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.

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.

I just recently bought CSE. I think it's the scariest pick I've ever made. I have not noticed other pitches, and even M* analysis, going deep into the exact nature of this company. I'll try to give a more informative analysis of the company, and explain my rationale for my purchase.

CSE is a REIT company engaged in the business of borrowing money and lending it to medium-to-small size companies. Its REIT structure fundamentally distinguishes it from other similar companies, and dictates the fundamental benefits and risks inherent in the company.

REITs are required by law to disburse at least 90% of their earnings to shareholders. This explains CSE's amazing yield, which is close to 13% at $17.80 per share. Additionally, REIT structure exempts CSE from federal income taxes for most of its activities. Hence, CSE's federal tax rate was about 20% last year, compared to 34% it would otherwise pay. Those are the upsides.

However, the requirement that it pay out 90% of its earnings severely hampers CSE's ability to accumulate capital. In other words, CSE can only grow by borrowing money or issuing more stocks. This explains the eye-popping 86% debt-to-equity percentage (industry average is less than 20%). With such heavy leverage, a single disaster could put the company belly-up within months, if not days.

There is additional risk associated with its REIT status. Because the company has to give out 90% or its earnings, not 90% of its free cash flow, the company can face cash flow squeeze, and in fact, for the last three years, the company had negative free cash flow. In 2006 annual report, the company openly admitted that it requires continuous additional borrowings to sustain its operation. To free up cash, the company is forced to issue additional stocks, diluting shareholder earnings. From 2004 to 2007, the number of outstanding shares increased approximately 60%, eating up much of shareholder gains.

So there you have it. This is a company that is, due to its heavy leverage, basically ropewalking, and will be ropewalking for the foreseeable future as it has to continuously borrow to grow. It's a company with a permanent 86% leverage ratio. The company is definitely not my usual Buffett-style pick (JNJ, BRK-A, Y, LOW, USB etc.).

So why did I pick the stock? I think the price is just too good. I don't think the company is particularly exposed to the subprime crises. Yes, the financial crunch may affect the company's ability to borrow, thereby restricting its growth. But it will not cause it to collapse as long as it can borrow enough to cover its negative cash flow, and there is no evidence the company is having any trouble doing that yet. Meanwhile, one can simply sit on the market-beating 13% dividend, even if the stocks stay still. I do believe they will pay out their dividends at least for the remainder of this year (that's 6% return on 4 months), and when they do, the share prices should see a moderate gain as well (maybe 3 to 4%)--so that's potentially 10% return on 4 months. Not too shabby.

I personally don't think there is too much room for upside swing on this one (not counting dividends). Its heavy leverage and very structure limits that possibility. I know plenty of investors who will simply refuse to buy company that has permanent 86% debt-to-equity percentage (Graham said his limit was 60%) and whose business plan requires continuous share dilution. There is some sign that the company's specialty market has been saturated (complex structured loans for middle to small cap companies) and it is branching outside its specialty (this is based on the fact that its charge-off rate has been on an increase, albeit slightly. Could be insignificant). Barring a catestrophy in the health-care segment (it's biggest clientele--33%), however, I think the company will do okay, despite its top-heavy structure.

Anybody who buys this company, however, is recommended to keep a hawk's eye on the cash flow of the company.

I own 1,000 shs, bought at $17.33. Imagine my surprise at seeing it close yesterday at $9.43. What a loss!!

Monday I will buy another 1,000 shs.

Every senior exec is either a CPA, lawyer, or both!

Each has been in the lending business for years. The main focus is the healthcare field.

The main financing method is(I believe, have not found perfect info) the "Pool". The Pool puts up the money and gets a mortgage on a property. Just one property, not 10 thousand properties! The Pool knows what it has and can easily value their asset.

Even the competition has endorsed CSE's business method, saying they are hard nosed and want to be able to get their money back.

This is a REIT. They pay out a % of their cash each year. That cash will vary from year to year(that is what I have against REIT's).

So the nice div they have now will vary, depending on their cash flow(funds from operations). Even if they drop the div to $2, at this price that is still over 20%! Don't let the div % scare you. Do the DD and you will see the co. has some staying power.

they got falsely screwed by the subprime mess, thats all there is to it. Commercial loans is almost all they do, nothing residential. They will be back to 32/share within a year, and add in the dividends and this is a great pick. I bought first last november, and continued to buy as they went down, my loswet buy was 10.42/share and i think my average buy price is down to about 19.22... this is a moneymaker for sure!

For a good analysis of the underlying financial dynamics at work, take a look at earningspower's post...I think it outlines many of the unique characteristics that make CSE at today's prices a compelling bargain for patient investors looking out 2-3yrs.

Amongst the current, and in some respects unprecedented turmoil, management has once again shown themselves to be amongst the savviest allocators of capital in the industry today. Its recent, and opportunistic purchase of Fremont General's deposit base (at rock bottom prices) is just the latest example of this mgmt. teams long history of operational excellence.

At it's core, my thesis here is relatively simple. If CSE's current dividend yield is delivered, which with the recent Fremont purchase is looking considerably more likely, this stock should trade at a price comparable to its commercial lending peer's yield's of roughly 8-10%. Ultimately, the success of this investment boils down to two questions:

1 - Can CSE achieve the levels of dividends mgmt has projected for the next few years, as well as convince investors that earnings and dividends will continue to grow from its current level?

2 - Will the stock trade, assuming the dividends come through...at prices more in line with its commercial lending peers?

