Annaly Capital Management: Opportunity or Value Trap?

After reporting a worse-than-expected third quarter, Annaly Capital Management and most of the rest of the mortgage REIT sector took a nosedive. In fact, shares of Annaly hit a new 52-week low after the report, as investors seem to be counting on yet another dividend cut and are bracing for the effects of rising, unpredictable interest rates.

However, market reactions (or overreactions) can create some of the best buying opportunities. Let's take a closer look at Annaly's most recent quarter and see whether or not it creates a bargain in the stock and other sector leaders such as American Capital Agency and Western Asset Mortgage Capital .

How bad was Annaly's quarter, really?
I don't want to gloss over the reality: The numbers were pretty bad. For the most recent quarter, Annaly earned $0.28 per share versus estimates of $0.34, which is significant since it will most likely mean a further dividend cut to $0.30 for this quarter.

Annaly's net income was down substantially from the previous quarter as well, and is down by about 14% on a year-over-year basis. The company's book value continues to fall and currently stands at $12.70, which is about 23.5% less than last year at this time.

However, I do see some signs that Annaly's management has its eye on the ball. For one, Annaly's leverage ratio is down to 5.4 times from 6.2 times in the second quarter, and is well below some of its peers. Its closest competitor, American Capital Agency, has leverage in excess of 7 times. It is certainly true that rising rates are harmful to mREITs, but Annaly seems to be bracing for the impact, and the lower leverage should make any rise in rates more manageable to absorb.

New lows: bargains or not?
So, aside from another dividend cut, it appears the company is taking prudent steps to manage its risk over the near future. The market reacted to this news by taking about 8% off of Annaly's already beaten-up share price in the two days after the earnings report.

Source: TD Ameritrade.

Given the company's recent history, it seems shares generally adjust to produce around a 12% dividend yield. At the beginning of the year, when Annaly paid a $0.45 quarterly dividend, this corresponded to a share price of $15, which is awfully close to the actual share price at that time.

The dividend was cut to $0.40 in June, which means a price of $13.33, right around where shares were. If the company declares a $0.30 dividend for the upcoming payment, as I suspect it will, expect the share price to hover around the $10 range until there is new information.

So, while I do believe Annaly will be fine over the long term, there may be a little more downside to go, but the dividend should keep the stock around $10.

The same can be said of some of its higher-leveraged peers. American Capital Agency, for example, yields just over 15% annually based on the current $0.80 quarterly payout. Shares are about 36% below their 52-week highs, and just like Annaly, they trade with a relatively constant dividend. Consider American Capital Agency's dividend was $1.25 for the first part of the year, and at a 15% annual yield, this would translate to a $33.33 share price, which is close to its high of $33.31.

Western Asset Mortgage Capital is even more leveraged, currently at around 8 times, which is slightly too high for comfort. The company currently yields 23%, which is sure to attract some investors, but you should be cautious with this one. It makes me nervous that Western Asset Mortgage Capital still pays the exact same quarterly dividend that it did a year ago and, in fact, is one of the only mortgage REITs that can make this claim.

The "play it safer" management style of some of the others may be more prudent right now.

Now may be the time to buy, but you'll need a strong stomach!
I think the fears of rapidly rising interest rates, in the near term, are overblown. Bear in mind the Fed has stated on several occasions that it intends to keep interest rates at all-time lows until the unemployment rate drops below 6.5%, which is unlikely for at least another year.

That being said, holding mREITs could be a roller-coaster ride for the next few years as interest rates adjust from their artificially low levels and the housing market continues to stabilize. While I believe that 10 years from now investors will be wishing they had bought more of these, I'm not sure you'll be saying that one year from now. The bottom line is that for those with a long-term horizon, mortgage REITs should offer tremendous rewards at bargain prices.

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Matthew Frankel owns shares of Annaly Capital Management. 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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