Stock Trak Idea: October 21, 2008Andrew Sullivan This is a sell idea, or at best hold.CapitalSource (NYSE: CSE) Price: $8.16 Market Capitalization $2.3B Total assets: $18.3B Equity: $3.1B Commercial Loan portfolio: $9.3 billion (30% commercial, 30% healthcare/specialty, 40% structured finance)Dividend/share: $0.20 Yield: 2.4% Payout Ratio: roughly 20%Forward P/E: 11x Company DescriptionCapitalSource is a commercial lender with a $9.3 billion portfolio, comprised of corporate, healthcare & commercial real estate, specialty, and structured finance loans. Most of its clients are medium-size businesses. The company also has $1.9 billion of residential mortgage investments and $1.6 billion in government sponsored mortgage securities. Why Sell?• Management appears too aggressive • Asset quality is poor • Timing of growth in deposits is unclear • $188 million lent to companies connected to Directors Aggressive managementCompensation for the CEO is all in stock and insiders own 5% of the company, so there is some alignment with shareholders. Management appears skillful, but the facts speak for themselves. The loan book grew from $2.4 billion to $9.8 billion in only three years (2004-2007), at the height of the credit/private equity/housing bubble. That makes me nervous. Not only that, CSE went into mortgages at the top of the market. Asset quality • 5.7% (or $536 million) of loans are delinquent as of June 2008 vs. 3.4% at Dec 2007• 29% of $9.3 billion commercial book is loans to fund LBOs and private equity transactions. These loans were made at the peak of the private equity bubble. In event of non performance, recovery of capital could be difficult and time-consuming. Hung loans are already appearing and tenor of loans increasing from 3 to 4 years. • Another 18% of the commercial book is commercial real estate, which has slowed dramatically. • CSE owns another $1.9 billion of prime residential mortgage loans with ARMs – all acquired in 2006. 1.8% of these are past due now vs. 0.72% at year end.• Unfunded commitments under credit lines exceeded unused credit and unrestricted cash by $813 million. Perhaps this is normal, but in this environment, could be a liability. Growth strategy• Company converted to a REIT in 2006 to reap tax efficiencies. Amazingly, the company is still spinning this as a good move. In 2009 it will de-REIT itself. • Purchasing a bank gave CSE access to low cost funding and stable deposit base, but timing of deposit increases is not clear. Interest costs to attract that capital will rise.
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