Description

This idea is in the vein of Bowd’s recent write-up on Anthracite, although probably not as profitable and certainly not as safe or well-reasoned: Fire, Ready, Aim. Credit markets are in turmoil. There are no buyers for sketchy paper, and quality paper has been marked down substantially. Mortgage REITs have been clobbered and at least one has gone belly, perhaps more to follow. What started out as a sub prime mortgage problem has spread to the private equity bubble, making deal financing iffy. What to do? Make a leveraged bet on a commercial REIT, which bet is contingent upon the closing of an announced deal. When you pull yourself off the floor laughing, read on.

CapitalSource is at its core a lender to middle market companies. They also have a portfolio of agency and AAA mortgages, but they hold those to qualify as a REIT. There was a VIC write-up on CapitalSource a year or 18 months back, just before their REIT conversion and special dividend. The stock is controversial because they are in to risky assets such as cash flow loans and loans backed by receivables and inventory, in addition to senior commercial mortgages which are bit safer. Some of their commercial loan portfolio is indeed what I would call risky, but I believe the management team is very astute and very careful in their underwriting, and in how they run the company in general. Bottom line, CapitalSource may be in the business of making risky loans but they are not terribly leveraged and they are funded decently. They recently reaffirmed the $2.40 dividend for 2007 and beat estimates for the quarter.

Now, you can imagine that a company like CapitalSource has seen its stock price plummet recently. It would be hard to imagine a scenario where some babies were not thrown out with the bathwater in an environment like this. At a yield of 12.3%, however, it starts to get interesting. The key word here is “starts.” I am not recommending it.

Why am I writing about CapitlSource when the idea submitted is TONE? On May 17^th, CapitalSource announced that it will acquire TierOne, the holding company of TierOne bank. The rationale behind the deal is that CapitalSource will access TierOne’s deposit funding, thereby lowing its cost of capital. Also, CapitalSource can place some loans they originate into TierOne, and increase the leverage on these loans as the bank has more leverage than CSE does. The main reason is the deposits though. TierOne had hit hard times due to problem real estate loans in Florida. CapitalSource did extensive due diligence and is comfortable with them.

Here’s the nitty gritty. If the deal goes through, which is admittedly something of an IF, you will get $6.80 in cash plus 0.675 shares of CSE for each share of TierOne. Plus, if CSE is trading below $25.1852 on average for the 10 days prior to the deal’s closing in Q4 of this year, you get another 0.405 shares of CSE, or if CSE is trading above that magic number, you get $10.20 in either CSE stock or cash, your choice. If CSE is below the magic number, as it is today, you get, in toto: 0.675 + 0.405 = 1.08 shares of CSE, plus $6.80 cash. At CSE’s current price of $19.55 this would be $21.11 in CSE stock plus the cash equals $27.94. TONE closed today at $21.78. I almost forgot to mention that at CSE’s current price, TONE can walk from the deal (at least that’s my understanding). CSE can walk too, but they would have to pay a fee.

Obviously people are banking on a train wreck here. Or to be more precise, people are not excited about betting on the deal closing. Why would you, with shares of perfectly good companies falling like they did today? So, you have two unattractive stocks – TONE with its Florida real estate loans, which may be acquired by CSE, the commercial REIT. Sounds like an excellent way to lose a lot of money fast.

But, consider TONE’s options. TONE is now trading below where it was prior to the deal being announced. If the deal closes, TONE shareholders would still be far better off than if TONE walks. If they walk, they have to find another buyer….good luck. As for CapitlSource, they are not like regular bank buyers. They are not doing this to take out costs, as most acquiring banks would. CSE wants the deposits. They will close national lending because they do that themselves (better than TONE, I would add), but otherwise they will keep TONE the way it is. CSE does not need to buy TONE in order to survive, but it is a neat idea for them to do so in the long term.

I mentioned above that TONE is trading below where it was prior to the deal being announced. In fact, the 52 week low was $19.76. The stock would blow thru that if the deal were called off, but perhaps not too far. I submit that the downside risk here is less than in other announced deals that may well fall through. 

And as for why anyone would want to own CapitalSource these days, I submit that it’s a question of price. It is reasonable to assume that CSE’s commercial portfolio may experience increasing charge-offs in a recession, and it is reasonable to assume we will have some kind of recession given what we’re about to experience with home prices (and you thought the party was already in full swing). However, as mentioned above, CSE’s management is pretty savvy and the charge-offs are unlikely to sink the company completely, in my humble opinion. My guess is that the absolute best case scenario for CSE is that analysts will turn bearish on the stock and nothing happens to the loan portfolio, in which case you have a 12%+ dividend and a low stock price. Not much fun. In the worst case scenario, charge offs are bad enough that the dividend is reduced and the share price declines significantly from today’s level. That would be much less fun. However, if the TONE deal goes through, as I believe it will, you would be getting CSE for something like $13.39/share (I’m subtracting the arbitrage difference from CSE’s share price) which would produce a dividend yield of 18%, assuming the dividend isn’t reduced or eliminated. This idea is essentially taking CSE and adding leverage to it, via assuming the risk of the TONE deal closing. Just the kind of thing one wants to do with the market crashing.

Catalyst