UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 2006
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from .....................to ........................
Commission File Number: 814-61
CAPITAL SOUTHWEST CORPORATION
(Exact name of registrant as specified in its charter)
Texas 75-1072796
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
12900 Preston Road, Suite 700, Dallas, Texas 75230
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (972) 233-8242
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
---- ----
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
One):
Large accelerated filer Accelerated filer X Non-accelerated filer
---- ---- ----
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Act). Yes No X
---- ----
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
3,886,051 shares of Common Stock, $1 Par Value as of January 31, 2007
TABLE OF CONTENTS
Page No.
--------
PART I. FINANCIAL INFORMATION
ITEM 1. Consolidated Financial Statements
Consolidated Statements of Financial Condition
December 31, 2006 (Unaudited) and March 31, 2006.....................3
Consolidated Statements of Operations (Unaudited)
For the three and nine months ended December 31, 2006 and
December 31, 2005....................................................4
Consolidated Statements of Changes in Net Assets
For the nine months ended December 31, 2006 (Unaudited) and year
ended March 31, 2006.................................................5
Consolidated Statements of Cash Flows (Unaudited)
For the three and nine months ended December 31, 2006 and
December 31, 2005....................................................6
Portfolio of Investments
December 31, 2006....................................................7
Notes to Consolidated Financial Statements.............................12
ITEM 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations............................15
ITEM 3. Quantitative and Qualitative Disclosure About
Market Risk....................................................18
ITEM 4. Controls and Procedures..........................................18
PART II. OTHER INFORMATION
ITEM 1A.Risk Factors.....................................................19
ITEM 6. Exhibits and Reports on Form 8-K.................................19
Signatures ...................................................................20
2
PART I. FINANCIAL INFORMATION
-----------------------------
Item 1. Consolidated Financial Statements
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES
Consolidated Statements of Financial Condition
----------------------------------------------
Assets December 31, 2006 March 31, 2006
----------------- --------------
(Unaudited)
Investments at market or fair value
Companies more than 25% owned
(Cost: December 31, 2006 - $32,632,356
March 31, 2006 - $23,114,866) $521,169,985 $298,481,983
Companies 5% to 25% owned
(Cost: December 31, 2006 - $18,798,896
March 31, 2006 - $18,595,746) 68,224,002 92,070,852
Companies less than 5% owned
(Cost: December 31, 2006 - $23,782,504
March 31, 2006 - $46,886,344) 71,712,439 159,875,248
------------ ------------
Total investments
(Cost: December 31, 2006 - $75,213,756
March 31, 2006 - $88,596,956) 661,106,426 550,428,083
Cash and cash equivalents 56,530,336 11,503,866
Receivables 288,259 135,887
Other assets 7,466,502 7,300,297
------------ ------------
Totals $725,391,523 $569,368,133
============ ============
Liabilities and Shareholders' Equity
Note payable to bank $ 8,000,000 $ 8,000,000
Other liabilities 1,598,172 1,697,086
Income taxes payable 11,080,699 982,653
Deferred income taxes 205,125,385 162,070,285
------------ ------------
Total liabilities 225,804,256 172,750,024
------------ ------------
Shareholders' equity
Common stock, $1 par value: authorized,
5,000,000 shares; issued, 4,323,416 shares
at December 31, 2006 and 4,297,616 shares
at March 31, 2006 4,323,416 4,297,616
Additional capital 10,004,264 8,109,797
Undistributed net investment income 4,700,087 3,744,830
Undistributed net realized gain on investments 105,481,131 86,432,040
Unrealized appreciation of investments -
net of deferred income taxes 382,111,671 301,067,128
Treasury stock - at cost (437,365 shares) (7,033,302) (7,033,302)
------------ ------------
Net assets at market or fair value, equivalent
to $128.56 per share at December 31, 2006 on
the 3,886,051 shares outstanding and $102.74
per share at March 31, 2006 on the 3,860,251
shares outstanding 499,587,267 396,618,109
------------ ------------
Totals $725,391,523 $569,368,133
============ ============
(See Notes to Consolidated Financial Statements)
3
CAPITAL SOUTHWEST CORPORATION
AND SUBSIDIARIES
Consolidated Statements of Operations
-------------------------------------
(Unaudited)
Three Months Ended Nine Months Ended
December 31 December 31
------------------ -----------------
2006 2005 2006 2005
---- ---- ---- ----
Investment income:
Interest $ 484,888 $ 99,140 $ 1,624,418 $ 342,806
Dividends 1,626,702 1,174,743 3,167,203 2,740,363
Management and directors' fees 163,750 178,950 542,150 658,420
------------ ----------- ------------ -----------
2,275,340 1,452,833 5,333,771 3,741,589
------------ ----------- ------------ -----------
Operating expenses:
Salaries 310,127 287,584 973,926 767,084
Net pension benefit (36,237) (29,187) (108,708) (87,560)
Other operating expenses 238,504 185,619 690,469 569,611
------------ ----------- ------------ -----------
512,394 444,016 1,555,687 1,249,135
------------ ----------- ------------ -----------
Income before interest expense and
income taxes 1,762,946 1,008,817 3,778,084 2,492,454
Interest expense 133,749 105,565 458,953 320,647
------------ ----------- ------------ -----------
Income before income taxes 1,629,197 903,252 3,319,131 2,171,807
Income tax expense 12,700 10,200 40,724 38,100
