What the News at Annaly Capital Means for Investors

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This article is part of our Rising Star Portfolios series. You can find out about the Dada Portfolio here.

Last week, Annaly Capital (NYSE: NLY  ) announced that it would issue 75 million new shares at $17.30 apiece, which it expects will raise $1.3 billion. (Underwriters will get the option to purchase an additional  11 million shares.)

Shares promptly fell 3% to $17.37 on the news, though they have since risen to $17.56.

What does it all mean for investors, including the Dada portfolio?

This is a fairly normal -- though intriguing -- event. As a REIT exempted from corporate income taxes, Annaly is required to pay out at least 90% of its earnings in the form of dividends. Since it can't retain much of its earnings, the company has to increase leverage or issue shares if it wants to expand. Together, American Capital Agency (Nasdaq: AGNC  ) , Chimera (NYSE: CIM  ) , and Hatteras Financial (NYSE: HTS  ) have issued billions in stock over the last few years.

But capital comes with a cost -- shareholders will be diluted some 12%. So a critical test for REIT shareholders is whether management issues shares at opportune times. You want to see new shares issued when the stock is expensive, and/or when Annaly needs the capital.

In the 10-year graph below, the blue line shows how pricey Annaly's shares have been, while the red line depicts stock sales. Ideally, share issuance should spike when the valuation is expensive, and rest when it's cheap.

Source: Author's calculations and Capital IQ, a division of Standard & Poor's.

On this measure, Annaly seems to have done a good job timing its selling in 2000 through 2003, resting as valuations plummeted in 2005, selling again as prices rose somewhat, before resisting the urge to raise capital after valuations collapsed in the financial crisis.

I'm more curious about the timing of the most recent $1 billion offering depicted in the chart, as well as the upcoming one. After all, these are some of the cheapest price-to-book multiples at which Annaly has issued shares during the last decade.

Why would management issue shares for around a mere 1.1 times book value? I can see three possible explanations:

  1. Annaly hasn't sold significant amounts of stock since the second quarter of 2008. It's patiently waited more than two years, and with valuations beginning to rebound, it may be eager to finally raise more capital.
  2. Management could expect a prolonged period of large interest rate spreads (the current 200-basis-point range is historically very high for the company) and high profitability, and it wants to capitalize.
  3. The move could also be a protective measure against an eventual rise in short-term rates.

I think Annaly probably based its decision on a combination of these factors. The current interest rate environment is extremely favorable for Annaly, but the company had to wait until now for a decent valuation before issuing new shares. At the same time, management is cautious because of the possibility that interest rates could rise. As COO Wellington Denahan-Norris noted earlier this month, in explaining why Annaly isn't using more leverage, "You're going into an environment where you potentially have monetary policy changes.... I just think that it's a good idea to continue to operate with maximum flexibility."

In short, issuing shares now is a safe way for Annaly to continue taking advantage of great market conditions. The Dada Portolio is happy to continue owning shares.

What do you think about Annaly Capital? Let us know on our discussion board. You can also follow the Dada Portolio @TMFDada.

At the time of publication, Ilan Moscovitz didn't own shares of any company mentioned. The Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (4) | Recommend This Article (38)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 25, 2011, at 10:00 PM, worthless111 wrote:

    I admire your explanations. I feel this is a sound 3 star REIT. With a 12 % dilution the stock price drops 3 %. This was a good entry point to buy.

    This article was compact as well as encompasing.

  • Report this Comment On February 26, 2011, at 10:43 AM, B1ll1am wrote:

    Ok, help me out here. With interest rate spreads so large and profits so high, why wouldn't the company leverage as much as possible? When interest rates go up are they going to buy then when it's less profitable? Also, why is it dilutive when a company sells shares and invests the money in assets? Seems to me that they are just swapping an asset for an asset. Do investors over-react on share sales like this? I like this article as it provokes thought and that enhances your ability to buy shares at the right time.

  • Report this Comment On February 26, 2011, at 1:31 PM, HappyEndingz wrote:

    Why would management issue shares for around a mere 1.1 times book value?

    I sorta think Bill Gross hit the nail on the head in his recommendation of NLY in the Barron's Roundable II in January:

    "It's at $17.75. The stock can't to up much because the minute the price gets above book value the company issues stock, as it did in late December. This is a dividend-earning vehicle. You wouldn't look for Annaly to rise from 17.75 to 22.50 in 12 months. But it produces a 14.5% yield. This is a finance company like AmEx or GMAC or CIT, although CIT is lower-quality than Annaly."

    "Annaly has a book value of about $16 a share. You are basically buying it at book, and giving the company the privilage of investing money for you, levering it 5-to-1, and offering you a 14.5% dividend yield. In the absence of another, crisis, you'll do well."

  • Report this Comment On February 28, 2011, at 9:33 AM, Jeo143 wrote:

    @ B1ll1am

    The reason for the stock it is that it will take time for the new capital to work. The quarterly dividend previously predicted was based on X number of shares and $Y in capital all being used to generate revenue.

    After the stock offering, the number of shares went up, but the capital has not been invested long enough to generate a full quarter of revenue. As a result, short-term the dividend is more likely to see a decline. Ultimately however you are correct that the eps should remain at about the same level since more capital means more revenue. The reaction was a short term move, which is why the stock has since gone back up.

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