Capital Southwest Corporation — Form 10-Q
Reporting period: Three months ended June 30, 2012 (the first quarter of the company’s fiscal year). Capital Southwest is an investment company and business development company; its results primarily reflect investment income, realized gains and changes in portfolio fair values.
Financial results and position
| Metric | Quarter ended June 30, 2012 | Comparable 2011 period / prior date |
|---|---|---|
| Investment income | $1.451 million | $1.197 million; up 21.2% |
| Operating expenses | $1.419 million | $1.165 million; up 21.7% |
| Net investment income | $18,000 | $14,000 |
| Net realized investment gain (loss) | $66.888 million | $(5.911) million |
| Change in unrealized appreciation | $(78.521) million | $(4.558) million |
| Decrease in net assets from operations | $(11.615) million | $(10.455) million |
| Operating cash flow | $66.154 million provided | $9.322 million used |
| Cash and cash equivalents | $65.735 million | $64.895 million at March 31, 2012 |
| Total investments at fair value | $485.658 million | $558.546 million at March 31, 2012 |
| Total assets / liabilities | $562.138 million / $10.104 million | $632.989 million / $4.283 million at March 31, 2012 |
| Net assets / NAV per share | $552.034 million / $145.73 | $628.706 million / $167.45 at March 31, 2012 |
The filing reports no corporate borrowing balance. Liabilities included a $5.950 million investment commitment payable, accrued pension cost and deferred taxes. The company said $2.7 million of cash held by its SBIC subsidiary could not be transferred to the parent without SBA consent. No conventional operating margin is presented; net investment income was approximately break-even relative to investment income.
Material changes and drivers
- The company sold 2,774,250 Encore Wire shares to Encore Wire and 50,000 Hologic shares, generating a combined reported realized gain of approximately $66.9 million. Encore Wire’s fair value declined by $85.7 million, driven by the share sale and a lower stock price; Hologic’s value fell by $3.1 million, including the effect of shares sold.
- Other material portfolio valuation decreases included Heelys, down $2.7 million, and Media Recovery, down $3.3 million. Increases included RectorSeal, up $7.5 million, and Alamo Group, up $3.7 million. The company attributed several gains to improved investee earnings.
- The company paid a $17.59-per-share capital-gains distribution, totaling $66.826 million. Net assets also reflected $1.505 million of distributions from undistributed investment income and $3.017 million in proceeds from employee option exercises. NAV per share fell by $21.72 during the quarter.
- Investment income rose primarily due to a $104,053 profit distribution from CapitalSouth Partners Fund III. Operating expenses increased mainly because of compensation changes effective in July 2011 and staff growth.
- Portfolio fair value fell by approximately $72.9 million from March 31. The share of investments classified as Level 3, relying on significant unobservable valuation inputs, rose from 56.9% to 68.7%; restricted securities represented 68.7% of portfolio value at June 30.
Liquidity, outlook and risks
Management stated that cash and other available sources were adequate for expected requirements, with investment dispositions also an important potential funding source. The company invested $5.950 million in TitanLiner and $301,046 in existing portfolio companies during the quarter. It had agreed, subject to conditions, to invest up to $10.138 million in nine portfolio companies. The TitanLiner investment was completed June 28 and funded July 2, leaving the commitment payable at quarter-end.
The filing provides no earnings or investment-return guidance. Management’s principal objective is capital appreciation, and it does not seek to maintain a consistent level of realized gains. Risks include market-price movements in publicly traded holdings, portfolio-company operating performance, commodity and raw-material costs, and uncertainty in fair values for private investments. Management warned that actual realized proceeds may differ materially from current valuations. RIC status depends on meeting distribution and portfolio-diversification requirements; future diversification compliance may not be fully controllable. Risk factors were reported as unchanged from the prior Form 10-K. The company reported no pending legal proceedings and no material change in internal control over financial reporting.
Important facts for investors to verify
- Reconcile the Encore Wire share sale, reported realized gain and large unrealized-value decline, including the effect on remaining ownership and portfolio concentration.
- Review the basis and sensitivity of Level 3 valuations, especially the increase in Level 3’s share of portfolio value and the assumptions used for private-company holdings.
- Confirm distribution treatment and tax reporting for the $17.59-per-share capital-gains distribution, and monitor the company’s ability to maintain RIC status.
- Assess cash availability after the distribution, the $5.950 million TitanLiner funding, remaining investment commitments and the restriction on transferring subsidiary cash.
- Compare portfolio-company performance and subsequent fair values with the quarter-end estimates, particularly for holdings with material valuation changes.