Capital Southwest Corporation
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Investment Notes

December 18, 2006

Here are some of my weekend “notes. to Barron’s article etal”

The article mentioned, no wall street following, projected 2006
revenues of $170M, typical consumer, ages 6 – 14, market cap of $900M (5.29X
projected 2006 sales), net margins projected of 15%, and get
this…….Heely’s might be a fad!

I was introduced to a simple formula a few years back….valuation can
be as follows

If Gross Margin is…. price to sales ratio could be...
5% 1X
10% 2X
15% 3X

Hence, one could argue that Heely’s is worth $600M, but $900M seems way to high.

I think the article ended, “look out below.”

with that said….. some quick back of envelope.

CSWC conservative value without Heely’s $80 share
Cash received for Heely’s last week on sale $  9 share
Heely’s value (a) $39 share
CSWC current value per share $128 share

(a) projected revenues F2007 $300M, use 2* revs = $600M. 40% of that =
240m, reduce for taxes of 35% = 156. 156/share count of 3857 = 39 per

August 30, 2006
1. Conversation with BT. He said something like (and this is complicated, probably immaterial, and I certainly may have gotten this very wrong., Code section 851 demands that Qualified Investment Co must for securities that do not represent > 5% of assets, or companies that have >10% voting stock. If you look at the some of those, plus existing cash, has to be at least 50% of assets. To get there, and this has been done numerous times in the past, they have borrowed funds, thereby reducing cash and qualifying investment assets > 50% mark. This enables them to maintain status of registered investment company. This happened this quarter because of security purchased in 2Q06. They had to re-qualify end of quarter. This results from a non qualifying purchase. BT mentioned that no fees of materiality were paid, other than an interest expense for a stub period, whereas they collected an interest income for the same stub period.

November 18, 2005

1. I asked the following of Marty Whitman of Third Avenue Value Fund a week or so ago: ” Marty, you mentioned Bill Thomas and Capital Southwest several years ago in OID. Would you please give us an update. Would you also please comment on Curtis Jensen selling?”
His response was something like this….
“I can’t comment on Jensen Selling, but you should ask him. I certainly haven’t sold. We just love to buy into well-financed companies, well managed and available at a substantial discount to NAV. BT has built value over the years. BT has done a fantastic job. He will continue to do a fantastic job, for a long time. I will stick with BT and CSWC till the ship goes down, and it’s not going down” Marty Whitman 11/3/05.
I asked Curtis afterwards. He mentioned that he just needed to lessen the number of investments in his fund, and he used CSWC for that reason. He had the opportunity, and it wasn’t liquid, so he sold. Funny thing is, I probably bought his shares (mid April 05, primarily 4/19 and 4/20).
Apparently, the TA Small Cap fund (run by MW’s protégé & heir-apparent Curtis Jensen) liquidated all 13,500 of its portfolio CSWC shares as of 4/30. Per Jensen’s commentary:
“The Fund eliminated its small position in the relatively illiquid shares of CSWC. While I have the greatest admiration for the talents and record of CEO Bill Thomas, it is not clear to me who might succeed him should he not be able to continue in that role. (As far as I can tell, Bill has zero plans to retire!) The sale is also consistent with my desire to keep the number of issues in the portfolio to a manageable level. Along those lines, my preference would be to prune the number issues in the portfolio in coming periods as investments [merit] and market conditions allow.”

2. Reading Wire’s 9/30/05 filings and such. Tied into copper prices. Revenues have accelerated. Inventories, accounts receivable have seem to risen faster than revenues. Yet, this has been rather explosive, and not necessarily a trend. Something to watch. Inventory turnover appears to be strong at 5 – 10X prior years.
Looks like Price to EV is a little below 1X. That seems okay, based on net margin being in the 5% area. ROE and other metrics seem healthy. Debt has increased this fiscal year by 34.5M. No data available on that debt.
Has had some insider selling lately. David Smith sold 8000 shares at 22ish. I have no idea of insider history. Didn’t notice smith in def14a.
Capital Southwest owns 17.69% of common per def14a.
CB and Pres each getting in the area of $800K in compensation.
Stock option compensation expense appears immaterial to eps.
Inventory has LIFO adjustment. All the more difficult for me to review.
According to WIRE, all capex is paid for via cash, and not via loans. Hence, all capex is included in statement of cash flows.
WIRE claims that new loans are for financing working capital. WIRE claims that inventory turns remain strong and that DSO’s on A/R remain at 63 days.