I believe the answer to these questions are yes, yes, and yes. The bottom line is that going forward, for a variety of quantitative and qualitative reasons, I believe the odds favor CSE trading at levels significantly above today's depressed price.

My guess is that opportunistic and patient investors will generate returns north of 100% over the next few years, as the market begins to appreciate this young and misunderstood company...and therefore price it at a much more appropriate level reflective of the quality and stability of its dividend, and future cash generating capabilities.

Here's a source for capital appreciation. Capital Source provides financing for Mid-sized companies. They make loans to these companies and generally collect a much better "spread" than banks do. It has a REIT structure which delivers a nice dividend (right now around 15%). This company is profitable and sits between the big financial boys and the small regional players. This gives them leverage to make more on their loans. Recent financial scares in the industry due to charge offs have brought the share price to a 52 week low. This is a good, profitable, well-run company sitting at a time when its industry and business is out of favor due to credit fears. Commercial credit at this point is not a culprit in this credit crisis so the market is handing us a dollar and saying its worth less than fifty cents. Yes, there's some risk but with heavy insider ownership (around 40%) the people running the company want to win too (and keep that dividend flowing). I believe that this is source of capital. Thank you Mr. Market, outperform!

CSE is an extremely high-quality lender and specialty finance company whose stock price has been absolutely taken to the woodshed. Its focus is in the healthcare industry, and all of its residential loans are prime quality. With seasoned and shareholder-friendly management and a huge, yet sustainable, 15 percent dividend yield, CSE is a sure bet to beat the market long-term; especially once the furor in the credit markets dies down.

I checked data at Morningstar. Dividend yield is 19.6%, but trailing P/E is only 13.6 (earnings yield of 7.35%). These values are inconsistent. ROA has decreased monotonically since 2003, and for calendar 2007 was only 1.06%. The report at http://www.fool.com/investing/value/2008/03/10/5-top-rated-value-stocks.aspx?source=iflfollnk0000003 says CSE has a "tax-free REIT status," yet its effective corporate income tax rate is 33.2%. Also, asset turnover is half the level it was in 2005.

These simple facts scream a warning to me.

Well, I picked CSE way too early, never seeing that the sub-prime crisis would grow into a general dislike of every financial company in America!. I liked the CSE dividend then, and I LOVE it now. I also think it's sustainable (warning: many analysts do not), and that CSE's recent Fremont acquisition creates exciting synergies to fuel further growth. There's nothing wrong with CSA expect spillover anxiety about finance companies in general. This is a well run company with a history of sustained growth and lots of opportunities to pick up cheap assets over the next few quarters. I doubled my position at just under $10 a share (yay!) after taking an initial position a year ago at $22ish (boo!) Patience, grasshoppers, patience.

For this company, besides for great dividends, there are also many plus points:
- low PE ratio
This means value for money.
- positive earnings/dividend ratio.
This implies sustainable dividends.
- High insider holdings
Thus implies confidence of management. This is very difficult to gauge from the outsider. Only an insider can tell!

Most of its portfolio is recession resistant (assisted living facilities).

Many competitors have exited the business and prices (loan rates) have improved, almost as much as cost rates, so their margin will remain fairly maintainable.

Fremont branches give the company access to over $3 billion of relatively cheap funding.

Lastly, the management team is one of the best I have witnessed in the banking business in some time (I am a 40 year banker)

I owned this stock and actually made about 10k on it after my stop loss kicked in and I picked up one of the dividend payments. They have openly acknowledged they are reconsidering their status as a REIT and the status of the dividend. So if you like to take a huge risk on thiings this is the way to go. It seems like the company is evolving itself into a bank and may potentially spin off its medical healthcare REIT business into a separate entity. So who knows which way this thing is going to bounce looking forward. For me personally there is too much risk hinging on whatever the next news release is on this CSE to consider it as a long term stock to hold. I'll be watching CSE in the future. If you are looking for a REIT with a huge dividend but less risk than CSE consider RAS. Again, a huge risk in these uncertain times for financial stocks but worth considering for its fundamentals looking forward.

A while back, I took a look at CapitalSource (CSE) on my blog as part of a four part series. Part 1 can be found here:

http://www.poeticportfolios.com/?p=168

At the time, I was concerned about their debt refinancings. There are still risks based on covenants on their restructured debt, but barring a complete economic collapse from here it looks like they're going to be okay. The new CapitalSource Bank should be an earnings machine once the market improves. For now, I believe book value is a good proxy for the company's worth. The current book value is around $8 per share. After a beating over a news article yesterday, that's about a double from here.

High dividends and coming out of its rut.

Been on the watchlist waiting for a dip like today's. May miss the dividend this time, but the 8% dip today will make up for that after an inevitable return to normalcy.

Great company with high dividend yield. Current dividend yield of over 20% is way too high. When the financial panic is over this will soar.

A profitable financial with conservative management, trading at book value and switching from lending on the commercial market to getting liquidity from deposits. What's not to like?

Someone a week ago pointed out the following (I haven't had the time to read through the past ratings to see if others have made the following points) CSE management has stated it is going to sharply reduce the dividend to that of typical banking stocks so people that think this stock is pretty because of the dividend might want to rethink their position. Also in the same webcast management has said it is dropping the REIT status in 2009 so it will not be requiredto pay out the large required REIT payment to stockhoders. The foregoing info is at the CSE web page at current press releases and webcast transcripts. When the dividend reduction hits, CSE will go lower.