Is Annaly's Dividend Too Big?

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.

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.

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