Annaly Capital Management, Inc. (NYSE:NLY) reported yet another story of spread and book value compression. However, the outlook for the second quarter of the current year looks promising. The remaining of the investment thesis will discuss the latest financial disclosures and see which factors will lead the company to reported growth in the second quarter.
Financial review
While Annaly Capital Management, Inc. (NYSE:NLY) reported EPS of $0.47, marginally above it’s $0.45 per share dividend rate, a large portion of it was from one-time items. Annaly Capital recognized $0.19 per share as gain on sale of securities, which is not considered part of the regular business at a mortgage REIT. Therefore, the adjusted EPS comes out to be $0.28, far behind the current dividend rate.
Spreads
Remember, spread is the difference between the interest earned on the interest earnings assets and the interest paid on the interest bearing liabilities- the wider the spread, the greater the income. Aggressive bond buying by the Fed resulted in a 4 bps compression in the interest rate spread (0.91%), as the average asset yield fell 8 bps over the linked quarter, partially offset by the 4 bps decline in the cost of funds.
Annaly Capital Management, Inc. (NYSE:NLY)’s spreads going forward are expected to increase, as the decreased funding costs and Crexus Investment Corp (NYSE:CXS)’ acquisition will increase Annaly Capital’s average spread and be immediately accretive to the spread.
In comparison, American Capital Agency Corp. (NASDAQ:AGNC) reported an 11 bps decline in its net interest rate spread, while its cousin American Capital Mortgage Investment Crp (NASDAQ:MTGE) reported 6 bps sequential decline in its net interest rate spread.
Funding maturities
Annaly Capital Management, Inc. (NYSE:NLY) continued to extend the weighted average maturity of its interest bearing liabilities. The weighted average maturity has now increased to 202 days from the linked quarter’s 197 days.
While the extension in the funding maturities reduces the risk short-term (or wholesale) funding poses, it also has the ability to reduce Annaly Capital’s net interest rate spread further, because liabilities with increased maturities demand higher interest payments. Therefore, I believe if Annaly Capital Management, Inc. (NYSE:NLY) continued to increase its funding maturity, it might escape regulators’ wrath; but at the same time it will hurt its future profitability.
Looking at its competitors, I see American Capital Mortgage Investment Crp (NASDAQ:MTGE) and American Capital Agency Corp. (NASDAQ:AGNC) doing the same. American Capital Mortgage Investment Crp (NASDAQ:MTGE) extended the weighted average maturity of its securities from 87 days at the end of the fourth quarter to 108 days at the end of the most recent quarter. Similarly, American Capital Agency Corp. (NASDAQ:AGNC) extended the weighted average maturity of its interest bearing liabilities to 183 days. However, the extension was only a modest one as the weighted average maturity for its liabilities at the end of the prior quarter was 181 days.
External management
By the end of this month, the issue of external management will be up for a proxy vote. This would be similar to the one being adopted by American Capital Agency Corp. (NASDAQ:AGNC), and its cousin American Capital Mortgage Investment Crp (NASDAQ:MTGE). Apparently, the company is reverting to external management to reduce expenses borne by shareholders. However, I believe the motives are different.
I think the external management structure would allow the company’s management to hide top management’s elevated compensation plans. Bloomberg reported that last year alone, Annaly Capital Management, Inc. (NYSE:NLY)’s CEO was paid more than double the average compensation of the six largest US banks. So, I believe this is the kind of disclosures that management is looking to hide.
Besides, I believe the external management will increase expenses instead of decreasing them. This will particularly be the case in the long-term as operating leverage is diminished. Therefore, the May 23, 2013 shareholder meeting holds a key answer to the company’s future strategy.
Prepayments
It seems that Annaly was able to take some advantage from the slowdown in refinance activity during the first quarter of the current year, reporting a modest decline in prepayment speeds. The reported CPR came down from 19% to 18% over the prior quarter.
This is still above the prepayment speeds for American Capital Agency Corp. (NASDAQ:AGNC)’s investment portfolio. American Capital Agency Corp. (NASDAQ:AGNC)’s investment portfolio is considered to have high prepayment protection attributes, which is why it reported a CPR of 10%, one of the lowest in the sector. American Capital Mortgage Investment Crp (NASDAQ:MTGE) reported a CPR of 6.3%, down from the prior quarter’s 6.5%.
Conclusion
Annaly Capital Management’s second quarter performance is highly reliant on how much the company is able to decrease its cost of funds, and the increase in the average asset yield due to the Crexus Investment Corp (NYSE:CXS) acquisition. While the future looks brighter for Annaly, investors should keep an eye on the May 23 shareholder meeting and any further extension in the maturities of the interest bearing liabilities.
The article Another Story of Compressed Spreads and Book Value, But the Outlook is Brighter originally appeared on Fool.com is written by Adnan Khan.
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