Capital Source: Analysis and Valuation

I am venturing into the wreckage here, looking for the undamaged or slightly dinged. I’ve been down this road before. Drawn to its high yield, I was nibbling at Thornburg Mortgage (NYSE: TMA) last summer when the credit crisis was just beginning. After the first round of dilution to meet a margin call, I determined the yield was just not going to be there and sold. Lucky me, I only lost 50% on that “investment.”

More painful has been my investment in First Marblehead (NYSE: FMD), a company totally blindsided by the credit crisis. I have yet to introduce the portolio where these investments occurred, but trust me when I say that I approach my look at CapitalSource (NYSE: CSE) with great trepidation.

There is no need to take a close look at an intrinsic value for CapitalSource. The story is all about whether it can maintain anywhere close to the 20% plus dividend yield that it currently has. This analysis of CapitalSource will focus on the balance sheet and the credit quality of the company’s assets.

In 2007, CapitalSource reported “adjusted” earnings of $448.2 million and had an “adjusted” return on equity of 18.83%. The company indicates that it has several non-cash or unrealized items such as depreciation in its net lease portfolio, mark to market adjustments on interest rate hedges and residential mortgage assets. These non-cash expenses are removed, thus the company's adjusted numbers.

Residential Mortgage Investment

Alarm bells certainly go off reading about residential mortgage assets, and this is certainly one of three segments in which CapitalSource operates. However, CapitalSource indicates that it owns mortgage assets to facilitate and optimize its REIT status. The company has been willing to sacrifice return in pursuit of safety and security in both asset quality and liquidity in this business segment. Its residential mortgage portfolio is focused on owning Fannie Mae (FNM) and Freddie Mac (FRE) “Agency MBS.” These securities are whole pools of conforming mortgages that benefit from a full guaranty from Fannie Mae or Freddie Mac.

At the end of 2007, its residential mortgage portfolio totaled $6.1 billion with 99% of them guaranteed. The large majority of its $4.1 billion agency-backed mortgage securities were pledged as collateral for repurchase agreements used to finance the acquisition of these investments. The company also held $2 billion in mortgage related receivables that are backed by agency-backed residential mortgages.

These holdings have a good degree of leverage. Of the $6.1 billion in mortgage holdings at year-end, $3.9 billion was financed through repurchase agreements. These financings represent 64% of the total residential mortgage holdings. The $4.1 billion in agency backed loans are held at a rate of 5.07%. The remaining $2 billion in receivables earn a rate of 5.38%. The $3.9 billion in repurchase agreements require CapitalSource to pay a rate of 5.12%. Looking at this from an income perspective going forward, the $4.1 billion in income produced by loans is offset by the $3.9 billion in financings. The net interest income is produced by the $2 billion in remaining receivables at 5.38%.

In 2007, this segment reported a loss of $58.5 million, largely as a result of a $79.6 million loss attributable to net realized and unrealized losses on derivative instruments related to residential mortgage investments. The portfolio saw a decline in carrying value of 1.2% in 2007, though the percentage of receivables 90 days past due was only 0.72%, and the percentage of loans foreclosed was only 0.16%.

The repurchase agreements noted above do require CapitalSource to deposit additional collateral if the market value of the collateral held drops. However, the quality and liquidity of these holdings resulted in a drop in value of only 1.2% throughout 2007. Capital Source looks to have more than enough additional collateral to meet any margin call by selling some of their remaining receivables. If its collateral value falls an additional 2.0% in 2008, this would require $82 million in additional collateral. Through cash and liquid receivables, CapitalSource could meet this obligation without requiring a dilutive event.

In all, CapitalSource’s residential mortgage portfolio totals 34% of total assets and represents 26% of borrowings.

Commercial Finance

The Commercial Finance segment originates Senior Secured Loans secured by a clients assets or cash flow, First Mortgage Loans on various commercial real estate, Second Lien and Mezzanine Loans, Equity Investments, and HUD Mortgages. At the end of 2007, Capital Source reported holding approximately $9.9 billion in loans and $227 million in investments. $5.7 billion of the loans were senior secured, $3 billion were first mortgage loans, and $1.2 billion were subordinate loans. Its loan portfolio is well-diversified, consisting of 1,214 loans to 759 clients. Most of the commercial loans have maturities of 2-5 years.

The source of funds for lending within the commercial segment is largely debt pegged to LIBOR. At the end of 2007, their borrowing cost was 6.31%. This cost increased from 6.12% in 2006. The weighted average balance of outstanding debt in 2007 was $9.3 billion. In the commercial finance segment, the average interest spread on their loans was 4.71% at the end of 2007, resulting in an average yield of 9.96%. The current rate and spread environment has compressed spreads while raising borrowing costs. This explains at least a portion of the decline in CapitalSource’s share price over the past year.

