Capital Southwest Corporation — Form 10-Q
Business context and reporting period. Capital Southwest is a business development company and investment company with a portfolio of controlled, developing, and publicly traded businesses. This report covers the quarter and six months ended September 30, 2012, the company’s fiscal second quarter and first half. Financial statement amounts below are in U.S. dollars; monetary figures are shown in millions unless noted.
Financial performance and position
| Metric | Three months ended September 30, 2012 | Six months ended September 30, 2012 | Comparable 2011 period |
|---|---|---|---|
| Investment income | $1.344 million | $2.795 million | $2.454 million for six months |
| Operating expenses | $1.438 million | $2.857 million | $2.370 million for six months |
| Net investment income/(loss) | $(0.121) million | $(0.102) million | $0.037 million for six months |
| Net realized investment gain | $(0.007) million | $66.881 million | $12.439 million for six months |
| Change in unrealized appreciation | $50.321 million | $(28.200) million | $(48.634) million for six months |
| Increase/(decrease) in net assets from operations | $50.193 million | $38.579 million | $(36.158) million for six months |
Balance sheet and liquidity. At September 30, 2012, investments at fair value were $536.269 million, cash and cash equivalents $59.687 million, total assets $606.559 million, and total liabilities $4.316 million. Net assets were $602.243 million and net asset value (NAV) was $158.65 per share, versus $167.45 at March 31, 2012. The filing reports no borrowings as a balance-sheet liability. Of cash, $4.8 million held by subsidiary CSVC could not be transferred to the parent without SBA consent.
Cash flow and distributions. Six-month operating activities provided $60.106 million, including proceeds from investment dispositions; financing activities used $65.314 million, principally reflecting a $66.826 million realized-gain dividend and $1.505 million distribution of undistributed investment income. Cash declined $5.208 million from March 31. The company paid a $17.59-per-share cash dividend in June 2012.
Material changes versus the prior comparable period
- Six-month investment income rose 13.9%, primarily from interest accrued on additional debt investments in Cinatra, Trax, TitanLiner, and iMemories. Operating expenses increased 20.5%, mainly due to compensation changes and staff growth; the pension benefit also declined as the discount rate fell from 6.00% to 5.25%.
- The company sold 2,774,250 Encore Wire shares, realizing a $66.037 million gain, and 50,000 Hologic shares, realizing an $0.851 million gain. Six-month realized gains were therefore substantially higher than in 2011.
- Unrealized appreciation decreased by $28.201 million over six months. Significant decreases included Encore Wire ($82.454 million), partly reflecting shares sold and a lower share price, and Media Recovery ($6.600 million). Significant increases included RectorSeal ($42.300 million) and Alamo Group ($10.485 million).
- Investment fair value fell from $558.546 million at March 31 to $536.269 million at September 30. The Level 3 share of the portfolio increased from 56.9% to 69.6%.
Outlook, risks, and unusual items
- Management said cash and other available sources were adequate for expected requirements; investment dispositions may also fund future investments. The filing gives no numerical earnings or NAV guidance.
- The company had agreed, subject to conditions, to invest up to $10.138 million in nine portfolio companies. It invested $5.950 million in new investment TitanLiner and $0.609 million in existing portfolio companies during the six months.
- Fair values for private and restricted holdings depend substantially on board judgments and unobservable inputs; the company cautions that realized gains or losses may differ materially from current estimates. Restricted securities represented 69.6% of portfolio value, and $373.5 million of investments were classified Level 3.
- Market risks include public-equity price changes and portfolio-company exposure to economic cycles, competition, foreign currency, and input costs. The company does not use derivatives to mitigate these risks.
- The company reported no material change in disclosed risk factors and no pending legal proceedings to which it was a party. It disclosed no material change in internal control over financial reporting.
- CSW and CSVC qualified as regulated investment companies for the quarter; future qualification depends in part on meeting diversification requirements. Failure to qualify could result in tax on taxable income.
Important facts for investors to verify
- Review the Encore Wire sale, remaining position, and valuation effects, including the large realized gain and decline in unrealized appreciation.
- Assess the assumptions and sensitivity behind Level 3 valuations, particularly given the portfolio’s increased concentration in restricted and privately valued securities.
- Verify portfolio concentration and company performance for major holdings, including RectorSeal, Alamo Group, and Whitmore Manufacturing.
- Check the sustainability of investment income relative to operating expenses and the impact of additional debt investments and any non-accrual or collection concerns.
- Confirm the status and funding requirements of the $10.138 million of conditional investment commitments, the SBA restriction on CSVC cash, and future distribution and RIC qualification requirements.