------------ ----------- ------------ -----------
Net investment income $ 1,616,497 $ 893,052 $ 3,278,407 $ 2,133,707
============ =========== ============ ===========
Proceeds from disposition of investments $ 31,578,052 $ 7,791,129 $ 42,020,132 $27,677,133
Cost of investments sold 12,046,678 1,474,330 12,872,995 10,184,203
------------ ----------- ------------ -----------
Realized gain on investments
before income taxes 19,531,374 6,316,799 29,147,137 17,492,930
Income tax expense 6,726,027 2,185,228 10,098,046 6,180,039
------------ ----------- ------------ -----------
Net realized gain on investments 12,805,347 4,131,571 19,049,091 11,312,891
------------ ----------- ------------ -----------
Increase in unrealized appreciation
of investments before income taxes 132,210,244 15,009,434 124,061,543 45,975,188
Increase in deferred income taxes
on appreciation of investments 46,023,000 5,254,000 43,017,000 16,092,000
------------ ----------- ------------ -----------
Net increase in unrealized
appreciation of investments 86,187,244 9,755,434 81,044,543 29,883,188
------------ ----------- ------------ -----------
Net realized and unrealized gain
on investments $ 98,992,591 $13,887,005 $100,093,634 $41,196,079
============ =========== ============ ===========
Increase in net assets from operations $100,609,088 $14,780,057 $103,372,041 $43,329,786
============ =========== ============ ===========
(See Notes to Consolidated Financial Statements)
4
CAPITAL SOUTHWEST CORPORATION
AND SUBSIDIARIES
Consolidated Statements of Changes in Net Assets
------------------------------------------------
Nine Months Ended Year Ended
December 31, 2006 March 31, 2006
----------------- --------------
(Unaudited)
Operations
Net investment income $ 3,278,407 $ 2,389,256
Net realized gain on investments 19,049,091 13,115,874
Net increase in unrealized appreciation
of investments 81,044,543 80,685,303
------------ ------------
Increase in net assets from operations 103,372,041 96,190,433
Distributions from:
Undistributed net investment income (2,323,150) (2,314,231)
Capital share transactions
Exercise of employee stock options 1,794,850 208,000
Stock option expense 125,417 --
------------ ------------
Increase in net assets 102,969,158 94,084,202
Net assets, beginning of period 396,618,109 302,533,907
------------ ------------
Net assets, end of period $499,587,267 $396,618,109
============ ============
(See Notes to Consolidated Financial Statements)
5
CAPITAL SOUTHWEST CORPORATION
AND SUBSIDIARIES
Consolidated Statements of Cash Flows
-------------------------------------
(Unaudited)
Three Months Ended Nine Months Ended
December 31 December 31
----------- -----------
2006 2005 2006 2005
---- ---- ---- ----
Cash flows from operating activities
Increase in net assets from operations $100,609,088 $14,780,057 $103,372,041 $ 43,329,786
Adjustments to reconcile increase in net
assets from operations to net cash
provided by operating activities:
Proceeds from disposition of investments 31,578,052 7,791,129 42,020,132 27,677,133
Purchases of securities (4,500) (1,209,231) (374,730) (14,194,097)
Maturities of securities -- -- 884,936 375,000
Depreciation and amortization 4,426 3,968 12,313 11,817
Net pension benefit (36,237) (29,187) (108,708) (87,560)
Realized gain on investments before
income taxes (19,531,374) (6,316,799) (29,147,137) (17,492,930)
Deferred taxes on realized gain on
investments 6,726,027 2,185,228 10,098,046 6,180,039
Net increase in unrealized appreciation
of investments (86,187,244) (9,755,434) (81,044,543) (29,883,188)
Stock option expense 43,586 -- 125,417 --
(Increase) decrease in receivables (105,087) 144,240 (152,372) 24,448
(Increase) decrease in other assets 3,391 5,353 (14,597) 21,050
Increase (decrease) in and other liabilities 38,330 11,529 (46,526) (148,156)
Decrease in accrued pension cost (36,567) (38,669) (107,602) (116,005)
Deferred income taxes 12,700 10,200 38,100 30,600
------------ ----------- ------------ ------------
Net cash provided by operating activities 33,114,591 7,582,384 45,554,770 15,727,937
------------ ----------- ------------ ------------
Cash flows from financing activities
Decrease in note payable to portfolio
company -- -- -- (5,000,000)
Distributions from undistributed net
investment income (1,551,100) (1,542,821) (2,323,150) (2,314,231)
Proceeds from exercise of employee options 697,350 -- 1,794,850 --
------------ ----------- ------------ ------------
Net cash used in financing activities (853,750) (1,542,821) (528,300) (7,314,231)
------------ ----------- ------------ ------------
Net increase in cash and cash
equivalents 32,260,841 6,039,563 45,026,470 8,413,706
Cash and cash equivalents at beginning
of period 24,269,495 7,479,078 11,503,866 5,104,935
------------ ----------- ------------ ------------
Cash and cash equivalents at end of period $ 56,530,336 $13,518,641 $ 56,530,336 $ 13,518,641
============ =========== ============ ============
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest $ 133,749 $ 104,287 $ 458,953 $ 319,147
Income taxes $ -- $ -- $ 20,000 $ 7,500
(See Notes to Consolidated Financial Statements)
6
Portfolio of Investments - December 31, 2006
--------------------------------------------
Company Investment (a) Cost Value (b)
------------------------------------------------------------------------------------------------------------------------------------
+AT&T INC. ++20,770 shares common stock (acquired 3-9-99) $ 12 $ 742,528
San Antonio, Texas
Global leader in local, long distance,
Internet and transaction-based voice
and data services.
+ALAMO GROUP INC. 2,821,300 shares common stock (acquired
Sequin, Texas 4-1-73 thru 10-4-99) 2,065,047 45,141,000
Tractor-mounted mowing and mobile
excavation equipment for governmental,
industrial and agricultural markets;
street-sweeping equipment for
municipalities.
