CapitalSource Finally Gets a Clue

A few months ago, I suggested that CapitalSource's (CSE) operational execution was being hindered by its overly broad SuperREIT structure.

At that time, it seemed pretty obvious to me that CapitalSource could unlock significant value by selling off its poorly performing residential mortgage portfolio, spinning off its profitable healthcare net lease REIT as a separate entity, and restructuring its corporate loan portfolio as a BDC.

I wasn't surprised, then, when CapitalSource announced some strategic changes in the wake of the Fremont bank purchase.

Closing the asset acquisition and commencing the operations of CapitalSource Bank may have other strategic implications for us in light of current market conditions.

1. Dividend Policy. As previously announced, we declared a $0.60 dividend for the second quarter of 2008, payable on or about June 30 to our stockholders of record on June 16. Upon the closing of the asset acquisition from FIL, we expect to reevaluate our dividend policy and may decide to retain a
   majority of our earnings, consistent with dividend policies of other commercial depository institutions, to redeploy in attractive lending opportunities, subject to satisfying our minimum distribution requirements to qualify as a REIT for 2008.
   
2. Possible Healthcare Net Lease Transaction. With our focus on our commercial lending activities, we expect to continue to explore ways to monetize our investment in our healthcare net lease assets, including a possible initial public offering of the common shares of an entity holding these assets.
   
3. REIT Status. We intend to qualify to be taxed as a REIT for 2008, which may require us to acquire a significant amount of additional residential mortgage or other real estate assets due to the addition of the assets and operations of CapitalSource Bank to those of our existing taxable REIT subsidiaries. As we assess the impact of a depository franchise on our overall business operations, we intend to reexamine the strategic rationale for our REIT election, and we may determine not to elect to qualify as a REIT beginning in 2009 or thereafter.

So perhaps CapitalSource has gotten a clue. It wasn't maximizing the REIT structure, failing to properly manage its agency portfolio and making most of its profit in its corporate loan TRS. Perhaps the new CapitalSource will be able to improve GAAP earnings by focusing on the commercial financing business as a C-corp and utilizing cheap depository funding.

In any case, the implication for CSE shareholders is that the Company will be transforming from an income stock to a growth stock by the end of 2008. Look for CSE to sell of its agency portfolio early in 2009 and also spinoff its healthcare net lease portfolio shortly thereafter.

Another Quarter, no Dividend Coverage at CapitalSource

No stranger to the blog, CapitalSource (CSE) earns some grouching over its failure to explain why it continues to declare a dividend that is 117% higher than its core earnings. John Delaney blithely explained the modest recent gap thusly:

Second, I was actually very pleased with the adjusted earnings performance of the business at $0.51 per share for the quarter, particularly since we recognized $0.09 in quarterly adjusted earnings loss, related to the reduction of our agency portfolio by over $600 million. We have continued to reduce our agency portfolio, and today it stands at about $1.6 billion, down from its peak of about $4 billion.

The reason for this reduction is simple. We didn't need as many agencies for recompliance, and we elected to reduce the portfolio, not because we had to, but simply because we could, and it resulted in a dramatic reduction in any funding risk against this portfolio.

More like, we don't like agencies, we don't know to manage them, we just have to have them. Just ignore them and focus on our better lines of business.

Giving CapitalSource a Break

While I'm in the mood for mea culpas, I have to mention CapitalSource (CSE). I have never gotten as much mail as I have about my recent critiques of CapitalSource (CSE). I still remain pretty critical of the Company's broadening business model, but I guess I can give them the benefit of the doubt. I've never recommended shorting CSE or anything like that, however -- I just feel as though their execution could be sharper. Call it urging a B-student to strive for an A. They got a sweet deal on the Fremont bank branches, so let's see what investments they make with those cheap deposits.

SuperREIT Swoops Up Fremont's Branches

I've complained before about CapitalSource (CSE) getting too big to focus on its core competencies, but with the acquisition of the Fremont branches, CapitalSource is looking less a mortgage REIT and more like, well, Countrywide (CFC). In fact, this deal reminds me a bit of the IndyMac (IMB) restructuring from a REIT to a thrift back in 1999 after liquidity concerns forced IMB to seek new sources of funding in order to grow the business.

Scott Valentin at FBR Capital Markets asked precisely the question that concerned me the most

Then as far as the REIT status, are there any implications in terms of trying to manage the REIT compliant assets with the bank?

CEO John Delaney poo-poohed Valentin's concerns, responding

No, actually one thing we can probably comment on is our agency portfolio, which a lot of people know has been driving our REIT optimization -- REIT compliance. We have actually been able to downsize that because we had overinvested in that. That portfolio is probably now down to $2.5 billion. And we think it is going to go smaller because we don't need quite as many assets. So managing the REIT structure right now has not been that difficult for us. So this doesn't change any of that.

CapitalSource hasn't proven to me that it can run a mortgage REIT just yet. Now they're going to run a bank in the middle of a severe financial crisis. I guess CSE really is the SuperREIT.

CapitalSource Can't Cover Its Dividend

Analysts may have hinted at it last week during CapitalSource's (CSE) fourth-quarter earnings call, but today the truth was confirmed -- CapitalSource is not covering its dividend with taxable income.

After the bell yesterday, CapitalSource put out a short press release announcing that the tax characteristics of its 2007 dividends were available on the Company's website. Those who've read my blog know that I track tax characteristics as a measure of a mortgage REIT's dividend health.

Despite CSE management playing up the $0.60/share quarterly dividend in its last earnings release:

Given the strength and performance of our business and, in particular, credit metrics that remain at the low end of historical ranges, we declared a $0.60 per share cash dividend for the first quarter of 2008 yesterday and we are projecting a $0.60 per share quarterly cash dividend for the balance of 2008...

