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CapitalSource Inc at Lehman Brothers Global Finance Services Conference - Final.

Article Excerpt
DARRIN PELLER, ANALYST, LEHMAN BROTHERS: All right, let's get started. So CapitalSource is here today with us. Clearly the company has undergone considerable changes over the past year. More recent moves include the acquisition of its $5 billion of deposits from Fremont as well as the upcoming IPO part of its Healthcare REIT. Clearly these moves are transitioning CapitalSource from more of a REIT, more of a commercial bank strategy, and a company that we believe is actually one of the best funded platforms in our entire coverage universe.

We have an [overweight] rating on the stock and we are very happy to have John Delaney, the CEO of the company, here with us today. So thanks, John.

JOHN DELANEY, CHAIRMAN AND CEO, CAPITALSOURCE, INC.: Thanks, Darrin. Let's start with an overview of the company and then we will drill down on some of the more relevant concepts. But in case people are new to this story and new to the company, let me cover a few of the basics.

Our principal business is middle market commercial finance, which we define as lending senior debt to a variety of businesses that are engaged in different industries typically using our financing to finance an acquisition, to finance growth, or to finance some form of recapitalization. So it is kind of classic middle market commercial financing.

We've organized ourselves along different kind of industry lines or sector lines and we think we have the leadership position in most of these businesses. We've got about 550 employees in the company in the commercial lending franchise. So we've been fully engaged in commercial lending as a leader in that space for about eight years.

We also own a retail banking franchise in Southern California and as Darrin gave you, this is a recent acquisition where we now own a bank with about $5 billion of deposits, 22 branches spread out across kind of an attractive market in Southern California and mostly in Orange County but some in LA County. And we have 65,000 customers in that banking franchise. These customers have been very sticky and very kind of long-standing customers of the bank.

We also have a healthcare net lease business. One of our main commercial lending businesses is in healthcare and out of that business, we developed kind of a healthcare triple net lease business. We call it a healthcare sale-leaseback business where rather than lending on healthcare assets, which we do in our healthcare lending business, we actually purchase the Healthcare Real Estate and we lease it back to operators across a long term.

This business is typically done in the context of a Healthcare REIT and we announced a little over a month ago that we would file a public offering for this business and effectively create a Healthcare REIT, what we are calling CapitalSource Healthcare REIT, out of that business of our company.

But the main business is commercial financing. We have a very large, diverse portfolio of borrowers in our commercial finance business, over 1000 loans in the portfolio, over 20 offices throughout the country and a loan portfolio that is a little over $9 billion of funded assets.

The business is best characterized as focused, meaning as a commercial lender, as a middle market commercial lender we don't really lead as a generalist. We lead as a specialist and so all of our businesses are organized along kind of industry lines or sector lines. It has been my judgment that as someone engaged in middle market commercial finance for some time that both your credit outcomes and your return outcomes are enhanced through a focused strategy. So we're very committed and very dedicated to the kind of focused lending platform and we think our credit results, which have been very strong and we expect to continue to be very strong will be kind of first evidence of the fact that as a focused commercial lender we can deliver a much better credit outcome and much higher returns.

The funding platform at this point is very strong. We have excess liquidity in our business, significant excess liquidity in our business, and we have diverse sources of funds. That funding strategy is now kind of anchored in deposits, where deposits are 45% of our kind of liability structure. But we also have a robust secured funding platform and an unsecured funding program and the company in its commercial lending business runs with relatively low leverage. Our leverage in our commercial lending business is about 4 to 1 debt to equity, which is lower than it has been in some time.

The management team has been at this for a while and we have good, strong insider ownership between management and Board, about one-third of the company is owned by those insiders.

The company has evolved over the last several years. The company was started in 2000 kind of on the heels of the last credit crisis, which in hindsight that seems to be more of a speed bump than a real crisis compared to what we have now. And the original thesis of the business was that it was a very good time to lend money after the last kind of credit meltdown and that we could build kind of from a clean slate a leading commercial lending platform and kind of adopt best-in-class management practices in this kind of focused asset strategy.

We largely built that commercial lending platform from 2000 to 2005 and we were very successful building out kind of this robust lending, credit, asset management machine which we have now and our results were very good both from a credit perspective and from a return perspective.

As we entered 2006, we were experiencing a market that could be best described as an intensely liquid market where there was tremendous competition at all points in the capital markets and at all points of the lending markets. And our response to that market was not to chase yield by going deeper in the capital structure but our response in that market was to try to stay very senior and very safe, recognizing we would have to compromise a return to do that.

And so our strategy is to how to best pursue that strategy at the time with the focus on operating efficiencies in the business. Again, we made a decision not to chase yield. We made a decision to stay safe, to stay senior, focused on credit and we understood that by making that decision we would have a lower unlevered return on our assets. So there was no other choice.

And so we focused on efficiencies in our business. And one of things we did was adopt a REIT structure for the company, which saved us a fair amount of taxes. It was our view that we can invest those tax savings into this kind of lower return but safer asset strategy. And that is what we did and that's why we made a decision to have the company treated as a real estate investment trust, which turned out to be a very good decision when you look at how much taxes we've saved and how we are able to keep this business kind of as a safe asset profile.

Soon to that strategy, we started to realize that deposit-based funding would be in our future as the business was growing and we became concerned that we were perhaps overly reliant upon the capital markets and that that wasn't a prudent way to run the business and we needed to adopt a deposit-based strategy.

So literally about three years ago, we started focusing on having deposits become a meaningful part of our business. I would describe our quest...

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