Business context and reporting period
Capital Southwest Corporation is a business development company and investment company investing in controlled and developing businesses and publicly traded securities. This Form 10-Q covers the quarter and six months ended September 30, 2011. The filing date is October 28, 2011. September 30 is the company’s second fiscal quarter, in the fiscal year ending March 31, 2012.
Financial performance and position
Amounts below are in millions except per-share data. The company’s investment-company performance is driven by investment income and realized and unrealized investment gains or losses; conventional operating margins are not meaningful here.
| Metric | Three months ended September 30, 2011 | Six months ended September 30, 2011 | Comparable 2010 period |
|---|---|---|---|
| Investment income | $1.257 | $2.454 | $1.164 quarter; $4.130 six months |
| Operating expenses | $1.205 | $2.370 | $1.064 quarter; $2.038 six months |
| Net investment income | $0.023 | $0.037 | $0.081 quarter; $2.044 six months |
| Net realized gain on investments | $18.350 | $12.439 | $0.530 quarter; $74.545 six months |
| Change in unrealized appreciation | -$44.076 | -$48.634 | +$23.360 quarter; -$42.383 six months |
| Increase (decrease) in net assets from operations | -$25.703 | -$36.158 | +$23.971 quarter; +$34.206 six months |
At September 30, total investments were $443.9 million, down from $489.3 million at March 31, 2011. Cash and cash equivalents were $53.3 million, of which $16.0 million held by the SBIC subsidiary could not be transferred to the parent without SBA consent. Total assets were $506.3 million, liabilities $4.1 million, and net assets $502.2 million. No borrowings are reported. Net asset value was $133.75 per share, versus $143.68 at March 31, a decline of $9.93 per share.
For the six months, operating activities provided $9.2 million of cash; financing activities used $1.4 million, including $1.5 million of distributions. Cash increased $7.8 million from March 31. The filing does not provide a clear conventional revenue-margin measure.
Material changes versus the prior comparable period
- Six-month investment income fell 40.6%, primarily because dividend income declined $1.77 million (59.7%). Dividend income was lower mainly because Balco paid no dividend in the 2011 period, compared with $1.82 million in 2010.
- Six-month net investment income fell to $0.037 million from $2.044 million. Operating expenses rose 16.3%, mainly due to higher salaries and bonuses, stock-option expense, and professional fees associated with divestitures.
- The company recorded $12.44 million of six-month realized gains, compared with $74.55 million in 2010, when the Lifemark sale generated substantial gains. 2011 realized items included an $17.85 million gain on the All Components management buyout, a $5.91 million loss on the sale of PHI Health securities, and a $0.5 million gain on settlement of the Essex Capital note.
- Unrealized depreciation of $48.63 million drove the six-month operating loss. Management attributed major declines to public holdings Alamo Group and Encore Wire, as well as Heelys; it also cited slowdowns at Cinatra Clean Technologies, KBI Biopharma, Media Recovery and RectorSeal. Whitmore Manufacturing appreciated $4.0 million.
Outlook, commentary, risks and unusual items
Management gave no quantified earnings or portfolio guidance. It said cash and other available resources were adequate for expected requirements and noted that investment dispositions may fund future investments. The company had agreed, subject to conditions, to invest up to $9.89 million in nine portfolio companies; it invested approximately $1.68 million in existing portfolio companies during the quarter.
Valuation is a significant uncertainty: 95.3% of portfolio value consisted of restricted securities, and 95.3% of investments were classified as Level 3, relying on significant unobservable inputs and Board-determined fair values. Management cautioned that actual realizations could differ materially from current valuations. Public-market declines, portfolio-company performance, competition, economic cycles, input costs and foreign-exchange movements may adversely affect investment values; the company does not use derivatives to mitigate these risks.
The company intends to maintain regulated investment company status and states it believes this is probable, but future diversification requirements may not be within its control. Failure to qualify could result in corporate-level tax on taxable income. The filing reports no pending legal proceedings and no material changes to previously disclosed risk factors. Disclosure controls were assessed as effective, with no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether the sharp unrealized markdowns, particularly in Alamo Group and Encore Wire, reflect continued market-price changes or changes in underlying portfolio-company outlook.
- The assumptions, third-party valuation work and liquidity implications for Level 3 and restricted investments; most portfolio value is not readily marketable.
- The expected timing and conditions for the up-to-$9.89 million of committed investments, and the practical availability of the $16.0 million of subsidiary cash.
- Whether dividend and fee income can support expenses and required shareholder distributions, given the steep decline in net investment income.
- The tax and shareholder implications of maintaining RIC status and of the company’s policy of retaining and paying tax on realized long-term capital gains.