|Shares Out. (in M):||0||P/E|
|Market Cap (in $M):||604||P/FCF|
|Net Debt (in $M):||0||EBIT||0||0|
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Publicly traded venture capital investment company Capital Southwest Corporation (CSWC) in Dallas is the life work of William R. Thomas, a gifted and disciplined manager whose long-term performance record is solidly in the mid-teens. What value investors, especially those managing their own tax-deferred accounts, such as IRAs, will find especially appealing are the remarkably understated net asset valuations per share.
CSWC recently announced that that the December 31, 2006 net asset value was $128.56 per share, up 27.8% for the quarter, and 48.4% for the calendar year, a surge largely attributable to the December IPO of Heelys, a portfolio company. CSWC shares closed at $155.53 April 13, 2007, a 21% premium.
But in Capital Southwest’s case, net asset value is determined quite differently from most other investment companies. For instance, it excludes an allowance for deferred taxes on unrealized appreciation, currently more than $50 per share.
To be sure, Bill Thomas is the ultimate buy-and-hold investor (one major holding was acquired in 1969). According to the 10-Q filed February 2, investments appraised at $661 million as of December 2006 have a cost basis of only $75 million. Were CSWC to suddenly realize these gains, and not distribute them to their shareholders, it would be liable, at a stiff 35% corporate rate, to pay a large tax bill, hence the $205 million reserve.
This reserve has a certain amount of logic to it, because CSWC is one of handful of regulated investment companies that have a policy of not distributing realized long-term capital gains. (In Capital Southwest’s case, it is for religious reasons: Thou shalt not consume principal.) For gains realized in 2006, for instance, CSWC will pay $2.85 per share in federal income taxes, 35% of the retained $8.15 gain.
But most CSWC investors are liable for no more than 15% federal tax on long-term capital gains. Sorting this out equitably involves the issuance of IRS Form 2439 to year-end record holders, of which more will follow. The tax law granting the 15% cap was sunseted, and may not last forever. But God and Nancy Pelosi willing, the actual tax consequences of buying into this low cost portfolio will never equal the $52.44 haircut applied to CSWC’s most recent net asset value calculation. For tax-deferred or tax-exempt investors, of course, no taxes are due. Retrieving monies already paid to the IRS is not an automatic process, however, as will also be developed later.
Adding back at least a portion of the deferred tax liability is not the only adjustment that can be made to CSWC’s conservatively stated net asset value. There is also the discount that Bill Thomas applies to portfolio holdings before subtracting the tax reserve.
The biggest example is Heelys, the roller shoe company that CSWC financed with a net amount of $124,000 in 2000, acquiring 45% of the equity. The growing success of what Thomas characterizes as a “very lucky” investment was reflected in a valuation of $30 million in March 2006, and, as plans for the IPO solidified, $60 million in September.
CSWC sold 14% of its position in the December offering, leaving it with 9.3 million unregistered shares. HLYS’ publicly traded stock closed out the year at 32.11, but CSWC somewhat whimsically chose to value its remaining stock at $21, equal to the IPO price 21 days earlier, a 34.6% discount.
The rationale for the $102 million haircut can be found in CSWC’s footnote definition of fair value: “…the amount which the Company may reasonably expect to receive for portfolio securities if such securities were sold on the valuation date [emphasis added].” The Heelys stock was restricted from resale to the general public. A large, sophisticated buyer willing to hold the unregistered piece could doubtlessly be found, but only at a significant discount from the public market price.
91.6% of Capital Southwest’s portfolio is similarly restricted, and 61% of that consists of four large holdings, including Heelys, for which there is a public market price:
Company Shares Last Sale Valuation Discount
Alamo Group (ALG) 2,821,300 23.46 16.00 31.8%
Encore Wire (WIRE) 4,086,750 22.01 15.00 31.9
Heelys (HLYS) 9,317,310 32.11 21.00 34.6
Palm Harbor Homes (PHHM) 7,855,121 14.02 9.00 35.8
Average weighted discount 34.1%
Does this mean that the remaining 39% of the restricted securities are similarly discounted? That calls for a highly subjective analysis, using limited information, but there are four additional large holdings, all private companies, that collectively account for all but 5% of the remaining restricted securities portfolio. The first two are treated as a pair:
RectorSeal, 100% owned, best known for its pipe thread sealants, and Whitmore, a specialty grease manufacturer 80% owned by CSWC and 20% by Rectorseal, earned a combined $10.4 million on sales of $113.1 million for the year ending March 2006. Appraised values for December 2006 totaled $124 million, less than 12 times earnings for a year that ended nine months earlier.
CSCW also owns 87.4% of Media Recovery, a diversified company that earned $5.0 million on sales of $142.6 million in a fiscal year ending September 2005. The current valuation of $42 million is less than 10 times Capital Southwest’s share of those earnings.
Lifemark Group, a wholly owned collection of cemeteries, mausoleums and mortuaries in Northern California, is the 1969 acquisition mentioned earlier, and was once the highest valued investment in Capital Southwest’s stable. High margin “death care” businesses are traditionally valued as a multiple of sales. Two to three times was once the norm. The frenzy of roll-ups in this still-fragmented industry in the late ‘90s, coupled with anticipation of the baby boomers’ imminent passing, ran up prices as high as 12 times revenues.
