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, 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 January 31, 2008
TABLE OF CONTENTS Page No. -------- PART I. FINANCIAL INFORMATION ITEM 1. Consolidated Financial Statements (1) Consolidated Statements of Financial Condition December 31, 2007 (Unaudited) and March 31, 2007.........3 Consolidated Statements of Operations (Unaudited) For the three and nine months ended December 31, 2007 and December 31, 2006........................................4 Consolidated Statements of Changes in Net Assets For the nine months ended December 31, 2007 (Unaudited) and year ended March 31, 2007............................5 Consolidated Statements of Cash Flows (Unaudited) For the three and nine months ended December 31, 2007 and December 31, 2006........................................6 Consolidated Statement of Investments December 31, 2007........................................7 Notes to Consolidated Financial Statements.......................12 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations....................18 ITEM 3. Quantitative and Qualitative Disclosure About Market Risk............................................20 ITEM 4. Controls and Procedures....................................21 PART II. OTHER INFORMATION ITEM 1 Legal Proceedings........................................22 ITEM 1A. Risk Factors...............................................22 ITEM 6. Exhibits and Reports on Form 8-K........................22 Signatures ...................................................................23 (1) As described in Note 2, the financial statements for fiscal year 2007 have been restated.
<TABLE> <CAPTION> PART I. FINANCIAL INFORMATION Item 1. Consolidated Financial Statements CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statements of Financial Condition ---------------------------------------------- Assets December 31, 2007 March 31, 2007 ------------- ------------- (Unaudited) as restated <S> <C> <C> Investments at market or fair value Companies more than 25% owned (Cost: December 31, 2007 - $28,758,246 March 31, 2007 - $28,632,356) $ 362,231,558 $ 526,993,983 Companies 5% to 25% owned (Cost: December 31, 2007 - $20,412,243, March 31, 2007 - $18,798,896) 48,765,256 76,398,002 Companies less than 5% owned (Cost: December 31, 2007 - $31,190,721, March 31, 2007 - $24,211,045) 93,097,989 77,763,048 ------------- ------------- Total investments (Cost: December 31, 2007- $80,361,210, March 31, 2007 - $71,642,297) 504,094,803 681,155,033 Cash and cash equivalents 31,949,168 38,844,203 Receivables 258,171 337,892 Other assets 9,477,698 9,170,185 ------------- ------------- Totals $ 545,779,840 $ 729,507,313 ============= ============= Liabilities and Shareholders' Equity Other liabilities $ 1,452,545 $ 1,457,847 Deferred income taxes 2,403,277 2,317,777 ------------- ------------- Total liabilities 3,855,822 3,775,624 ------------- ------------- Shareholders' equity Common stock, $1 par value: authorized, 5,000,000 shares; issued, 4,326,516 shares at December 31, 2007 and 4,323,416 shares at March 31, 2007 4,326,516 4,323,416 Additional capital 116,777,926 116,373,960 Undistributed net investment income 6,979,403 5,655,020 Undistributed net realized loss on investments (2,860,118) (3,100,142) Unrealized appreciation of investments 423,733,593 609,512,737 Treasury stock - at cost (437,365 shares) (7,033,302) (7,033,302) ------------- ------------- Net assets at market or fair value, equivalent to $139.34 per share at December 31, 2007 on the 3,889,151 shares outstanding and $186.75 per share at March 31, 2007 on the 3,886,051 shares outstanding 541,924,018 725,731,689 ------------- ------------- Totals $ 545,779,840 $ 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 Nine Months Ended December 31 December 31 ------------------------------ ------------------------------ 2007 2006 2007 2006 ------------- ------------- ------------- ------------- as restated as restated <S> <C> <C> <C> <C> Investment income: Interest $ 552,950 $ 484,888 $ 1,797,079 $ 1,624,418 Dividends 1,838,757 1,626,702 3,003,651 3,167,203 Management and directors' fees 222,449 163,750 673,849 542,150 ------------- ------------- ------------- ------------- 2,614,156 2,275,340 5,474,579 5,333,771 ------------- ------------- ------------- ------------- Operating expenses: Salaries 380,247 310,127 945,468 973,926 Net pension benefit (81,837) (36,237) (245,508) (108,708) Other operating expenses 481,128 238,504 1,034,286 690,469 ------------- ------------- ------------- ------------- 779,538 512,394 1,734,246 1,555,687 ------------- ------------- ------------- ------------- Income before interest expense and income taxes 1,834,618 1,762,946 3,740,333 3,778,084 Interest expense -- 133,749 -- 458,953 ------------- ------------- ------------- ------------- Income before income taxes 1,834,618 1,629,197 3,740,333 3,319,131 Income tax expense 28,500 12,700 82,660 40,724 ------------- ------------- ------------- ------------- Net investment income $ 1,806,118 $ 1,616,497 $ 3,657,673 $ 3,278,407 ============= ============= ============= ============= Proceeds from disposition of investments $ 670,339 $ 31,578,052 $ 1,398,891 $ 42,020,132 Cost of investments sold 1,158,868 12,046,678 1,158,868 12,872,995 ------------- ------------- ------------- ------------- Net realized gain (loss) on investments before taxes (488,528) 19,531,374 240,024 29,147,137 Income tax expense -- 11,080,699 -- 11,080,699 ------------- ------------- ------------- ------------- Net realized gain (loss) on investments (488,528) 8,450,675 240,024 18,066,438 Net increase (decrease) in unrealized appreciation of investments (64,798,599) 132,210,244 (185,779,143) 124,061,543 ------------- ------------- ------------- ------------- Net realized and unrealized gain (loss) on investments $ (65,287,127) $ 140,660,919 $(185,539,119) $ 142,127,981 ============= ============= ============= ============= Increase (decrease) in net assets from operations $ (63,481,009) $ 142,277,416 $(181,881,446) $ 145,406,388 ============= ============= ============= ============= </TABLE> (See Notes to Consolidated Financial Statements) 4
