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No. of Recommendations: 16
Write up of the Annaly Mortgage Management 10-K and comments

History of the company: Annaly was founded in 1997. It's current set-up qualifies it as a REIT and the company intends to maintain this status. It has raised 1.5 billion dollars in stock offerings since inception.

In a REIT no more than 50% of the company's stock may be owned by 5 or fewer individuals.

Self proclaimed goal: to generate net income for distribution from the spread between interest income on investment activities and the cost of borrowing to finance acquisition.

“we strive to establish a balance between the underutilization of leverage, which would reduce returns to our shareholders, and over-utilization of leverage, which would reduce our ability to meet our obligations under adverse market conditions”

Annaly is self advised and self managed.

FIDAC (fixed income discount advisory company) is a wholy owned subisdiary of Annaly. Under REIT regulation, FIDAC cannot contribute more than 20% of Annaly's total assests.

Annaly deals largely in the business of mortgage backed securities (MBS). These MBS consist of mortgage pass-through certificates, collateralized mortgage obligations and agency callable debitures. All of Annaly's MBS are agency backed: that is, although the MBS are not rated, they are AAA “implied” since the MBS come through FNM, GNM and FHLMC. This means that Annaly takes no risk that the originator of the mortgage will not be able to pay the interest and principle of the mortgage.

Annaly feels that the current “problems” at FNM do not affect its business:

62% of the MSB consist of adjustable rate pass through certificates
29% are fixed rates, pass through
9% are collateralized mortgage obligatons (CMO) floaters

Pass through means that the principle and interest payments are passed onto Annaly from the mortgager through the selling agency. Adjustable rate means that as interest rates fluctuate, so shall the interest rates on the mortgage. Fixed rate mean that the rate will not fluctuate. As interest rates go down, a fixed rate will become more valuable and can be sold. CMO is debt backed by mortgages.

The current spread: the weighted average yield of investments was 3.4% and the weighted average yield of borrowing was 2.46% (for 2004).

How the spread is affected: rate adjustment are frequent. There is a lag between borrowing rates and investment rates - the average borrowing rate is adjusted every 11 DAYS and the investment rate every 24 MONTHS. This is a potential problem spot when interest rates go up.

How it makes money: revenues streams are generated by the spread between investing and borrowing money, from selling assets when market conditions are favorable (that is, selling fixed interest assets when interest rates have gone down) and from FIDAC (although this revenue stream is limited by law).

The company discussed potential effect of changes in the prime interest rate.

The company has not engaged in any formal hedging to date, although the 10-K does not preclude this practice to protect against variations in interest rates (interest rate swaps). They pledge not to use hedging as a speculative tool. The company does perform some practical hedging by trying to have some adjustable rate mortgages (aligning investment and borrowing), diversified revenue stream with FIDAC and only investing in areas in which they believe that they understand well. Annaly makes a point that the lack of off-balance sheet derivatives gives them a transparent statement.

Here are their views on derivatives:

In addition, their current income is during a time of high refinancing rates, which causes pre-payment and loss of income to Annaly. The current constant prepayment ratio (CPR) has decreased from 42% last year to 27% 2004. If rates were to go up, this refinancing would drop and losses would therefore decline in this area. They also try to buy securities that will provide a profit over a large range of interest rates.

Annaly has a certain required capital base with two major components - first, they must maintain a current aggregate over collateralization amount (HAIRCUT) for their current MBS. That amount is determined by lender based on the risk and liquidity of the MBS, with FNM/GNM being 3% and certain private issuer ranging as high as 20%. The current average weighted haircut level is 3.95%. In addition, Annaly also maintains an excess capital cushion that is self imposed in case the actual value of the MBS declines. This excess capital cushion is determined by Annaly managers for each MBS AND THUS IS A KEY QUALITATIVE MEASUREMENT of Annaly managment.

Annaly liquidity is determined by ability to turn non cash assets into cash: thus, liquidity is determined by cash on hand and unused borrowing capacity.

