CapitalSource was last written up for VIC by 85bears on November 1, 2009. That writeup provides a terrific snapshot of the company at that time, and the shares have performed quite well during the past two years. Much has changed, just as management said back then, so we thought we'd submit the idea again. We've been involved with CSE for more than three years, and we continue to believe it is undervalued with a solid margin of safety.
CapitalSource (CSE) has gone through a dramatic transformation over the past few years. Today, the business is actually quite simple. The company owns a depositary institution in southern California (CapitalSource Bank) which today accounts for the vast majority of value. They are also working through a legacy loan portfolio generated prior to 2008 that will likely require another couple of years to completely run off. We believe the shrinking legacy portfolio is masking very healthy growth at the bank, and thus masking earning power for the company.
Importantly, this writeup will draw from both 3Q11 numbers and 4Q11 numbers. CapitalSource Bank has filed their Call Report for the year ending 12/31/11 with the FDIC. So, investors can examine the bank as of year-end despite the fact that CSE has not officially posted their 4Q results yet. Missing in the Call Report are the parent company (legacy) loans, and any associated writedowns that may exist in that portfolio during 4Q. We believe those writedowns, and the changes in the legacy portfolio over time, are causing investors to miss the bigger picture -- what will the bank look like in a couple of years?
Let's start with CapitalSource Bank. The following table shows some metrics that we believe reveal the strength of this company --
4Q10 4Q11 % Change
Deposits $4,621,273 $5,124,995 10.9%
Loans, net $3,653,097 $4,675,116 28.0%
Interest income $87,033 $106,887 22.8%
Clearly, the bank is one of very few banks able to meaningfully grow their loan book in the current economic environment. We believe this is simply due to their loan generation platform. They are not looking for retail borrowers, but instead have built the business around some niche lending platforms (equipment finance, healthcare real estate, SBA, etc) that have a national presence. We believe CSE Bank can continue to build their loan portfolio profitably given their expertise in their lending platform. Importantly, nearly all of the loans on the CSE Bank balance sheet were originated after 2008.
The remaining element of the business is the legacy company loan portfolio from the original CSE (loans generated prior to 2008). This portfolio consisted of $1.3 billion in loans at the end of 3Q11. Just for reference, when 85bears wrote up CSE in Nov, 2009, the legacy portfolio was $5.7 billion. We've been around the company awhile, and we believe we have a reasonable handle on the quality of the legacy loan book and the likely recoveries. The parent company book value at 3Q11 was $672M. We think there is a very high probability that we wind up liquidating the portfolio with around that book value left over for CSE shareholders.
The CSE story gets more interesting when you add the capital allocation strategy to the thesis. Before last summer, the company was not in a position to return capital from a likely overcapitalized balance sheet to shareholders. In the minds of regulators, the CSE Bank was still de novo and not allowed to return capital to the parent. The legacy portfolio was still large enough that management prudently retained capital to hedge against unforeseen losses there. Furthermore, the company had enough parent company debt that the wise use of capital was through debt reduction.
That changed in an important way during 3Q11. The company acquired roughly 15% of their sharecount during 3Q for $309M ($6.19 per share). They further authorized an additional $200M share repurchase (leaving them with $266M going into the fourth quarter). We believe it is likely that they were buyers throughout the quarter, though we'll find out for sure in about a week.
Equally interesting, the company redeemed $298M of 12.75% coupon 2014 senior secured notes during 3Q. They paid a premium for the extinguishment of debt and took the charge during the third quarter ($78M premium paid for the senior notes redemption will save the company $108M of interest costs). They also repurchased $358M of convertible notes during 3Q11. As a result, the only debt due in 2012 is an additional $174M of convertible notes that are puttable this July. The company has ample cash on the balance sheet to redeem these notes when they mature.