<TABLE> <CAPTION> CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statements of Changes in Net Assets ------------------------------------------------ Nine Months Ended Year Ended December 31, 2007 March 31, 2007 ------------- ------------- (Unaudited) as restated <S> <C> <C> Operations Net investment income $ 3,657,673 $ 4,233,340 Net realized gain on investments 240,024 14,966,296 Net increase (decrease) in unrealized appreciation of investments (185,779,143) 147,681,609 ------------- ------------- Increase (decrease) in net assets from operations (181,881,446) 166,881,245 Distributions from: Undistributed net investment income (2,333,291) (2,323,150) Net realized gains deemed distributed to shareholders -- (11,417,283) Capital share transactions Allocated increase in share value for deemed distribution -- 11,417,283 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 175,676 169,003 ------------- ------------- Increase (decrease) in net assets (183,807,671) 167,695,699 Net assets, beginning of period as restated 725,731,689 558,035,990 ------------- ------------- Net assets, end of period $ 541,924,018 $ 725,731,689 ============= ============= </TABLE> (See Notes to Consolidated Financial Statements) 5
<TABLE> <CAPTION> CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows ------------------------------------- (Unaudited) Three Months Ended Nine Months Ended December 31 December 31 ----------- ----------- 2007 2006 2007 2006 ------------- ------------- ------------- ------------- as restated as restated <S> <C> <C> <C> <C> Cash flows from operating activities Increase (decrease) in net assets from operations $ (63,481,009) $ 142,277,416 $(181,881,446) $ 145,406,388 Adjustments to reconcile increase in net assets from operations to net cash provided by (used in ) operating activities: Proceeds from disposition of investments 670,339 31,578,052 1,398,891 42,020,132 Purchases of securities (817,186) (4,500) (10,032,280) (374,730) Maturities of securities -- -- 154,500 884,936 Depreciation and amortization 8,089 4,426 18,770 12,313 Net pension benefit (81,837) (36,237) (245,508) (108,708) Realized (gain) loss on investments after income taxes 488,528 (8,450,675) (240,024) (18,066,438) Net (increase) decrease in unrealized appreciation of investments 64,798,599 (132,210,244) 185,779,143 (124,061,543) Stock option expense 87,989 43,586 175,676 125,417 (Increase) decrease in receivables (155,215) (105,087) 79,720 (152,372) (Increase) decrease in other assets (11,451) 3,391 (41,859) (14,597) Increase (decrease) in other liabilities 132,468 38,330 57,084 (46,526) Decrease in accrued pension cost (34,467) (36,567) (101,301) (107,602) Increase in deferred income taxes 28,500 12,700 85,500 38,100 ------------- ------------- ------------- ------------- Net cash provided by (used in) operating activities 1,633,347 33,114,591 (4,793,134) 45,554,770 ------------- ------------- ------------- ------------- Cash flows from financing activities Decrease in notes payable to bank -- -- -- -- Distributions from undistributed net investment income (1,555,661) (1,551,100) (2,333,291) (2,323,150) Proceeds from exercise of employee stock options -- 697,350 231,390 1,794,850 ------------- ------------- ------------- ------------- Net cash used in financing activities (1,555,661) (853,750) (2,101,901) (528,300) ------------- ------------- ------------- ------------- Net increase (decrease) in cash and cash equivalents 77,686 32,260,841 (6,895,035) 45,026,470 Cash and cash equivalents at beginning of period 31,871,482 24,269,495 38,844,203 11,503,866 ------------- ------------- ------------- ------------- Cash and cash equivalents at end of period $ 31,949,168 $ 56,530,336 $ 31,949,168 $ 56,530,336 ============= ============= ============= ============= Supplemental disclosure of cash flow information: Cash paid during the period for: Interest $ -- $ 133,749 $ -- $ 458,953 Income taxes $ -- $ -- $ -- $ 20,000 </TABLE> (See Notes to Consolidated Financial Statements) 6
