Annaly Capital Management (NYSE: NLY ) is an incredibly popular stock. It pays a double-digit dividend yield, invests largely in riskless, agency-backed mortgage securities, and is led by a CEO that 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% -- even though it is one of the portfolio's worst performers.
While the current economic environment is challenging for REITs, Fool analyst Jim Royal believes the mortgage REIT giant should be able to weather the 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 non-negligible amount of pain.
What follows, in turn, is the third and last in a series of articles on what I believe are Annaly's biggest problems. The first article asked whether Annaly's dividend payout is too big. The second article dug into two of Annaly's biggest equity investments. This article takes up the company's unconventional executive compensation structure.
Looking at executive compensation
When most people think of executive compensation problems, it's generally assumed the issue is related to either excessive compensation or some type of ridiculous golden parachute. With respect to excessive executive compensation, I'd say the cake goes to Ray Irani, the Chairman and CEO of Occidental Petroleum, who made almost $136 million in 2010 alone! In terms of outrageous golden parachutes, I'd give the award to James Kilt, the former head of Gillette, who was paid $165 million when Proctor & Gamble absorbed his company in 2005.
While there's definitely something to be said about these excesses, I tend to think the primary issue concerns the misalignment between executives' incentives and shareholders' interests. Executive compensation consultant Robin Ferracone discussed this during an interview with Mac Greer here at The Motley Fool, commenting that boards have to be "very thoughtful about what they're incentivizing management to do, because they're going to get a lot of it." Moreover, Charlie Munger, the Vice Chairman of Berkshire Hathaway, has said, "I've been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther."
So how does Annaly line up?
There's no question that Annaly's executives get paid well. Its chairman and CEO, Michael A.J. Farrell, received a total compensation of $23.6 million in 2010. Its COO, Wellington Denahan-Norris, got the same amount. Annaly's less-senior executives were paid between $4.7 million and $9.5 million the same year. All in all, the company's total executive compensation increased more than threefold between 2006 and 2010.
The more interesting issue, however, concerns what the company ties executive bonuses to. While many companies use profitability or operational metrics like earnings per share or gross margin, Annaly ties the size of its executives' bonuses to book value. And to Ferracone's point, they've gotten a lot of it.
Since the beginning of 2006, Annaly's book value has increased nearly twelvefold, going from $1.33 billion to $15.73 billion in the third quarter of 2011. And it's done so not by retaining earnings, as its dividend payout ratio over that time period exceeded 100%, but primarily by issuing new shares. As you can see in the chart below, it has issued a whopping 845 million of them since 2006. That's more than 100 million new shares a year!
Before you get the wrong idea…
It's important to note that many other mortgage REITs do the same thing. REITs are required by law to pay out at least 90% of their earnings in the form of dividends in order to avoid corporate income taxes, so issuing new shares and borrowing more money are the two main avenues available for growing their balance sheets. Since mortgage REIT Invesco Mortgage Capital (NYSE: IVR ) went public in 2009, for example, its outstanding share count has increased from around 9 million to 115 million. American Capital Agency's (Nasdaq: AGNC ) outstanding shares went from 15 million at the end of 2007 to 179 million today. And Armour Residential's (NYSE: ARR ) started at 32 million in 2007 and is now at 76 million.
It should also be noted, that while Annaly has managed to increase its book value per share at the same time, going from approximately $11.50 per share in 2006 to a little over $16 today -- Chimera Investment (NYSE: CIM ) , which it advises, has seen its book value per share plummet from $11 in 2008 to just over $3 today.
So what's the problem?
In the first case, Annaly's executives are incentivized to make its shares as attractive as possible to ensure it can continue selling new issues. Because the attractiveness of a REIT is based largely on its dividend, however, it follows that Annaly's executives are indirectly incentivized to maximize the size of the dividend payout.
And in my opinion, they've done this to the detriment of the company's finances. As I discussed in an earlier article, the company's current payout ratio is 124% -- and 105% if you look at the five years encompassing 2006 to 2010. This means that the company pays out more in dividends than it records in net income. At some point, something's gotta give.
In addition, rewarding executives for growth in book value via share issues is independently unsustainable. While it's hard to predict the ultimate size of the market for Annaly's shares, it's fair to say it isn't infinite. At some point, the company won't be able to issue more.
Not to mention, when the market is exhausted, will the company's executives be content with bonuses that don't grow from year to year? My guess is no. They'll either leave the company in search of greener pastures, or change the way their bonuses are calculated -- neither of which is likely to be in shareholders' interest. It's for these reasons, in turn, that I think investors should be wary of owning Annaly's stock.
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