ALL COMPONENTS, INC. 10% subordinated note due 2008 (acquired
Addison, Texas 10-28-03 thru 10-3-05) 3,000,000 3,000,000
Electronics contract manufacturing; 150,000 shares Series A convertible preferred
distribution and production of memory stock, convertible into 600,000 shares of
and other components for computer common stock at $0.25 per share (acquired
manufacturers, retailers and value-added 9-16-94) 150,000 1,000,000
resellers; distribution of automotive ----------- ------------
accessories. 3,150,000 4,000,000
+ALLTEL CORPORATION ++8,880 shares common stock (acquired 7-1-98) 88,699 537,062
Little Rock, Arkansas
Owner and operator of the nation's
largest wireless network.
BALCO, INC. 445,000 shares common stock and 60,920 shares
Wichita, Kansas Class B non-voting common stock (acquired
Specialty architectural products used in 10-25-83 and 5-30-02) 624,920 2,500,000
the construction and remodeling of
commercial and institutional buildings.
BOXX TECHNOLOGIES, INC. 3,125,354 shares Series B convertible preferred
Austin, Texas stock, convertible into 3,125,354 shares of
Workstations for computer graphics common stock at $0.50 per share (acquired
imaging and design. 8-20-99 thru 8-8-01) 1,500,000 300,000
CMI HOLDING COMPANY, INC. 10% convertible subordinated notes, convertible
Richardson, Texas into 706,144 shares of common stock at $1.32
Owns Chase Medical, which develops and per share, due 2007 (acquired 4-16-04 thru
sells devices used in cardiac surgery to 12-17-04) 750,000 750,000
relieve congestive heart failure; develops 2,327,658 shares Series A convertible preferred
and supports cardiac imaging systems. stock, convertible into 2,327,658 shares of
common stock at $1.72 per share (acquired
8-21-02 and 6-4-03) 4,000,000 2,000,000
Warrants to purchase 109,012 shares of common
stock at $1.72 per share, expiring 2012
(acquired 4-16-04) - -
----------- ------------
4,750,000 2,750,000
7
Company Investment (a) Cost Value (b)
------------------------------------------------------------------------------------------------------------------------------------
+COMCAST CORPORATION ++43,104 shares common stock (acquired 11-18-02) $ 21 $ 1,821,575
Philadelphia, Pennsylvania
Leading provider of cable, entertainment
and communications products and services.
DENNIS TOOL COMPANY 20,725 shares 5% convertible preferred stock,
Houston, Texas convertible into 20,725 shares of common stock
Polycrystalline diamond compacts (PDCs) at $48.25 per share (acquired 8-10-98) 999,981 999,981
used in oil field drill bits and in mining 140,137 shares common stock (acquired 3-7-94
and industrial applications. and 8-10-98) 2,329,963 2
----------- ------------
3,329,944 999,983
+DISCOVERY HOLDING COMPANY ++70,501 shares Series A common stock
Englewood, Colorado (acquired 7-21-05) 20,262 1,134,361
Provider of creative content, media
management and network services
worldwide.
+EMBARQ CORPORATION ++4,500 shares common stock (acquired 5-17-06) 46,532 236,520
Overland Park, Kansas
Local exchange carrier that provides
local voice and data services, including
high-speed Internet.
+ENCORE WIRE CORPORATION 4,086,750 shares common stock (acquired
McKinney, Texas 7-16-92 thru 10-7-98) 5,800,000 61,301,000
Electric wire and cable for residential
and commercial use.
EXTREME INTERNATIONAL, INC. 39,359.18 shares Series C convertible preferred
Sugar Land, Texas stock, convertible into 157,436.72 shares of
Owns Bill Young Productions, Texas common stock at $25.00 per share (acquired
Video and Post, and Extreme Communica- 9-30-03) 2,625,000 5,314,000
tions, which produce radio and television 3,750 shares 8% Series A convertible preferred
commercials and corporate communica- stock, convertible into 15,000 shares of
tions videos. common stock at $25.00 per share (acquired
9-30-03) 375,000 506,000
Warrants to purchase 13,035 shares of common
stock at $25.00 per share, expiring 2008
(acquired 8-11-98 thru 9-30-03) - 133,000
----------- ------------
3,000,000 5,953,000
+FMC CORPORATION ++6,430 shares common stock (acquired 6-6-86) 66,726 492,217
Philadelphia, Pennsylvania
Chemicals for agricultural,
industrial and consumer markets.
+FMC TECHNOLOGIES, INC. ++11,057 shares common stock (acquired 1-2-02) 57,051 681,443
Houston, Texas
Equipment and systems for the energy,
food processing and air transportation
industries.
+HEELYS, INC. 9,317,310 shares common stock (acquired 5-26-00) 102,490 195,664,000
Carrollton, Texas
Heelys stealth skate shoes sold through
sporting goods chains, department stores,
footwear retailers and on-line at Heelys.com.
8
Company Investment (a) Cost Value (b)
------------------------------------------------------------------------------------------------------------------------------------
HIC-STAR CORPORATION 10% subordinated note due 2007 (acquired
Dallas, Texas 10-19-04 and 1-13-05) $ 352,646 $ 352,646
Holding company previously engaged in 12% subordinated notes due 2008 (acquired
mortgage banking operations, which have 3-25-05 thru 2-27-06) 717,523 354,738
now been sold. 12% demand note (acquired 12-15-06) 4,500 4,500
Warrants to purchase 463,162 shares of Series A
common stock at $1.00 per share, expiring 2014
(acquired 3-31-04 thru 1-13-05) - -
----------- ------------
1,074,669 711,884
+HOLOGIC, INC. ++316,410 shares common stock (acquired 8-27-99) 220,000 14,940,880
Bedford, Massachusetts
Medical instruments including bone
densitometers, mammography devices
and digital radiography systems.
