Capital Southwest Corporation — Form 10-Q Summary
Reporting period: Third fiscal quarter and nine months ended December 31, 2011; comparisons are to the corresponding 2010 periods. Capital Southwest is a business development company whose results depend primarily on investment income and changes in portfolio investment values.
Key financial metrics
| Metric | Three months ended Dec. 31, 2011 | Nine months ended Dec. 31, 2011 |
|---|---|---|
| Investment income | $5.624 million, versus $2.362 million | $8.078 million, versus $6.492 million |
| Operating expenses | $1.212 million, versus $1.109 million | $3.583 million, versus $3.147 million |
| Net investment income | $4.385 million, versus $1.227 million | $4.421 million, versus $3.271 million |
| Net realized gain (loss), after tax | $(2.360) million, versus $(28.797) million | $10.079 million, versus $45.748 million |
| Change in unrealized appreciation | $48.798 million, versus $21.837 million | $0.165 million, versus $(20.545) million |
| Increase in net assets from operations | $50.823 million, versus a $5.733 million decrease | $14.665 million, versus $28.474 million |
Balance sheet and liquidity: At December 31, 2011, investments were valued at $479.8 million, cash and cash equivalents were $63.2 million, total assets were $557.1 million, and net assets were $551.8 million. Net asset value was $146.95 per share, up from $143.68 at March 31, 2011. Total liabilities were $5.4 million; the filing does not show corporate borrowings. Cash held by the SBIC subsidiary that could not be transferred without SBA consent was $5.6 million. Nine-month operating cash flow was $20.6 million, down from $71.7 million in 2010; cash increased $17.7 million over the period.
Changes and notable items
- Nine-month investment income rose 24%, mainly because dividend income increased $1.3 million; operating expenses rose 14%, primarily from salaries and bonuses, stock-option expense, and divestiture-related professional fees.
- Quarterly results benefited substantially from unrealized appreciation, including reported increases in Encore Wire, RectorSeal, and other holdings. For the nine-month period, the company reported a $10.1 million after-tax realized gain, compared with $45.7 million in 2010, which included the Lifemark sale.
- Investment dispositions and impairments included a $17.9 million gain on the All Components management buyout and a $9.9 million gain on the sale of Texas Capital BancShares shares, offset in part by a $10.8 million loss when Palm Harbor Homes was declared bankrupt and a $5.9 million loss on the sale of PHI Health securities.
- The company elected to retain 2011 long-term capital gains as deemed distributions and paid approximately $1.25 million in federal tax on shareholders’ behalf. It also paid $3.0 million in ordinary dividends for the 2011 tax year.
- Investments were down from $489.3 million at March 31, 2011. The company invested $1.6 million in existing portfolio companies during the quarter and had conditional commitments to invest up to $9.7 million in nine portfolio companies.
Outlook, risks, and contingencies
Management said cash and other available sources were adequate for expected requirements; investment sales may also fund future activity. The filing provides no numerical earnings or investment-return guidance. Management’s forward-looking statements are subject to risks, and the company undertook no obligation to update them.
Valuation is a significant risk: 97.7% of portfolio value was in restricted securities and 97.7% was classified as Level 3, relying substantially on unobservable inputs and board-determined fair values. Management cautioned that realized proceeds may differ materially from current estimates. Other risks include portfolio-company performance, economic and competitive conditions, commodity and labor costs, and public-market equity price changes. The company does not use derivatives to mitigate these risks. It reported no current pending legal proceedings and no material changes to previously disclosed risk factors.
Investor verification priorities
- Review the assumptions and support for Level 3 portfolio valuations, particularly for major holdings and the quarter’s large unrealized gains.
- Verify the status, collectability, and valuation of troubled investments, including Cinatra Clean Technologies and the consequences of Palm Harbor Homes’ bankruptcy.
- Assess portfolio concentration and liquidity, including the high proportion of restricted investments and the SBA restriction on subsidiary cash.
- Confirm the company’s RIC qualification, deemed-distribution tax treatment, and the timing and terms of its conditional $9.7 million investment commitments.