What Smart Investors Will Be Looking For in Annaly Capital Management, Inc.'s Earnings This Week

When mREIT Annaly Capital Management reports on Wednesday, good investors will look beyond the headlines and be on the lookout for several keys to the underlying business.

May 6, 2014 at 12:00PM

After the bell this upcoming Wednesday, Annaly Capital Management (NYSE:NLY) reports 2014 first quarter results.  After tumbling in 2013, the common shares have been on a tear since the beginning of this year, rising some 16%.  The double-digit dividend has added gloss to the record.

Annaly Capital Management -- YTD Price and VolumeG

 courtesy of bigcharts.marketwatch.com

Beyond the headlines, what should savvy Annaly investors look for in the earnings announcement?  Here's a short list:

Net interest margin
Between the third and fourth quarters last year, Annaly's net interest margin blew out, increasing 36 bps to 1.43%.  This was far greater than peer mREIT American Capital Agency (NASDAQ:AGNC) where its NIM increased just 2 bps to 1.39%.  Adding to the suspense, American Capital surprised investors last week when they reported an unexpectedly big drop in 2014 1Q net interest margins: from 1.39% down to 1.19%.  However, much of this was attributed to TBA dollar roll -- a type of mortgage securities repurchase transaction.

If Annaly's net margin widens, or just holds tight, it's one signal the business is stabilizing with respect to interest rate spreads. Effectively, mREITs make money by borrowing short and going long.  The ability of the portfolio to generate cash is largely a function of the net interest spread. 

Leverage and Prepayment Rates
Of late, Annaly management has elected to de-lever its portfolio. During 2013, leverage had been taken down to 5.0x from 6.5x.  This is the lower end of the company's historic range.  On the other hand, American Capital was levered up to 7.5x at year-end 2013. Upon the last earnings conference call, Annaly senior leadership indicated that it could begin to lever up again if market opportunities presented itself. 

One clue to watch are prepayment rates.

Banks have noted mortgage prepayment rates have rolled off the table, declining by some 70% since the end of 2012. It appears the refi boom is over. At year-end 2013, Annaly and American Capital had a constant prepayment rates of 7% and 8%, respectively. If the prepayment rate remains low, Annaly must lever back up to invest in higher yielding securities.

Therefore, a continued low prepayment rate combined with increased leverage indicates management has well-positioned itself and become more bullish on the mREIT market.

Book Value
A key mREIT valuation metric is book value. Annaly's net book has been heading south since late 2012, settling at a low of $12.13 a share as of December 31, 2013.

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However, expectations are the bottom is nigh. Watch for a recovery in book value. This would be another positive development. 

Beware: American Capital Agency reported last week that its net book did rise, but only 2.3%. The Street was disappointed. It was one reason traders sold off AGNC shares on the news. Annaly must beat that bogey or risk raising traders' ire, too.

Commercial Investment Portfolio
While primarily a mREIT investment, Annaly Capital diversified its portfolio when it merged with Crexus about a year ago. Crexus is a commercial REIT; investing in commercial property paper versus mortgage-backed securities.  Annaly management has significantly amplified exposure to commercial mortgages and property management since the union.

Commercial investment as a function of total portfolio equity has risen from 8% after the merger to 14% at the end of 2013.  The commercial side of the house is viewed as being a bit more stable than residential mortgages.  Look for that percentage to rise further.

Annaly Capital Management operates in a volatile environment. The juicy current 10.3% yield may be offset by potential capital destruction due to liquidity, prepayment, and interest rate risks. Investors must gauge their own tolerance for the mREIT business model ups-and-downs before buying shares.    

Last year, some yield-chasing investors piled into Annaly and other mREITs, perhaps not fully understanding the corresponding risk-and-reward profile. The subsequent share price fall was in part exacerbated by panic selling. It's best to invest in what you know.

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Raymond Merola is long NLY and NLY-D. Please do your own careful due diligence before making any investment. This article is not a recommendation to buy or sell any stock. The Motley Fool has no position in any of the stocks mentioned. 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.

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