Poetic Portfolios

About one year ago, I took a look at CapitalSource (NYSE: CSE), and have since bought shares. At the time, I was drawn to their dividend yield and wanted to make sure that the assets of the company were stable enough for investment. A lot has happened since then in both the broader economy and at the company.

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In the past year, CapitalSource has bought a bank, withdrawn its REIT status, and sold its residential loan portfolio. The transition underway coupled with the distrust of financial companies have driven CapitalSource shares to $1.40 and a market cap of $424 million. Yet the CapitalSource balance sheet shows $2.8 billion in total equity. With Capitalsource priced at 17% of book value, the question is whether or not this is a tremendous opportunity or a value trap.

During the company’s 4th quarter conference call, Chairman and CEO John Delaney offered his opinion:

We do believe there is significant value in our business, certainly more value than the market currently is giving us credit for…. When you add it all up, we have $916 million of equity in the bank, approximately $650 million of equity and related party debt in CS healthcare REIT. $910 million of equity in the securitizations, and $1.2 billion of equity in the parent company loans pledged to credit facilities. That is how we think about the value of the business.

CapitalSource is a complex company, and I’m certainly tempted to put them in the “too hard” category and move on to something more stable and easy. However, this company is just too tempting for me. I want to take a look at the four components of their business to determine a value for each and also make sure that there is no potential for permanent loss of capital. In other words, are there any components that can bring down the whole company? I am breaking this analysis in to four parts, with part one included in this post.

Part One: CapitalSource Bank

In July of 2008, CapitalSource acquired $5.2 billion in deposits, the “A-Participation Interest”, and 22 retail bank branches from Fremont Investment and loan. Thus CapitalSource Bank was born. Soon after, the bank purchased $2.2 billion of commercial loans from other CapitalSource subsidiaries. The founding of CapitalSource Bank was an important development for the company, as it provided a funding source for loans that are not dependent on the capital markets.

The “A-Participation Interest” is a new term for me. It is basically a participation interest in a loan where the holder receives 70% of the principal payments to effectively amortize the loan more rapidly. The lead lender for these participations is iStar Financial.

There is no separate balance sheet noted in the CapitalSource annual report. A combined balance sheet of nonguarantor assets seems to combine the Bank and the Health Care Reit. John Delaney noted in the conference call that the Bank had $6 billion in assets at year-end with $1.9 billion in cash and marketable securities and $2.7 billion in loans. A-Participation interest is also noted in the conference call, and the combined balance sheet notes $1.4 billion here. That combination rounds out the $6 billion in assets.

A drill-down on the loans and participation interests is problematic as the commercial loans are co-mingled with parent company loans for reporting purposes. Delaney, however, notes that the portfolio is clean with no non-accruals or delinquencies at year-end. That said, he also notes that this portfolio of loans comprises a good portion of their reserves.

On the liability side, CapitalSource Bank has $5 billion in deposits. Again, this is a great source of funding. Delaney notes that twice this amount in deposits can be supported without adding a single branch. Equity in the bank totals approximately $916 million.

Now is a good time for healthy banks, rare as they are. Because there are so few banks lending, healthier banks have less competition and can get more favorable terms. CapitalSource does not break out income separately. Interest income of $490 million is offset by $218 million in interest expenses in their non-guarantor subsidiaries. This seems to be a bit high. More traditional banking returns would be 1.0% return on assets or 15% return on equity. This would result in $60 million and $137 million respectively. A third way to estimate income from CapitalSource Bank is to assume a 3.0% spread on loans, resulting in $81 million in net income. Based on this range of net income, I would think $80 million is a conservative estimate of net interest income from CapitalSource Bank.

CapitalSource Bank Valuation

I’ve already covered the estimated book value of CapitalSource Bank at approximately $916 million. However, assuming a price-to-earnings ratio of 15x applied to net income of $80 million would place the value of the bank at $1.2 billion. All of this, of course assumes that the portfolio is clean and that there won’t be significant defaults. Still, a book value of the bank alone at $916 million relative to market capitalization for the whole of CapitalSource at $424 million indicates that the market is pricing in some serious problems within the other three parts of the company.

Tomorrow I will take a look at the Health Care REIT portion of CapitalSource and determine a reasonable value for that component of the company.

Disclosure: I currently hold shares of CapitalSource

Related Entries CapitalSource Part Three: Securitization Residuals CapitalSource Part Two: Real Estate Portfolio CapitalSource Part Four: The Commercial Portfolio CapitalSource’s Third Quarter and Current Outlook A Look at Capital Source

This entry was posted on Monday, March 30th, 2009 at 4:40 am and is filed under CapitalSource. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.