August 5, 2005 10Q notes
1. debt paid down of $5M. I previously mentioned this was paid off. This was a loan from Skylawn.

2. stock option compensation would reduce NAV by $0.08 per share or 1/10th of 1%

3. shares o/s stayed the same from year ago period.

4. Net Assets per share increased 7.7% from year ago period.

5. Investment Income increased by approx $80K from year ago period. Part of this is from:

Dennis Tool Company $37,499
PalletOne $44,921

6. Reduced value of Alamo by $8,463,000.

July 6, 2005

Review of DEF 14A filed 5/27/05

1. Ownership as reported on 5/27/05 via Form DEF 14A

Bill Thomas and Family, ESOPS,  trusts, etc 947,155 24.6%
Artisan Partners 377,569 9.8%
Third Avenue Mgt 323,798 8.4%
First Manhattan Co 242,987 6.3%
Gary Martin 206,302 5.3%
Patrick Hammer 135,458 3.5%

I reviewed ownership back to 6/12/03. There has not been a material amount of change. There were some apparent sales between 6/8/04 and 5/27/05, yet nothing that seems concerning at all. The reason I mentioned apparent sales is because Bill Thomas reported 947,155 shares on 5/27/05, and 965,799 on 6/8/04. I looked at edgar and saw no sales by BT. Again, not material and probably a logical explanation (which I don’t know and probably will not inquire about).

2. Compensation Table (including esops, bonuses and other)

Name 2005 2004 2003
Bill Thomas 280,917 270,000 260,000
Gary Martin 348,789 232,735 195,885
Patrick Hammer 265,083 252,708 221,458
William Ashbaugh 263,833 245,000 204,312

As you can see from above, the salaries do not appear to be anywhere near excessive.

June 10, 2005

Spoke with Bill Thomas ( BT)for quite a while. Long and very informative conversation. His responses are in the paragraph below my questions.

1. Quick note as a reminder to read through purchases and sales from 3/31/95 till present, see about Alamo and others. Just looking for bell ringers.

2. Look at Price/Sales, Price Earnings ratios, net margin and valuation assumptions along with management (BT) consistency.

3. Any material tangible assets that are not reflected in valuations because of historical cost. Primarily, I am thinking of Skylawn when I write that. See Skylawn below

4. Look at Insider Activity. I did this and nothing at all sticks out.

He mentioned that he thinks the following are approximate ownerships:

Bill Thomas 16%
3 Institutional’s 25%
   Total 50%

5. Look at compensation levels of officers that are part of the holdings. Ask BT if the compensation issues of which he discusses are relevant to the companies we hold.

I asked BT this. He didn’t see any egregious situation of this of our owned companies of which he can influence.
ALG paid $300K + bonus – well worth it
PHHM paid $200K + bonus – all industry fine. PHHM much fairer than competition.
Some of our companies which we have no influence over, would have this compensation effect. Most bothersome is Cenveo. Someone has surfaced which will mobilize takeover. They have overpaid management, excessive sentiments.

6. Ask BT to explain the nature of the restrictions.
All are 144 restrictions. Felt prices would drop if filing was made.

7. Ask BT if he has been interested in buying anything new of substance. Does he feel pressured to do so? Does his age have anything to do with the slowdown? What does he do during the typical day? Does he have any other jobs. Is he 100% dedicated in time to CSWC? Typical Buffett questions.

