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 June 30, 2007 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 incorporation (I.R.S. Employer 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. 3,889,151 shares of Common Stock, $1 Par Value as of July 31, 2007
TABLE OF CONTENTS PART I. FINANCIAL INFORMATION Page No. -------- ITEM 1. Consolidated Financial Statements Consolidated Statements of Financial Condition June 30, 2007 (Unaudited) and March 31, 2007.............3 Consolidated Statements of Operations (Unaudited) For the three months ended June 30, 2007 and June 30, 2006.......................................4 Consolidated Statements of Changes in Net Assets For the three months ended June 30, 2007 (Unaudited) and year ended March 31, 2007...........................5 Consolidated Statements of Cash Flows (Unaudited) For the three months ended June 30, 2007 and June 30, 2006.......................................6 Portfolio of Investments June 30, 2007............................................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.........................................17 ITEM 4. Controls and Procedures.................................18 PART II. OTHER INFORMATION ITEM 1A. Risk Factors...............................................18 ITEM 6. Exhibits and Reports on Form 8-K...........................18 Signatures ...................................................................19 2
<TABLE> <CAPTION> PART I. FINANCIAL INFORMATION - ------------------------------ Item 1. Consolidated Financial Statements CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statementrs of Financial Condition ----------------------------------------------- Assets June 30, 2007 March 31, 2007 ------------- ------------- (Unaudited) <S> <C> <C> Investments at market or fair value Companies more than 25% owned (Cost: June 30, 2007 - $28,758,246 March 31, 2007 - $28,632,356) $537,279,981 $526,993,983 Companies 5% to 25% owned (Cost: June 30, 2007 - $18,948,896 March 31, 2007 - $18,798,896) 81,892,002 76,398,002 Companies less than 5% owned (Cost: June 30, 2007 - $31,982,402 March 31, 2007 - $24,211,045) 87,178,742 77,763,048 ------------- ------------- Total investments (Cost: June 30, 2007 - $79,689,544 March 31, 2007 - $71,642,297) 706,350,725 681,155,033 Cash and cash equivalents 31,264,000 38,844,203 Receivables 152,972 337,892 Other assets 9,227,147 9,170,185 ------------- ------------- Totals $746,994,844 $729,507,313 ============= ============= Liabilities and Shareholders' Equity Other liabilities $ 1,320,521 $ 1,457,847 Income taxes payable 231,274 231,274 Deferred income taxes 219,604,301 213,474,680 ------------- ------------- Total liabilities 221,156,096 215,163,801 ------------- ------------- Shareholders' equity Common stock, $1 par value: authorized, 5,000,000 shares; issued, 4,326,516 shares at June 30, 2007 and 4,323,416 shares at March 31, 2007 4,326,516 4,323,416 Additional capital 11,493,477 11,221,601 Undistributed net investment income 5,518,081 5,655,020 Undistributed net realized gain on investments 102,977,794 102,766,040 Unrealized appreciation of investments - net of deferred income taxes 408,556,182 397,410,737 Treasury stock - at cost (437,365 shares) (7,033,302) (7,033,302) ------------- ------------- Net assets at market or fair value, equivalent to $135.21 per share at June 30, 2007 on the 3,889,151 shares outstanding and $132.36 per share at March 31, 2007 on the 3,886,051 shares outstanding 525,838,748 514,343,512 ------------- ------------- Totals $746,994,844 $729,507,313 ============= ============= </TABLE> (See Notes to Consolidated Financial Statements) 3
<TABLE> <CAPTION> CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statements of Operations ------------------------------------- (Unaudited) Three Months Ended June 30 ------------------ 2007 2006 ------------ ------------ <S> <C> <C> Investment income: Interest $ 564,687 $ 205,852 Dividends 363,427 782,566 Management and directors' fees 225,200 198,450 ------------ ------------ 1,153,314 1,186,868 ------------ ------------ Operating expenses: Salaries 274,136 343,465 Net pension benefit (36,237) (29,187) Other operating expenses 264,964 221,228 ------------ ------------ 502,863 535,506 ------------ ------------ Income before interest expense and income taxes 650,451 651,362 Interest expense -- 146,982 ------------ ------------ Income before income taxes 650,451 504,380 Income tax expense 9,760 12,824 ------------ ------------ Net investment income $ 640,691 $ 491,556 ============ ============ Proceeds from disposition of investments $ 325,775 $ 397,016 Cost of investments sold -- -- ------------ ------------ Realized gain on investments before income taxes 325,775 397,016 Income tax expense 114,021 138,956 ------------ ------------ Net realized gain on investments 211,754 258,060 ------------ ------------ Increase (decrease) in unrealized appreciation of investments before income taxes 17,148,445 (5,217,480) Increase (decrease) in deferred income taxes on appreciation of investments 6,003,000 (2,195,000) ------------ ------------ Net increase (decrease) in unrealized appreciation of investments 11,145,445 (3,022,480) ------------ ------------ Net realized and unrealized gain (loss) on investments $11,357,199 $(2,764,420) ============ ============ Increase (decrease) in net assets from operations $11,997,890 $(2,272,864) ============ ============ </TABLE> (See Notes to Consolidated Financial Statements) 4
<TABLE> <CAPTION> CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statements of Changes in Net Assets ------------------------------------------------ Three Months Ended Year Ended June 30, 2007 March 31, 2007 ------------- -------------- (Unaudited) <S> <C> <C> Operations: Net investment income $ 640,691 $ 4,233,340 Net realized gain on investments 211,754 16,334,000 Net increase in unrealized appreciation of investments 11,145,445 96,343,609 ------------- ------------- Increase in net assets from operations 11,997,890 116,910,949 Distributions from: Undistributed net investment income (777,630) (2,323,150) Capital share transactions: Exercise of employee stock options 231,390 1,794,850 Adjustment to initially apply FASB No. 158, net of tax -- 1,173,751 Stock option expense 43,586 169,003 ------------- ------------- Increase in net assets 11,495,236 117,725,403 Net assets, beginning of period 514,343,512 396,618,109 ------------- ------------- Net assets, end of period $525,838,748 $514,343,512 ============= ============= </TABLE> (See Notes to Consolidated Financial Statements) 5
<TABLE> <CAPTION> CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows ------------------------------------- (Unaudited) Three Months Ended June 30 ------- 2007 2006 ------------- ------------- <S> <C> <C> Cash flows from operating activities Increase (decrease) in net assets from operations $ 11,997,890 $ (2,272,864) Adjustments to reconcile increase in net assets from operations to net cash provided by operating activities: Proceeds from disposition of investments 325,775 397,016 Purchases of securities (8,051,747) -- Maturities of securities 4,500 402,445 Depreciation and amortization 4,409 3,865 Net pension benefit (36,237) (29,187) Realized gain on investments before income taxes (325,775) (397,016) Deferred taxes on realized gain on investments 114,021 138,956 Net (increase) decrease in unrealized appreciation of investments (11,145,445) 3,022,480 Stock option expense 43,586 4,120 (Increase) decrease in receivables 184,920 (15,871) Increase in other assets (6,729) (19,943) Decrease in other liabilities (119,163) (106,582) Decrease in accrued pension cost (36,568) (34,467) Deferred income taxes 12,600 10,200 ------------- ------------- Net cash provided by (used in) operating activities (7,033,963) 1,103,152 ------------- ------------- Cash flows from financing activities Increase in notes payable to bank -- 150,000,000 Distributions from undistributed net investment income (777,630) (772,050) Proceeds from exercise of employee stock options 231,390 1,097,500 ------------- ------------- Net cash provided by (used in) financing activities (546,240) 150,325,450 ------------- ------------- Net increase (decrease) in cash and cash equivalents (7,580,203) 151,428,602 Cash and cash equivalents at beginning of period 38,844,203 11,503,866 ------------- ------------- Cash and cash equivalents at end of period $ 31,264,000 $162,932,468 ============= ============= Supplemental disclosure of cash flow information: Cash paid during the period for: Interest $ -- $ 123,763 Income taxes $ -- $ 20,000 </TABLE> (See Notes to Consolidated Financial Statements) 6
