CSWC Financial Analysis

Analysis Date: 2/5/2025

Business Model

Capital Southwest Corporation is an internally managed business development company (BDC) focused on providing flexible financing solutions to support the acquisition and growth of middle market businesses. They generate revenue primarily through interest income from debt investments, dividend income from equity investments, and fee income.

Revenue Sources

• Interest income from non-control/non-affiliate investments, affiliate investments, and control investments.
• Payment-in-kind (PIK) interest income from non-control/non-affiliate investments and affiliate investments.
• Dividend income from non-control/non-affiliate investments and control investments.
• Fee income from non-control/non-affiliate investments, affiliate investments, and control investments.
• Other income, which includes prepayment penalties, income from cash held, amendment fees, waiver fees and arranger fees.

Income Statement Analysis

• Total Investment Income increased by 6.7% compared to the previous quarter, driven by an increase in fees and other income, indicating strong deal activity and prepayment fees. (Pro)
• Operating expenses excluding interest expense increased slightly by 7.7%, primarily due to an increase in accrued bonus compensation and write-off of deferred offering costs. (Neutral to Con depending on sustainability)
• Interest expense increased by 16.9% due to an increase in average debt outstanding, reflecting increased leverage to fund investments. (Con - increased cost of capital)
• Net Investment Income increased by 2.1% despite higher interest expenses, showcasing effective revenue growth management. (Pro)

Balance Sheet Analysis

• Total Investments increased by 12.8%, reflecting continued deployment of capital and portfolio growth. (Pro - growth in assets)
• Cash and Cash Equivalents decreased by 23.8%, likely due to funding new investments. (Neutral - expected use of cash for investment)
• Total Liabilities increased significantly by 17.9%, primarily due to the issuance of 2029 Convertible Notes and increased Credit Facilities. (Con - increased leverage, but also reflects capital raise)
• Net Asset Value per Share remained flat at $16.59, indicating that while asset base grew, per-share value was maintained. (Neutral)
• Regulatory Debt to Equity ratio increased to 0.90x from 0.80x, indicating increased leverage, but still within target range (0.8x to 0.95x). (Neutral - within target leverage)

Capital Allocation

Capital Southwest demonstrates a balanced capital allocation strategy: Dividends: Committed to consistent quarterly regular dividends with a track record of increases. Also utilizes supplemental dividends based on excess earnings and realized gains, showing shareholder return focus. Share Repurchases: Has a share repurchase program to opportunistically buy back shares when trading below NAV, indicating value focus. Business Reinvestment: Actively reinvesting in the business through new originations and add-on investments, as evidenced by the significant increase in total investments. Also investing in a second SBIC license to access cost-effective capital for further growth. Debt Management: Proactively manages debt by issuing convertible notes and redeeming older notes to optimize capital structure, reduce interest expense, and extend maturities.

Management Commentary

Generated pre tax net investment income of $0.64 per share, which fully covered both our regular dividend of $0.58 per share and our supplemental dividend of $0.05 per share paid during the quarter.

Portfolio earnings continued to be strong and as of the end of the quarter, we estimate that our undistributed taxable income was $0.68 per share, which is up from our prior quarter estimate of $0.64 per share.

Our Board has declared an increase to the supplemental dividend to $0.06 per share from the $0.05 per share in the December quarter, bringing total dividends declared for the March quarter to $0.64 per share.

Deal flow in the lower middle market was very strong this quarter and the competitive environment around quality deals continued at the feverish pace we have seen for the past few quarters.

We are weighing the impacts of future base rate reductions and maintaining adequate cushion levels to allow us the flexibility to potentially increase leverage to support future earnings and dividend growth.

The main depreciation is coming from companies that aren't in NII. So it's more of an NAV effect on us as opposed to earnings effect. But that's hopefully helpful general color on what's happening.

Overall Sentiment: Positive. Management expresses confidence in continued strong performance, dividend sustainability, and growth prospects. They highlight strong deal flow, robust portfolio performance, and proactive capital management. While acknowledging competition, the overall tone is optimistic and forward-looking.

Recommendation

Rating: Buy

Reason for Rating: Based on the analysis, a 'Buy' recommendation is warranted. Capital Southwest demonstrates strong and consistent financial performance, highlighted by robust investment income and effective dividend coverage. The company is proactively managing its capital structure, diversifying funding sources, and maintaining a healthy balance sheet. The increasing supplemental dividend and strong undistributed taxable income signal potential for further shareholder returns. While operating expenses and leverage have increased, they appear to be managed within acceptable parameters to support growth. Positive management sentiment and a track record of dividend growth and value creation further support a 'Buy' rating.

Disclaimer: This report is for informational purposes only and not investment advice. The analysis is based on limited information and subject to change. Investing in securities involves risks, including potential loss of principal. Past performance doesn't guarantee future results. Always conduct your own research, understand the risks, and consult a financial professional before making investment decisions.

Generated on: 2/5/2025, 8:07:58 AM