Annaly Capital Management, Inc

Moat: 1/5

Understandability: 2/5

Balance Sheet Health: 3/5

Annaly Capital Management is a leading diversified capital manager, primarily investing in agency mortgage-backed securities and provides financing to the mortgage industry.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Annaly Capital Management, Inc (NLY), is a mortgage real estate investment trust (REIT) that primarily invests in agency mortgage-backed securities (MBS) that are guaranteed by the US government.

Business Overview

Annaly Capital Management operates as a real estate investment trust (REIT), primarily focusing on agency mortgage-backed securities (MBS). This implies they primarily invest in securities backed by mortgages that are guaranteed by government agencies (like Fannie Mae and Freddie Mac).

Unlike traditional REITs that own and manage physical properties, Annaly is a mortgage REIT. This means it derives income from the interest paid on mortgage-backed securities rather than from renting physical space or buildings.

Here are some key components of the business:

  • Agency Mortgage-Backed Securities (MBS): NLY’s primary investments are in MBS issued by agencies like Fannie Mae and Freddie Mac. They are considered low risk, and their cash flows are more predictable as they are federally guaranteed.

  • Financing Operations: Given the nature of the company, leverage and financial management form the core of their operations. They use financing agreements like repurchase agreements and similar short-term borrowing to fund their investments in MBS.

  • Investment Portfolio: While primarily invested in Agency MBS, they also have a diversified portfolio that is allocated across varied securities like Agency-backed MBS, Agency Credit Risk Transfer Securities, and non-Agency Residential mortgage backed securities.

  • Geographic Reach: Even though all investments are USA, they are diversified across different regions, like Western U.S., Eastern U.S., Midwest, and other U.S. regions.

Annaly has three reporting segments: Agency, Residential Credit, and Commercial Real Estate, with Agency MBS being the main focus.

Competitive Landscape

The competitive landscape for Annaly is characterized by a few key factors:

  1. Large Number of Players: The mortgage REIT sector has numerous competitors, many of which are publicly traded. This market is crowded, and it does not have a few clear leaders in the industry, which lowers the moat.

  2. Sensitivity to Interest Rate Movements: Changes in interest rates significantly affect these companies profits, making them highly competitive for investor interest. These factors mean that companies compete mainly on the lowest yield to be considered competitive.

  3. Access to Financing: Companies are highly dependent on short-term financing for their operations. This means it can be very risky in the face of financial shocks.

  4. Limited Differentiation: Most mREITs buy and sell very similar assets, meaning very little ability for moat creation. Their returns are purely based on how well they manage liquidity and how stable they can keep financing.

  5. Leverage: High usage of leverage means these companies have little leeway for mistakes, or if a black swan event occurs. Many competitors are also highly leveraged.

Financial Analysis

Here is an in-depth look at NLY’s financials:

Income Statement:

  • Net Interest Income: The primary source of income for NLY is Net Interest Income. As a Mortgage REIT they aim to capitalize on the spread between the interest they earn on their investments (MBS and other mortgages) and the interest they pay on their borrowings. As of September 30, 2022, their Net Interest Income was $590.2 million.

  • Expenses: The company’s interest expense on the borrowings they use for their investments is a major expense, along with operating expenses. Other non-interest expenses include general and administrative expenses such as employee compensations. For the three months ended September 30, 2022, Net interest expense was $1.3 billion with operating expenses reaching $53.6 million.

  • Net Income (Loss): NLY has suffered heavy loss from 2021 onward, as of September 30, 2022, they suffered a loss of $982.3 million, the main reason was that interest income and the cost of funds were heavily affected during recent rapid rate hikes.

Recent changes have shown NLY is very vulnerable to the recent rate hike environment, with high increase in interest expense and decreasing net interest income. As the Fed continues to increase rates, there is a very high risk that NLY could continue posting losses.

Balance Sheet:

  • Total Assets: NLY has total assets of $88.4 billion, comprising of Agency MBS, Non-Agency Residential Mortgages, and Securities, etc.
  • Total Liabilities and Equity: Total liabilities of the company are $78.9 billion which includes a lot of short-term borrowings. The company also has total equity of 10.1billion
  • Debt Structure: As of September 2022, NLY’s had total debt to equity of 7.8x . These numbers are very concerning, because a high debt amount means more risk.

The company is highly levered, and its business is highly sensitive to movements in interest rates, as it uses short-term borrowing to make long-term investments. Any sudden change to the interest rate environment may cause severe damage.

Key Ratios:

  • Net Interest Spread: A spread of 3.6 percent over three months ended September 30, 2022, shows how their returns are being compressed.
  • Net Interest Margin: NLY has an average net interest margin of 1.92% for the past 12 months, which signals difficulty in making profits, as they can quickly turn negative.

In general, the main indicator of performance of mREITs is the difference between their asset yields and borrowing costs. This metric is called the interest spread or net interest margin. It’s the equivalent of a margin in a normal company. A higher spread generally reflects more profitability.

Recent Concerns, Controversies, and Management Statements

  • Rate Hikes: The most concerning part for Annaly is the recent rate hikes, which have severely compressed its profitability in the short-term. Management has stated they will be changing their investment portfolio to adapt to the new environment, but this will likely mean the company will undergo losses for the next few quarters, as well as have difficulty in creating profits.

