Is NLY Stock a Good Buy?

Is NLY Stock a Good Buy? With dividends now well into the double digits, shares in mortgage REIT Annaly Capital (NYSE:NLY) may look appealing to investors looking for stocks that return large amounts of liquid cash.

 

Despite its enormous yield, NLY could carry risks that conservative and moderate investors would find unacceptable. Here’s why.

 

In Q3, Annaly increased its total assets to $86.2 billion, up nearly $4 billion from the previous quarter. The company’s residential credit portfolio grew by 6 percent, while its mortgage servicing rights division grew by 9 percent.

 

Earnings, however, were quite negative for the quarter. On a GAAP basis, Annaly lost $0.70 per share in Q3.

Earnings available for distribution were reported at $1.06 per share, which covered the dividend and left some margin of safety. Return on equity was -9.9 percent.

In the coming year, Annaly is expected to see its overall earnings shrink by nearly 25 percent. This continued earnings drop could drive share prices considerably lower, especially if interest rates remain high.

 

Because Annaly’s business is tied both to interest rates and demand for real estate, the company could see a very difficult period ahead in terms of growth. Analysts expect the company to contract at a rate of about 5 percent per year over the next five years.

 

Annaly Capital’s high dividend is the main argument in favor of the stock. The yield on NLY currently stands at 15.62 percent, and each share pays out $3.52 annually.

 

Although the company’s earnings could drop in the coming year and force the dividend down, NLY’s high yield gives it some room to lose ground while still offering ample income.

 

Over the next three years, Annaly is expected to shrink its dividend at a compounded rate of less than 3 percent annually.

 

Over the next year, analysts expect NLY to fall to $21. This would represent a loss of 6.8 percent. While no analysts rate the stock as a Sell, the consensus on NLY is to Hold.

 

In terms of valuation, Annaly Capital appears to be reasonably priced. The stock trades at about 7 times expected earnings, despite its massive dividend yield.

 

Cash flow per share comes in at $7.04, more than 25 percent of the current share price. Annaly’s one major drawback from a value perspective is its debt load, which is currently 0.83 to equity.

 

The first risk factor investors should be aware of when analyzing NLY is the fact that it is a mortgage REIT. Unlike traditional REITs that own income-generating properties, mortgage REITs invest in portfolios of mortgage finance products.

 

These REITs are notoriously risky, especially during volatile economic times. As such, they tend to offer higher yields but much less stability than trusts backed by physical real estate.

 

In the short term, it also seems likely that Annaly’s total returns will underperform the broader market.

 

While a dividend of over 15 percent is attractive, the expected loss in NLY’s share price would bring its total return to under 10 percent over the coming 12 months.

 

If a general economic recovery takes place in 2023, this could make Annaly Capital a weak performer. It should be noted, however, that lower share prices could still be beneficial for long-term investors who plan to reinvest their dividends.

 

Macroeconomics could also work against Annaly’s business. Though the Federal Reserve is expected to hold interest rates at about 5 percent this year, persistent inflation could force the central bank to pursue further rate hikes.

 

High interest rates are also likely to continue exerting downward pressure on new mortgage originations and refinancing.

 

Annaly Capital’s balance sheet also appears fairly precarious. The company’s current liabilities total $65.8 billion, while its total current assets stand at just $4.9 billion. Of that, only $1.5 billion is in cash or cash equivalents. As such, the company has little buffer room in the event of further disruptions in the mortgage market.

 

Annaly’s existing risks are compounded by the fact that a large part of its portfolio is made up of mortgages that are not backed by Fannie Mae or Freddie Mac. While this allows Annaly to earn more interest on its loans, it also increases the risk to the company’s employed capital.

 

Although NLY offers a superior dividend yield, it’s difficult to recommend the stock as a buy at this time.

 

The company’s balance sheet and the likelihood of persistently higher interest rates both make it a high-risk proposition. Even at over 15 percent, NLY’s dividend may not be enough to compensate for the losses investors could see in the share price.

 

Annaly Capital also appears to be headed in the wrong direction in terms of earnings and growth. Shrinking earnings and negative growth rates could ultimately put pressure on the company’s dividend and increase the risk that NLY will underperform the market. Until conditions in the mortgage market improve, NLY simply appears to have too many negatives stacked against it.

 

Finally, Annaly Capital has far less protection than competitive mortgage REITs from government-guaranteed loans. While mortgage REITs come with unique challenges, some of these are offset by the common use of securities backed by Fannie Mae and Freddie Mac mortgages.

 

In Annaly’s case, this risk management tool isn’t employed as widely. As such, Annaly could see outsized losses relative to competitors if a recession or other sudden economic event pushes delinquency and default rates up.

 

Aggressive dividend investors with longer time horizons and a commitment to reinvesting may find NLY’s yield compelling enough to include a small amount of the stock within a larger income-generating portfolio. In this capacity, NLY could be a useful niche stock. For most investors focused on long-term income, however, the risks in Annaly Capital appear to outweigh the potential rewards.

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