Annaly increased equity by issuing common stock in 2004. On 1/20/2004, the company sold 20,700,000 shares and raised $363 million. In 3/1/2004 4.2 million preferred shares raised $103 million then in 10/2004 sold another 3.1 million shares preferred shares for $74.5 million. They also issued 2.2 milion shares to FIDAC shareholders at value of $18.40, the 12/31/2003 closing price. Finally, 2 million shares were issued through the Equity Shelf Program netting $37 million and 57K options were exercised and 127,000 shares were purchased through the DRIP for 2.3 million. There was an increase in the number of shares from 2003 to 2004 of 25,188,904 raising $476 million in equity. At a debt to equity ratio of 10:1 this increased equity thus enables the company to borrow almost 5 billion dollars more and the potential for generating 30% or so more net income in net interest income.

Annaly is trying to achieve cost efficiencies through a facility sharing agreement with FIDAC. They will also seek to lower their effective borrowing rate by seeking direct funding from collateralized lenders and may try to use commercial paper and medium note programs.

Some accounting notes: Annaly pays a premium to acquire investments with a higher interest rate return. The premium is amortized over the life of the MBS. Fully 98% of Annaly's MBS were bought at a premium. However, Annaly must calculate its equity at mark-to-market and therefore equity is subject to variation in interest rates.

discussion of leverage: Annaly uses a lot of leverage. Typically, debt to equity is in the range of 8 to 12:1 - which only makes sense since the company makes money from the gap between borrowing and lending. They note that if interest rates change or the value of their MBS' decline, margins may be called and they may be forced to sell MBS' in an unfavorable market (in other words, at a loss). The company has an excellent page on discussing leverage on their website.

executive compensation: Farrell is paid $2.4 million per year and gets 5 paid weeks of vacation a year. The Board can increase but not decrease his salary. He is also eligible for a bonus of 0.25% of the book value of the company at the end of the year. His severance package is worth over $6 million (nice parachute). The other executive have similar packages going down to $300,000 a year.

stock options - as of 3/1/2005 there were 121,272,323 shares issued. The company may grant its executives stock options numbering up to the higher of 500,000 shares or 9.5% of the total numbers of shares outstanding. They currently have issued 1,645,721 shares at a weighted average of $15.66 and there are therefore 9,874,264 shares potentially up for options.

This is too many, but with perhaps not the same implications as a non-REIT company - given that the company pays ot most of its taxable income every year, the potential for the stock price rise much higher is limited - the potential for growth is not zero but is much more attenuated compared to a company that can retain income.

FIDAC: merger was completed at the close of business June 4, 2004 and the consolidated cash flows and and operations sheets reflects this closing date. Former FIDAC shareholders may receive up to $50 million of NLY stock from 2005-2007 if FIDAC attains certain peformance targets.

The total cost of the FIDAC purchase cannot be calculated until the final stock shares are issued for performance in 2007. However, up this point, I calculate that FIDAC cost $2.2 million X 18.40 = $40.5 million plus up to $8 million in addidtional admin costs (does not look to me like FIDAC meger costs were broken out but please correct if I am wrong) for $48 million and has returned $12.5 million in 6 months for a run rate for $24 million. The NAV was $42.8 million of which $15 million was customer relations and $22 million was “goodwill”. Customer relations are calculated to have an indefinite life and are not amortized while goodwill shall be. So FIDAC should pay for itself over 3-4 years, neglecting continued increased admin costs minus supposed economies of scale and the effect of performance offsetting issuance of up to $50 million of new shares.

The Numbers
key pages for discussion of numbers in the 10K are 34 to 46 (of the pdf coresponding to pp28-39 of the 10-K) and then the F supplement.
Year     Net income/share         Total                        ROE
2004 $2.04 $248.6 million 16%
2003 $1.95 $180 million 16%
2002 $2.68 $219 million 22%

The company paid out $1.98 per common share in 2004 as compared to $1.95 in 2003 and $2.67 in 2002.

