Yes and Not Yes

This is a post of the “research” I performed on Capitalsource (CSE). The inspiration came from a write-up submitted by another author to the Value Investors Club on November 1, 2009, so I think a better description of the work I did was due diligence and fact-checking to make sure the author was more or less correct.

I can’t vouch that everything is correct, but I feel enough is correct to provide a good margin of safety. I do not own any shares of CSE, but it is certainly an interesting stock. Stocks like Capitalsource that appear dangerous or overly complex often provide great opportunities as people are just lazy and do not want to take the time to understand them.

Claim 1 – CapitalSource Bank is worth $2.50/share at 1x BV

As of 9/30/09, the bank had assets of $5,529,035 and total liabilities of $4,674,844 which gives a book value of $854,191 or $2.64 per share at 1x BV. Goodwill is $173,366, which gives a TBV of $680,825 or $2.11 per share at 1x TBV.

The bank is extremely well capitalized compared to many other banks. For the most recent quarter, CapitalSource has core capital (leverage) ratio of 12.52% and a Tier 1 ratio of 15.47%.

And though the bank has negative returns on assets and equity, these figures have improved over the last quarter. Concurrently, the cost of funding earning assets has decreased (from 2.25% to 1.79%) and the net interest margin has increased (from 3.12% to 4.2%) over the most recent quarters.

The author also claims, “New loans are being written today at LIBOR + 500 (or more) with LIBOR floors, giving the bank substantial earnings power in the future.” I am not certain as to the accuracy of new loans being made at LIBOR plus 500, but it is a fact that the majority of the current commercial loan portfolio bears interest at a spread to the LIBOR rate or a prime-based rate. Possible evidence of this may be found on page 63 of the most recent 10-Q. On page 75 of the most recent 10-Q the company talks about the state of its loans:

The majority of the CapitalSource Bank loan portfolio bears interest at adjustable rates pegged to an interest rate index plus a specified margin. Approximately 68% of the portfolio is subject to an interest rate floor. Due to low market interest rates as of September 30, 2009, substantially all loans with interest rate floors were in the money and bearing interest at such floors. The weighted average spread between the floor rate and the fully indexed rate on the loans with floors in the money was 2.60% as of September 30, 2009. To the extent the underlying indices subsequently increase, CapitalSource Bank’s interest yield on this portfolio will largely remain constant until such time as the fully indexed rate of interest on a loan exceeds the applicable floor rate.

Furthermore, from page 91 of the most recent 10-Q:

Approximately 54% of the aggregate outstanding principal amount of our commercial loans had interest rate floors as of September 30, 2009. Of the loans with interest rate floors, approximately 97% had contractual rates below the interest rate floor and the floor was providing a benefit to us.

Claim 2 – Healthcare net leases are worth ~ $2.00/share at a discount to peer valuation

According to the 2008 10-K on page 3, the company had “$1.0 billion in direct real estate investments comprising 186 healthcare facilities leased to 40 tenants through longterm, triple-net operating leases.”

On 12/22/2009, CapitalSource announced the sale of 40 long-term care facilities to Omega Health Care Investors (OHI):

CapitalSource received net proceeds from Omega of $234.8 million, consisting of $184.2 million in cash; and 2,714,959 shares of Omega common stock (valued at $50.6 million under the Purchase Agreement).  Additionally, Omega assumed $59.4 million of debt associated with the 40 properties purchased.  Included in the purchase price was $25 million for an option which can be exercised by Omega to acquire 63 additional long-term care facilities at any time through December 31, 2011 (step three of the Purchase Agreement).  CapitalSource expects step two of the transaction for an additional 40 long-term care facilities to close on or about April 1, 2010.

This transaction comes out to $175.4 million for 40 facilities, or $4.385 per facility. This transaction values the remaining 126 facilities at a total of roughly $552.51. Adding $552.51 to the facilities already acquired for $175.4 and the $25 received for the option, this is a total of $752.91 million, or $2.33 per share. Claim 2 definitely checks out.

Claim 3 – Legacy loans with non-recourse obligations ~$2.00/share of value @ high end of management cumulative loss scenario

The author writes:

The non-recourse obligations include the six securitizations, the combined credit facility, the CSVII credit facility, and the CS Europe credit facility. The securitizations have a combined $1 billion of CSE residual interest and the credit facilities have a combined $370m residual interest. CSE provides the mix of collateral type for each facility and securitization and also provides a consolidated cumulative loss estimate for its entire loan portfolio. I apply the high end of the loss range (30% cumulative loss on CRE, 15% on cash flow loans, 3% on asset based loans) to each securitization/credit facility to get ~$700m of residual value.

Based upon the most recent data, I found that CSE has about $1.02 billion residual interest with the securitizations and $350m with its credit facilities. After applying the high end of the loss ranges to the collateral types in each securitization and credit facility, I found that the total value would be about $1.125 billion, or about $3.48 per share.

Claim 4 – Legacy loans with recourse obligations ~$1.50/share of value@ high end of management cumulative loss scenario

The author writes:

This is the syndicated credit facility which was reduced in July 2009 to a $600m commitment. The facility has $1,276m of collateral at current marks (originally value of $1,650m) and $531m of outstanding principal after the CSE capital raise in July 2009.

This info was correct as it pertained to the June 30 data. Also,

At the high end loss scenario provided by management, the facility would sustain $260m of losses, leaving $480m of value left for CSE.

As of the June 30 data, the facility would sustain about $260m in losses, but I calculate CSE would have $424m in value left. Updating these calculations for the more recent Sept 30 data, I find that CSE would have about $379.14m in value left after a high end loss scenario, or $1.17 per share in value.

Though management has not provided full credit quality details of the collateral pool, management has indicated that the embedded CRE in the pool is much higher quality than the overall book. As this facility is 2.4x overcollateralized, CSE would need to sustain 60% cumulative losses in the asset pool to default on the structure.

I have not been able to figure out how the author arrived at the claim that this facility is 2.4x overcollateralized.

Claim 5 – Other assets ~$0.35/share of value

The author writes: “The company has $93m of equity investments and $95m of REO. At a 40% discount, these would be worth $110m.”

As of September 30, 2009 CSE had $67.1 million of REO (“real estate owned”) (pg. 18 of 9/30/09 10-Q). I’ve been unable to find how the author arrived at $93m of equity investments, so I will not include that in the calculation.  For just the $67.1m in REO, this is worth about $0.20 per share in value.

Claim 6 – Other liabilities ~$4/share of liability

The author writes:

The company has $580m of convertible debt ($330m puttable in July 2011 and $250m puttable in July 2012), $300m of senior secured notes (July 2014), and $439m of trust preferred debt (mostly matures after 2035).

This all checks out in the 6/30/09 10-Q. Updating this to the most recent data, CSE has $559 of convertible debt, $283 of senior secured notes, and $440 of trust preferred securities. This total works out to about $3.96 per share of liability, which is in line with $4 estimate.

Adding It All Up

The following is a sum of the parts valuation for CapitalSource:

CapitalSource is worth about $5.68 per share on a conservative, sum of the parts basis.