54 bps from the same quarter of last year. This is explained by a much stronger increase in the cost of liabilities than assets, as the company invests in long-term rates, while borrows in short-term rates. As the interest rate curve is currently inverted, which means short rates are higher than long rates, Annaly's net interest margin (including PAA) has collapsed and turned negative in the last quarter, showing how rising interest rates and an inverted yield curve negatively impact its operations.
This is a business model that is to some extent similar to retail banks, with the major difference being that banks rely heavily on deposits on the funding side, which usually are much stickier and have lower costs than other short-term funding sources.
Therefore, Annaly's business model works well when the yield curve has an upward trend, given that to generate a positive net interest income (the difference between interest received and interest paid) its average assets yields must be higher than funding costs. This is quite similar to how banks work, even though Annaly's asset mix is much more concentrated (in agency MBS), while banks take much more credit risk, by offering several financial products, such as mortgages, consumer loans, or credit cards.
Another important factor of its business model is leverage, which is key for Annaly to have a good level of profitability, measured by the return on shareholders' equity (ROE) ratio. Despite the challenging market backdrop for the company's operations, its annualized ROE was 5.4% in Q2, compared to negative numbers in the previous quarters.
While its current earnings are not particularly impressive and short-term prospects aren't much different, especially as the Federal Reserve has recently raised interest rates by 25 bps to 5.25%-5.5%, and signaled that further hikes may be possible in the coming months.
However, as inflation has cooled in the past few months and seems to be in a downtrend, even though it remains well above the Fed's target of around 2%, the prospects of further rate hikes seem to be somewhat low. Indeed, as shown in the next graph, the market's implied Fed funds rate at the end of this year is quite close to its current level, showing that the aggressive hiking pace since March 2022 may be close to the end.
While the timing of when the Fed decides to stop its hiking campaign is quite uncertain, more important in my opinion is the cooling of inflation expectations if future readings confirm the current downward trend, which is likely to have a great impact on long-term rates.
While Annaly currently is largely hedged regarding interest rate risk, at that time it will make sense to increase the balance sheet sensitivity to interest rates, which will be a strong tailwind for a higher book value ahead. I think it's not much likely that the Fed will start to cut rates this year, but it's possible that inflation declines to an annual level below 3% in the coming months, which would put downward pressure on long-term rates and be positive for Annaly's economic value.
This doesn't seem to be currently expected by the market, given that analysts' estimates expect Annaly's EPS to maintain a downward trajectory over the next couple of years, which may be too conservative and probably don't reflect a potential scenario of lower interest rates in the near future.
Regarding its dividend, Annaly has maintained its quarterly dividend unchanged at $0.65 per share, which remains covered by its earnings available for distribution, thus its dividend seems to be sustainable for the time being. At its current share price, Annaly offers a dividend yield of about 12.5%, which is very high compared to other REITs and financial companies and is one of the main attractive factors of Annaly's investment case.
Conclusion
Annaly's financial performance in Q2 was acceptable considering the challenging market environment for a mREIT that suffers from higher rates, being the stable book value one of the most positive signals of its recent earnings.
On the other hand, its business model benefits from lower interest rates, being therefore a very good play on potentially lower long-term interest rates in the coming months. This means that Annaly is interesting from a cyclical perspective for investors that expect interest rates to peak in the short term, being also rewarded with a high-dividend yield that seems to be sustainable for the time being. In my personal portfolio I have recently bought Annaly because I expect interest rates to peak in the near future, and will probably add more shares if inflation continues to moderate in the coming months.
For further details see:
Annaly Capital Q2 Earnings Review: Upgrading To Buy On Potential Peak Rates