The rise in net income reflects an increasing asset base and positive interest spread plus the addition of $12.5 million from FIDAC fees after the merger in 6/2004 . FIDAC charges 10-15 basis points of gross AUM with AUM (gross) being about $15 billion generating net fees of $9.7 million. The FIDAC meger also increased administrative fees for 2004. The ROE reflects the difference in the spread in 2002 that was 2.12%, 2003 at 1.23% and in 2004 1.51% balanced against increased income from FIDAC, increased admin expenses from the FIDAC merger.

The interest spread went from 1.23% in 2003 to 1.51% in 2004. There was a decrease in income generated by the sale of MBS (these would be MBS sold when interest rates went down) from $40.9 million in 2003 to $5.2 million in 2004.

The largest expense by far is the cost of borrowed funds. In 2004 this was $270 million compared to interest income that was $532 million. In 2004 the average weighted value of borrowed funds was $15 billion.

Some other Fool ratios and numbers (not sure if these are worthwhile for a mREIT, happy to hear opinions)

enterprise value - supposed to be calculated as market cap + long term debt - cash (what would it cost to buy the company). Given the structure of an mREIT which is all about debt, I used 121 million shares x $18.3 for market cap then added total liabilities of 17.86 billion and subtracted 19.56 b assets for $540 million EV. (reference page F-2)

free cash flow - I'm not sure how to calculate this with a financial company. The formula is cash from operations minus cap ex. The former is $416 million and the latter doesn't seem to exist on the cash flow (F-5).

ROA = 1.2%. 2004 1.3% 2003

ROE was given by the company as 16.04% but I get a different number for 2004 of $248 m/1,700 million = 14.6% (net income from F-12 and equity from F-2). Reasons for the difference?

ROIC (return on invested capital): in my limited reading on ROIC (mosty by Dale Wettlaufer in 2001 at TMF) seems to make distinctions between ROIC and ROE that are tough to apply to a financial services company. Is there any important distinction?

EV/FCF = $540 m/$416 m = 1.3 and FCF/EV of 0.77. Can this be correct? With the extreme amount of debt taken on by a highly leveraged company, do these ratios have meaning?

research on the Fool can be found on the REIT board - type in NLY, Annaly and mREIT into the search tool.

Annaly does have a DRIP

There are no legal procedings of note against Annaly.

Annaly notes that the decrease in dividend payout taxes has decreased the advantage REIT's have over C corporations.

Summary: Even Smith-Barney, who downgraded Annaly recently causing a 6% drop in stock price (welcome by those of us on a DRIP plan) state that Annaly is one of the most well run REIT's. The question is whether or not interest rate changes will affect Annaly's ability to generate profits. Profits are not straight line attached to interest rates as outlined above due to alignment of borrowing and investing, changes in CPR and changes in equity leading to higher assets and thus higher volume of MBS transactions.

Annaly is stuck in their ability to generate more capital due to REIT payout requirements. Hopefully FIDAC will be able to feed equity into Annaly's borrowing system - Annaly will undoubtably try to bring FIDAC to just under the REIT limits. Otherwise, since they are required to pay out virtually all of their income as distributions, I don't see much alternative to raising equity beyond selling more stock.

Share dilution is not usually desireable, but if a dollar of equity can be leveraged into $10 with a ROE of 15% = $11.50, there is money to be made. The run rate for the $363 million raised in 2004 through offerings thus comes out to $54 million in income at ROE of 15%. While shares are diluted 25% (from 96 m to 120 m) income appears to gain. I tried to isolate the effect of the added equity and shares by taking the 2003 equity and shares of 1,149 million and 96 million, respectively with a ROE of 15% and got $1.79 per share, then added only the $363 to the 2003 equity for 1,512 million equity and did ROE of 15% divided by 120 milion shares to get $1.89 per share.

Ultimately, much depends on the quality of Annaly's managment to properly assess risk and reward for their MBS purchase decisions. I would think that the REIT requirements of payout will provide a hard floor for the stock price. In fact, if earnings drop this year due to a decrease in the interest rate gap, I for one look to buy as much as I can, anticipating there is a strong chance that the future will bring more favorable conditions to this well run company.

I appreciate any comments and constructive criticism.

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