|Shares Out. (in M):||16||P/E||0||0|
|Market Cap (in M):||635||P/FCF||0||0|
|Net Debt (in M):||-123||EBIT||0||0|
We believe Capital Southwest Corp (NASDAQ: CSWC) represents a compelling long investment over the next 12 months with event-driven catalysts. CSWC is admittedly small and off the beaten path with a $600M market cap and $4M of daily trading liquidity. However, we believe that the company is in the early innings of a transformation that has the potential to unlock significant value over the coming 12 months.
This investment has many hallmarks that we desire in a long candidate including: (i) competent new management with a fresh perspective, (ii) hidden balance sheet value, (iii) insider buying, (iv) unfollowed / off the beaten path and (v) identifiable catalyst including announced spin-off transaction that will be completed in 2015.
We see 50+% upside in CSWC over the coming 12 months (and more looking out over a multi-year period) and limited downside as detailed below.
Capital Southwest Corp is a sleepy Dallas, TX based Business Development Corp (“BDC”) that has been around for more than 50 years. The company’s objective is to achieve capital appreciation through long-term investments in private companies.
CSWC has had a unique focus over the years on control-oriented investments vs. typical BDCs that focus on mezzanine debt and minority investments. Two investments, RectorSeal and Whitmore Manufacturing, currently account for an outsized portion of the NAV of the company (52% of NAV at 9/30/14).
CSWC acquired RectorSeal in 1973 and Whitmore Manufacturing in 1979. Both of these investments have been extraordinarily successful with RectorSeal returning 5,243x invested capital (not a typo) and Whitmore returning 55x invested capital at current carrying values.
These two assets put CSWC in an awkward position for a BDC with massive concentration and potentially onerous taxable gains if the investments were sold.
Enter new management and a strategic review. In June 2013, Joseph Armes was hired to become the new CEO of CSWC. Joe Armes is a former corporate lawyer that spent most of his professional career working with Dallas billionaire Tom Hicks. Most recently, Joe was the COO of Hicks Holdings from 2005-2010. Joe has been involved with private equity investments and leveraged transactions for most of his career.
Good background on Joe: http://www.law.ttu.edu/faculty/bios/armes/
Kelly Tacke was appointed CFO in late 2013 as well. Kelly is well known to CSWC having served as the CFO of Palm Harbor Homes, a former portfolio investment of CSWC.
Bowen Diehl was also hired in 2014 as Chief Investment Officer having spent nearly 20 years in the private equity / private debt investment industry mostly recently as a Managing Director at American Capital.
After the management shuffle, CSWC went through a strategic review culminating in the announcement on December 2, 2014 that the company would separate into two public traded companies.
See announcement here: http://ir.capitalsouthwest.com/releasedetail.cfm?ReleaseID=885564
See investor presentation here: http://www.sec.gov/Archives/edgar/data/17313/000114036114043871/ex99_2.htm
See Q&A call here: http://www.sec.gov/Archives/edgar/data/17313/000114036114043871/ex99_3.htm
We believe that the announced spin-off transaction has the potential to create enormous value for CSWC shareholders.
At ~$40 CSWC is currently trading for 0.8x stated NAV (9/30/14). We believe that NAV is understated due to the potential value of a public Industrial SpinCo that will have ~$50M in EBITDA with a roll-up M&A mandate, an underleveraged balance sheet and a management team freed from operating within the more restrictive BDC structure.
Further, we believe that the remaining BDC is effectively starting from scratch with $200M of cash to invest and a hidden asset in their SBIC license that will allow them to tap cheap government leverage at the fund level to magnify equity returns over time.
Taken together, we think CSWC could be worth $60-70 in 12 months representing 50-75% upside from current levels. We see further upside on a multi-year basis as the key businesses compound capital.
We would highlight that management seems to agree with our bullish view. We count 13 open market purchases made during 2014 by 8 officers / directors including the CEO and newly hired CIO of the BDC business. The average price of these purchases was ~$36, a mere 10% lower than the current stock price
Insider buying is usually noteworthy but we found it particularly interesting when combined with the new management team and spin-off announcement.
We decided to take a deeper dive on what management might be so bullish about and have identified 2 sources of meaningful upside.
Source of Upside #1: Private to Public Arbitrage of Industrial Spin-Co
CSWC owns three high quality and acquisitive industrial products and specialty chemicals businesses: RectorSeal, Jet-Lube and Whitmore.