<TABLE> <CAPTION> CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statement of Investments ------------------------------------- December 31, 2007 Company Investment (a) Cost Value (b) - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> +AT&T INC. ++20,770 shares common stock (acquired 3-9-99) $ 12 $ 863,201 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 38,209,050 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 Austin, 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 6,600,000 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 12,600,000 resellers. +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 2 CMI HOLDING COMPANY, INC. 10% convertible subordinate note, due 2009 (acquired 7-2-07) 2,363,347 1,000,000 Richardson, Texas 2,327,658 shares Series A convertible preferred stock, Owns Chase Medical, which convertible into 2,327,658 shares of common stock develops and sells devices at $1.72 per share (acquired 8-21-02 and 6-4-03) 4,000,000 2 used in cardiac surgery to Warrants to purchase 109,012 shares of common stock relieve congestive heart at $1.72 per share, expiring 2012 (acquired 4-16-04) - - failure; develops and Warrants to purchase 431,982 shares of Series A-1 supports cardiac imaging convertible preferred stock at $1.72 per share systems. expiring 2012 (acquired 7-2-07) - - --------- --------- 6,363,347 1,000,002 7
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statement of Investments ------------------------------------- December 31, 2007 (continued) Company Investment (a) Cost Value (b) - ------------------------------------------------------------------------------------------------------------------------------------ +COMCAST CORPORATION ++64,656 shares common stock (acquired 11-18-02) $ 21 $ 1,180,619 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 1,770,280 Englewood, Colorado Provider of creative content, media management and network services worldwide. +EMBARQ CORPORATION ++4,500 shares common stock (acquired 5-17-06) 46,532 222,885 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 44,954,250 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 $29.00 per share (acquired 9-30-03) 2,625,000 8,391,000 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 $29.00 per share (acquired 9-30-03) 375,000 800,000 television commercials and Warrants to purchase 13,035 shares of common stock corporate communications at $29.00 per share, expiring 2008 (acquired 8-11-98 videos. thru 9-30-03) - 375,000 --------- --------- 3,000,000 9,566,000 +FMC CORPORATION ++12,860 shares common stock (acquired 6-6-86 and 9-13-07) 66,726 701,513 Philadelphia, Pennsylvania Chemicals for agricultural, industrial and consumer markets. +FMC TECHNOLOGIES, INC. ++22,114 shares common stock (acquired 1-2-02 and 8-31-07) 57,051 1,253,864 Houston, Texas Equipment and systems for the energy, food processing and air transportation industries. 8
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statement of Investments ------------------------------------- December 31, 2007 (continued) Company Investment (a) Cost Value (b) - ------------------------------------------------------------------------------------------------------------------------------------ +HEELYS, INC. 9,317,310 shares common stock (acquired 5-26-00) 102,490 37,269,240 Carrollton, Texas Heelys stealth skate shoes, equipment and apparel sold through sporting goods chains, department stores and footwear retailers. +HOLOGIC, INC. ++316,410 shares common stock (acquired 8-27-99) 220,000 21,712,054 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 5,351,661 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 1,664,125 Englewood, Colorado ++42,463 shares Series C common stock (acquired 9-6-05) 100,870 1,552,023 Owns interests in broadband, --------- --------- distribution and content 207,423 3,216,148 companies. +LIBERTY MEDIA CORPORATION ++35,250 shares of Liberty Capital Series A common stock Englewood, Colorado (acquired 5-9-06) 51,829 4,106,273 Holding company owning ++176,252 shares of Liberty Interactive Series A common stock interests in electronic (acquired 5-9-06) 66,424 3,362,888 retailing, media, communi- --------- --------- cations and entertainment 118,253 7,469,161 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, Dallas, Texas convertible into 800,000 shares of common stock at Computer datacenter and $1.00 per share (acquired 11-4-97) 800,000 6,000,000 office automation supplies 4,000,000 shares common stock (acquired 11-4-97) 4,615,000 30,000,000 and accessories; impact, --------- --------- tilt monitoring and 5,415,000 36,000,000 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) 150,000 750,000 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 61,000 lumber. --------- --------- 1,748,896 2,811,000 +PALM HARBOR HOMES, INC. 7,855,121 shares common stock (acquired 1-3-85 thru 7-31-95) 10,931,955 51,058,287 Dallas, Texas Integrated manufacturing, retailing, financing and insuring of manufactured housing and modular homes. 9
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statement of Investments ------------------------------------- December 31, 2007 (continued) Company Investment (a) Cost Value (b) - ------------------------------------------------------------------------------------------------------------------------------------ +PETSMART, INC. ++300,000 shares common stock (acquired 6-1-95) $ 1,318,771 $ 7,056,000 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) 52,600 120,000,000 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 1,181,700 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 8,906,843 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 1,118 shares Series C preferred stock (acquired 11-01-07) 281,523 281,523 Designer, manufacturer and --------- ------- distributor of high-quality 4,840,523 281,525 office seating. WELLOGIX, INC. 4,664,627 shares Series A-1 convertible participating Houston, Texas preferred stock, convertible into 4,664,627 shares Developer and supporter of of common stock at $1.1011 per share (acquired software used by the oil and 8-19-05 thru 12-15-07) 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 28,000,000 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) 19,656 119,537 Little Rock, Arkansas Provider of voice, broadband and entertainment services. 10
