Annaly Capital's Q3 Valuation and Risk Profile: Assessing Discounted Equity and Income Stability Amid Rising Rates

The investment case for Annaly Capital Management (NLY) in a rising rate environment hinges on two critical questions: Is its equity valuation meaningfully discounted relative to fundamentals, and can its income generation withstand the volatility of interest rate-sensitive markets? The third-quarter 2023 results, while mixed, offer a nuanced picture of a company navigating a challenging macroeconomic landscape with a blend of caution and strategic adaptability.

A Tale of Two Metrics: Core Earnings vs. GAAP Net Income

Annaly reported a core earnings per share (EPS) of $0.73 for Q3 2023, narrowly exceeding the consensus forecast of $0.72. This figure, however, masks a GAAP net income loss of $1.21 per average common share, driven by non-cash adjustments such as mark-to-market losses on its mortgage-backed securities (MBS) portfolio and premium amortization. The divergence underscores the limitations of GAAP in capturing the economic reality of a REIT whose value is heavily tied to interest rate dynamics. While core EPS provides a clearer view of operational performance, the GAAP loss highlights the fragility of book value in a high-yield, low-spread environment.

Valuation at a Discount: Graham's Lens

According to a recent analysis, Annaly's stock trades at a 39% discount to its estimated Graham number-a metric derived from book value per share ($19.25) and forward EPS projections. The Graham number, calculated as the square root of (22.5 × book value × 12-month forward earnings), suggests a potential fair value of approximately $35.44, compared to the current share price. This discount is further reinforced by a market P/E ratio of 7.41x, which falls below the estimated Graham P/E of 8.5x, implying a 13% undervaluation. Such metrics are compelling, but they must be weighed against the risks of book value erosion from widening MBS spreads and equity dilution-a persistent threat for leveraged REITs.

Interest Rate Risk: A Delicate Balancing Act

Annaly's management, led by CEO David Finkelstein, has adopted a conservative posture in response to rising global yields and volatile fixed income markets. The company increased its hedge ratio from 105% to 115% during the quarter by adding longer-dated hedges, while extending the weighted average days to maturity for repurchase agreements to 52 days. These adjustments reflect a strategic effort to align duration mismatches and mitigate the impact of rate hikes.

However, the economic leverage ratio climbed to 6.4x from 5.8x in the prior quarter, and GAAP leverage reached 7.1x. While leverage is a tool for amplifying returns, it also magnifies losses in a rising rate environment-a duality that investors must scrutinize.

Forward-Looking Outlook: Modest Growth Amid Uncertainty

Consensus estimates project a slight decline in EPS for Q4 2023, followed by flat performance in 2024 and 2025, with full-year 2025 EPS expected at $2.90 and a modest uptick to $2.96 in 2026. These projections, while cautious, suggest a floor for income stability, particularly as Annaly's Residential Credit and Mortgage Servicing Rights (MSR) businesses show resilience. The former benefited from strong whole loan correspondent channel performance, while the latter capitalized on rising yields and stable cash flows. Yet, the path to earnings normalization remains contingent on the Federal Reserve's policy trajectory and the technical health of the MBS market.

Risks and Resilience

The primary risks to Annaly's valuation and income stability are twofold. First, book value erosion from MBS spreads, which have widened in response to rate volatility, could persistently depress equity valuations. Second, equity dilution-whether through share issuance to fund leverage or to meet dividend obligations-threatens to erode shareholder value over time. While management's dynamic hedging and liquidity management provide a buffer, these strategies cannot fully insulate the company from macroeconomic headwinds.

Conclusion

Annaly Capital's Q3 results reveal a company at a crossroads. Its discounted valuation, as measured by Graham's metrics, is attractive, but the sustainability of its income stream depends on its ability to navigate a fragile interest rate environment. For investors with a medium-term horizon and a tolerance for volatility, Annaly offers a compelling case of value investing-if the risks of book value erosion and leverage are carefully managed. The coming quarters will test whether its strategic adjustments translate into a durable recovery or merely delay an inevitable reckoning.