He mentioned that availability of capital was way to great. Acquisitions have certainly declined, not because of his age, but because of liquidity and hedge funds and such. He feels the decline is partly his outlook on the world, and partly his degree of conservatism. He mentioned that on many situations he is being outbid now, more than ever. He feels these venture operations are creating mini-auctions.
I asked about continuity after Bill is gone. I asked if he knows already who his replacement will be. He said it is and has been a topic of discussion amongst the board of directors. There is no current obvious successor. He certainly does not envision any significant change of investment philosophy and would expect continuation of investment philosophy (heck, he should interview me 😉
Typical day includes sitting in on investment meetings, reviewing financials, working on tax qualification (see 9 below) and administrative work. He spends a fair amount of time on the key holdings. He mentioned he has been spending a bit of time on Skylawn (see below).
He mentioned that he is totally 100% working on the company only. When he sits on a board, the fees get paid to CSWC and not BT.
He prefers the stock cheaper than more expensive as they are buying for the esop and not selling.

8. I asked him about Heely’s.

He mentioned that they are a “funny company” He said the owner owns a sizable stake. He mentioned that CSCW brought in the president and BT thinks that the president has bought a bit of non-optioned shares. 2004 was a lean year, 2005 is going strong. CSWC has recently been paid back $120K of preferred shares. They still own stock in full, only debt was paid off. He said they were doing “surprisingly well”, yet he does worry about the investment, because of their fad nature.

9. I asked what the risks would be on the corporate level if the investment company act was disallowed by IRS.

He explained that the shareholders would lose preferential tax treatment. Yet, he mentioned on the corporate level, not much would change. He mentioned that taxes would still be owed when gain was realized and not before. He mentioned that he thinks the code section for qualification is code sec. 851. This is tax qualification for mutual funds. There is a diversification requirement for tax pass-through treatment. They have quite a few non qualifying investments, and claims they have to be careful on new investments, in order to not disqualify. This is often achieved via purchasing of preferred’s, convert’s or non-voting stock. He mentioned that sometimes they will borrow funds in order to satisfy a cash requirement. I would need to have the code section reviewed to satisfy myself on that one. He claims that 4 accounting firms found the tax situation to be in order. He mentioned that after a year of purchase and theoretical concern of qualification, the fear goes away, since qualification in year 1 is deemed to carryover to future.

10. He mentioned that the 3 holdings of wholly owned companies, “all have comfortable balance sheets”.

June 9, 2005

Comparing 2005 annual report to 2004

1. Palm Harbor Homes equity ownership from 3/31/04 to 3/31/05, went down from 34.4% to 30.5%. How did that occur? The price * shares for 2005 and 2004 do not seem to flow correctly per my schedule. Ask about this.

BT explained, that CSWC shows a fully diluted presentation. The reason was because PHHM sold a convertible during 2004. Conversion price is way out of the money. Conversion is $25.92 per share. Citigroup did the offering, with full registration provision. The entire offering was done with prospectus and not registration. Hedge funds listened to story and by the end of the day, maybe next day, and offering was done quickly. The gain at hazard to company, was a short straddle from convert. Convert was priced at 38% premium to market price. BT mentioned that floor plan debt is similar to auto dealer, financing of inventory. This debt has been in good shape, no pressure to repay. This made debt less vulnerable to future business. BT feels good financing.

I asked why CSWC was not listed as a top institutional holder of PHHM. He wasn’t sure why services weren’t picking them up. He thinks that ALG is showing the same situation. He claims that 13D filings certainly mention this.
2. Encore Wire, price relationship changed as well. What is method? How is differential arrived at? Is price subject to mood swings?

BT responds with the following: No mechanical process to discounts. Discounts have been influenced by perception of what CSWC thinks is fundamental value. WIRE has fluctuation of quarterly earnings. Net, net, BT values based on what they think is fundamental value. WIRE is based on copper price significantly, but not direct correlation. BT looks at it as long term holder, feels a registration would knock the price.

