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CSWC > SEC Filings for CSWC > Form 10-Q on 9-Nov-2012All Recent SEC Filings

Show all filings for CAPITAL SOUTHWEST CORP



Quarterly Report

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our financial statements and the notes thereto included elsewhere in our Annual Report on Form 10-K for the fiscal year ended March 31, 2012 (the "Form 10-K").

The information contained herein may contain "forward-looking statements" based on our current expectations, assumptions and estimates about us and our industry. These forward-looking statements involve risks and uncertainties. Words such as "believe," "anticipate," "estimate," "expect," "intend," "plan," "will," "may," "might," "could," "continue" and other similar expressions identify forward-looking statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of several factors more fully described in "Risk Factors" and elsewhere in this Form 10-Q, and in our Form 10-K for the year ended March 31, 2012. The forward-looking statements made in this Form 10-Q related only to events as of the date on which the statements are made. You should read the following discussion in conjunction with the consolidated financial statements and related footnotes and other financial information included in our Form 10-K for the year ended March 31, 2012. We undertake no obligation to update publicly any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.

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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 income from interest, dividends and fees and its combined operating and interest expenses, net of applicable income taxes. The second element is "Net realized gain (loss) 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 based on the Company's tax year. The third element is the "Net increase in unrealized appreciation of investments," which is the net change in the market or fair value of the Company's investment portfolio, compared with stated cost. It should be noted that the "Net realized gain (loss) 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 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

For the six months ended September 30, 2012, total investment income was $2,794,800, a $340,687, or 13.9%, increase from the $2,454,113 total investment income for the six months ended September 30, 2011. This comparable period increase was primarily attributable to interest income accrued on additional debt investments made in Cinatra, Trax, TitanLiner and iMemories in 2012.

The Company's principal objective is to achieve capital appreciation. Therefore, a significant portion of the investment portfolio is structured to maximize the potential return from equity participation and provides minimal current yield in the form of interest or dividends. The Company also earns interest income from the short-term investment of cash funds, and the annual amount of such income varies based upon the average level of funds invested during the year and fluctuations in short-term interest rates. During the six months ended September 30, 2012 and 2011, the Company also had interest income from temporary cash investments of $35,628 and $20,423, respectively.

The Company also receives management fees primarily from its controlled affiliates, which aggregated $300,400 and $276,150 for the six months ended September 30, 2012 and 2011, respectively.

During the six months ended September 30, 2012 and 2011, the Company recorded dividend income from the following sources:

                                          Six Months Ended
                                            September 30,
                                        2012            2011
Alamo Group, Inc.                    $   339,876     $   339,756
CapitalSouth Partners Fund III           151,350          49,189
Encore Wire Corporation                  107,985         163,470
The RectorSeal Corporation               480,000         480,000
TCI Holdings, Inc.                        40,635          40,635
The Whitmore Manufacturing Company       120,000         120,000
                                     $ 1,239,846     $ 1,193,050

Due to the nature of its business, the majority of the Company's operating expenses are related to employee and director compensation, office expenses, legal, professional and accounting fees and the net pension benefit. Total operating expenses, increased by $486,882 or 20.5% during the six months ended September 30, 2012 as compared to the six months ended September 30, 2011. The increase in 2012 is primarily due to compensation adjustments which went into effect in July 2011 as well as staff growth. In addition, net pension benefit decreased significantly due to decrease in discount rate from 6.00% to 5.25%.

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Net Realized Gain (Loss) on Investments

During the six months ended September 30, 2012, we sold 2,774,250 shares of common stock in Encore Wire Corporation held by our subsidiary, CSVC, to Encore Wire generating a capital gain of $66,037,485. We also sold 50,000 shares of common stock of Hologic, Inc. generating a capital gain of $850,548. These gains were offset by a $7,000 capital loss adjustment related to a final true-up of the Lifemark Group, Inc. divesture from June 2010. In addition, we declared and paid a cash dividend in the amount of $17.59 per share of common stock in June 2012. As a result, we have undistributed net realized gains of $55,251 during the six months ended September 30, 2012.