+KIMBERLY-CLARK CORPORATION ++77,180 shares common stock (acquired 12-18-97) 2,358,518 5,244,381
Dallas, Texas
Manufacturer of tissue, personal care and
health care products.
+LIBERTY GLOBAL, INC. ++42,463 shares Series A common stock
Englewood, Colorado (acquired 6-15-05) 106,553 1,237,796
Owns interests in broadband, distribution ++42,463 shares Series C common stock
and content companies. (acquired 9-6-05) 100,870 1,188,964
----------- ------------
207,423 2,426,760
+LIBERTY MEDIA CORPORATION ++35,250 shares of Liberty Capital Series A
Englewood, Colorado common stock (acquired 5-9-06) 51,829 3,452,738
Holding company owning interests in ++176,252 shares of Liberty Interactive Series A
electronic retailing, media, communications common stock (acquired 5-9-06) 66,424 3,799,993
and entertainment businesses. ----------- ------------
118,253 7,252,731
LIFEMARK GROUP 1,449,026 shares common stock (acquired 7-16-69) 4,510,400 40,000,000
Hayward, California
Cemeteries, mausoleums and mortuaries
located in northern California.
MEDIA RECOVERY, INC. 800,000 shares Series A convertible preferred
Graham, Texas stock, convertible into 800,000 shares of common
Computer and office automation supplies stock at $1.00 per share (acquired 11-4-97) 800,000 7,000,000
and accessories; impact and tilt monitoring 4,000,000 shares common stock (acquired 11-4-97) 4,615,000 35,000,000
devices to detect mishandled shipments; ----------- ------------
dunnage for protecting shipments. 5,415,000 42,000,000
PALLETONE, INC. 12.3% senior subordinated notes due 2012
Bartow, Florida (acquired 9-25-06) 1,553,150 2,000,000
Wood pallet manufacturer with 17 150,000 shares common stock (acquired 10-18-01) 150,000 1,714,000
pallet manufacturing facilities. Warrant to purchase 15,294 shares of common stock
at $1.00 per share, expiring 2011 (acquired
2-17-06) 45,746 159,000
----------- ------------
1,748,896 3,873,000
+PALM HARBOR HOMES, INC. 7,855,121 shares common stock (acquired 1-3-85
Dallas, Texas thru 7-31-95) 10,931,955 70,696,000
Integrated manufacturing, retailing,
financing and insuring of manufactured
housing and modular homes.
9
Company Investment (a) Cost Value (b)
------------------------------------------------------------------------------------------------------------------------------------
+PETSMART, INC. ++300,000 shares common stock (acquired 6-1-95) $ 1,318,771 $ 8,658,000
Phoenix, Arizona
Retail chain of more than 885 stores
selling pet foods, supplies and
services.
PHARMAFAB, INC. 6% convertible subordinated notes, $4,205,616
Grand Prairie, Texas principal amount, convertible into Series A or
Contract manufacturer of branded and B convertible preferred stock, convertible into
generic pharmaceutical drugs; developer 560,750 shares of common stock at $7.50 per
of drug delivery technology. share, due 2013 (acquired 2-28-06) 4,000,000 2
Warrants to purchase 16,668 shares of Series A
or B convertible preferred stock at $100.00
per share, convertible into 222,240 shares
of common stock at $7.50 per share,
expiring 2012 and 2013 (acquired 6-16-05
and 2-28-06) - -
----------- ------------
4,000,000 2
THE RECTORSEAL CORPORATION 27,907 shares common stock (acquired 1-5-73
Houston, Texas and 3-31-73) 52,600 98,000,000
Specialty chemicals for plumbing, HVAC,
electrical, construction, industrial, oil
field and automotive applications; smoke
containment systems for building fires;
owns 20% of Whitmore Manufacturing Company.
+SPRINT NEXTEL CORPORATION ++90,000 shares common stock (acquired 6-20-84) 457,113 1,700,100
Reston, Virginia
Diversified telecommunications company.
TCI HOLDINGS, INC. 21 shares 12% Series C cumulative compounding
Denver, Colorado preferred stock (acquired 1-30-90) - 677,250
Cable television systems and microwave
relay systems.
+TEXAS CAPITAL BANCSHARES, INC. ++489,656 shares common stock (acquired 5-1-00) 3,550,006 9,729,465
Dallas, Texas
Regional bank holding company with
banking operations in six Texas cities.
VIA HOLDINGS, INC. 9,118 shares Series B preferred stock
Sparks, Nevada (acquired 9-19-05) 4,559,000 2,300,000
Designer, manufacturer and distributor of
high-quality office seating.
WELLOGIX, INC. 4,417,815 shares Series A-1 convertible
Houston, Texas participating preferred stock, convertible into
Developer and supporter of software used 4,417,815 shares of common stock at $1.1318 per
by the oil and gas industry to control share (acquired 8-19-05 thru 9-15-06) 5,000,000 2
drilling and maintenance expenses.
THE WHITMORE MANUFACTURING COMPANY 80 shares common stock (acquired 8-31-79) 1,600,000 26,000,000
Rockwall, Texas
Specialized mining, industrial and railroad
lubricants; coatings for automobiles and
primary metals; fluid contamination control
devices.
10
Company Investment (a) Cost Value (b)
------------------------------------------------------------------------------------------------------------------------------------
+WINDSTREAM CORPORATION ++9,181 shares common stock (acquired 7-17-06) $ 19,656 $ 130,554
Little Rock, Arkansas
Provider of voice, broadband and entertain-
ment services.