<TABLE> <CAPTION> Portfolio of Investments - June 30, 2007 ---------------------------------------- Company Investment (a) Cost Value (b) - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> +AT&T INC. ++20,770 shares common stock (acquired 3-9-99) $ 12 $ 861,955 San Antonio, Texas Global leader in local, long distance, Internet and transaction-based voice and data services. +ALAMO GROUP INC. 2,830,300 shares common stock 2,190,937 48,115,000 Sequin, Texas (acquired 4-1-73 thru 5-25-07) Tractor-mounted mowing and mobile excavation equipment for governmental, industrial and agricultural markets; street-sweeping equipment for municipalities. ALL COMPONENTS, INC. 8.25% subordinated note due 2012 (acquired 6-27-07) 6,000,000 6,000,000 Addison, Texas 150,000 shares Series A convertible preferred stock, Electronics contract manu- convertible into 600,000 shares of common stock facturing; distribution at $0.25 per share (acquired 9-16-94) 150,000 1,000,000 and production of memory Warrant to purchase 350,000 shares of common stock and other components for at $11.00 per share, expiring 2017 (acquired 6-27-07) - - computer manufacturers, --------- --------- retailers and value-added 6,150,000 7,000,000 resellers. +ALLTEL CORPORATION ++8,880 shares common stock (acquired 7-1-98) 88,699 599,844 Little Rock, Arkansas Owner and operator of the nation's largest wireless network. +ATLANTIC CAPITAL BANCSHARES, INC. 300,000 shares common stock (acquired 4-10-07) 3,000,000 3,000,000 Atlanta, Georgia Holding company of Atlantic Capital Bank a full service commercial bank. BALCO, INC. 445,000 shares common stock and 60,920 shares Wichita, Kansas Class B non-voting common stock 624,920 4,500,000 Specialty architectural (acquired 10-25-83 and 5-30-02) products used in the construction and remodeling of commercial and insti- tutional 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 common stock at $0.50 per share graphics imaging and design. (acquired 8-20-99 thru 8-8-01) 1,500,000 300,000 CMI HOLDING COMPANY, INC. 10% demand note (acquired 6-7-07) 150,000 150,000 Richardson, Texas 10% convertible subordinated notes, convertible Owns Chase Medical, which into 720,350 shares of common stock at $1.32 develops and sells devices per share, due 2007 (acquired 4-16-04 used in cardiac surgery to thru 12-17-04) 750,000 750,000 relieve congestive heart 2,327,658 shares Series A convertible preferred stock, failure; develops and convertible into 2,327,658 shares of common stock supports cardiac imaging at $1.72 per share (acquired 8-21-02 and 6-4-03) 4,000,000 2,000,000 systems. Warrants to purchase 109,012 shares of common stock at $1.72 per share, expiring 2012 (acquired 4-16-04) - - --------- --------- 4,900,000 2,900,000 7
Company Investment (a) Cost Value (b) - ------------------------------------------------------------------------------------------------------------------------------------ +COMCAST CORPORATION ++64,656 shares common stock (acquired 11-18-02) $ 21 $ 1,816,187 Philadelphia, Pennsylvania Leading provider of cable, entertainment and communi- cations 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 at $48.25 per share (acquired 8-10-98) 999,981 999,981 compacts (PDCs) used in oil 140,137 shares common stock (acquired 3-7-94 and 8-10-98) 2,329,963 2,000,000 field drill bits and in --------- --------- mining and industrial 3,329,944 2,999,981 applications. +DISCOVERY HOLDING COMPANY ++70,501 shares Series A common stock (acquired 7-21-05) 20,262 1,618,703 Englewood, Colorado Provider of creative content, media management and network services worldwide. +EMBARQ CORPORATION ++4,500 shares common stock (acquired 5-17-06) 46,532 285,165 Overland Park, Kansas Local exchange carrier that provides voice and data services, including high-speed Internet. +ENCORE WIRE CORPORATION 4,086,750 shares common stock (acquired 7-16-92 thru 10-7-98) 5,800,000 75,605,000 McKinney, Texas 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 common Owns Bill Young Productions, stock at $25.00 per share (acquired 9-30-03) 2,625,000 6,449,000 Texas Video and Post, and 3,750 shares 8% Series A convertible preferred stock, Extreme Communications, convertible into 15,000 shares of common stock at which produce radio and $25.00 per share (acquired 9-30-03) 375,000 614,000 television commercials and Warrants to purchase 13,035 shares of common stock corporate communications at $25.00 per share, expiring 2008 (acquired 8-11-98 videos. thru 9-30-03) - 210,000 --------- --------- 3,000,000 7,273,000 +FMC CORPORATION ++6,430 shares common stock (acquired 6-6-86) 66,726 574,778 Philadelphia, Pennsylvania Chemicals for agricultural, industrial and consumer markets. +FMC TECHNOLOGIES, INC. ++11,057 shares common stock (acquired 1-2-02) 57,051 875,936 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) 102,490 186,346,000 Carrollton, Texas Heelys stealth skate shoes, equipment and apparel sold through sporting goods chains, department stores and footwear retailers. 8