Credit quality is the main concern in this market. In its commercial segment, the percentage of problem loans actually declined as compared to 2006 from 4.11% to 3.42%. The loan loss reserve at year-end was 1.41%.

In all, CapitalSource’s commercial loan portfolio totals 53% of total assets and represents 48% of borrowings.

Healthcare Net Lease

CapitalSource owns one of the larger equity oriented healthcare businesses within a REIT. In this segment, it acquires skilled nursing and assisted living facilities and lease them to quality operators under long-term leases. At the end of the year, CapitalSource had $1 billion in direct real estate investments in this segment. This portfolio produced $97 million in operating lease income in 2007. The properties in this portfolio are triple-net leased with the tenants responsible for taxes, insurance, and operating expenses. The interest expense from mortgages in this portfolio totaled $41 million. After other, non pass-through expenses and depreciation expenses, net income from this segment was $9.5 million in 2007. Adding back depreciation, total cash flow was $41.5 million in 2007.

The borrowing cost for these mortgages was 6.87% at year-end 2007. Outstanding debt at year-end was $284.4 million. This is a very low leverage level for these property types.

CapitalSource also had other borrowings on its balance sheet totaling $1.6 billion. The $284.4 million in mortgage debt is included in this total.

Conclusion

The risks to CapitalSource’s business model are largely held in its commercial finance segment. This division, however, is fairly well diversified with moderate levels of leverage. CapitalSource retains additional financing capacity on their credit lines. There does not appear to be substantial balance sheet risk.

Going forward, it looks as if higher borrowing costs and declining lending spreads will put pressure on CapitalSource’s income and dividend levels. However, the market appears to be pricing in more risk than is actually present. CapitalSource has maintained a $0.60 per share quarterly dividend over the past four quarters. Even if this dividend were to be cut in half, CapitalSource would present investors with a dividend yield of over 9%.

Disclosure: No current position in CapitalSource

Comments

[Inquiring Mind]

What are your thoughts about the Fremont asset purchase?

[mushercf]

For a posting and analysis as of 4/25/08 there is no analysis or reference of the Fremont purchase in CA. How that might lower cost of funds - change structure of funds - seems significant for this company. There seems nothing new here.

[User 148335]

Could you look at ACAS as well as CSE.

[jakw]

Not bad for a guy who admits 2 dub plunges in the area before but CSE is far from Tbr or that kind of mortgage company with headquartes filled with bright guys. So in spite of your generaly favorable conclsion a beg you to not buy shares. Your history mplies te kiss of doom. Yes, I own CSE. I advised those who asked to not buy Tberg Mortgage. They did, like you did. Oh woe ......

[Dragonsbane]

I'm sure these two points will come as a shocker to those with an interest in CSE. But borrowing short and lending long doesn't work too well in a credit crunch (Mortgage REITS). And delinquency rates on commercial loans do tend to go up during a recession...

[spooky]

Obviously, if the credit crunch ends, there could be significant upside to CSE. Also, by diversifying their cost of borrowing by owning bank deposit accounts should decrease costs over the long term. Recent trend has also been positive.

[macroguy]

truth is... none of us can know what the portfolio looks like without insider access. your bet, should you choose to buy or hold on to what you have, is that management and the board (many of whom are large investors) have made, and are making, prudent investment decisions and capital allocations. if they are, and i suspect they are, the assets are worth par. if the assets repay per terms, and if they can continue to generate a mid teens roe, the stock will rise to about 1.5 to 1.75 times book value.... in 12 to 24 months. if they are hiding stuff and the assets can't meet terms....

[jjrg]

I beleive there is more to CapitalSource than meets the eye. We recently refinanced a $34m credit facility we had in place with CSE. Though the loan was performing, CSE has been impossible to deal with since the credit markets tightened. Not only were they slow to make decisions but management displayed a complete lack of integrity and reason in their dealings with us. Things did work out as our new facility is considerably less expensive. However, I question wether this is an institution in which one would want to invest.

[Mango]

Having a three-part company like CapitalSource makes them so much stronger in the long term versus competitors... Just as importantly, i've already made a large chunk of money just since investing last November due to that 16-20% dividend yield... I'm not a stock expert by ANY means, but any company that can continue to post gains in the last year is OK in my book. (and with the stock price being under $11-12 a share right now, it's a GREAT time to buy!) I recently read that CSE is looking into changing their dividend yield, but like the author said, even a 9% yield (and a much more stable CSE) will make their investors smile!