Annaly Capital Management (NLY -0.70%) released fourth quarter and full-year results on Tuesday after the market closed and reported a net income loss of $0.71 per share for the quarter, this is compared to Zack’s consensus estimates of $0.31. For the year, Annaly reported a net loss of $0.96 per share.
Although the bottom line leave a lot to be desired, as a mortgage REIT, Annaly has a very unique business model and net income does not always give an accurate glimpse in to what actually happened during the quarter.
A closer look at earning
The company suggested that the net income loss for the quarter “was primarily attributable to mark-to-market losses on our interest rate swaps.” In fact, Annaly took a whopping $873 million in unrealized losses on their interest rate swaps – derivatives used to lock in borrowing costs.
As an investment company, however, Annaly will often take significant unrealized gains and losses on their mortgage securities. Because this is not included in net income, comprehensive income is often a better indicator of the company’s performance. That was certainly the case in the fourth quarter, as Annaly took $1.2 billion in unrealized gains on their securities, which more than offset their losses. This allowed Annaly to post comprehensive income of $514 million for the quarter. This helped boost the company's book value per share by 1.8% compared to the third quarter of 2014.
An even closer look at earning
While comprehensive income can give insight into the big picture, by removing one time charges and non-reoccurring gains and losses, core earnings helps you zoom on the company’s, well, core operations.
Annaly core earnings were $0.30 per share for the quarter and $1.14 for 2014.
This is a non-GAAP measure, and how it is calculated will vary from company to company, so take it for what it’s worth, but I find it a useful measure for judging dividend stability. For instance, core earning for 2013 totaled $1.21 per share, and Annaly dividend payout was $1.50. Year-over-year, core earnings are down and, unsurprisingly, so is the dividend payout which totaled $1.20 in 2014.
What is driving lower core earnings?
Annaly earns the spread, or difference, between what it cost to borrow and the yield on their assets. Historically, the larger the spread the better Annaly’s returns, and the bigger their dividend tends to be. Over the past year, however, spreads have tightened dramatically.
For a good visual, Annaly’s spread tends to follow the difference between the 10 and 2-year treasury rate.
As you can see, the gap between treasury rates has narrowed significantly, and this, ultimately, make things much more difficult for Annaly.
Looking forward
Overall, I think shareholders should be extremely pleased with Annaly’s performance in 2014, especially considering that conventional wisdom assumed interest rates would rise in 2014 and that Annaly would get hammered. Annaly CEO Wellington Denahan disagreed with this notion, and she was right, interest rate fell and Annaly had a solid year.
So, here we are again, today's conventional wisdom is calling for rising interest rates, but this time Denahan isn't fighting the tide:
“We fully expect the Federal Reserve to adjust policy accommodation sometime this year and the markets to endure higher levels of volatility. We look forward to the opportunities that will accompany that adjustment and remain comfortable in our continued ability to deliver attractive relative returns.”
All signs seem to point toward the upcoming environment being a difficult one for Annaly and the mortgage REIT industry. With that said, I'm a firm believer in the market cycle, I think that interest rates will rise and fall and spreads will widen and narrow, and Annaly will see more than its fair share of opportunities over time. So, while I see Annaly as solid a long-term investment, due to the difficult environment ahead think Annaly is a hold right now.
