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About one year ago, I took a look at CapitalSource (CSE), and have since bought shares. At the time, I was drawn to their dividend yield and wanted to make sure that the assets of the company were stable enough for investment. A lot has happened since then in both the broader economy and at the company.


In the past year, CapitalSource has bought a bank, withdrawn its REIT status, and sold its residential loan portfolio. The transition underway coupled with the distrust of financial companies have driven CapitalSource shares to $1.40 and a market cap of $424 million. Yet the CapitalSource balance sheet shows $2.8 billion in total equity. With Capitalsource priced at 17% of book value, the question is whether or not this is a tremendous opportunity or a value trap.

During the company’s 4th quarter conference call, Chairman and CEO John Delaney offered his opinion:

We do believe there is significant value in our business, certainly more value than the market currently is giving us credit for…. When you add it all up, we have $916 million of equity in the bank, approximately $650 million of equity and related party debt in CS healthcare REIT. $910 million of equity in the securitizations, and $1.2 billion of equity in the parent company loans pledged to credit facilities. That is how we think about the value of the business.

CapitalSource is a complex company, and I’m certainly tempted to put them in the “too hard” category and move on to something more stable and easy. However, this company is just too tempting for me. I want to take a look at the four components of their business to determine a value for each and also make sure that there is no potential for permanent loss of capital. In other words, are there any components that can bring down the whole company? I am breaking this analysis in to four parts.

Part One: CapitalSource Bank

In July of 2008, CapitalSource acquired $5.2 billion in deposits, the “A-Participation Interest”, and 22 retail bank branches from Fremont Investment and loan. Thus CapitalSource Bank was born. Soon after, the bank purchased $2.2 billion of commercial loans from other CapitalSource subsidiaries. The founding of CapitalSource Bank was an important development for the company, as it provided a funding source for loans that are not dependent on the capital markets.

The “A-Participation Interest” is a new term for me. It is basically a participation interest in a loan where the holder receives 70% of the principal payments to effectively amortize the loan more rapidly. The lead lender for these participations is iStar Financial.

There is no separate balance sheet noted in the CapitalSource annual report. A combined balance sheet of nonguarantor assets seems to combine the Bank and the Health Care Reit. John Delaney noted in the conference call that the Bank had $6 billion in assets at year-end with $1.9 billion in cash and marketable securities and $2.7 billion in loans. A-Participation interest is also noted in the conference call, and the combined balance sheet notes $1.4 billion here. That combination rounds out the $6 billion in assets.

A drill-down on the loans and participation interests is problematic as the commercial loans are co-mingled with parent company loans for reporting purposes. Delaney, however, notes that the portfolio is clean with no non-accruals or delinquencies at year-end. That said, he also notes that this portfolio of loans comprises a good portion of their reserves.

On the liability side, CapitalSource Bank has $5 billion in deposits. Again, this is a great source of funding. Delaney notes that twice this amount in deposits can be supported without adding a single branch. Equity in the bank totals approximately $916 million.

Now is a good time for healthy banks, rare as they are. Because there are so few banks lending, healthier banks have less competition and can get more favorable terms. CapitalSource does not break out income separately. Interest income of $490 million is offset by $218 million in interest expenses in their non-guarantor subsidiaries. This seems to be a bit high. More traditional banking returns would be 1.0% return on assets or 15% return on equity. This would result in $60 million and $137 million respectively. A third way to estimate income from CapitalSource Bank is to assume a 3.0% spread on loans, resulting in $81 million in net income. Based on this range of net income, I would think $80 million is a conservative estimate of net interest income from CapitalSource Bank.

Bank Valuation

I’ve already covered the estimated book value of CapitalSource Bank at approximately $916 million. However, assuming a price-to-earnings ratio of 15x applied to net income of $80 million would place the value of the bank at $1.2 billion. All of this, of course assumes that the portfolio is clean and that there won’t be significant defaults. Still, a book value of the bank alone at $916 million relative to market capitalization for the whole of CapitalSource at $424 million indicates that the market is pricing in some serious problems within the other three parts of the company.

Recap: CapitalSource has a current market capitalization of under $500 million, yet CapitalSource Bank has a book value of $910 million. At year-end there were no delinquencies or non-accruals in the bank’s portfolio, though it had a good portion of CapitalSource’s reserves based mostly on their macro view of the economy. The bank appears to be worth every bit of its book value.