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statement of Investments ------------------------------------- December 31, 2007 (continued) Company Investment (a) Cost Value (b) - ------------------------------------------------------------------------------------------------------------------------------------ MISCELLANEOUS - BankCap Partners Fund I, L.P. - 6.0% limited partnership interest (acquired 7-14-06 thru 12-21-07) $ 2,457,140 $ 2,457,140 - 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) - 195,000 - 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 2,400,000 - ------------------------------------------------------------------------------------------------------------------------------------ TOTAL INVESTMENTS $ 80,361,210 $504,094,803 ============= ============ - ------------------------------------------------------------------------------------------------------------------------------------ +Publicly-owned company ++ Unrestricted securities as defined in Note (a) </TABLE> 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, 2007, restricted securities represented approximately 87.9% 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 Form 10-K/A 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. Restatement of Consolidated Financial Statements Capital Southwest Corporation (the "Company") filed an amendment to its Annual Report on Form 10-K for the year ended March 31, 2007, to amend and restate its consolidated financial statements and selected per share data and ratios for each of the fiscals years ended March 31, 2007, 2006 and 2005 and our selected per share data and ratios for the years ended March 31, 2004 and 2003. In addition, we filed an amendment to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2007. After reviewing the accounting treatment for deferred taxes on realized appreciation of investments, the Company has determined its long-standing policy of recording deferred taxes on unrealized appreciation of investments was not in conformity with generally accepted accounting principles and its previously issued financial statements required restatement. The effect of the restatement on the consolidated statement of financial conditions as of March 31, 2007; the consolidated statement of operations and consolidated statement of cash flows for the three months and nine months ended December 31, 2006; the consolidated statement of changes in net assets for the nine months ended December 31, 2006 and year ended March 31, 2007 is as follows and shown in tables below: (A) A Regulated Investment Company (RIC) is required to record deferred taxes when it is probable the RIC will not qualify under Subchapter M of the Internal Revenue Code for a period longer than one year. Historically, management believed it was probable the Company would not maintain its qualifying status as a RIC in future years and recorded a deferred tax liability on the unrealized appreciation of investments. However, upon further analysis, the Company determined it was only reasonably possible, but not probable, the Company would not maintain its qualifying status as a RIC. Thus the deferred tax liability consistently recorded and disclosed should not have been recognized. (B) The Company historically has accrued income taxes payable on its investment gains as they have been incurred, as it has been the Company's practice to retain its investment gains. However, RICs are required to accrue federal 12
<TABLE> <CAPTION> Notes to Consolidated Financial Statements (continued) income taxes on investment gains that are retained only on the last day of the tax year. The Company incorrectly recorded the tax impact of its investment gains in periods other than the last day of its tax year, December 31. Therefore, the income taxes payable recorded at times other than the tax year end should not have been recognized. (C) The Company incorrectly classified its' return of capital contributions cumulatively as "undistributed net realized gains on investments." RICs are required to classify return of capital contributuions as "additional capital" in the period in which tax basis amounts become permanent; and reflect undistributed amounts remaining since its' previous tax year end adjusted for temporary tax basis differences as "undistsributed net realized gains on investment." The restatement will eliminate the accrual for deferred taxes on unrealized appreciation of investments, and income taxes payable and related tax carryforwards on realized gains, increasing the net asset value per share and net assets from operations for the periods restated; reclassify return of capital contributions to "additional capital." As of March 31, 2007 -------------------- Previously Consolidated Statement of Financial Condition Reported (3) As Restated (2) - --------------------------------------------- ----------- ----------- <S> <C> <C> Total assets 729,507,313 729,507,313 =========== =========== Income taxes payable 231,274 -- (B) Deferred income tax 213,474,680 2,317,777 (A)(B) ------------ ------------ Total liabilities 215,163,801 3,775,624 ------------ ------------ Additional capital 11,221,601 116,343,960 (C) Undistributed net realized gains (losses) 102,766,040 (3,100,142) (B)(C) Net unrealized appreciation of investments 397,410,737 609,512,737 (A) Net assets at market or fair value 514,343,512 725,731,689 ------------ ------------ Total liabilities and shareholders equity 729,507,313 729,507,313 =========== ============ Nine Months Ended December 31, 2006 ----------------------------------- Previously Consolidated Statement of Operations Reported (1) As Restated (2) - ------------------------------------ ----------- ----------- Net investment income 3,278,407 3,278,407 Net realized gain on investments 29,147,137 29,147,137 (B) Income tax expense 10,098,046 11,080,699 ----------- ----------- Net realized gain on investments 19,049,091 18,066,438 Increase in unrealized appreciation of investments 124,061,543 124,061,543 (A) Increase in deferred income taxes on appreciation of investments 43,017,000 -- ----------- ----------- Net increase in unrealized appreciation of investments 81,044,543 124,061,543 Net realized and unrealized gain on investments 100,093,634 142,127,981 ----------- ----------- Increase in net assets from operations 103,372,041 145,406,388 =========== =========== Three Months Ended December 31, 2006 ------------------------------------ Previously Consolidated Statement of Operations Reported (1) As Restated (2) - ------------------------------------ ----------- ----------- Net investment income 1,616,497 1,616,497 Net realized gain on investments 12,805,347 8,450,675 (B) Net decrease in unrealized appreciation of investments 86,187,244 132,210,244 (A) ----------- ----------- Net realized and unrealized gain on investments 98,992,591 140,660,919 ----------- ----------- Increase in net assets from operations 100,609,088 142,277,416 =========== =========== </TABLE> 13
<TABLE> <CAPTION> Notes to Consolidated Financial Statements (continued) Year Ended March 31, 2007 ------------------------- Previously Consolidated Statement of Changes in Net Assets Reported (3) As Restated (2) - ----------------------------------------------- ------------ ------------ <S> <C> <C> Net investment income 4,233,340 4,233,340 Net realized gain on investments 16,334,000 14,966,296 (B) Net increase on unrealized appreciation before distributions 96,343,609 147,681,609 (A) ------------ ------------ Increase in net assets from operations before distributions 116,910,949 166,881,245 Undistributed net investment income (2,323,150) (2,323,150) Net realized gains deemed distributed to shareholders -- (11,417,283) (C) Allocated increase in share value for deemed distribution -- 11,417,283 (C) Employee stock options exercised 1,794,850 1,794,850 Stock option expense 1,173,751 1,173,751 Adjustment to initially apply FASB Statement No. 158, net of tax 169,003 169,003 ------------ ------------ Increase in net assets 117,725,403 167,695,699 Net assets, beginning of year 396,618,109 558,035,990 ------------ ------------ Net assets, end of year 514,343,512 725,731,689 ============ ============ Net asset value, per share $ 132.36 $ 186.75 ============ ============ Nine Months Ended December 31, 2006 ----------------------------------- Previously Consolidated Statement of Changes in Net Assets Reported (1) As Restated (2) - ----------------------------------------------- ------------ ------------ Net investment income 3,278,407 3,278,407 Net realized gain on investments 19,049,091 18,066,438 (B) Net increase in unrealized appreciation of investments 81,044,543 124,061,543 (A) ------------ ------------ Increase in net assets from operations 103,372,041 145,406,388 Distributions from undistributed net investment income (2,323,150) (2,323,150) Capital share transactions Exercise of employee stock options 1,794,850 1,794,850 Adjustment to initially apply FASB No. 158, net of tax -- -- Stock option expense 125,417 125,417 ------------ ------------ Increase in net assets 102,969,158 145,003,505 Net assets, beginning of year 396,618,109 558,035,990 ------------ ------------ Net assets, end of year 499,587,267 703,039,495 ============ ============ Net asset value, per share $ 128.56 $ 180.91 ============ ============ Nine Months Ended December 31, 2006 ----------------------------------- Previously Consolidated Statement of Cash Flow Reported (1) As Restated (2) - ----------------------------------- ------------ ------------ Net cash provided by operating activities 45,554,770 45,554,770 ----------- ----------- Net cash used in financing activities (528,300) (528,300) ----------- ----------- Net increase in cash and cash equivalents 45,026,470 45,026,470 =========== =========== 14
