Business Context and Reporting Period
Company: Capital Southwest Corp (Investment Company)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: December 31, 2006 (Nine months ended Dec 31, 2006; Three months ended Dec 31, 2006)
Business Overview: The company invests in a portfolio of public and private companies, including restricted securities of publicly-owned companies and debt/equity of private entities. As of December 31, 2006, restricted securities represented approximately 91.6% of the portfolio value.
Key Financial Metrics
| Metric | Nine Months Ended Dec 31, 2006 | Nine Months Ended Dec 31, 2005 |
|---|---|---|
| Total Investments (Market Value) | $661,106,426 | $550,428,083 (Mar 31, 2006) |
| Net Investment Income | $3,278,407 | $2,133,707 |
| Net Realized Gain on Investments | $19,049,091 | $11,312,891 |
| Net Increase in Unrealized Appreciation | $81,044,543 | $29,883,188 |
| Total Increase in Net Assets from Operations | $103,372,041 | $43,329,786 |
| Net Assets (End of Period) | $499,587,267 | $343,549,462 (Dec 31, 2005) |
| Net Asset Value (NAV) per Share | $128.56 | $89.07 |
| Cash and Cash Equivalents | $56,530,336 | $13,518,641 (Dec 31, 2005) |
| Debt (Note Payable to Bank) | $8,000,000 | $8,000,000 |
| Available Credit Line | $17,000,000 | N/A |
Material Changes vs. Prior Period
- NAV Growth: Net asset value per share increased 48.4% over the past twelve months and 27.8% in the quarter ended December 31, 2006.
- Investment Portfolio: Total investment value rose from $550.4 million (March 31, 2006) to $661.1 million (December 31, 2006).
- Realized Gains: Net realized gains increased significantly to $19.0 million (9 months 2006) from $11.3 million (9 months 2005). This was driven by a $31.1 million gain on the sale of Heelys, Inc. shares and an $8.9 million gain on Cenveo, Inc. shares, partially offset by losses on Hic-Star Corporation and PharmaFab, Inc.
- Unrealized Appreciation: Net unrealized appreciation surged to $81.0 million, primarily due to a $170.0 million increase in the value of the remaining Heelys, Inc. investment following its IPO. This was partially offset by decreases in the value of Palm Harbor Homes ($27.5 million) and Encore Wire ($20.4 million).
- Liquidity: Cash and cash equivalents increased from $11.5 million at the start of the fiscal year to $56.5 million, bolstered by investment sales and a temporary $150 million borrowing (repaid July 2006) to maintain RIC tax status.
Outlook, Risks, and Management Commentary
- Management Commentary: Management attributes the strong performance to the Heelys, Inc. IPO and subsequent stock appreciation. They note that the company retains realized gains to sustain future investment activity.
- Liquidity Strategy: The company maintains a $25.0 million revolving credit line ($17.0 million available) and holds significant unrestricted publicly-traded securities ($55.7 million) as a liquidity source. Funds may also be transferred from wholly-owned portfolio companies.
- Future Investments: The company agreed to invest up to $10.3 million in three portfolio companies, subject to conditions.
- Risks:
- Market Risk: Performance is tied to the profitability of portfolio companies, which are subject to economic cycles and commodity price fluctuations. Most portfolio companies do not hedge raw material costs.
- Valuation Risk: 91.6% of the portfolio consists of restricted securities valued at fair value by the Board, which may differ from amounts realized upon sale.
- Concentration: Significant value is tied to specific holdings (e.g., Heelys, Encore Wire, Palm Harbor Homes).
- Accounting Changes: The company adopted SFAS 123R for stock-based compensation effective April 1, 2006. They are evaluating the impact of SFAS 157 (Fair Value Measurements) and SFAS 158 (Pension Accounting).
Investor Verification Checklist
- Heelys, Inc. Valuation: Verify the sustainability of the $170 million unrealized gain on Heelys following its IPO and the impact of the remaining restricted shares.
- Restricted Securities: Review the Board's methodology for valuing the 91.6% of the portfolio classified as restricted securities, as these are not freely marketable.
- Deferred Taxes: Confirm the $52.44 per share allowance for deferred taxes on unrealized appreciation and the potential cash impact if these gains are realized.
- Portfolio Concentration: Assess the risk exposure to specific underperforming holdings like Palm Harbor Homes and Encore Wire, which saw significant value declines.
- Debt Repayment: Note the repayment of the $8 million note payable on January 2, 2007, and the utilization of the $25 million credit line.