Recommendation. Company Overview

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1 Ticker: NLY Sector: Mortgage REITs Industry: Finance Recommendation: BUY Pricing Closing Price $ wk High $ wk Low $13.39 Market Data Market Cap $9.47B Shares Out. 553M Avg Volume 10.5M Valuation EPS $3.51 P/E 4.88 Div Yield 15.19% Beta.42 Profitability & Effectiveness ROA 3.09% ROE 23.22% Operating Margin 93.8% Net Profit Margin 92.17% By: Taylor Fox Recommendation There are numerous positive and negative factors regarding an investment in this security. My recommendation is a: Buy The attractive dividend along with our tax advantage obviously presents an opportunity. As the economy continues to improve, the risk of default on mortgage interest payments decreases and banks will be more willing to lend to companies like Annaly Capital Management. I simply don t see enough downside risk to discount the value of the dividend. They generate a lot of cash and they had their most profitable year by a considerable margin in Company Overview Annaly Capital Management, Inc. (Annaly) owns, manages and finances a portfolio of real estate related investment securities, including mortgage pass-through certificates, collateralized mortgage obligations (CMOs), agency callable debentures, and other securities representing interests in the obligations backed by pools of mortgage loans. The Company s wholly owned subsidiaries offer real estate, asset management and other financial services. Fixed Income Discount Advisory Company (FIDAC) and Merganser Capital Management, Inc. (Merganser) manage a number of investment vehicles and separate accounts for which they earn fee income. The Company s subsidiary, RCap Securities Inc. (RCap) operates as a broker-dealer. At December 31, 2009, approximately 21% of the investment securities were adjustable-rate passthrough certificates. At December 31, 2009, approximately 74% of the investment securities were fixed-

2 rate, pass-through certificates or CMOs, and approximately 5% of the investment securities were CMO floaters. The adjustable-rate, pass-through certificates are backed by adjustable-rate mortgage loans and have coupon rates, which adjust over time, subject to interest rate caps and lag periods, in conjunction with changes in short-term interest rates. The fixed-rate, pass-through certificates are backed by fixed-rate mortgage loans and have coupon rates which do not adjust over time. Under their capital investment policy, at least 75% of total assets must be comprised of high-quality mortgage-backed securities and short-term investments. High quality securities means securities that (1) are rated within one of the two highest rating categories by at least one of the nationally recognized rating agencies, (2) are unrated but are guaranteed by the United States government or an agency of the United States government, or (3) are unrated but they determine them to be of comparable quality to rated high-quality mortgage-backed securities. The remainder of their assets, comprising not more than 25% of total assets, may consist of other qualified REIT real estate assets which are unrated or rated less than high quality, but which are at least investment grade (rated BBB or better by Standard & Poor s In Lehmans terms, they make money from the difference between the interest income on our investment securities and borrowing costs of our repurchase agreements and from dividends we receive from our subsidiaries Annaly Capital made $350 million off interest rate swaps whereas in 2008 they lost 750 million. They cut their repurchase agreement interest expense by $600 million. All of this translates into after tax earnings of $1.9 billion as opposed to $325 million in Cheers to that. Dividend At over 15% yield, the dividend for Annaly looks very attractive. It is funded by the significant amount of cash they generate from their interest producing assets. An article recently came out cautioning investors about this specific dividend. Fannie Mae and Freddie Mac have been buying assets aggressively and calling some of Annaly s bonds, reducing their return. They now must buy new assets but the yield will not be as high. The remedy to this problem is more leverage. However, this advice also states that most of these problems will resolve themselves after June and recommends waiting until then.

3 Threats Tight Credit Market: They rely on short term debt and make their money on the spread between the interest rates. If banks aren t willing to loan, they can t make money. However, I feel the worst is behind them and they have done ok through the recession. Strategy involves a lot of leverage: When things are going well, they have great returns but if assets begin defaulting or they get on the wrong side of the interest rate spread, their losses are magnified as well. Interest Rate increase: As I have said, they make money on the spread from their investment and borrowings. However, most of their investment securities are adjustable rate. Increase in the number of prepayments: They lose the potential earnings from interest if people begin prepaying. I am having a tough time deciding which will happen as the economy picks up. Prepayment rates generally increase when interest rates fall and decrease when interest rates rise and that is what we forecast will happen. However, people will also have spending money for the first time in a few years and will be more cautious about their mortgages after this recession. Fannie Mae and Freddie Mac o They could be negatively affected in a number of ways depending on the manner in which related events unfold for Fannie Mae and Freddie Mac. Annaly relies on their Mortgage-Backed Securities as collateral for our financings under their repurchase agreements. Any decline in their value, or perceived market uncertainty about their value, would make it more difficult for them to obtain financing on acceptable terms or at all, or to maintain our compliance with the terms of any financing transactions. Further, the current credit support provided by the Treasury to Fannie Mae and Freddie Mac, and any additional credit support it may provide in the future, could have the effect of lowering the interest rates they expect to receive from Mortgage-Backed Securities, thereby tightening the spread between the interest they earn on our Mortgage-Backed Securities and the cost of financing those assets. A reduction in the supply of Mortgage-Backed Securities could also negatively affect the pricing of Mortgage-Backed Securities by reducing the spread between the interest they earn on our portfolio of Mortgage-Backed Securities and their cost of financing that portfolio.

4 Competition There is a significant amount of competition in this industry primarily from: Institutional Investors Banks Mutual and pension funds Mortgage REITs As far as focusing specifically on Mortgage REITs, you can see below they are the market leader by far. This sector enjoys very high dividend yields and Annaly is on par with the field. They compare most with ANH and MFA with respect to size and nature of business. Annaly enjoys higher margins and ROE than both of these similar competitors.

5 Chart Comparing Annaly with ANG and the S&P 500 over the past year: 5-Year Stock Price Chart 1-Year Stock Price Chart

6 Valuation Analysts: Mean Target Price: $19.13 High: $23 Low: $15.75 The last three upgrades/downgrades however, have all been downgrades. Three times in March 2010, 3 research firms changed their recommendation from Buy to neutral. Earnings Surprises: All positive surprises in 2009.

7 Personal Valuation: Below is the Discounted Cash flow model I used. However, there are a couple major assumptions I made that render the valuation almost irrelevant. In this model, I claim net income was $450 Million. This is similar to the 2008 and 2007 numbers, but in 2009 they earned $1.94 billion. Changing the net income number to this yields an intrinsic value of over $88 per share. Further, the growth rates are a complete guess. Revenue was actually down this year but due to favorable interest rates, net income was off the charts. I really feel this valuation is essentially worthless and should not be used as a basis for any decisions.

8 Income Statement

9 Balance Sheet

10 Statement of Cashflows