Company Investment (a) Cost Value (b) - ------------------------------------------------------------------------------------------------------------------------------------ HIC-STAR CORPORATION 10% subordinated note due 2007 (acquired 10-19-04 and Dallas, Texas 1-13-05) $ 352,646 $ - Holding company previously 12% subordinated notes due 2008 (acquired 3-25-05 thru engaged in mortgage banking 2-27-06) 717,523 100,000 operations, which have now Warrants to purchase 463,162 shares of Series A common been sold. stock at $1.00 per share, expiring 2014 (acquired 3-31-04 thru 1-13-05) - - --------- --------- 1,070,169 100,000 +HOLOGIC, INC. ++316,410 shares common stock (acquired 8-27-99) 220,000 17,500,637 Bedford, Massachusetts Medical instruments including bone densi- tometers, mammography devices and digital radiography systems. +KIMBERLY-CLARK CORPORATION ++77,180 shares common stock (acquired 12-18-97) 2,358,518 5,162,570 Dallas, Texas Manufacturer of tissue, personal care and health care products. +LIBERTY GLOBAL, INC. ++42,463 shares Series A common stock (acquired 6-15-05) 106,553 1,742,682 Englewood, Colorado ++42,463 shares Series C common stock (acquired 9-6-05) 100,870 1,667,097 Owns interests in broadband, --------- --------- distribution and content 207,423 3,409,779 companies. +LIBERTY MEDIA CORPORATION ++35,250 shares of Liberty Capital Series A common stock Englewood, Colorado (acquired 5-9-06) 51,829 4,144,343 Holding company owning ++176,252 shares of Liberty Interactive Series A common stock interests in electronic (acquired 5-9-06) 66,424 3,932,182 retailing, media, communi- --------- --------- cations and entertainment 118,253 8,076,525 businesses. LIFEMARK GROUP 1,449,026 shares common stock (acquired 7-16-69) 4,510,400 44,000,000 Hayward, California Cemeteries, mausoleums and mortuaries located in northern California. MEDIA RECOVERY, INC. 800,000 shares Series A convertible preferred stock, Graham, Texas convertible into 800,000 shares of common stock at Computer datacenter and $1.00 per share (acquired 11-4-97) 800,000 7,500,000 office automation supplies 4,000,000 shares common stock (acquired 11-4-97) 4,615,000 37,500,000 and accessories; impact, --------- --------- tilt monitoring and 5,415,000 45,000,000 temperature sensing devices to detect mishandled shipments; dunnage for protecting shipments. PALLETONE, INC. 12.3% senior subordinated notes due 2012 (acquired 9-25-06) 1,553,150 2,000,000 Bartow, Florida 150,000 shares common stock (acquired 10-18-01) 150,000 1,000,000 Manufacturer of wooden Warrant to purchase 15,294 shares of common stock at pallets and pressure-treated $1.00 per share, expiring 2011 (acquired 2-17-06) 45,746 87,000 lumber. --------- --------- 1,748,896 3,087,000 +PALM HARBOR HOMES, INC. 7,855,121 shares common stock (acquired 1-3-85 thru 7-31-95) 10,931,955 70,696,000 Dallas, Texas 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 $ 9,726,000 Phoenix, Arizona Retail chain of more than 928 stores selling pet foods, supplies and services. THE RECTORSEAL CORPORATION 27,907 shares common stock (acquired 1-5-73 and 3-31-73) 52,600 108,850,000 Houston, Texas Specialty chemicals for plumbing, HVAC, electrical, construction, industrial, oil field and automotive applications; smoke contain- ment systems for building fires; also owns 20% of The Whitmore Manufacturing Company. +SPRINT NEXTEL CORPORATION ++90,000 shares common stock (acquired 6-20-84) 457,113 1,863,900 Reston, Virginia Diversified telecom- munications company. TCI HOLDINGS, INC. 21 shares 12% Series C cumulative compounding preferred Denver, Colorado 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 10,938,915 Dallas, Texas Regional bank holding company with banking operations in six Texas cities. VIA HOLDINGS, INC. 9,118 shares Series B preferred stock (acquired 9-19-05) 4,559,000 2 Sparks, Nevada Designer, manufacturer and distributor of high-quality office seating. WELLOGIX, INC. 4,540,883 shares Series A-1 convertible participating Houston, Texas preferred stock, convertible into 4,540,883 shares Developer and supporter of of common stock at $1.1011 per share (acquired software used by the oil and 8-19-05 thru 6-15-07) 5,000,000 2 gas industry to control drilling and maintenance expenses. THE WHITMORE MANUFACTURING COMPANY 80 shares common stock (acquired 8-31-79) 1,600,000 26,600,000 Rockwall, Texas Specialized mining, railroad and industrial lubricants; coatings for automobiles and primary metals; fluid contamination control devices. +WINDSTREAM CORPORATION ++9,181 shares common stock (acquired 7-17-06) 19,656 135,512 Little Rock, Arkansas Provider of voice, broadband and entertainment services. 10
