Why I'm Still Holding on to CapitalSource

Jan. 6.10 | About: CapitalSource, Inc. (CSE)

I continue to hold CapitalSource (NYSE:CSE) because I believe it will recover very quickly as the economy improves. However, this is a company in transition, and with each news release it is as if the company is completely new. I’m often tempted to sell simply based on how complicated it is. My four part series took a close look at this company, and I thought it would be useful to take another look after its third quarter earnings and other recent announcements.

CapitalSource Bank

When all is said and done, this will be the business that remains. It will be the funding source for CapitalSource’s lending going forward. For the quarter, CapitalSource Bank reported a net loss of $15.1 million, largely due to increased provision expense of $48.5 million. These provisions should decline in the coming year, which will result in quarterly income of around $33 million. That’s $132 million annually, just from CapitalSource Bank. At 15x earnings, that’s a market cap of about $2 billion. As of this writing, the whole of CapitalSource has a market cap of $1.35 billion.

The bank remains well-capitalized with a total risk-based capital ratio of 16.75% and tier one leverage ratio of 12.52%. It is also important to note that the loan portfolio is still not equal to the level of deposits. As the loan portfolio grows, the company will be able to produce greater interest income.

Real Estate Portfolio

Since the end of the third quarter, CapitalSource has announced the sale of its commercial net leased portfolio. In my analysis, I had estimated a value of these assets at about $650 million above and beyond debt outstanding. CapitalSource indicated in its press release that it should receive proceeds of $495 million after closing costs. This is a case where confusion about this company may create value for those that dig deeper. Despite my estimate being short on the net lease portfolio, a healthy bank well exceeds my conservative estimate at book value. The liquidity generated by this sale greatly relieves liquidity concerns at the parent company.

Securitization Residuals

I had not counted on any value from these residuals in my analysis. CapitalSource did not break out a separate analysis of these residuals, but appears to have combined them within the “other commercial finance” portion of its earnings release.

Other Commercial Finance: Parent Company Assets

The dark cloud of the market primarily hangs over this segment of CapitalSource. As I noted above, liquidity levels should be much improved here with the sale of CSE's net leased portfolio. I also think there will be more clarity here once loan losses begin to subside.

On its Q309 conference call, the Company noted that the cash position at the parent company improved from $200 million to $300 million by the end of the quarter. This improvement came from a combination of an equity raise, loan payoffs, and a senior secured note offering. This position should improve even more given the $495 million it should receive from the sale of its real estate portfolio.

In its press release, CapitalSource notes that the “Other Commercial Finance” Segment had average loans of almost $6 billion, average assets of $8.4 billion, average interest earning assets of $7.3 billion, and average borrowings of $6.8 billion for average equity of $1.3 billion. Credit quality, again, is the main concern in this portfolio as the provision for loan losses totaled $173 million for the quarter following a $113 million provision in the second quarter.

The Company also notes on its conference call that the primary cause for these provisions are the result of commercial real estate loans, which total about 20% of CapitalSource's legacy portfolio. There are 75 commercial real estate loans in the bank's legacy portfolio that total about $1.6 billion. Of the 75 loans, 60 are first liens and 15 are second liens. Of the $120 million second liens, there are provisions for losses totaling 54% already. Land loans totaling $294 million have been marked down by 26%. The total commercial real estate portfolio has provisions totaling $370 million or 23% as of 9/30/09. CapitalSource anticipates additional provisions in the range of $33-$198 million. If provisions increase by $198 million, total provisions would be $568 million, or approximately 44% of its total commercial real estate portfolio.

Given the state of commercial real estate in this country, I would expect provisions to reach the upper limit of $200 million. I think this is a conservative view. If this occurs over the next two quarters, losses from this segment should total about $0.65 per share. If the bank is at break-even, I would expect book value to fall to around $6.96 per share. I think this is a decent short-term valuation for the company as a whole.

Valuation

Looking ahead 2-4 years, CapitalSource Bank’s valuation comes into play. The Bank is producing about $130 million in income before provisions. At 15x earnings, that’s about $2 billion. Add in proceeds from the net lease sale of $500 million, and the company is worth close to $2.5 billion assuming no residual value from the parent company portfolio or securitization residuals. At current shares outstanding, that equates to a value of about $8.00 per share. At a little less than double the current share price, it is certainly worth holding as I wait for this story to play out. If the economy stabilizes, provisions should decline and even reverse a bit over the next several quarters. This should provide additional clarity into CapitalSource’s true earnings potential.

Disclosure: I currently hold shares of CapitalSource

Dan Wieman previously on CapitalSource