3 Things to Watch When Annaly Capital Management, Inc. Reports Earnings

By Markets Fool.com

Annaly Capital Management is set to report fourth quarter and full-year results on Tuesday, and for investors who want to stay on top of the company's health there is no better way than analyzing quarterly results.

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However, because of Annaly's unique business model, reviewing the company's earnings can feel like your deciphering the Rosetta stone. So, to make this earnings season a little less painful, here are three things to watch for when Annaly reports.

3. One way to judge earnings
While net income is normally the go-to metric for earnings, it does not include unrealized gains and losses on securities. Because Annaly is an investment company, these gains and losses can be substantial. This is why comprehensive income is often a more useful metric.

For example, nine months into 2013 Annaly and had generated $2.7 billion in net income. Which sounds great, until you learn that Annaly took $4.1 billion worth of unrealized losses on their chief asset class, mortgage-backed securities. Although these losses are unrealized, they have a very real impact on Annaly's book value, and since the company's stock price is impacted by its book value, investors took serious losses in 2013.

Cut to the first nine months of 2014, and the story was been the exact opposite. Annaly's net income was negative, but because of improved unrealized gains, its comprehensive income was strong. This contributed to modest book value growth and a slightly improved stock performance.

In my opinion, this trend is likely to have continued in the fourth quarter. Looking toward fourth-quarter results, interest rates fell considerably. Because Annaly's assets appreciate in value when interest rates fall, Annaly should have taken unrealized gains during the quarter.

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In fact, American Capital Agency, which has a similar business model and asset base, released earnings earlier this month and took unrealized gains on securities of $599 million for the fourth quarter. This helped lift the company's comprehensive income, and they posted a 0.8% gain in book value. With this in mind, my guess is that Annaly will have similar numbers with modest book value growth.

2. Another way to judge earnings
After you get the big picture, you will want to zoom in on so-called "core earnings." Although this metric is calculated differently from mortgage REIT to mortgage REIT, it is normally how companies justify their current dividend.

For Annaly, they take their quarterly net income and throw out all nonrecurring gains and expenses. So, for instance, something like the sale of assets may make them money during the quarter, but since they won't sell assets every quarter, they exclude that number from their calculation of core earnings.

After all the adjustments are made, you should end up with a number in the same range as their current dividend, which is $0.30 per quarter and $1.20 for the year. Core earnings above those numbers would be fantastic, while a figure below that could be a sign that a dividend cut may be on the way.

3. Debt ratios
The last thing I will be looking for is how much risk Annaly is taking. To determine this, I generally look at two specific metrics. The first is the debt-to-equity ratio, or leverage, and the second is the capital ratio.

Both metrics are better understood if we think in terms of a mortgage on a house. For instance, if you buy a house for $100,000 and take out a $90,000 mortgage, you have a debt-to-equity ratio of nine -- $9 of debt for every $1 of equity.

Since you are investing in the house using borrowed funds, much like Annaly does with securities, if the house gains or losses value your return is much greater or worse than if you owned the house outright. Moreover, the greater your leverage the more dramatic the gains and losses will be.

Now, for simplicity, imagine the house is your only asset. Divide equity by total assets and you get the capital ratio, which in this case would be 10% -- $10,000 in equity and $100,000 in assets. Unlike leverage, where a lower number denotes safety, the capital ratio is the opposite; the higher it is the safer it is.

During the third quarter Annaly had a debt-to-equity ratio of 5.4 and a capital ratio of 15%. Considering that Annaly invests in safe securities that are protected against default, this is a modest amount of risk. However, Annaly has the ability to ramp up their debt quickly so investors should look out for any dramatic changes. Although, based on what management has suggested in recent conference calls, I do not believe there will be.

The article 3 Things to Watch When Annaly Capital Management, Inc. Reports Earnings originally appeared on Fool.com.

Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool recommends Apple and Bank of America. The Motley Fool owns shares of Apple and Bank of America. 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.