  • Dividend Reduction: NLY has steadily reduced its dividends in the past few years, and there is no guarantee they can maintain current dividends going forward. The earnings and cash flow is not sufficient, which creates a high risk of dividend cuts going forward. Management has noted they are committed to the dividend, but they can not guarantee it at current levels.

  • Economic Uncertainty: Global uncertainty and the US economy entering a slowdown may negatively impact the value of some of the less liquid MBS holdings that Annaly has, and increase defaults of non-agency residential mortgages. These events are hard to forecast, and may negatively affect the company.

  • Management Statements: Management has stated in recent quarterly calls that they are focused on managing risks, optimizing the portfolio, and making necessary adjustments to create profits in new economic scenarios. They are also focusing on maintaining liquidity and financial flexibility while trying to grow their assets and net interest spread. Management has indicated they have become much more focused on risk assessment, and risk management is now a core part of their business model.

Moat Rating: 1/5

Annaly Capital Management has a very weak moat for several reasons:

  1. Commoditized Assets: The company primarily buys and sells Agency MBS, which are widely available and easily traded. Therefore, they don’t have unique holdings or an edge over competitors to provide better returns.

  2. Low Switching Costs: From an investor’s perspective, it is very easy to switch away from NLY. There are numerous similar investment vehicles, many from big-name players such as Blackrock, PIMCO, etc.

  3. Highly Leveraged Business: A highly levered business is riskier, and can have greater chances of severe losses. A highly levered business does not constitute a moat.

  4. Intensely Competitive Industry: Many competitors in the market are providing near identical services and products. The competitive landscape also does not allow any pricing power for the company, as margins are based on market conditions and competitive actions.

  5. Dependency on the Macro Environment: Annaly’s profitability is extremely sensitive to interest rate fluctuations and credit spreads. These factors are outside the control of the company, and it is not capable of taking strategic steps to avoid these factors.

Understandability Rating: 2/5

Annaly Capital Management’s business model is relatively easy to understand, but some aspects of its financials and trading are complex:

  1. Simple Overview: The base concept of borrowing money to buy mortgages is easy for investors to get.
  2. Complicated Financials: Understanding how complex accounting for MBS works and what a “yield” spread represents is harder.
  3. Complex Business Environment: The impact of interest rates, credit spreads, the yield curve, etc. is confusing for an inexperienced investor, as it changes their value constantly and very predictably.
  4. Financial Jargon: Many terms like MBS, ARM, Repurchase agreements, LIBOR, leverage, etc, are common in the business but a new investor may struggle to understand.
  5. Reliance on Forecasted Rate Expectations: NLY performance is directly tied to expectations of future interest rates, and knowing how exactly rates will move is very difficult.

Balance Sheet Health Rating: 3/5

The company’s balance sheet is in the middle of the pack:

  1. High Leverage: NLY’s reliance on debt financing is very high, which increases risk. In this rate increase environment, a higher debt load increases financial pressure on the company.
  2. Good Liquidity: The company’s operations are reasonably liquid, meaning it can convert its assets into cash fairly quickly. However, the price of these assets can also change drastically.
  3. Reliance on Fair Value Measurements: Many of NLY’s assets and debt are revalued using mark-to-market values every quarter. This can be beneficial or detrimental depending on market conditions, and is not a definite book value.
  4. Good Coverage: Although the company has been posting losses and struggling, its asset coverage over liabilities, meaning that it has a good margin of safety on current assets.
  5. Short Term Liabilities: Although a good portion of debt is fixed rate, NLY has a very high proportion of short-term debt, putting the company at risk of refinancing debt at higher interest rates.

Legitimate Risks

  • Interest Rate Risk: Changes in interest rates can lead to significant losses for the company, by either increasing the cost of their financing or by diminishing the value of their investments, both for the book value and market value.

  • Credit Risk: Although Agency MBS is considered low risk, non-Agency MBS securities are subject to defaults and other credit events. These could impact NLY’s income as well as value of assets.
  • Prepayment Risk: MBS are subject to prepayments, which impacts cash flows and valuations, and causes difficulty in predicting the amount of cash the company will earn and their returns over time.

  • Liquidity Risk: Reliance on short-term borrowing for investments may cause liquidity issues in times of financial instability or rate hikes and could impact operations.

  • Regulatory Risk: The changing landscape of regulation around the mortgage market, including rules by Government Sponsored Enterprises, etc, has unpredictable affects and changes how the company operate.

  • Economic Downturn: Any kind of economic downturn can be very disruptive to the company and cause issues with its asset’s prices as well as its ability to access financing markets.

Business Resilience

Annaly has been around for many years and has survived multiple financial crises. This track record indicates the company has an ability to maintain its operations even when faced with economic hardships. NLY has also been actively managing the company with the new market conditions, with a focus on deleveraging, and changing to more stable assets. This focus on managing risk in the long term, signals that the company is likely to be resilient.

Overall, Annaly is a relatively complex and risky company. It has a weak moat in a highly competitive market and is sensitive to changes in the economic environment, especially interest rates. However, management is actively trying to mitigate many of these risks by changing asset allocation, improving financial flexibility, and maintaining stable operations, though there are no assurances of success with the volatile rate environment. For any average investor, this is a company to be taken with extreme caution.