The truth is that two-thirds of CapitalSource's 2007 dividends were classified as a return of capital. That's right, fully $1.60/share of the $2.38 in '07 dividends amounted to CSE shareholders being handed back their original investment. Thus, if you were invested in CapitalSource at the beginning of 2007, and you sold CapitalSource shares to harvest tax losses, well, your capital loss just got cut by $1.60/share.

In other words, CSE can't generate enough taxable income to maximize the advantages of being a REIT. Instead of owning up to this and retaining the excess capital tax-free, CSE chose to keep pumping out dividends and diluting existing shareholders through its DRIP and direct stock purchase plan -- during one of the worst credit crises in recent history. If nothing else, CapitalSource could have retained the capital and repurchased common shares as a better means of supporting shareholder value.

By their very nature, REITs maximize their value when they can fully utilize their tax-advantaged structure. CapitalSource, meanwhile, reported an effective tax rate of 33.2% for 2007. Being a mortgage REIT is not just about paying a dividend. It's about utilizing a complex structure to deliver returns on shareholder equity.

Could Carving Up CapitalSource Create More Value?

CapitalSource (CSE), a diversified REIT, reporting a disappointing $0.07/share fourth-quarter GAAP loss amidst serious derivative losses, mark-to-market losses on its MBS portfolio, and a growing provision for loan losses.

CapitalSource seemingly brushed off the actual results, focusing instead on a healthy dividend outlook and a less competitive landscape for 2008. Analysts on the call seemed a bit dazed and confused, with Moshe Orenbuch at Credit Suisse asking:

And then, I guess with respect to your thoughts on kind of the adjusted earnings level versus the dividends, someone asked a question or kind of inferred that since part of that dividend is paid at the start, is there a period of time where you are willing to under earn the dividend, how should we think about that?

Maybe you should think beyond the smoke and mirrors that CapitalSource is throwing up. The Company has a strong record of delivering on its investments, but the overall structure is suffering under management's one-stop shop attitude. CSE bills itself as a SuperREIT, a hybrid diversified vehicle that can do it all. Unfortunately, the REIT structure is not quite as accommodating as CSE would like for it to be.

CapitalSource's entire reasoning for converting to REIT structure was to enjoy significant tax advantages. However, CSE posted an "overall effective tax rate in 2007, expressed as a percentage of consolidated pre-tax GAAP net income, [of] 33.2%." Obviously, the Company is earning most of its income within its TRS subsidiaries and not with the tax-sheltered qualified REIT subsidiaries.

CSE is basically structured as conglomerate of three separate divisions: 1) a corporate finance TRS, 2) a healthcare net lease REIT, and 3) some sort of structured finance segment. It's a BDC, a healthcare triple net lease REIT, and a poorly performing mortgage REIT all in one!

Seems pretty obvious to me that CapitalSource could unlock significant value by selling off its poorly performing residential mortgage portfolio, spinning off its profitable healthcare net lease REIT as a separate entity, and restructuring its corporate loan portfolio as a BDC. The Company already operates with low leverage, and could eliminate a lot of repurchase agreements by disposing of the residential mortgage portfolio holding up its REIT status.

CapitalSource can perform from an operations standpoint. I wish they'd give themselves the opportunity to do so.

Farallon Collects More CapitalSource

Hedge fund Farallon Capital has recently been an active buyer of CapitalSource (CSE) since the beginning of December, purchasing an additional 2.8 million shares to bring its total stake in CSE to 15.2%. Based on the most recent 13F-HR filing as of 9/30/07, CapitalSource is Farallon's largest single company holding.

Farallon, you'll remember, was the hedge fund that bailed out Accredited Home Lenders (LEND) until LEND was taken private by Lone Star Partners.

Although Farallon discloses its holdings in CSE on Form 13-D, it hasn't announced any intention to purchase CapitalSource or otherwise rabblerouse - yet. However, with the price of CapitalSource shares down about a third this year, expect to see Farallon get more active with its investment.

CapitalSource's Convenient Oversight

CapitalSource (CSE), a middle-market commercial lender and investor, was out with 3rd quarter earnings of $0.15/share, materially down from $0.45/share in 2nd quarter earnings. The reduction in current period income (and to be fair, I give CapitalSource credit for having positive net income) is due primarily to the $30 million valuation charge the Company took against its residential investment portfolio. Although the residential portfolio comprises over 25% of CSE's net investment income, it is rarely mentioned throughout CSE's earnings release, perhaps because the yield on the agency securities is so low compared to CapitalSource's other investments. It seems fairly obvious that those agency securities have been retained to help CSE maintain REIT compliance.

CapitalSource elected to maintain a dividend payout of $0.60/share, despite posting adjusted earnings (roughly equivalent to taxable income) of just $0.50/share. Year-to-date, CSE has earned $1.82/share of adjusted earnings and paid out dividends of $1.78/share. The dividend coverage is pretty minimal - reflecting CapitalSource's bullish outlook for the fourth quarter.

The conference call was very positive and confident, and CapitalSource does focus on a niche -- healthcare -- that is largely noncyclical. Nonetheless, CapitalSource feels very comfortable about its ability to access the securitization market -- a view that is in sharp contrast to that of its peers.

CapitalSource converted from being a BDC to the REIT structure at the beginning of 2006, so management is largely untested at satisfying REIT requirements during times of stress. Investors in CapitalSource may wish to review the Q carefully for hints that maintaining REIT status will be a challenge at year-end.