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Is CapitalSource (CSE) still attractive at this level?

|Includes: CapitalSource, Inc. (CSE)

CaptialSource (NYSE:CSE) has risen 52% for the last twelve months and almost 30% year-to-date. It may not be a coincidence that CSE appears to be a good value play. Based on recently released 13F filings for 4Q09, numerous well-known value investors have been piling up the stock.

Pabrai has initiated a new position of around 3M shares on CSE that contributed to roughly 3.5% of his total equity portfolio. Being a long-term investor of CSE, Klarman has also increased his holding to 20.3M shares (+15.4%) in the quarter, not to mention his holding in the bond portfolio. While in a smaller scale, Michael Price, Klarman’s mentor, has also topped up to about 0.8M shares (+19.9%) on the finance company.


Valuation
Despite the recent run-up since Mar-09, the stock is still trading considerably below tangible book value ($7.51 as of 3Q09). We believe the low valuation is a result of the company’s yet to return to profitability (recorded $0.87 loss per share) that is primarily dwarfed by its substantial credit loss.

On the flip side, the dampened stock price offers a valuable opportunity for long term investors to build up a meaningful position in this quality stock.

Since 1Q09, as the company started to realize the financial crisis has gone into a level that has impacted worse than that they has anticipated. The management has been taking aggressive step to pursue charge-off and reserve built throughout the year. As expressed in CSE’s recent investor presentation, reserve built is close to the end for most of the asset classes, but only the commercial real estate portfolio is still under severe pressure given the continued stress in the real estate market. While not trying to predict when the real estate market will turn the corner, it is better to look at the company’s value if the current environment remains unchanged in the near term. If we take the management’s estimated total loss as our basis for the worst case scenario, their high (worst) case scenario marked in 2Q09 will be $1.49B as the cumulative credit loss. Through 3Q09, $1.05 provisions have been accounted for. The remaining provision will be left with only about $439.7M (or $1.36 per share) as shown in the table below. (Note: The numbers come from the company’s 2Q09 and 3Q09 investor presentation.) To err on the conservative side, let’s assume the company manages to break even for 2010 prior to provisions.  After netting out the remaining loss provision as estimated, the tangible book value still worth $6.2 per share that is still 20% above the current stock price. In other words, it is still well within an attractive entry level based on Martin Whitman who recommends 0.8X P/B as a rule of thumb for valuing small banks.

That said, there is still a risk that the company may have to further adjust its provision estimate in the coming quarters as the US real estate market still showing sign of softness. Given the company’s 5.8% reserve level and stabilizing trend in the general environment, I would expect the probability to be low.

When the company manages to hit its inflection point, it is likely to see the stock being traded at certain level in excess of its book value.

 

 

$ in million

$ per share

Tangible book value

2,427.0

7.51

 

   

Remaining target loan loss provision:

   

Mid case scenario

161.3

0.50

High case scenario

439.7

1.36

 

   

Tangible book value less full loan loss provision:

   

Mid case scenario

2,265.7

7.0

High case scenario

1,987.3

6.2

 

Liquidity

What amazed me is that CSE has never been short of options to maintain its strong capital base throughout the financial headwind. The bank unit has around $4.7B. In addition, the management team has also been taking different steps to de-lever its balance sheet, such as issuing new shares, reducing existing commitment and the recent sale of net leases assets and HUD financing.

Sufficient cash base on one hand can provide enough cushions to any further external shock. On the other hand, it could provide much better flexibility for the company to make selective quality finance deals in this market that is still lack of liquidity.


Earning

Looking ahead, it may take some time for the company to return to higher normalized earnings. But when the credit has finally cleaned itself up, CSE will be well position to take advantage of the low cost of fund while originating lucrative margin in the specialized middle-market credit space.

In addition, Chairman - John Delaney has mentioned in 3Q’s earning call, they have an option to grow their deposit base if necessary. That should be one of the company’s long term objectives in the pipeline to position for further long term growth.


Competitive Advantage

While CSE is a value play, it also presents a case as a Buffett type growth franchise in my opinion. A committed team of management (insider-ownership contributed to 18.4%), an effective cost structure and a culture of speedy execution would potentially help the group to create a strong competitive advantage within its dedicated niche in the middle market business. It is worth noting that the company has been steady growing its ROE for its first 5 years since public offering before the financial crisis.

With the company’s new focus to transform itself into a full banking franchise, it is still a decent bargain with a free option that can ride on its long term growth before the general environment fully recovers.



Disclosure: Long CSE