Capital Southwest Corporation (CSWC) is a financial services company that lends to medium-sized businesses. By borrowing at a lower yield or issuing equity, Capital Southwest aims to grow its portfolio of loans and equity investments.
The company’s earnings come from the spread between the yield on the money it lends and the yield on the debt it borrows. Over the past year, the stock has gained 40% in value, an impressive performance for a high-dividend security.
Portfolio of Assets
Capital Southwest manages a diverse portfolio consisting of senior secured loans, subordinated debt, and equity investments. The company’s strategy focuses on lower-middle-market companies with strong cash flows and growth potential, positioning itself in a risky but potentially rewarding segment.
- Equity Investments: 24.9% of total assets, one of the highest in the industry.
- Credit Portfolio: 97% in senior secured loans and 3% in subordinated debt.
- Yield on Debt Investments: 13.5%, slightly lower than Trinity Capital’s 14.2%.
Capital Southwest’s portfolio is nearly entirely composed of floating-rate debt investments. A decrease in interest rates by 1.45 percentage points would reduce investment income by 10.7%.
Financing
The company maintains a leverage (debt/equity) ratio of 1.05, which is moderate and within regulatory limits. Liabilities have increased by 20%, and equity has grown by 25%, resulting in a 2.4% increase in NAV per share.
Despite a 40% increase in stock price, this suggests caution as the premium investors assign to the company has increased substantially.
- Cost of Debt: Overall cost is 5.3%, with 66% of debt at a fixed rate.
- Cash and Cash Equivalents: $88.7 million, representing 2.7% of total assets.
- Credit Facilities: $195 million from the Corporate Credit Facility and $150 million from the SPV Credit Facility.
Financial Performance
Capital Southwest’s primary business is earning a spread between borrowing costs and lending yields. Net investment income has been growing at a solid 60% pace, but it is highly sensitive to changes in interest rates.
If rates decrease by 1.45 percentage points, net investment income would drop by 11.2%.
- Income Source: 90% from interest rates, indicating a lack of diversification.
- Operating Income: High at 86%, growing annually.
- Dividend Payout: 82.96%, suggesting net investment income can decrease by 17% before affecting the distribution.
Valuation
Capital Southwest’s stock currently trades at a forward P/E of 20.2, with the valuation suggesting it might be overvalued in the short term. The company’s price-to-value ratio, which includes NAV and dividends, is in the low historical range, indicating potential undervaluation if dividends are considered.
- Price-to-Value Ratio: From 1.1 to 0.79, with 2024 at the lowest range.
- Price-to-NAV Ratio: In the premium range of 1.69 to 0.94, with 2024 at 1.56.
- Comparison with Peers: Capital Southwest has a higher premium than Trinity Capital, Horizon Technology Finance, and Ares Capital but lower than Hercules Capital.
Risks
- Interest Rate Risk: The primary risk, with significant exposure to changes in interest rates.
- Credit Risk: The company’s focus on lower-middle-market companies adds credit risk. Capital Southwest had no debt investments on non-accrual status as of March 31, 2024, but payments-in-kind (PIK) have grown significantly, which could indicate potential credit quality issues.
Conclusion
Capital Southwest stands out as one of the top business development companies, with a risky but potentially rewarding strategy. The company’s portfolio is diversified across industries with strong cash flows, and it maintains a high-quality debt portfolio.
While the market assigns a premium over NAV, considering dividends, the company appears undervalued. However, given the potential for a lower interest rate environment, waiting for more favorable conditions might be prudent before making an investment.
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Kris is a finance consultant, content marketer, and speaker specializing in helping brands and business owners navigate complex concepts and decisions. Since earning her Finance and Accounting degree, Kris has spent over half a decade writing about financial and technological concerns of brands spanning different life cycles.