MISCELLANEOUS - BankCap Partners Fund I, L.P. - 6.2% limited
partnership interest (acquired 7-14-06) 167,080 167,080
- Diamond State Ventures, L.P. - 1.9% limited
partnership interest (acquired 10-12-99
thru 8-26-05) 146,000 146,000
- First Capital Group of Texas III, L.P. - 3.3%
limited partnership interest (acquired
12-26-00 thru 8-12-05) 964,604 964,604
- Humac Company - 1,041,000 shares common stock
(acquired 1-31-75 and 12-31-75) - 169,000
- STARTech Seed Fund I - 12.1% limited
partnership interest (acquired 4-17-98 thru
1-5-00) 178,066 1
- STARTech Seed Fund II - 3.2% limited
partnership interest (acquired 4-28-00 thru
2-23-05) 950,000 1
- Sterling Group Partners I, L.P. - 1.7% limited
partnership interest (acquired 4-20-01 thru
1-24-05) 1,064,042 1,064,042
------------------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS $75,213,756 $661,106,426
=========== ============
------------------------------------------------------------------------------------------------------------------------------------
+Publicly-owned company ++Unrestricted securities as defined in Note (a)
Notes to Portfolio of Investments
---------------------------------
(a) Unrestricted securities (indicated by ++) are freely marketable securities
having readily available market quotations. All other securities are restricted
securities which are subject to one or more restrictions on resale and are not
freely marketable. At December 31, 2006, restricted securities represented
approximately 91.6% of the value of the consolidated investment portfolio.
(b) Under the valuation policy of the Company, unrestricted securities are
valued at the closing sale price for listed securities and at the lower of the
closing bid price or the last sale price for Nasdaq securities on the valuation
date. Restricted securities, including securities of publicly-owned companies
which are subject to restrictions on resale, are valued at fair value as
determined by the Board of Directors. Fair value is considered to be the amount
which the Company may reasonably expect to receive for portfolio securities if
such securities were sold on the valuation date. Valuations as of any particular
date, however, are not necessarily indicative of amounts which may ultimately be
realized as a result of future sales or other dispositions of securities.
Among the factors considered by the Board of Directors in determining the fair
value of restricted securities are the financial condition and operating results
of the issuer, the long-term potential of the business of the issuer, the market
for and recent sales prices of the issuer's securities, the values of similar
securities issued by companies in similar businesses, the proportion of the
issuer's securities owned by the Company, the nature and duration of resale
restrictions and the nature of any rights enabling the Company to require the
issuer to register restricted securities under applicable securities laws. In
determining the fair value of restricted securities, the Board of Directors
considers the inherent value of such securities without regard to the
restrictive feature and adjusts for any diminution in value resulting from
restrictions on resale.
11
CAPITAL SOUTHWEST CORPORATION
AND SUBSIDIARIES
Notes to Consolidated Financial Statements
------------------------------------------
(Unaudited)
1. Basis of Presentation
Principles of Consolidation. The consolidated financial statements have
been prepared in accordance with accounting principles generally accepted in the
United States of America for investment companies. Under rules and regulations
applicable to investment companies, we are precluded from consolidating any
entity other than another investment company. An exception to this general
principle occurs if the investment company has an investment in an operating
company that provides services to the investment company. Our consolidated
financial statements include our management company.
The financial statements included herein have been prepared in
accordance with accounting principles generally accepted in the United States
for interim financial information and the instructions to Form 10-Q and Article
6 of Regulation S-X. The financial statements should be read in conjunction with
the consolidated financial statements and notes thereto included in our annual
report on Form 10-K for the year ended March 31, 2006. Certain information and
footnotes normally included in financial statements prepared in accordance with
accounting principles generally accepted in the United States have been
condensed or omitted, although we believe that the disclosures are adequate for
a fair presentation. The information reflects all adjustments (consisting of
normal recurring adjustments) which are, in the opinion of management, necessary
for a fair presentation of the results of operations for the interim periods.
2. Stock-Based Compensation
In December 2004, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 123 (revised 2004), Share-Based Payment ("SFAS 123R"), which
revised SFAS 123. SFAS 123R also supersedes APB 25 and amends SFAS No. 95,
Statement of Cash Flows. SFAS 123R eliminates the alternative to account for
employee stock options under APB 25 and requires the fair value of all
share-based payments to employees, including the fair value of grants of
employee stock options, be recognized in the income statement, generally over
the vesting period.
In March 2005, the Securities and Exchange Commission issued Staff
Accounting Bulletin ("SAB") No. 107, which provides additional implementation
guidance for SFAS 123R. Among other things, SAB 107 provides guidance on
share-based payment valuations, income statement classification and
presentation, capitalization of costs and related income tax accounting.
Effective April 1, 2006, we adopted SFAS 123R using the modified
prospective transition method. We recognize compensation cost over the
straight-line method for all share-based payments granted on or after that date
and for all awards granted to employees prior to April 1, 2006 that remain
unvested on that date. The fair value of stock options are determined on the
date of grant using the Black-Scholes pricing model and are expensed over the
vesting period of the related stock options. Accordingly, for the quarter and
nine months ended December 31, 2006, we recognized compensation expense of
$43,586 and $125,417, respectively.
The following table illustrates the effect on net asset value and net
asset value per share for the nine months ended December 31, 2006 if we had
applied the fair value recognition provisions of FASB Statement No. 123 to
stock-based compensation for options granted prior to the implementation of FASB
Statement No. 123.
12
Notes to Consolidated Financial Statements
(continued)
December 31, December 31,
2006 2005
---- ----
Net asset value, as reported $499,587,267 $343,549,462
Deduct: Total fair value computed
stock-based compensation - 113,202
------------ ------------
Pro forma net asset value $499,587,267 $343,436,260
============ ============
Net asset value per share:
Basic - as reported $128.56 $89.07
======= ======
Basic - pro forma $ - $89.04
======= ======
Diluted - as reported $128.43 $88.90
======= ======
Diluted - pro forma $ - $88.87
======= ======
As of December 31, 2006, the total remaining unrecognized compensation
cost related to non-vested stock options was $1,215,039, which will be amortized
over the weighted-average service period of approximately 7.78 years.