3. Skylawn reported different earnings and revenues in F2005 report on F2004, than they did in F2004 annual report. Why is that? Why is Skylawn awarded a large p/e multiple of 18.6X, and p/s multiple of 1.6X

BT mentioned: Purely change of audited amounts. No biggie and I’m cool with that . To gauge valuation would we use an asset approach. Skylawn has a substantial amount of excess cash. CSWC had loan payable to Skylawn for $5M. Skylawn has some land value. Maybe 1/3 to ½ of Skylawn’s value would be based on asset approach. Using multiples of ebitda, this would be conservative. He can’t disclose what ebitda multiple will be. They are building a large funeral home at San Mateo location. Skylawn will be using excess cash and then some for construction of funeral home. At that time valuation will be determined by Land Value and for some period of time value will be based on cost. This will occur until earnings capitalization kicks in. Picture will be changing. Approval process and zonings took over 5 years. Funeral home and cemetery combined is best. Built in market from current owners of future used plots. This will be a magnificent structure. More than needed, but since zoning was so tuff they went for it. Financing is all done by Skylawn. If Skylawn needed to borrow, say $5m to complete, they will go to bank. CSCW will not guarantee any loans. No related party vendors. This is about 500 acres, of which ½ is not useable. Probably 250 usable acres. Have probably used about 50 acres. Long term annuity per BT.
4. Media Recovery, same as 3. above.

BT says has been cyclical business. Ebitda was running strong at 9/30/00, at 9/30/01. NI and ebitda dropped at 9/30/02, went up in ’03 and ’04. This company was part of an LBO. Basically they increased value based on expectations and business climate. Change in valuation was lagging, but tended to bring it to more logical valuation. If there was an earnings dip or increase, it would probably stay at these levels. A co-investor there will need to sell out during next few years, CSCW will buy back at that time.

5. Pallet One common was not valued at F2004, yet in F2004 has value of $150K. Preferred shares and value went up. Preferred shares increased to 1796850 in F2005 from 1633500 in F2004. How did this occur?

BT mentioned that all valuation for all companies are subjective. Fully agreed. Their NI “soared” in 2004 to 2003. They adjusted valuation at this time period. They are high debt company.

My notes are as follows , nothing to do with BT, but with discussion with Pallet One, “claims to have $180 Mil in revs, $60 Mil in assets, won’t disclose debt levels. CEO and CB own a combined 10%, EQS owns 20.6% (and is on BOD), CSWC of course owns a disclosed 8.8%. 2003 was a tuff year. “EQS and CSWC are a good group of guys”. claims that CSWC is conservative in valuation (yet, we see similar valuations by EQS and CSWC anyway (did anyone pick up on my initial error, or did I make any others). Business was good in 2004 and remains good so far in 2005. Has over 1000 employees.”
6. Texas Shredder value went up by $3.5M. Try to find out why.

BT mentioned that earnings increased a lot. They make shredders that chew up scrap autos. They will be influenced by scrap of steel and capacity type situations. Best years ever. Kind of a niche market. Revenue and eps up substantially. Realization that this is cyclical business.
7. How could I learn the finances of selected companies?

You can’t according to BT. “If you looked at the larger private holdings (i.e. RectorSeal).
8. Can you discuss anything about each company that hasn’t been in annual reports. Does each company have audited financials. Can you explain the review process of these.

He claims that he can’t or won’t reveal anything more. He mentioned that it is of his belief that CSWC offers more info than others. He understood my desire for further review, but I understand the partial secrecy is just the nature of the business.
He mentioned upon questioning, that his valuation techniques of non public entities are similar to those of public companies. Yet, important to realize that the lack of liquidity would cause lesser multiples. This means that if a public company was awarded a 9X earnings multiple, that a private company would generally be less.

Comparing 2003 annual report to 2004

1. Why did value of Media Recovery go up so much in relation to revenues and earnings from F2003 till F2005?
2. Review all companies for P/S and P/E ratios. Then ask BT.

June 8, 2005

Notes from Annual Report 3/31/05

1. As of March 31, 2005 restricted securities were 86.4% of portfolio.

2. 4 companies represent 55.4% of total investments. Taking out PHHM, the average price earnings ratio is 12.1.

3. 4 investment categories

Holdings in 3 wholly owned companies ( RectorSeal, Skylawn and Whitmore) 31.0%
3 restricted securities of publicly held investments ( PHHM, WIRE and ALG) 36.5%
Venture Capital Assets 18.9%
Marketable Securities 13.6%
                     Total 100.0%

4. What are the restrictions of publicly held companies. I should look this up.

5. All holdings at one time or another were derived from venture capital activities. This is their “essential source of past and future holdings.”