Real Estate Portfolio

Another source of value for CapitalSource is its Healthcare REIT. The healthcare portfolio consists of 180 nursing homes located across the United States. Each of these facilities is leased triple-net leased on a long-term basis. Total investments in this portfolio totaled $990 million at year-end. Mortgage debt on the portfolio was $330 million. Total equity in this portfolio is approximately $650 million.

The Healthcare Net Lease Portfolio produced $15 million in net income in 2008. This doesn’t tell the whole story. Depreciation expenses in direct real estate investments totaled $35 million. This results in an implied funds from operations of $50 million. Net operating income for the portfolio looks to be about $96 million. At an 8.5% capitalization rate, the value of these properties is $1.1 billion. The market value of this portfolio may be over $100 million over gross book value.

Recap: Stepping through the confusion that is CapitalSource, we have CapitalSource Bank that is worth at least book value of $916 million plus a Healthcare Net Lease Portfolio also worth at least $650 million. All this for a company with a market value of less than $500 million.

I’ve estimated income from CapitalSource Bank at about $80 million. Couple this with $50 million from the REIT and the company is priced at 4x cash flow with two more components to look at.

Both of these subsidiaries, however, are fairly well insulated. The Bank needs its own capital for regulatory purposes. Earnings will be retained within the Bank and not passed through to the parent. Cash flow could pass from the Health Care Portfolio, but CapitalSource continues to look for opportunities to spin-off this portfolio and realize its market value. At this point, holding the real estate is the prudent move for shareholders.

Securitization residuals

Now I’m taking a look at CapitalSource’s interest in six separate securitizations. These bonds were issued between 2004 and 2007, and CapitalSource retained all classes subordinate to triple-As. Because of the amount of these securities retained, CapitalSource believes that they are the primary beneficiary of each issue and therefore record all the individual trusts assets and liabilities on their own balance sheet.

This couldn’t be more confusing. The liabilities of the individual trusts are not the responsibility of CapitalSource. However, CapitalSource has purchased over $162 million in loans that experienced a credit event from these trusts. This was done, presumably, to maintain the credit quality of the trusts, but in effect seems like a liability if these purchases are more or less required.

In effect $4.6 billion in loan assets on CapitalSource’s balance sheet are offset by $3.6 billion in debt within these trusts. CapitalSource estimates about $900 million in equity in these residuals.

Like many securitizations, the credit quality and repayment rate are difficult to determine. In determining a valuation, I would be skeptical of ascribing significant value or income from these residuals. Given the repurchases of problem loans in the past from these trusts, I do not want to view them as an asset or a liability in any valuation. If there is income available after the triple-As have been paid, I would consider that a nice benefit as a CapitalSource shareholder. This income and the equity in these residuals are effectively part of the margin of safety in a CapitalSource investment.

I’ve looked at CapitalSource Bank, CapitalSource’s Health Care Real Estate Portfolio, and CapitalSource’s equity in securitization residuals. The equity in each component of these businesses is $916 million, $650 million, and $910 million respectively. All of this for a company with a market capitalization of less than $500 million.

Commercial Portfolio

From a liability perspective, only the securitization residuals have required any capital. Despite the $4.6 billion in loan assets being match funded by approximately $3.6 billion in loans within six separate special purpose entities, CapitalSource has in the past purchased $162 million in problem loans from these trusts to preserve the credit quality of these issues. So the question remains, why is CapitalSource priced at such a small fraction of its book value?

Parent Commercial Loan Portfolio

In its annual report, CapitalSource notes that its commercial loan portfolio totals $9.5 billion. However, this includes commercial loans in both CapitalSource Bank and the securitization trusts that technically do not result in liabilities to CapitalSource. In their year-end earnings call, CapitalSource notes that $2.2 billion of this total are loans held at CapitalSource Bank, and $4.6 billion are loans held in securitizations, leaving about $2.6 billion held at the parent level. The conference call notes $2.3 billion.

Liabilities at the parent company level have to be calculated as well. The conference call transcript has the best summary of this information. The majority of the almost $7 billion in total debt outstanding is matched to various asset pools and is not recourse to CapitalSource. The syndicated credit facility totaling $972 million is the one exception. The syndicated facility is secured by $1.6 billion in loans.