3. Employee Stock Option Plan
On July 19, 1999, shareholders approved the 1999 Stock Option ("Plan"),
which provides for the granting of stock options to employees and officers and
authorizes the issuance of common stock upon the exercise of such options for up
to 140,000 shares of common stock. All options are granted at or above market
price and generally expire ten years from the date of grant and are generally
exercisable on or after the first anniversary of the date of grant in five to
ten annual installments.
At December 31, 2006, there were 58,500 shares available for grant
under the Plan. The per share weighted-average fair value of the stock options
granted on May 15, 2006 was $31.276 per option using the Black-Scholes pricing
model with the following assumptions: expected dividend yield of .64%, risk-free
interest rate of 5.08%, expected volatility of 21.1%, and expected life of 7
years. The per share weighted-average fair value of the stock options granted on
July 17, 2006 was $33.045 per option using the Black-Scholes pricing model with
the following assumptions: expected dividend yield of .61%, risk-free interest
rate of 5.04%, expected volatility of 21.2%, and expected life of 7 years.
The following summarizes activity in the stock option plan since March
31, 2006:
Number Weighted-Average
of shares Exercise Price
--------- --------------
Balance at March 31, 2006 45,300 $68.411
Granted 57,500 94.136
Exercised (25,800) 69.568
Canceled (24,500) 89.482
------- -------
Balance at December 31, 2006 52,500 86.184
======= =======
At December 31, 2006, the range of exercise prices and weighted-average
remaining contractual life of outstanding options was $65.00 to $98.44 and 8.03
years, respectively. The total intrinsic value of options exercised during the
nine months ended December 31, 2006 was $571,565 with the exercise prices
ranging from $65.00 to $77.00 per share. New shares were issued for the
$1,794,850 cash received from option exercises for the nine months ended
December 31, 2006.
13
Notes to Consolidated Financial Statements
(continued)
At December 31, 2006, the number of options exercisable was 8,515 and
the weighted-average exercise price of those options was $69.15.
4. Summary of Per Share Information
Three Months Ended Nine Months Ended
December 31 December 31
----------- -----------
2006 2005 2006 2005
---- ---- ---- ----
Investment income $ .58 $ .38 $ 1.37 $ .97
Operating expenses (.13) (.12) (.40) (.33)
Interest expense (.04) (.03) (.12) (.08)
Income taxes - - (.01) (.01)
------- ------- ------- -------
Net investment income .41 .23 .84 .55
Distributions from undistributed
net investment income (.40) (.40) (.60) (.60)
Net realized gain on investments 3.29 1.07 4.90 2.93
Net increase in unrealized appreciation
of investments after deferred taxes 22.18 2.53 20.86 7.75
Exercise of employee stock options* (.08) - (.21) -
Stock option expense .01 - .03 -
------- ------- ------- -------
Increase in net asset value 25.41 3.43 25.82 10.63
Net asset value:
Beginning of period 103.15 85.64 102.74 78.44
------- ------- ------- -------
End of period $128.56 $ 89.07 $128.56 $ 89.07
======= ======= ======= =======
Increase in deferred taxes on
unrealized appreciation $ 11.74 $ 1.36 $ 10.79 $ 4.17
Deferred taxes on unrealized appreciation:
Beginning of period 40.70 33.17 41.65 30.36
------- ------- ------- -------
End of period $ 52.44 $ 34.53 $ 52.44 $ 34.53
======= ======= ======= =======
Shares outstanding at end of period
(000s omitted) 3,886 3,857 3,886 3,857
* Net decrease is due to the exercise of employee stock options at prices
less than beginning of period net asset value.
5. Recent Accounting Pronouncements
In June 2006, the Financial Accounting Standards Board (FASB) issued
Interpretation No. 48 (FIN48), which clarifies the accounting for uncertainty in
income taxes recognized in an entity's financial statements in accordance with
FASB Statement 109, "Accounting for Income Taxes". FIN 48 prescribes a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken in a
tax return. We have evaluated the positions in the tax returns we have filed and
do not believe that FIN 48 will have a material impact on our financial
statements.
The state of Texas recently passed House Bill 3 (HB3), which revises
the existing franchise tax system to create a new tax on virtually all Texas
businesses. Starting in the fiscal year 2007, HB3 changes the franchise tax
base, lowers the tax rate and extends coverage to active businesses receiving
state law liability protection. We have been subject to an immaterial amount of
Texas franchise taxes and expect the HB3 to have some affect, but have not
determined the extent of this impact.
14
Notes to Consolidated Financial Statements
(continued)
In September 2006, the FASB issued Statement of Financial Accounting
Standard No. 157, "Fair Value Measurements" (SFAS 157). The standard defines
fair value, outlines a framework for measuring fair value, and details the
required disclosures about fair value measurements. The standard is effective
for years beginning after November 15, 2007. We are evaluating the impact of
SFAS 157.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108,
"Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements" (SAB 108). SAB 108 clarifies
the SEC staff's beliefs regarding the process of quantifying financial statement
misstatements and is effective for fiscal years ending after November 15, 2006.
We do not expect SAB 108 to have a material impact on our financial statements.
In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting
for Defined Benefit Pension and Other Postretirement Plans." SFAS No. 158
requires employers to fully recognize the obligations associated with
single-employer defined benefit pension, retiree healthcare and other
post-retirement plans in their financial statements. The provisions of SFAS No.