6. 12 holdings represent 85.9% of investment portfolio.

Companies I should try and search for and review

7. Smoke Guard Corporation was bought by RectorSeal. This equates to about 1% of Total Investments. Smoke Guard is a manufacturer of smoke containment systems to prevent smoke from migrating onto or out of elevator hoistways, in the event of building fires.

8. CMI Holding (Chase Medical) is about 1% of value of portfolio. They have an imaging system to enable cardiologists to observe heart function.

9. Pallet One, as of 3/31/05, CSWC values this at 1.00 per share, just as EQS does..this was not the same as 2004. Pallet One claims to have $180 Mil in revs, $60 Mil in assets, won’t disclose debt levels. CEO and CB own a combined 10%, EQS owns 20.6% (and is on BOD), CSWC of course owns a disclosed 8.8%. 2003 was a tuff year. “EQS and CSWC are a good group of guys”. claims that CSWC is conservative in valuation (yet, we see similar valuations by EQS and CSWC anyway (did anyone pick up on my initial error, or did I make any others). Business was good in 2004 and remains good so far in 2005. Has over 1000 employees.

10. See this link for company grid and some quick workups I did.
Table of various presentations of Asset Values, etc. Taken from 3/31/05 annual report

Year (A) Deferred Taxes (B) NAV ( C ) Market Price Gross Assets (A + B) Deferred/Gross Net / Gross Market/ Gross Market / Net
1985 2.42 11.05 8.56 13.47 17.97% 82.03% 63.55% 77.47%
1986 3.18 12.91 9.88 16.09 19.76% 80.24% 61.40% 76.53%
1987 5.78 17.58 17.5 23.36 24.74% 75.26% 74.91% 99.54%
1988 8.44 22 17.13 30.44 27.73% 72.27% 56.27% 77.86%
1989 9.15 23.33 18.25 32.48 28.17% 71.83% 56.19% 78.23%
1990 9.29 26.16 21.38 35.45 26.21% 73.79% 60.31% 81.73%
1991 9.97 26.86 20.75 36.83 27.07% 72.93% 56.34% 77.25%
1992 9.27 29.51 24.25 38.78 23.90% 76.10% 62.53% 82.18%
1993 10.35 32.99 36.5 43.34 23.88% 76.12% 84.22% 110.64%
1994 12.36 35.81 38.13 48.17 25.66% 74.34% 79.16% 106.48%
1995 14.26 39.46 38 53.72 26.55% 73.45% 70.74% 96.30%
1996 18.35 50.18 60 68.53 26.78% 73.22% 87.55% 119.57%
1997 21.59 58.13 67.88 79.72 27.08% 72.92% 85.15% 116.77%
1998 31.33 78.15 94 109.48 28.62% 71.38% 85.86% 120.28%
1999 25.29 67.16 73 92.45 27.36% 72.64% 78.96% 108.70%
2000 21.8 62.09 54.75 83.89 25.99% 74.01% 65.26% 88.18%
2001 20.79 59.4 65 80.19 25.93% 74.07% 81.06% 109.43%
2002 24.05 65.42 68.75 89.47 26.88% 73.12% 76.84% 105.09%
2003 17.7 53.92 48.15 71.62 24.71% 75.29% 67.23% 89.30%
2004 27.79 75.35 75.47 103.14 26.94% 73.06% 73.17% 100.16%
2005 30.36 78.44 79.1 108.8 27.90% 72.10% 72.70% 100.84%


April 21, 2005

reread the CSWC 10K. i also read the 10K’s of AGL, TCBI, WIRE and PHHM. You know what they all have familiar? They all use Ernst and Young as the auditors. Interesting if the fly on the wall could honestly describe why they are no longer the auditors of CSWC.

I took notes and will post at some point. I basically came to the conclusion, that I do like the portfolio make up. i was able to test value some valuations they are using. I like WIRE alot.

All companies seem to have good management, honest. I didnt see any glaring management distributions.

Seems to reek of diligently allocated capital. With that said. One could see the potential for overvaluating. perhaps a floor of 50 a share is possible (barring a major recession)


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