Notes to Consolidated Financial Statements (continued) Three Months Ended December 31, 2006 Previously Consolidated Statement of Cash Flow Reported (1) As Restated (2) - ----------------------------------- ----------- ----------- Net cash provided by operating activities 33,114,591 33,114,591 Net cash used in financing activities (853,750) (853,750) ----------- ----------- Net decrease in cash and cash equivalents 32,260,841 32,260,841 =========== =========== </TABLE> - ------------------ (1) As presented in the Company's original Form 10-Q for the quarter ended December 31, 2006. (2) Adjusted to reflect the restatement described above. (3) As presented in the Company's original Form 10-K for the fiscal year ended March 31, 2007. (A), (B) and (C) are described in detail above. 3. Income Taxes For the tax years ended December 31, 2007 and 2006, Capital Southwest Corporation ("CSC") and Capital Southwest Venture Corporation ("CSVC") qualified to be taxed as RICs. We intend to meet the applicable qualifications to be taxed as a RIC in future years; management feels it is probable that we will maintain our RIC status for a period longer than one year. However, either company's ability to meet certain portfolio diversification requirements of RICs in future years may not be controllable by such company. As permitted by the Internal Revenue Code, a RIC can designate dividends paid in the subsequent tax year as dividends of the current year ordinary taxable income and long-term capital gains if those dividends are both declared by the extended due date of the RIC's federal income tax return and paid to shareholders by the last day of the subsequent tax year. For the tax years ended December 31, 2007 and 2006 we declared and paid dividends in the amounts of $2,333,291 and $2,323,150, respectively. Additionally, we are also subject to a nondeductible federal excise tax of 4% if we do not distribute at least 98% of our investment company ordinary taxable income during our tax year. For the tax years ended December 31, 2007 and 2006 we distributed 100% of our investment company ordinary taxable income. As a result we have made no provision for income taxes on ordinary taxable income for the tax years ended December 31, 2007 and 2006. For the tax year ended December 31, 2007, we have an estimated net long-term capital loss of $961,655 for tax purposes and $860,118 for book purposes, which will be carried forward and offset by future net long-term capital gains. For the tax year ended December 31, 2006, we had net long-term capital gains of $31,659,140 for tax purposes and $31,932,775 for book purposes, which we elected to retain and treat as a deemed distribution to our shareholders. In order to make the election to retain capital gains, we incurred and paid a federal tax on behalf of our shareholders of $11,080,699 for the tax year ended December 31, 2006. CSMC, a wholly owned subsidiary of CSC, is not a RIC and is required to pay taxes at the current corporate rate. The Company sponsors a qualified defined benefit pension plan which covers its employees and employees of certain of its wholly owned portfolio companies. Deferred taxes related to the qualified defined pension plan are recorded as incurred. 15
Notes to Consolidated Financial Statements (continued) 4. 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, 2007, we recognized compensation expense of $87,988 and $175,676, respectively. As of December 31, 2007, the total remaining unrecognized compensation cost related to non-vested stock options was $1,883,824, which will be amortized over the weighted-average service period of approximately 6.2 years. 5. 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 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 December 31, 2007, there were 37,500 shares available for grant under the Plan. The per share weighted-average fair value of the stock options granted on May 15, 2006 was $31.28 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 $33.05 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 per share weighted-average fair value of the stock options granted on July 16, 2007 was $41.78 per option using the Black-Scholes pricing model with the following assuptions: expected dividend yield of .39%, risk-free interest rate of 4.95%, expected volatility of 19.9%, and expected life of 5 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 $ 86.18 Granted 25,000 152.98 Exercised (3,100) 74.64 Canceled (4,000) 93.49 ------- ------- Balance at December 31, 2007 70,400 $109.99 ======= ======= 16
<TABLE> <CAPTION> Notes to Consolidated Financial Statements (continued) At December 31, 2007, the range of exercise prices and weighted-average remaining contractual life of outstanding options was $65.00 to $152.98 and 6.16 years, respectively. The total intrinsic value of options exercised during the nine months ended December 31, 2007 was $75,129 with the exercise prices ranging from $65.00 to $93.49 per share. A total of 3,100 new shares were issued for the $231,390 cash received from option exercises for the nine months ended December 31, 2007. At December 31, 2007, the number of options exercisable was 9,930 and the weighted-average exercise price of those options was $79.01. 6. Summary of Per Share Information Three Months Ended Nine Months Ended December 31 December 31 ----------- ----------- 2007 2006 2007 2006 --------- --------- --------- --------- as restated as restated <S> <C> <C> <C> <C> Investment income $ .67 $ .59 $ 1.41 $ 1.37 Operating expenses (.20) (.13) (.46) (.40) Interest expense -- (.04) -- (.12) Income taxes (.01) -- (.01) (.01) --------- --------- --------- --------- Net investment income .46 .42 .94 .84 Distributions from undistributed net investment income (.40) (.40) (.60) (.60) Net realized gains deemed distributed to shareholders -- (2.94) -- (2.94) Net realized gain on investments (.12) 2.17 .06 4.66 Net increase (decrease) in unrealized appreciation of investments (16.66) 34.02 (47.77) 31.92 Allocated increase in share value for deemed distributions -- 2.94 -- 2.94 Exercise of employee stock options * -- (.20) (.09) (.50) Stock option expense .02 .01 .05 .03 --------- --------- --------- --------- Increase (decrease) in net asset value (16.70) 36.02 (47.41) 36.35 Net asset value: Beginning of period 156.04 144.89 186.75 144.56 --------- --------- --------- --------- End of period $139.34 $180.91 $139.34 $180.91 ========= ========= ========= ========= Shares outstanding at end of period (000s omitted) 3,889 3,886 3,889 3,886 </TABLE> * Net decrease is due to the exercise of employee stock options at prices less than beginning of period net asset value. 