Is Annaly's Dividend Too Big?

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Annaly Capital Management (NYSE: NLY  ) is an incredibly popular stock. It pays a double-digit dividend yield, invests in largely riskless agency-backed mortgage securities, and is led by a CEO whom many consider to be an industry sage. It's even included in fellow Fool Dan Dzombak's high-yield dividend portfolio, which is beating the S&P 500 by almost 8 percentage points -- though it is one of the portfolio's worst performers.

While Annaly's shares are down since the beginning of last year, Fool analyst Jim Royal believes the mortgage real estate investment trust should be able to continue weathering the current economic storm without cutting its 14% dividend yield. I'm not as certain. In fact, I see a number of threats looming on Annaly's horizon. And although they may not be terminal or immediate, I do believe they will eventually cause the company's shareholders a fair amount of pain.

What follows, in turn, is the first in a series of articles on what I believe are Annaly's biggest problems.

The size of Annaly's dividend
To qualify as a mortgage REIT -- which grants highly preferable pass-through tax treatment -- Annaly is obligated to pay out at least 90% of its earnings via dividends. While this may sound like an unusual arrangement, it's actually quite common among companies that Congress perceives to provide a social good. In addition to REITs, Congress accords similar tax treatment to business development companies like Apollo Investment and master limited partnerships like pipeline company Energy Transfer Partners, among others. According to The Wall Street Journal, the percentage of U.S. corporations organized as nontaxable businesses has grown from about 24% in 1986 to about 69% as of 2008.

The issue with Annaly is its habit of paying out more in common stock dividends than it records as net income available to its common stock shareholders. According to Morningstar, from 2006 to 2010, the company paid out $219 million more of the former than it recorded of the latter, equating to an adjusted dividend payout ratio of 105.5%. Over the last 12 months, moreover, Yahoo! Finance lists its non-adjusted dividend payout ratio as 124%. As you can see in the table below, the latter number ranks it second among mortgage REITs in this regard.


Current Dividend Payout Ratio

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ARMOUR Residential (NYSE: ARR  ) 135% Add
Annaly 124% Add
Chimera Investments (NYSE: CIM  ) 116% Add
Invesco (NYSE: IVR  ) 98% Add
American Capital Agency (Nasdaq: AGNC  ) 78% Add

Source: Yahoo! Finance.

I don't hate dividends
Now I know what you're probably thinking: What's this guy got against dividends? And the answer is "nothing." It's been proven that companies with high dividend yields generally outperform companies with low yields. To borrow an illustration from Fool analyst Morgan Housel, $1,000 invested in the S&P 500 in 1957 was worth $176,000 in 2006. The same amount invested in the 10 S&P companies with the highest dividend yields was worth $1.3 million. Not to mention, academic studies show that dividends are typically the best way to reward shareholders -- as opposed to acquisitions or stock buybacks.

My issue, on the other hand, is twofold. In the first case, Annaly is passing up an opportunity to accumulate an equity cushion via organic means. It's important to remember that mortgage REITs are popular stocks among income-seeking investors, many of whom assume that dividend stocks are less risky than their nondividend-paying brethren. In light of this, I believe Annaly has a duty to act as conservatively as possible without jeopardizing its REIT status -- that is, it should retain 10% of its net income each year. Had it done so from 2006 to 2010, it would have an additional $600 million to protect against future economic shocks.

The second issue I have with Annaly's payout ratio concerns the source of the additional capital. In other words, where's the additional money coming from to pay the dividend if it's not coming from net income? The answer is that it's either using borrowed money, or it's redeploying capital from its annual stock-issuing frenzies. In my opinion, the fact that Annaly pays out more than it earns while at the same time issuing new shares is evidence in itself of imprudent capital allocation. As David Einhorn said about Allied Capital, "Traditional companies that pay large dividends do not generally issue fresh equity because the dividends reflect an unneeded surplus of capital."

The counterargument is that Annaly's GAAP earnings don't necessarily reflect its ability to pay dividends absent debt and/or additional stock issues. Although this is true in the short term, given the frequency and magnitude of noncash charges on its income statement, the cash and accrual numbers should theoretically reconcile given enough time. And in this case, at least going back to 2006, they don't.

Foolish bottom line
Ultimately, while I applaud Annaly's commitment to rewarding its shareholders with dividend payouts, in the long run, I believe its decision not to retain any of its earnings leaves the company more vulnerable than necessary to economic and financial shocks in the future, and it limits the company's ability to grow book value in the absence of new stock issues.

But not all dividend stocks do this. Some of the best that I've found are disclosed in our free report about 11 dividend stocks with generous yields and a stable outlook. It includes a handful of well-known companies like AT&T and Proctor & Gamble, as well as a lesser-known, but very intriguing, investment bank with a high dividend yield and impressive recent performance. To access this report while it's still available, click here now -- it's free.

Fool contributing writer John Maxfield does not own shares in any of the companies mentioned above. The Motley Fool owns shares of Chimera Investment and Annaly Capital Management. Motley Fool newsletter services have recommended buying 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 (5) | Recommend This Article (29)

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 January 13, 2012, at 2:59 AM, brianrenners wrote:

    When interest rates drop, homeowners take notice. If rates dip lower than your current rate, refinancing may allow you to lower your monthly payment, potentially reducing the interest expenses you’ll pay over the life of the loan. Shop around use sources like 123 Refinance to compare rates

  • Report this Comment On January 17, 2012, at 11:55 AM, Bearofaday wrote:

    I read your report on Anally with interest. I understand the leverage used and think I read it is about 7 to 1. If the rate for borrowed funds increases does this cause a rapid elimination of equity in the leveraged portfolio or does it simply reflect on the future spread reducing future earnings?


  • Report this Comment On January 17, 2012, at 12:54 PM, Seansonfire wrote:

    Annaly is paying out more than its net income because it is able to borrow at such low rates (.5% a year on Repurchase Agreements, 1.53% on Treasuries). By buying stock in Anally you are taking advantage of these low rates, as they are essentially borrowing for you at near zero rates, and paying that money out to shareholders.

    Its like having access to really cheap money when you buy stock in Annaly.

    Obvious risk is when the rates rise.

  • Report this Comment On January 20, 2012, at 9:18 AM, nairbv wrote:

    ...NLY is a mortgage REIT. It must pay out 90% of it's *TAXABLE* earnings, which may be higher than its reported GAAP earnings.

    NLY is unlikely to be paying any more of its earnings than it is legally obligated to pay... so this article is completely invalid.

    (I am long NLY)

  • Report this Comment On January 20, 2012, at 5:10 PM, ajstudebaker wrote:

    As the comment from brianrenners implies, continued low interest rates for mortgages will gradually reduce NLY's returns from its portfolio and thus reduce the earnings available for the dividend.

    It would be useful to see if a cash flow analysis indicates that NLY is retaining some of the 10% of taxable earnings that it's not obligated to pay in dividends.

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