CapitalSource, Inc. (CSE)

ValueArbitrage (98.78) Submitted: 9/18/2008 3:12:52 PM : Start Price: $10.22 CSE Score: -54.54

Unlike so many commercial or investment banks today, CapitalSource is a bank with ultra low leverage and an outstanding team of managers who are focused on credit quality analytics for credit decisions, full use of collateral, and conservative lending practices (no 40x leverage and volume at any cost production processes here). Additionally, this company is currently going through a significant transformation, positioning itself to be both stronger and more profitable in the future.

CSE's underlying financial dynamic looking forward includes...

Reduced lending competition at a time when demand for their typical loan will increase significantly (as access to capital at economic rates for mid-sized businesses becomes increasingly scarce), should provide management with significant pricing power and improving profitability on new business over the next few years. In case your wondering, I believe that any increase in CSE's funding costs resulting from the current distress within the capital markets should easily be passed on to clients...therefore allowing the company to benefit from increasing yields as competitive pressures decrease (a wonderful combination).

Recent evidence confirms this, as most banks are raising capital for defensive reasons and not making new loans, the result of which has been increasing rates on the loans that CSE provides. A quick perusal of CapitalSource's latest results shows that their loan spreads have recently moved from 300 bps to 800 bps. Considering its low absolute level of leverage, CSE's net margins are all the more impressive.

Access to low cost deposit funding from their recent acquisition of Fremont General should assist in driving profits and shareholder returns going forward as well. The benefits of 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) is a crucial competitive advantage in today's environment. Importantly, over the last few quarter's CSE has shown it's ability to access capital exactly when it is most difficult to do so, and at attractive relative rates...something many financial companies have not been able to do in this environment.

In truth, their ability to access capital has been extraordinary. With $5.2B in deposits from the Fremont deal, $365M from their recent secondary offering, $300M expected from the Health Care REIT carveout, $65M from the latest DRIP, and renewing $2.4B worth of credit lines during the summer, this company is looking to deploy lots of capital at very attractive rates.

As CSE's stock price has been taken to the woodshed (along with everything else financial) over the last year or so, savvy investors have an opportunity to buy an above average business at a rock bottom price. I believe CSE is conservatively worth $21, and assuming management executes on their plans to make high return loans on its existing capital (as they have always done) it is worth considerably more. Taking into account that this 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 it's recent Fremont General acquisition...not to mention it's historically large and growing (going forward) cash generation capabilities today's valuation simply makes no sense. Expect returns of 100%+ over the next 3-5 years.