Company Investment (a) Cost Value (b) - ------------------------------------------------------------------------------------------------------------------------------------ MISCELLANEOUS - BankCap Partners Fund I, L.P. - 6.0% limited partnership interest (acquired 7-14-06 thru 4-3-07) $ 2,371,476 $ 2,371,476 - 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) - 173,000 - PharmaFab, Inc. - contingent payment agreement (acquired 2-15-07) 2 2 - 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 2,200,000 - ------------------------------------------------------------------------------------------------------------------------------------ TOTAL INVESTMENTS $ 79,689,544 $706,350,725 ============= ============ - ------------------------------------------------------------------------------------------------------------------------------------ </TABLE> +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 June 30, 2007, restricted securities represented approximately 91.0% 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, 2007. 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 ended June 30, 2007, we recognized compensation expense of $43,586. As of June 30, 2007, the total remaining unrecognized compensation cost related to non-vested stock options was $1,127,866, which will be amortized over the weighted-average service period of approximately 7.34 years. 12
Notes to Consolidated Financial Statements (continued) 3. Employee Stock Option Plan On July 19, 1999, shareholders approved the 1999 Stock Option ("Plan"), which provided for the granting of stock options to employees and officers and authorized the issuance of common stock upon exercise of such options for up to 140,000 shares. All options are granted at or above market price, 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 June 30, 2007, 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, 2007: Number Weighted-Average of shares Exercise Price ----------- ------------ Balance at March 31, 2007 52,500 $86.184 Granted - - Exercised (3,100) 74.642 Canceled - - ----------- ------------ Balance at June 30, 2007 49,400 86.908 =========== ============ At June 30, 2007, the range of exercise prices and weighted-average remaining contractual life of outstanding options was $65.00 to $98.44 and 7.66 years, respectively. The total intrinsic value of options exercised during the three months ended June 30, 2007 was $37,529 with the exercise prices ranging from $65.00 to $93.49 per share. New shares were issued for the $231,390 cash received from option exercises for the three months ended June 30, 2007. At June 30, 2007, the number of options exercisable was 8,915 and the weighted-average exercise price of those options was $76.80. On July 16, 2007, a stock option to purchase 25,000 shares of common stock was issued to the new president, Gary L. Martin. 13
Notes to Consolidated Financial Statements (continued) 4. Summary of Per Share Information Three Months Ended June 30 2007 2006 ------ ------ Investment income $ .30 $ .31 Operating expenses (.13) (.14) Interest expense -- (.04) Income taxes -- -- ------ ------ Net investment income .17 .13 Distributions from undistributed net investment income (.20) (.20) Net realized gain on investments .05 .07 Net increase (decrease) in unrealized appreciation of investments after deferred taxes 2.87 (.78) Exercise of employee stock options* (.05) (.13) Stock option expense .01 -- ------ ------ Increase (decrease) in net asset value 2.85 (.91) Net asset value: Beginning of period 132.36 102.74 ------ ------ End of period $135.21 $101.83 ====== ====== Increase (decrease) in deferred taxes on unrealized appreciation $ 1.50 $ (.74) Deferred taxes on unrealized appreciation: Beginning of period 54.58 41.65 ------ ------ End of period $ 56.08 $ 40.91 ====== ====== Shares outstanding at end of period (000s omitted) 3,889 3,875 * 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 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 future effect of HB3 to also be immaterial. 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, therefore we will adopt SFAS 157 effective April 1, 2008. We are evaluating the impact of SFAS 157. 14