What happens next? Clearly, the management team is executing a strategy that will ultimately leave CSE shareholders with only CSE Bank (as the parent loan portfolio runs off over time). Depending on share price, we believe that nearly all of the book value from the parent company will eventually be used to repurchase shares. Assuming some additional costs to run down the parent portfolio, we believe there is at least $600M of excess capital at the parent that will eventually be returned to shareholders primarily through a share repurchase (at last check parent book value was $672M). To be conservative, if we assume an average share price of $8.50, we should see the CSE sharecount migrate toward 200 million shares. There is another very valuable element to the share purchase capacity in the form of a deferred tax allowance that we'll discuss later in this writeup.
Rather than attempt to value both the parent company portfolio and CSE Bank, we'll simply focus on the bank and assume excess parent company capital is used to repurchase shares. Again, we'll use the assumption that $600M is used to buy shares at $8.50, leaving us with approximately 200M shares in a couple of years.
With that, let's consider the bank over the next couple of years. We believe the bank is very overcapitalized today. At 12/31/11, bank equity stood at $1.05 billion which supported total assets of $6.78 billion (assets/equity of 6.5:1). Deposits are $5.1 billion, and the company stated on the 3Q conference call that they plan to grow deposits to $6 billion by y/e 2012. Net loan growth grew by approximately $1 billion at the bank during 2011. We believe that the company could essentially grow loans by nearly $2 billion without much need for additional capital (and remember, CSE Bank turned 3 years old this past summer, so their regulatory scrutiny will diminish as they've proven themselves capable of running a de novo bank). We also believe that growing the loan portfolio will not require substantial additions to the company's overhead structure.
In 2011, the bank generated earnings before tax of $170.6 million (we'll discuss the tax issue later). CSE Bank expects their NIM to be in the 4.50%-4.75% range in 2012 (a period of time when many financial institutions are struggling mightily to keep their NIM from contracting too dramatically). The capacity to add $2B to their loan book given their existing balance sheet (no credit given here for earnings during the time they add $2B to their loan book), and the low overhead requirements associated with these loans gives us confidence that earnings before tax could easily be $225 million by the end of 2013.
CSE Bank accrued taxes at a 34% tax rate in their 2011 financial statements. However, the parent company has a $474 million deferred tax asset on their books. To be precise, it is not on their books because the accountants are requiring the company to book an allowance against that DTA until they've proved their ability to generate enough profits to use it (we're not sure when the timing of that might be). For now, the bank books taxes on their income statement and pays the parent company for use of the DTA. So, economically, CSE Bank will not pay cash taxes for quite some time. Importantly, this payment from CSE Bank to the parent company for use of the DTA is another source of liquidity for CSE. This source of funds is not evident in audited financial statements, but is clearly an economic benefit that CSE can use to fund an even larger share repurchase than we've assumed so far in our analysis. Conservatively, the parent company could repurchase another $200M of stock through "monetization" of the DTA over the next 3-4 years.
Putting it all together, we think that within a couple of years, CSE Bank will be generating around $1.25/share of earnings before tax (with no cash tax impact at that time). As such, we think CSE shares are trading at less than 6x a "normalized" earnings run rate once the parent company is done with the legacy portfolio. We also think that book value will be around $7/share at that time depending on whether CSE Bank pays much in the way of dividends to shareholders between now and then. Given the earnings growth and the economics of the company's cash flows (especially cash taxes), we think the shares are worth at least $10/share today.
There are some additional sources of upside over time, but we've decided not to figure those into our valuation. First, the company is chartered as a California industrial bank. Under that regulatory profile, they are prohibited from certain lines of business that are generally quite profitable for other bank charters. CSE Bank intends to apply for a different charter once the entire company is cleaned up and this may allow them to extend products to existing customers that could alter their profitability in a meaningful way. Second, we think that the loan growth that we'll likely see at CSE Bank (especially at the NIM they achieve) deserves a significant premium to most banks which are having trouble generating much in the way of loan growth. Third, we believe the CSE Bank footprint in southern California gives them incredible opportunities to deposit fund their balance sheet growth on very favorable terms during the next couple of years. Finally, we believe that CSE Bank makes for a terrific acquisition target for a buyer that would like to show some loan growth.
Legacy loan portfolio runoff
DTA allowance recognition
CSE Bank loan growth