The web of credit facilities and matched collateral is difficult to map out. In my opinion, this coupled with the covenant modifications on their syndicated facility provide the bulk of the reason behind the low price to book ratio. CapitalSource has $473 million in structured facilities secured by $950 million in commecial loans. These facilities are as follows:


Facility Capacity Balance Maturity
CS III $100MM $74MM 4/29/09
CS Europe $175MM $166MM 9/23/09
CS VII $285MM $177MM 3/31/10
CSE QRS I $250MM $16MM 4/24/10
CS VIII $40MM $40MM 7/19/10

There have been no announcements regarding the combining or refinance of these facilities, though they are not recourse to CapitalSource. Still, they are secured by $950 million in loans and CapitalSource remains at the mercy of their lenders to renew or extend these facilities. It would be nice to see an announcement soon regarding the credit facility maturing at the end of April.

The reliance on these facilities is a risk for CapitalSource. In addition to these facilities, CapitalSource has a syndicated credit facility totaling $995 million that is recourse to CapitalSource. This facility matures March 13, 2010 and has step-down provisions to $900MM by June 30, 2009 and $700MM by December 31, 2009. In December 2008, this syndicated facility had to be amended to provide more flexibility for charge-offs. As part of this amendment, the facility was collateralized, and the rate was increased. Then in the first quarter of this year, the syndicated (recourse) facility was again amended to avoid a default under the interest average covenant due to loss provisions.

These credit facilities all appear to be well-secured based on collateral margins, but they are secured by commercial loans. CapitalSource has traditionally tended to be further out on the risk spectrum to gain higher yields to offset their funding costs. Now, when CapitalSource needs loan repayment most to meet their own obligations, credit quality in their portfolio is the most strained.

CapitalSource Bank helped to offset some of the funding cost issues, but they still remain at the parent level. Now de-leveraging is very important to remove the risks of these facilities at a time when lending is constrained. CapitalSource must look to their more stable business units to help in the deleveraging process. CapitalSource Bank will likely retain all their earnings over the next 2-3 years. So liquidity will have to come from the real estate portfolio, securitization residuals, and the parent loan portfolio.

In their conference call, management noted that they had $265 million in liquidity at year-end, though this includes both cash and amounts available under their lines. Investors were told that CapitalSource has sufficient liquidity to meet their obligations, though management’s assumptions were not shared. Cash flow is difficult to break-out, especially considering the Bank will retain their earnings. In the fourth quarter, CapitalSource reported $145MM in net investment income before provisions for losses. Assuming one-third of this comes from CapitalSource Bank leaves about $100 million in quarterly cash flow to pay down their lines. Assuming the lines maturing 4/30/09 and 9/23/09 are renewed or extended, it looks like management’s assessment of liquidity is correct. Through 2009, $400 million in net investment income will allow CapitalSource to step down to their $700 million line balance by year-end.

Other Considerations

Liquidity is the primary focus for the company, or it should be. The syndicated facility has step down provisions requiring significant paydowns over the next year. So it was only somewhat surprising to see CapitalSource issue stock at $3.15 per share to raise about $61 million in liquidity. This, however, was followed by the board authorizing a $25 million buyback.

To construct the four components of CapitalSource was no easy task. The annual report for the company is 195 pages long, and appears to obfuscate rather than explain with any reasonable clarity. The commercial loan portfolio is often discussed as a whole rather than being divided between a bank, securitized pools, and collateral for various credit facilities. Hopefully management at CapitalSource can better clarify the holdings of the company and where the risks lie in the future.

Investors have certainly been waiting for positive news regarding the refinance or consolidation of CapitalSource’s structured facilities, but instead received word that their CFO, Thomas Fink, recently resigned. He is now being replaced by Donald Cole. There is certainly a lot of turmoil at this company, and this announcement does not exactly inspire confidence.

Conclusion

There is certainly a lot of potential upside to CapitalSource. The company has shareholder equity of $2.5 billion and a market cap under $500 million. There is a good deal of stability at CapitalSource Bank, a stable source of cash flow in their Health Care Net Lease Portfolio, and at least limits on liability in their securitization residuals.

All of this value is clouded by the debt and liquidity issues at the parent company level. The company has managed the transition in their business model fairly well by capturing deposits at CapitalSource Bank, but work still remains. More clarity and less drama are needed for shareholders at this point.

Based on these issues, I will likely proceed with caution regarding a CapitalSource investment. Debt at the parent company appears to be under control, though I’d like to see further deleveraging, fewer losses, and debt easily within covenants before making any significant purchases of their shares. That said, management has not inspired a long-term commitment based on their candor and recent turmoil within managment.

Disclosure: I currently hold shares of CapitalSource

Source: CapitalSource: Tremendous Opportunity or Value Trap?