158 are effective for us as of the end of our fiscal year ending March 31, 2007.
We are evaluating the impact of the provisions of this statement on our
consolidated financial position, results of operations and cash flows.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Net asset value at December 31, 2006 was $499,587,267 equivalent to
$128.56 per share after deducting an allowance of $52.44 per share for deferred
taxes on net unrealized appreciation of investments. Assuming reinvestment of
all dividends and tax credits on retained long-term capital gains, the December
31, 2006 net asset value reflects increases of 27.8% during the preceding three
months and 48.4% during the past twelve months.
December 31, December 31,
2006 2005
---- ----
Net assets $499,587,267 $343,549,462
Shares outstanding 3,886,051 3,857,051
Net assets per share $128.56 $89.07
Results of Operations
The composite measure of our financial performance in the Consolidated
Statements of Operations is captioned "Increase in net assets from operations"
and consists of three elements. The first is "Net investment income", which is
the difference between our income from interest, dividends and fees and our
combined operating and interest expenses, net of applicable income taxes. The
second element is "Net realized gain on investments", which is the difference
between the proceeds received from disposition of portfolio securities and their
stated cost, net of applicable income tax expense. The third element is the "Net
increase in unrealized appreciation of investments", which is the net change in
the market or fair value of our investment portfolio, compared with stated cost,
net of an increase in deferred income taxes which would become payable if the
unrealized appreciation were realized through the sale or other disposition of
the investment portfolio. It should be noted that the "Net realized gain on
investments" and "Net increase in unrealized appreciation of investments" are
directly related in that when an appreciated portfolio security is sold to
realize a gain, a corresponding decrease in net unrealized appreciation occurs
15
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
by transferring the gain associated with the transaction from being "unrealized"
to being "realized". Conversely, when a loss is realized on a depreciated
portfolio security, an increase in net unrealized appreciation occurs.
Net Investment Income
Interest income of $1,624,418 in the nine months ended December 31,
2006 increased from $342,806 in the year-ago period due to an increase in excess
cash and interest rates and a $631,000 interest payment from a portfolio company
for prior interest that had been on a non-accrual basis. During the nine months
ended December 31, 2006 and 2005, we recorded dividend income from the following
sources:
Nine Months Ended
December 31
-----------
2006 2005
---- ----
Alamo Group Inc. $ 507,834 $ 507,834
Balco, Inc. - 252,960
Dennis Tool Company 62,499 49,999
Kimberly-Clark Corporation 113,455 104,193
Lifemark Group 450,000 450,000
PalletOne, Inc. 89,842 134,764
The RectorSeal Corporation 1,629,947 866,893
TCI Holdings, Inc 60,953 60,953
The Whitmore Manufacturing Company 180,000 180,000
Other 72,673 132,767
---------- ----------
$3,167,203 $2,740,363
========== ==========
Net Realized Gain on Investments
During the nine months ended December 31, 2006, we reported a realized
gain before income taxes of $29,147,137 which included a gain of $31,070,149 on
our sale of 1,591,790 shares of Heelys, Inc. and a gain of $8,884,936 on our
sale of 500,000 shares of Cenveo, Inc. which were offset by losses of $6,529,167
on Hic-Star Corporation and $5,500,000 on PharmaFab, Inc.
Net Increase in Unrealized Appreciation of Investments
Set forth in the following table are the significant increases and
decreases in unrealized appreciation (before the related change in deferred
income taxes and excluding the effect of gains or losses realized during the
periods) by portfolio company:
Three Months Ended Nine Months Ended
December 31 December 31
----------- -----------
2006 2005 2006 2005
---- ---- ---- ----
Encore Wire Corporation $ (28,608,000) $20,433,000 $ (20,434,000) $28,607,000
Heelys, Inc. 140,040,908 4,250,000 170,040,908 12,000,000
Palm Harbor Homes, Inc. (3,928,000) - (27,493,000) 15,710,000
The RectorSeal Corporation 10,500,000 - 10,500,000 2,100,000
On December 8, 2006, we realized a significant gain on the sale of a
small fraction of our Heelys investment, and during the nine months ended
December 31, 2006, the value of our remaining Heelys stock increased from the
March 31, 2006 value by $170,040,908. This was attributable to the dramatic
increases in the company's sales and earnings during 2006 and the very strong
market interest in the initial public offering of Heelys common stock, which
16
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
attracted a severalfold over-subscription. This producer of specialty footwear
with a removable wheel housed in the heel of the shoe completed the initial
public offering of its stock on December 8, 2006, selling a total of 7,393,750
shares at $21.00 per share. A total of 4,268,750 shares were sold by selling
stockholders including 1,591,790 shares sold by our Company.
Offsetting part of the major increase in Heelys' value during the nine
months ended December 31, 2006 were significant decreases in the values of the
restricted stocks of two of our major holdings, which experienced earnings
declines in the face of unfavorable industry conditions. These included Palm
Harbor Homes and Encore Wire, which decreased in value by $27,493,000 and
$20,434,000 respectively.
Portfolio Investments
During the quarter ended December 31, 2006, we made an additional
investment of $4,500 in an existing portfolio company.
We have agreed, subject to certain conditions, to invest up to
$10,319,820 in three portfolio companies.
Financial Liquidity and Capital Resources
At December 31, 2006, we had cash and cash equivalents of approximately
$56.5 million. Pursuant to Small Business Administration ("SBA") regulations,
cash and cash equivalents of $2.2 million held by Capital Southwest Venture
Corporation ("CSVC") may not be transferred or advanced to us without the
consent of the SBA. Under current SBA regulations and subject to SBA's approval
of its credit application, CSVC would be entitled to borrow up to $16.4 million.
