CapitalSource, Inc. (CSE)

Skepticism regarding stocks with double digit dividend yields is generally well founded, but in the case of CSE intelligent investors have cause to rub their eye's....and look again. At today's prices CapitalSource presents patient long term investors with a truly extraordinary investment opportunity. This young and misunderstood company is likely to offer returns well in excess of 100% looking out over the next three years or so with minimal downside.

Concerns regarding turmoil in the credit markets offer savvy investors the chance to opportunistically pick up shares while Mr. Market (and his recent, severe aversion to all things financial) continues to shoot first and ask questions later. Bargains of this magnitude are exceedingly rare, and generally are not around very long...I expect this opportunity to be no different.

Why?

First and foremost, the foundation of CSE's business is strong, and current market turmoil will likely only make it stronger. As weaker, and less disciplined competitors have gone by the wayside, this conservatively capitalized specialty lender currently finds itself in a position of power going forward. Profitability going forward should remain healthy due to a convergence of factors (both macro and micro). A few examples include...

A favorable pricing environment due to reduced lending competition, especially at a time when demand for their typical loan will increase significantly as access to capital (at economic rates) for midsized businesses becomes increasingly scarce. Additionally, access to low cost deposit funding from their recent aquisition of Tier One should provide another lever for CSE to enhance profitability going forward (not to mention the stability that this cheaper source of funding adds as bank deposits are far less likely to be pulled away than most alternative sources of short term credit).

Essentially this thesis revolves around three core variables:
- The quality of management
- Continued high quality credit analysis, and
- Appropriately pricing their loans to compensate for the risk involved

CSE's experienced and shareholder friendly management team has a long and successful paper trail of generating above average wealth (ROIC) for it's shareholders. Management has mentioned many times that their experience ('98) during previous periods of distress and capital markets upheaval has played a large role in forming CSE's current operating model and competitive strategy (a model founded on conservative lending and liquidity practices). Mgmt. teams that share my enthusiasm for looking at the downside (with an eye towards preserving principal) first and foremost, especially before considering any potential upside, are near and dear to my heart, especially in this business. Additionally, Mgmt. eats their own cooking which I find especially insightful/important for spread lenders...where quality of underwriting is everything over the long term. My take is that mgmt's significant stake goes a long way towards ensuring that intelligent underwriting will not give way to myopic short term policies typical of young and fast growing lenders...such as when loan quantity is put before quality (profitability), as these type of companies relax credit standards in order to expand too quickly. Incentives are intelligently alligned across the board.

Credit analysis at CSE is best in class. Their two pronged approach regarding profitable underwriting is unique, and in my opinion brilliant. A quick review of their track record proves this, and can be seen in their current reserve for loan losses, which covers roughly two and a half years of potential credit losses at their current rate. CSE has two seperate business units review all potential loans. The first unit will do a typical review of the co's in questions ability to pay based on estimated future cash flows, earning power, etc. (your standard due dilligence review). The second unit (capital analytics) evaluates every potential loan through the eyes of a forensic accountant, hoping to uncover any and all financial shenanigans or overly generous assumptions within the business in questions financials that the first unit may have missed within their evaluation. By institutionalizing a screening process that includes both an enterprising as well as defensive evaluation of every loan in which they underwrite, investors in CSE should expect underwriting results to look in the future, very much like they have in the past...i.e. nothing short of outstanding.

When you put each piece of this very attractive puzzle together (mgmt., best in class credit analysis, focus on profitability, etc.) it should be relatively easy to come to the conclusion that CSE will continue to appropriately price its loans relative to the risk inherent within each.

The bottom line is:

Any increase in CSE's funding costs resulting from the shutdown within the capital markets (in which we are currently experiencing), in my opinion will easily be passed on to its loan customers, therefore allowing the company to benefit from increasing yields as competitive pressures decrease. More, if not most importantly, CSE over the most recent quarter has shown it's ability to access capital exactly when it is most difficult to do so, and at attractive relative rates. Put a little differently, during periods of widening credit spreads, CSE was able to access capital very easily, something many financial companies have not been able to do in this environment. Putting more capital to use when the benefits are increasing is exactly what this company has set out to do...something it's founders have long envisioned, indeed, they created this unique business model for this exact purpose.

No matter which way you slice it, CSE represents the type of compelling investment opportunity intelligent investors constantly search to uncover. The market truly has thrown the baby out with the bathwater...in this case, giving investors the opportunity for incredible risk adjusted long term returns with minimul chance of permanent capital loss (heads I win, tails I don't lose much...Dhando!!). Assuming very conservative growth in it's dividend from today's level (of roughly $2.40 per share) of 5% over the next five years, 3% growth in years 6-10, and a 1% growth for the years thereafter, the company would be worth roughly $21 per share using a 15% discount rate. This seems likely, if not absurdly so, considering the company continues to make quality loans and good investments, has access to capital during the toughest of times, will have access to demand deposits from Tier One to lower its cost of funding, as well as the ability to charge higher prices for it's loans to compensate for the risk it takes. My bet is that Capitalsource and its savvy management team do considerably better.