Notes to Consolidated Financial Statements (continued) In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" (SFAS 159). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 is effective for us beginning April 1, 2008. The impact, if any, from the adoption of SFAS 159 has not been determined. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Net asset value at June 30, 2007 was $525,838,748 equivalent to $135.21 per share after deducting an allowance of $56.08 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 June 30, 2007 net asset value reflects an increase of 36.4% during the past twelve months. June 30, June 30, 2007 2006 ---- ---- Net assets $525,838,748 $394,674,815 Shares outstanding 3,889,151 3,875,751 Net assets per share $135.21 $101.83 Results of Operations The composite measure of our financial performance in the Consolidated Statements of Operations is captioned "Increase (decrease) 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 (decrease) 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 (decrease) 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 (decrease) 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 Interest income of $564,687 in the three months ended June 30, 2007 increased from $205,852 in the year-ago period due to an increase in excess cash and interest rates. During the three months ended June 30, 2007 and 2006, we recorded dividend income from the following sources: 15
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Three Months Ended June 30 ------- 2007 2006 ---------- ---------- Alamo Group Inc. $169,278 $169,278 Dennis Tool Company 25,000 37,499 Encore Wire Corporation 81,735 - Kimberly-Clark Corporation 40,905 37,818 Lifemark Group - 150,000 PalletOne, Inc. - 44,921 The RectorSeal Corporation - 240,000 TCI Holdings, Inc 20,318 20,318 The Whitmore Manufacturing Company - 60,000 Other 26,191 22,732 ---------- ---------- $363,427 $782,566 ========== ========== Net Increase (Decrease) 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 June 30 ------- 2007 2006 ---- ---- Encore Wire Corporation $ 6,130,000 $ 8,174,000 Heelys, Inc. (9,318,000) - Palm Harbor Homes, Inc. - (7,855,000) The RectorSeal Corporation 10,850,000 - During the three months ended June 30, 2007, the value of our investment in Encore Wire Corporation was increased $6,130,000 due to an increase in the company's stock price. The value of our investment in The RectorSeal Corporation was increased $10,850,000 due to increased sales and earnings at the company. Offsetting the gains at RectorSeal and Encore Wire during the three months ended June 30, 2007, was a $9,318,000 decline in the value of Heelys, which has experienced a market price decline in each of the past two quarters. Portfolio Investments During the quarter ended June 30, 2007, we made an investment of $3,000,000 in a new portfolio company and additional investments of $5,051,747 in existing portfolio companies. We have agreed, subject to certain conditions, to invest up to $4,115,423 in two portfolio companies. Financial Liquidity and Capital Resources At June 30, 2007, we had cash and cash equivalents of approximately $31.3 million. Pursuant to Small Business Administration (SBA) regulations, cash and cash equivalents of $3.2 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 16
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) 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 $25.0 million was available at June 30, 2007. 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 39 years. Retention of future gains is viewed as an important source of funds to sustain our investment activity. Approximately $63.4 million of our investment portfolio is represented by unrestricted publicly-traded securities which represent a source of liquidity. 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. 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 $9,000,000 at June 30, 2007, equivalent to 1.3% 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 17
Item 3. Quantitative and Qualitative Disclosures About Market Risk (continued) 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 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 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 Secretary-Treasurer, as appropriate, to allow timely decisions regarding such required disclosure. During the fiscal quarter ended June 30, 2007, 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. 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, 2007. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit 31.1- Certification of President 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 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. 18
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 Date: August 3, 2007 By: /s/ Gary L. Martin ---------------- ------------------------------------- Gary L. Martin, President (chief executive officer) Date: August 3, 2007 By: /s/ Susan K. Hodgson ---------------- ------------------------------------- Susan K. Hodgson, Secretary-Treasurer (chief financial/accounting officer) 19