We also have an unsecured $25.0 million revolving line of credit from a
commercial bank, of which $17.0 million was available at December 31, 2006. With
the exception of a capital gain distribution made in the form of a distribution
of the stock of a portfolio company in the fiscal year ended March 31, 1996, we
have elected to retain all gains realized during the past 38 years. Retention of
future gains is viewed as an important source of funds to sustain our investment
activity. Approximately $55.7 million of our investment portfolio is represented
by unrestricted publicly-traded securities which represent a source of
liquidity.
On June 30, 2006, we borrowed $150 million from JPMorgan Chase in order
to maintain our tax status as a regulated investment company. On July 3, 2006,
we repaid the $150 million note payable to bank from our cash and cash
equivalents.
On January 2, 2007, we repaid the $8 million note payable to bank from
our cash and cash equivalents.
Funds to be used by us for operating or investment purposes may be
transferred in the form of dividends, management fees or loans from Lifemark
Group, The RectorSeal Corporation and The Whitmore Manufacturing Company,
wholly-owned portfolio companies, to the extent of their available cash reserves
and borrowing capacities.
Management believes that our cash and cash equivalents and cash
available from other sources described above are adequate to meet our expected
requirements. Consistent with our long-term strategy, the disposition of
investments from time to time may also be an important source of funds for
future investment activities.
17
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are subject to financial market risks, including changes in
marketable equity security prices. We do not use derivative financial
instruments to mitigate any of these risks.
Our investment performance is a function of our portfolio companies'
profitability, which may be affected by economic cycles, competitive forces,
foreign currency fluctuations and production costs including labor rates, raw
material prices and certain commodity prices. Most of the companies in our
investment portfolio do not hedge their exposure to raw material and commodity
price fluctuations. However, the portfolio company with the greatest exposure to
foreign currency fluctuations generally hedges their exposure. All of these
factors may have an adverse effect on the value of our investments and on our
net asset value.
Our investment in portfolio securities includes fixed rate debt
securities which totaled $6,461,886 at December 31, 2006, equivalent to 1.0% of
the value of our total investments. Generally these debt securities are below
investment grade and have relatively high fixed rates of interest; therefore,
minor changes in market yields of publicly-traded debt securities have little or
no effect on the values of debt securities in our portfolio and no effect on
interest income. Our investments in debt securities are generally held to
maturity and their fair values are determined on the basis of the terms of the
debt security and the financial condition of the issuer.
A portion of our investment portfolio consists of debt and equity
securities of private companies. We anticipate little or no effect on the values
of these investments from modest changes in public market equity valuations.
Should significant changes in market valuations of comparable publicly-owned
companies occur, there may be a corresponding effect on valuations of private
companies, which would affect the value and the amount and timing of proceeds
eventually realized from these investments. A portion of our investment
portfolio also consists of restricted common stocks of publicly-owned companies.
The fair values of these restricted securities are influenced by the nature of
applicable resale restrictions, the underlying earnings and financial condition
of the issuers of such restricted securities and the market valuations of
comparable publicly-owned companies. A portion of our investment portfolio also
consists of unrestricted, freely marketable common stocks of publicly-owned
companies. These freely marketable investments, which are valued at the public
market price, are directly exposed to equity price risks, in that a change in an
issuer's public market equity price would result in an identical change in the
value of our investment in such security.
Item 4. Controls and Procedures
As of the end of the period covered by this report, an evaluation was
performed under the supervision and with the participation of our management,
including the President and Chairman of the Board and Secretary-Treasurer, of
the effectiveness of the design and operation of our disclosure controls and
procedures (as defined in Rules 13a-15 and 15d-15 of the Securities Exchange Act
of 1934). Based on that evaluation, the President and Chairman of the Board and
Secretary-Treasurer concluded that our disclosure controls and procedures are
effective to ensure that the information required to be disclosed is recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commission's rules and forms, and is accumulated and
communicated to management, including the President and Chairman of the Board
and Secretary-Treasurer, as appropriate, to allow timely decisions regarding
such required disclosure.
During the fiscal quarter ended December 31, 2006, there were no
changes to the internal controls over financial reporting that have materially
affected, or are reasonably likely to materially affect our internal controls
over financial reporting.
18
PART II. OTHER INFORMATION
--------------------------
Item 1A. Risk Factors
There have been no material changes to our risk factors as disclosed in
Item 1A, "Risk Factors", in our Annual Report on Form 10-K for the
fiscal year ended March 31, 2006.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit 31.1- Certification of President and Chairman of the
Board required by Rule 13a-14(a) or Rule 15d-14(a) of the
Securities Exchange Act of 1934, as amended (the "Exchange
Act"), filed herewith.
Exhibit 31.2- Certification of Secretary-Treasurer required by
Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act, filed
herewith.
Exhibit 32.1- Certification of President and Chairman of the
Board required by Rule 13a-14(b) or Rule 15d-14(b) of the
Exchange Act and Section 1350 of Chapter 63 of Title 18 of the
United States Code, furnished herewith.
Exhibit 32.2- Certification of Secretary-Treasurer required by
Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and
Section 1350 of Chapter 63 of Title 18 of the United States
Code, furnished herewith.
(b) Reports on Form 8-K
No reports on Form 8-K have been filed during the quarter for
which this report is filed.
19
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CAPITAL SOUTHWEST CORPORATION
/s/ William R. Thomas
Date: February 2, 2007 By:
--------------------------- -----------------------------------------
William R. Thomas, President and Chairman
of the Board (chief executive officer)
/s/ Susan K. Hodgson
Date: February 2, 2007 By:
--------------------------- -----------------------------------------
Susan K. Hodgson, Secretary-Treasurer
(chief financial/accounting officer)
20