7. Subsequent Events On January 9, 2008, the Company filed its Form 10-Q for the quarter ended September 30, 2007 with the Securities and Exchange Commission and NASDAQ. Additionally, the Company filed its restated Form 10-K/A for the year ended March 31, 2007 and Form 10-Q/A for the quarter ended June 30, 2007 with the Securities and Exchange Commission as explained in Note 2 "Restatement." On January 10, 2008, the Company received a "moot" letter from NASDAQ informing it that its filing delinquency had been cured. Accordingly, the Company is in compliance with Rule 4310(c) (14). 17
Notes to Consolidated Financial Statements (continued) 8. Recent Accounting Pronouncements 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. 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. We are evaluating the impact of SFAS 159. The impact, if any, from the adoption of SFAS 159 has not been determined. Net asset value at December 31, 2007 was $541,924,018, equivalent to $139.34 per share. Assuming reinvestment of all dividends and tax credits on retained long-term capital gains, the December 31, 2007 net asset value reflects a decrease of 22.63% during the past twelve months. December 31, December 31, 2007 2006 ---- ---- as restated Net assets $541,924,018 $703,039,495 Shares outstanding 3,889,151 3,886,051 Net assets per share $139.34 $180.91 Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations 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 (loss) on investments", which is the difference between the proceeds received from disposition of portfolio securities and their stated cost. 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. It should be noted that the "Net realized gain (loss)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 "unrealized" to "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 $1,797,079 for the nine months ended December 31, 2007 increased from $1,624,418 for nine months ended December 31, 2006, due to an increase in excess cash and interest rates. During the nine months ended December 31, 2007 and 2006, we recorded dividend income from the following sources: 18
<TABLE> <CAPTION> Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Nine Months Ended December 31 ----------- 2007 2006 ---- ---- Alamo Group Inc. $ 508,914 $ 507,834 Balco, Inc. 224,400 -- Dennis Tool Company 49,999 62,499 Encore Wire Corporation 245,205 -- Kimberly-Clark Corporation 122,716 113,455 Lifemark Group 571,333 450,000 PalletOne, Inc. -- 89,842 PETsMart, Inc. 27,000 27,000 The RectorSeal Corporation 914,133 1,629,947 TCI Holdings, Inc. 60,953 60,953 The Whitmore Manufacturing Company 228,533 180,000 Other 50,465 45,673 ----------- ----------- $ 3,003,651 $ 3,167,203 =========== =========== Net Increase (Decrease) in Unrealized Appreciation of Investments Set forth in the following table are the significant increases and decreases in unrealized appreciation by portfolio company: Three Months Ended Nine Months Ended December 31 December 31 ----------- ----------- 2007 2006 2007 2006 ---- ---- ---- ---- <S> <C> <C> <C> <C> Alamo Group, Inc. $ (9,905,950) $ -- $ (9,878,840) $ -- Encore Wire Corporation (30,650,750) (28,608,000) (24,520,750) (20,434,000) Heelys, Inc. (18,634,760) 135,681,510 (158,394,760) 165,681,510 Palm Harbor Homes, Inc. (11,782,713) (3,928,000) (19,637,713) (27,493,000) The RectorSeal Corporation 11,150,000 10,500,000 22,000,000 10,500,000 </TABLE> During the nine months ended December 31, 2007, the value of our investment in The RectorSeal Corporation was increased by $22,000,000 due to increased sales and earnings at the company derived largely from growing demand for the smoke containment systems manufactured by its Smoke Guard subsidiary. Offsetting the gain at RectorSeal during the nine months ended December 31, 2007, was a $158,394,760 decline in the value of Heelys, Inc., which experienced significantly slower growth and an extreme decline in market price during the past quarter; a $24,520,750 decline in the value of Encore Wire Corporation due to reduced demand attributable to the residential slowdown and declining margins needed to be competitive; a $19,637,713 decline in the value of Palm Harbor Homes, Inc. due to the deterioration of the manufactured housing market; and a $9,878,840 decline in the value of Alamo Group, Inc. due to inventory shortages that are back logged and excessive startup expenses for the manufacturing of its sweeper line. Portfolio Investments During the quarter ended December 31, 2007, we made additional investments of $817,186 in an existing portfolio company. We have agreed, subject to certain conditions, to invest up to $6,029,760 in three portfolio companies. 19
