January 23, 2015 - 10:27am EST by
2015 2016
Price: 41.00 EPS 0 0
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
TEV (in $M): 512 TEV/EBIT 0 0

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  • Hidden Assets
  • BDC
  • Insider Buying
  • Specialty Chemicals
  • Small Cap
  • Sum Of The Parts (SOTP)
  • Management Change
  • Potential Spin-Off
  • Analyst Coverage
  • M&A Catalyst



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.

Business Overview:

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:

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:

See investor presentation here:

See Q&A call here:

The Opportunity:

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.

Insider Buying:

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.

Joseph Armes will become the CEO of the “Industrial SpinCo” business which will pursue an active M&A strategy to compound shareholder value over time. This is not a departure from the current strategy of these businesses which have completed 30 tuck-in acquisitions since 1991. This strategy has clearly served shareholders well with a cumulative return on equity of 240x invested capital. We believe there is a long runway for Industrial SpinCo to continue to leverage their experience in tuck-in M&A expertise and cheap debt financing to compound shareholder value at favorable rates of return over time.

Admittedly, the estimates below are a bit of swag given the current vacuum of information prior to the spin, but we estimate that Industrial SpinCo will generate $53M of EBITDA in FY 2016 ending March (approximately the next 12 months). We assume 5% organic topline growth and 40% incremental EBITDA margins along with $3M of public company costs added to the business.

Mid-cap specialty chemical comps trade for 10-13x 2015 EBITDA. We expect Industrial SpinCo could trade for 12x EBITDA given the “platform value” and their expertise in conducting value accretive M&A transactions.

This private to public arbitrage exists because CSWC values the Industrial SpinCo businesses at 7-8.5x EBITDA on their balance sheet today. Thus, we expect the spin-off transaction and platform potential of the business to unlock as much as $15.25 in value per share or 38% upside from the current stock price.

CSWC expects to file a Form 10 for the spin-off in Q2 2015 and complete the spin-off by the end of Q3 2015.

Source of Upside #2: Clean Sheet BDC with Hidden Value in SBIC License

CSWC has been pruning their portfolio of investments including selling stakes in publicly held companies since the September 10Q came out. As of September 2014, CSWC has $766.5M of book value of which $616.4M were investments (80% of book value). Another $113.0M of the book value was cash on the balance sheet.

Since September, CSWC sold their stake in Alamo Group and Encore Wire which we estimate raised after-tax cash proceeds of $90.1M.

We estimate that CSWC is now sitting on $200M of cash which is dry powder that can be put to work in investments through the BDC.

Post the Industrial SpinCo spin-off, CSWC is effectively a clean sheet BDC with $200M of cash and a valuable SBIC license that they can tap to compound book value over time.

In 1958, the Federal Government created the Small Business Investment Company Program to facilitate access to long term capital for small businesses.

CSWC has held a SBIC license but has not used it historically. We expect CSWC to finally leverage their SBIC license and pair that with the $200M of cash on their balance sheet to deploy up to $425M in mezzanine debt investments in private companies over the coming 4-5 years.

Here is a good overview of the SBIC program:

The government will lend to an SBIC fund up to $150M or $225M across multiple funds at very attractive interest rates. The current SBIC debenture rate is 3.015%. There are also one-time commitment fees and admin fees that equate to about 3% of the loan balance. Assuming capital is deployed over 5 years, the all-in cost of the SBIC debt is about 3.6% annually.

SBIC Debenture Rates since 2001:

Deploying capital via the SBIC program at a 1:1 leverage ratio into mezzanine securities yielding 12% over 5 years would equate to a 2.0x multiple of money on the equity for CSWC over 5 years. We believe 12% IRRs over 5 years is a sufficiently conservative assumption as returns can often by enhanced by equity participation or warrants.

A doubling of the $200M of cash / dry powder on the CSWC balance sheet today would add $13 to the balance sheet or another 33% to the stock price over the next 5 years.

Put another way, at $40 we are paying 0.8x stated book value for CSWC today based on the September 2014 balance sheet. If we value the SpinCo at 12x EBITDA, you are paying 0.65x book value for the remaining assets. $200M of that book value is cash that can be deployed at a ~15% annual return on equity using 1:1 cheap leverage from Uncle Sam.

We think there is significant hidden value in the “Clean Sheet” BDC that will be realized as they deploy capital at favorable rates of return relative to the cost of their SBIC debt.

Valuation / Price Target

For valuation, we begin with the stated book value on September 30, 2014. We then make adjustments for the sale of Alamo and Encore assuming a 35% tax burden (per management guidance). This reduces book value by $27M. We then back out the value of Whitmore and RectorSeal on the balance sheet and add back our value of Industrial SpinCo at 12x EBITDA or $637.8M.

This gets us to a price target of $62.85 or nearly 60% upside that could be realized by year end 2015 due to the pending spin-off catalyst.

Finally, we add $13 to our price target to represent the doubling of the $200M cash balance as it is deployed in through the “Clean Sheet” BDC.

This gets us to our ultimate price target of $76 or ~90% upside from the current stock price. The BDC upside will clearly take longer to develop but could be accelerated if investors begin to see tangible progress of successful new investments.

For downside, we see no reason why the stock would trade much lower than 0.75x stated book value given the pending spin-off transaction that should unlock meaningful value. This would be $37 per share or 7.5% downside from here and roughly equates to the average insider purchase price during 2014 which gives us further comfort.

We think CSWC is an opportunity to invest in a catalyst-rich potential multi-year compounder at a meaningful discount to economic NAV today. This opportunity likely exists because the company has zero equity research coverage and a small market capitalization. There is also a current vacuum of information as we await further details of the spin-off transaction which we expect will be lifted over the coming months.


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


Form 10 and investor roadshow for Industrial SpinCo in Q2 / Q3 2015

Closing of Industrial SpinCo spin-off transaction by end of Q3 2015

Longer term: Industrial SpinCo successfully executing on accretive M&A to drive shareholder returns

Longer term: BDC makes successful new investments using cash on B/S and cheap debt from SBIC program leading to growth in book value per share

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