During the six months ended September 30, 2011, we sold all of our shares of preferred stock (Series A, Series B and Series C) in Phi Health, Inc, generating net cash proceeds of $38,959 and a realized loss of $5,910,655; we sold all of our shares of Series A convertible preferred stock, along with warrants to purchase additional shares of common stock of All Components, Inc. in a management buy-out generating cash proceeds of $18,000,000 and a realized gain of $17,850,000; and we received $500,000 in cash proceeds from Essex Capital Corporation as settlement for an unsecured promissory note generating a gain of $500,000, which was the by-product of an option exercise agreement. In total, we recognized undistributed net realized gains of $12,439,345 for the six months ended September 30, 2011.

Management does not attempt to maintain a consistent level of realized gains from year to year, but instead attempts to maximize total investment portfolio appreciation. This strategy often dictates the long-term holding of portfolio securities in pursuit of increased values and increased unrealized appreciation, but may at opportune times dictate realizing gains or losses through the disposition of certain portfolio investments.

Net Increase/(Decrease) in Unrealized Appreciation of Investments

For the six months ended September 30, 2012, we recognized a $28,200,550 decrease in net change in unrealized appreciation of investments. The largest decreases in unrealized appreciation were attributable to Encore Wire Corporation, which decreased $82,454,460 primarily due to our recent sales of CSVC's interest in Encore Wire Corporation as well as a decline in their stock price; Heelys, Inc. decreased $3,726,924 attributable to decreases in stock price; Hologic, Inc. decreased $1,835,180 attributable primarily to recent sales of 50,000 shares as well as a decrease in stock price at September 30, 2012; and Media Recovery, Inc. decreased $6,600,000; and Cinatra Clean Technologies, Inc. decreased 2,386,393 due to slowdowns in their respective business segments. Offsetting these decreases were Alamo Group, Inc. which increased $10,485,486 due to an increase in stock price; The Rectorseal Corporation, which increased $42,300,000; KBI Biopharma, which increased $2,200,000; Trax Holdings, Inc., which increased $2,400,000; and Instawares Holding Company, LLC. increased $735,000. All of these increases were attributable to increases in the entities' respective earnings.

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Set forth in the following table are the significant increases and decreases in unrealized appreciation by portfolio company:

                                                 Three Months Ended                  Six Months Ended
                                                   September 30,                       September 30,
                                               2012             2011              2012              2011
Alamo Group, Inc.                          $  6,822,228     $  (6,372,675 )   $  10,485,486     $ (14,825,575 )
Cinatra Clean Technologies, Inc.             (2,960,000 )      (2,593,703 )      (2,386,393 )      (2,593,703 )
Encore Wire Corporation                       3,268,125       (13,281,938 )     (82,454,460 )      (6,130,125 )
Heelys, Inc                                  (1,024,904 )      (1,928,683 )      (3,726,924 )      (2,254,789 )
Hologic, Inc.                                 1,270,547        (3,138,787 )      (1,835,180 )      (4,417,084 )
Instawares Holding Company, LLC                 161,000                 -           735,000                 -
KBI Biopharma, Inc.                             700,000                 -         2,200,000        (2,600,000 )
Media Recovery, Inc.                         (3,300,000 )       2,500,000        (6,600,000 )      (1,700,000 )
The RectorSeal Corporation                   34,800,000        (3,600,000 )      42,300,000        (3,400,000 )
Trax Holdings, Inc.                           2,200,000           268,771         2,400,000            41,970

A description of the investments listed above and other material components of the investment portfolio are included elsewhere in this report under the caption "Consolidated Schedule of Investments - September 30, 2012 and March 31, 2012."

Portfolio Investments

During the six months ended September 30, 2012, we invested $5,950,000 into a new investment, TitanLiner, Inc., and $609,046 in existing portfolio companies.

We have agreed, subject to certain conditions, to invest up to $10,138,169 in nine portfolio companies as of September 30, 2012.

Financial Liquidity and Capital Resources

At September 30, 2012, the Company had cash and cash equivalents of approximately $59.7 million. Pursuant to the SBA regulations, cash and cash equivalents of $4.8 million held by CSVC may not be transferred or advanced to CSW without the consent of the SBA.

Management believes that the Company's cash and cash equivalents and cash available from other sources described above are adequate to meet its expected requirements. Consistent with the long-term strategy of the Company, the disposition of investments from time to time may also be an important source of funds for future investment activities.

Application of Critical Accounting Policies and Accounting Estimates

There have been no changes during the quarter ended September 30, 2012 to the critical accounting policies or the areas that involve the use of significant judgments or estimates we described in our Form 10-K.

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