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Financial Liquidity and Capital Resources At December 31, 2007, we had cash and cash equivalents of approximately $31.9 million. Pursuant to Small Business Administration (SBA) regulations, cash and cash equivalents of $4.6 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. 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 $61.0 million of our investment portfolio is represented by unrestricted publicly-traded securities, and 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 Disclosure 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 its exposure. All of these factors may have an adverse effect on the value of our investments on our net asset value. Our investment in portfolio securities includes fixed-rate debt securities which totaled $9,000,000 at December 31, 2007, equivalent to 1.8% 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. 20
Item 3. Quantitative and Qualitative Disclosure About Market Risk (continued) 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 fair value of our investment in such security. Item 4. Controls and Procedures An evaluation was performed under the supervision and with the participation of our Management, including the President and Controller, 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 Controller concluded that our disclosure controls and procedures were not effective due to a material weakness in the Company's internal control over financial reporting ("ICFR") disclosed in "Item 9A. Controls and Procedures" of the Company's Annual Report on Form 10-K/A, for the fiscal year ended March 31, 2007. The following material weakness is the basis for our conclusion: o We did not maintain an adequate process to assess and determine the probability of the Company maintaining its qualifying status as a RIC subject to subchapter M of the IRC over the next twelve months at any given quarter. To address this material weakness, Management will add a formal evaluation to consider whether it is probable the company will not qualify as a RIC subject to Subchapter M of the IRC over the next 12 months at any given quarter. Additionally, the Company will review its investment gains quarterly and calculate the tax impact on those gains it will retain, however, they will only record the tax liability at the last day of the tax year. Management will also determine, based on materiality, any footnote disclosure that may be required during the interim periods. Furthermore, Management will review and assess temporary and permanent differences for reclassification to "additional capital" at each tax year end. When considered necessary by Management, an independent attorney or accountant with requisite knowledge of investment company taxation will be consulted in order to provide necessary guidance. Accordingly, Management believes that the financial statements included in this report fairly represent in all material respects the Company's financial position, results of operations and cash flows for the periods presented. There were no changes in the Company's internal control over financial reporting that have materially affected, or are reasonably likely to materially affect our ICFR during the fiscal quarter ended December 31, 2007. 21
PART II. OTHER INFORMATION - -------- ----------------- Item 1. Legal Proceedings We are currently the subject of certain legal actions. In our judgment, none of the lawsuits currently pending against us, either individually or in the aggregate, is likely to have a material adverse effect on our business, results of operations, or financial position. We, Capital Southwest Corporation and Capital Southwest Venture Corporation, have been named in a lawsuit filed on August 27, 2007 in the United States District Court of the Northern District of Texas, Dallas Division, against Heelys, Inc and its Chief Executive Officer, Chief Financial Officer and the directors who signed its registration statement with the Securities and Exchange Commission in connection with its December 7, 2006 initial public offering ("IPO"), and its underwriters for the IPO. The complaint alleges violations of Sections 11 and 15 of the Securities Act of 1933 and the plaintiffs are seeking compensatory damages in an unspecified amount, as well as reasonable costs and expenses incurred in the action, including counsel fees and expert fees. Four similar suits were also filed in September and October 2007 in the United States District Court of the Northern District of Texas making substantially similar allegations under Sections 11, 12 and 15 of the Securities Act of 1933, and seeking substantially similar damages. These lawsuits have been transferred to a single judge, and we expect that all the cases will be consolidated into a single action, with a consolidated complaint filed shortly thereafter. We believe that the plaintiffs' claims are without merit, we deny the allegations in the complaints, and we intend to vigorously defend the lawsuits. 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/A 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 Controller 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 Controller 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. 22
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/ Gary L. Martin Date: February 8, 2008 By: -------------------------- ------------------------------ Gary L. Martin, President (chief executive officer) /s/ Tracy L. Morris Date: February 8, 2008 By: -------------------------- ------------------------------ Tracy L. Morris, Controller (chief financial/accounting) 23