The pendulum has now swung the other way, due in part to a significant stretch-out in life expectancies. Service Corp, the largest aggregator, recently bought Alderwoods, the second largest, for only 1.6 times sales, which is about where CSWC values Lifemark, at $42 million, compared to March 2006 sales of $27.2 million.
But Alderwoods was damaged goods, the remnants of the Loewen bankruptcy. It probably lacked the high maintenance levels enjoyed by Lifemark’s properties, the generous reserves for “pre-need” sale liabilities, or new facilities, such as the gold-plated mortuary recently constructed on Lifemark’s flagship cemetery, Skylawn, bigger than Arlington and only 10% “under grass,” on the San Mateo ridgeline.
Lifemark also has two hidden assets, a large, well-managed perpetual care endowment fund, the income from which can be used to maintain its cemetery plots, and surplus property on a busy corridor in Sacramento. And, yes, the boomers will die, eventually.
In sum, it is tempting for value investors to conclude that, as a recurring footnote puts it, Capital Southwest’s restricted security fire sale valuations “are not necessarily indicative of amounts which may ultimately be realized as a result of future sales or other dispositions of securities,” and to mark up the restricted securities portion of the portfolio by, say, 50%, or $77.89 per share. Additionally, tax deferred or tax-exempt investors can add back the $52.44 deferred tax reserve. For them, the adjusted net asset value might look like this:
Stated net asset value per share as of December 2006 128.56
Removal of restricted stock discount (assumed to be 1/3) 77.89
Add back tax reserve 52.44
Adjusted net asset value for non-taxable accounts $258.89
Reality check #1: Almost 23% of this total belongs to one portfolio stock, Heelys. HLYS is a lot of things, but it is not a value stock. The IPO boosted tangible book from 94 cents to $3.01, still less than 10% of current market. Of course, tax-exempt high rollers can always use CSWC as a cautious way to play the Heelys mania by paying 65% (tax reserve) of approximately 66% (restricted stock discount) of Heelys’ market price. As of December 2006, Heelys, net of taxes, was valued at less than $14 by CSWC.
Reality check #2: CSWC has consistently traded at or near the stated net asset value for a long, long time. As of March 31 (fiscal year end) on each of the last 20 years, the stock has traded at a premium ten times, and at a discount ten times. The average is slightly on the plus side. Investors paying significantly more than stated net asset value are ignoring a lot of history.
About taxes. CSWC shares should be of special interest to non-taxable shareholders because the low cost bases shouldn’t matter. What does matter is that CSWC pays the tax anyway, and issues Form 2439, stating the capital gains taken and the tax paid, proportionate to each shareholder’s interest.
Tax paying shareholders use the 2439 much like a W-2, with the portion of the tax paid by CSWC applied as a credit on their returns, usually much more than enough to pay the capital gains. Copy B of the 2439 must be physically attached to the return, which cannot be filed electronically.
Tax-exempt shareholders are entitled to receive all of the tax back in the form of a refund. But they have to go after it, using Form 990 as a claim form. It is this affirmative act required of the nominal owner that may explain why the rank and file of CSWC shareholders are individual investors and not their retirement accounts. It should be the other way around.
Note the reference to nominal owners. The IRA custodian must file the claim, not the beneficial owner. This can be very efficient, actually, with a single composite claim (Form 990-T) made of behalf of all clients long the same position.
But there are probably less than a dozen regulated investment companies that issue Form 2439, and some IRA custodians (read: brokerage firms) are equipped to file refund claims; others, at least in the past, are not. In the former category are firms using the Thomson Beta operating system, including A. G. Edwards and Wedbush Morgan Securities. Among the clueless are/were Quick & Reilly, since acquired by Banc America, PaineWebber, since acquired by UBS, and Fidelity. The trend is positive, however.
Self-trusteed retirement accounts and 503(c)3 non-profits must file their own Form 990s, and results are not automatic. Such claims are not commonly encountered by the Service, and may be regarded as a novelty, depending on whose desk it lands, requiring follow-up. “I’m trying to understand this. You expect us to send you money?” Responses commonly take a year.
Cover letters may be helpful, as are year-end brokerage statements, relevant sections of the 990 form instructions, and Capital Southwest’s treatment of the subject. It’s worth the trouble, especially in a year like 2006, when $2.85 per CSWC share was available for the claiming.
Two concluding comments. CSWC’s decades-long buy-and-hold policy has predictably produced a very lumpy portfolio. The eight portfolio companies mentioned above collectively account for almost 80% of the assets. Investors needing a degree of diversification common to most investment companies should look elsewhere.
And, finally, what about Bill Thomas, age 78? What happens when he retires, becomes disabled, or dies? A successor has yet to be anointed. One candidate, former senior staff member Pat Hamner, bailed last year to become chairman of Heelys. Value investors, cold-hearted ones, that is, trying to identify a catalyst for change, might note that Thomas’ conservative appraisals have consistently benefited CSWC buyers, not sellers, and may not universally lament a change in leadership.
But they may have to wait awhile: Bill Thomas just purchased another 3,000 shares. He’s not done yet.
Disclaimer. This piece was written solely for the purpose of gaining admission to the Value Investors Club, is not an analysis of equity securities of individual companies or industries, and does not provide information reasonably sufficient upon which to base an investment decision. It is not a research report.
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