CapitalSource Can't Cover Its Dividend

Analysts may have hinted at it last week during CapitalSource's (CSE) fourth-quarter earnings call, but yesterday the truth was confirmed -- CapitalSource is not covering its dividend with taxable income.

After the bell Monday, CapitalSource put out a short press release announcing that the tax characteristics of its 2007 dividends were available on the Company's website. Those who've read my blog know that I track tax characteristics as a measure of a mortgage REIT's dividend health.

Despite CSE management playing up the $0.60/share quarterly dividend in its last earnings release:

Given the strength and performance of our business and, in particular, credit metrics that remain at the low end of historical ranges, we declared a $0.60 per share cash dividend for the first quarter of 2008 yesterday and we are projecting a $0.60 per share quarterly cash dividend for the balance of 2008...

The truth is that two-thirds of CapitalSource's 2007 dividends were classified as a return of capital. That's right, fully $1.60/share of the $2.38 in '07 dividends amounted to CSE shareholders being handed back their original investment. Thus, if you were invested in CapitalSource at the beginning of 2007, and you sold CapitalSource shares in December to harvest tax losses, well, your capital loss just got cut by $1.60/share.

In other words, CSE can't generate enough taxable income to maximize the advantages of being a REIT. Instead of owning up to this and retaining the excess capital tax-free, CSE chose to keep pumping out dividends and diluting existing shareholders through its DRIP and direct stock purchase plan -- during one of the worst credit crises in recent history. If nothing else, CapitalSource could have retained the capital and repurchased common shares as a better means of supporting shareholder value.

By their very nature, REITs maximize their value when they can fully utilize their tax-advantaged structure. CapitalSource, meanwhile, reported an effective tax rate of 33.2% for 2007. Being a mortgage REIT is not just about paying a dividend. It's about utilizing a complex structure to deliver returns on shareholder equity.

Disclosure: none

Comments

[jakw]

Given the record (I've been an investor and manager of client portfolios for more than 50 years) and the lousy history of accountants, analysts and economists who feed the press and talking heads I would recomend Mr Harden join the real world by holding his hypothetical guess about companies in the deep, dark closet of other failed pharohs. The unholy predictions before EVERY quarter are followed by the classic one liner ... "analysts were surprised" ... and ... the even more simplistic stupidity ... "XYZ missed their quarter which analysts predicted to be xxx". How come the analysts, accountants, and economists don't get burned at the stake? Did CSE tell us how the dividend would be paid? YES. Did CSE tell us how the year 08 looked from their business point of view? Yes. If these writers of no accomplishment want a panel in the Hall of Fame, they might try working in the real world for a few years before peddling amateurish crapola.

[reader]

Dear User,

By your comments are you saying that CSE is still a stock that I may want to hold onto?

[Maybe4Less]

In answer to reader's question, I the answer is yes.

To be fair, CSE is classified as a mortgage REIT, but that is not the nuts and bolts of the operation. Most of their business is making loans to mid-sized companies.

At some point (I think a few years ago), they bought a few mortgages and had themselves classified as a REIT in an attempt to obtain tax-exempt status. Clearly this is not working so well as much of their dividends were actually returns of capital and their effective tax rate was over 30%, but that does not mean their business is not doing well. Their loan business seems to be doing fine and whether or not those distributions are dividends or returns of capital is irrelevant to me. I just love the current monster yield.

In short, the title is disingenuous, as CSE CAN cover the dividend, they just can't do it from tax-exempt income.

[Patrick1980SC]

I appreciate the spirited commentary about my article. This article was a follow-up to my recent article suggesting that CapitalSource might realize more efficiencies if it split its businesses. I believe that the tax treatment of CSE's dividends confirms that the nature of the company's business may not be best suited to the REIT structure. CapitalSource has executed well from an operational standpoint, but could unlock value by restructuring as a separate healthcare net lease REIT and a BDC that makes corporate loans. That's where CSE's competitive advantages lie.

[long cse]

I agree with user's comments that the title is disingenious, at best, if not downright misleading. These are the kind of titles that, unfortunately, we have to put up with from Seeking Alpha. Another writer blamed the title choice on the editors, so shame on them for going for shock and awe in an industry that should be relying on and reporting on hard facts. The fact is that CSE is covering it's dividend, which is something that most of it's counterparts in the financial industry (see Citi, WaMu, etc.) have not been able to do. Cutting its dividend would have spelled disaster for existing shareholders, so CSE mgmt did the wise thing by keeping status quo. They are confident that CSE will return to its old form and produce earnings in excess of its dividend within 6-12 months. With a dividend around 15% why wouldn't you buy this stock now, knowing the dividend is secure, and watch the stock price rise as conditions in the financial sector improve in 2008 and beyond?

[blackrock]

Have been a holder of CSE stock for the better part of a year and have not seen or heard anything that would make me think that I wont be this time next year

[deefree]

It's very similar to a closed end fund trading at a discount to NAV. If you buy now, you are getting the original shareholder's money handed to you at a discount. They just filed their 10-K so will take a look.

[maker]

Harden, appreciate your follow-up. Good points. I'm long and confident, and considerations as to how to improve shareholder value are always welcome.

[nbr3bagshotrow]

Is anyone a buyer of CSE at these prices?

[skrummydummy]

Yep, I just bot cse today. Hoppin to impruve me luck after buyin BSC las week.

Skrummy

[Richard G.]

CSE appears to be tarred with the same brush as many of the financials. As for the analysts and their projections, that process is so much hogwash. The problem is that people listen to these "seers" and regard the comments as gospel. Let the stock drop earnings by a penny a share and its "Chicken Little" time. With CSE, I will trust their management and enjoy the $0.60 per share dividend each quarter. If it is return of capital, the tax advantage is mine

[Gat]

I know this is not news, just facts re 2005. So what effect can losses from defaults have one the firm's cash flow in 2008 on assuming borrowers are stressed on loan re-pricing? Now that interest rate levels have been somewhat reduced, it may be less of a concern? This fact saet beow is what I see as factual that concerns investors in CSE, otherwise it appears to be the broad brush affecting them...?


CSE:
"As part of its efforts to qualify as a REIT, the company purchased $2.3 billion in residential mortgage-backed securities during
the fourth quarter 2005. It also purchased an additional
$1.1 billion in residential mortgage-backed securities and
purchased apx. $2.5 billion in residential prime whole
loans. As of Dec. 31, 2005, all the residential mortgage
investments were in hybrid adjustable-rate mortgage
securities with underlying mortgage loans that were
originated as 3/1, 5/1 and 7/1 hybrid ARM loans."