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SOURCE CAPITAL, INC.
THIRD QUARTER REPORT
September 30, 1997
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OFFICERS AND DIRECTORS
[LOGO]
SOURCE CAPITAL, INC.
DIRECTORS
Wesley E. Bellwood
Julio J. de Puzo, Jr.
David Rees
Robert L. Rodriguez
Lawrence J. Sheehan
Charles W. Stanton
Kenneth L. Trefftzs
OFFICERS
Julio J. de Puzo, Jr., PRESIDENT
Eric S. Ende, SENIOR VICE PRESIDENT AND CHIEF
INVESTMENT OFFICER
Robert L. Rodriguez, SENIOR VICE PRESIDENT
Steven R. Geist, VICE PRESIDENT
Janet M. Pitman, VICE PRESIDENT
Steven T. Romick, VICE PRESIDENT
J. Richard Atwood, TREASURER
Sherry Sasaki, SECRETARY
Christopher H. Thomas, ASSISTANT TREASURER
INVESTMENT ADVISER
First Pacific Advisors, Inc.
11400 West Olympic Blvd., Suite 1200
Los Angeles, California 90064
CUSTODIAN
State Street Bank and Trust Company
Boston, Massachusetts
COUNSEL
O'Melveny & Myers LLP
Los Angeles, California
TRANSFER AND SHAREHOLDER SERVICE AGENT
ChaseMellon Shareholder Services, L.L.C.
85 Challenger Road
Overpeck Centre
Ridgefield Park, NJ 07660
(800) 279-1241 or (212) 613-7427
REGISTRAR
ChaseMellon Shareholder Services, L.L.C.
Ridgefield Park, New Jersey
STOCK EXCHANGE LISTING
New York Stock Exchange:
Symbols: SOR Common Stock
SOR+ Preferred Stock
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LETTER TO SHAREHOLDERS
TO OUR SHAREHOLDERS:
The stock market continued to charge ahead during the Third Quarter, led by
smaller market-cap companies. It was the second consecutive quarter of
outperformance by the small stock indexes, and they have now largely caught up
with the big stocks year-to-date.
During the most recent quarter, Source Capital's total net assets increased to
$441,137,978 from $413,458,918 at mid-year. Net asset value per Common Share
increased to $52.97 at September 30, 1997 from $49.18 at June 30, 1997. This
increase is after payment of a $1.00 cash distribution during the quarter.
INVESTMENT RESULTS
In the most recent quarter, Source Capital's net asset value per share of
Common Stock increased 9.8% while total net assets gained 8.8% with both
comparisons reflecting reinvestment of dividends and distributions paid during
the period. In comparison, the Russell 2500 Index increased 14.4% during the
quarter, also on a reinvested basis.
For the nine months ended September 30, 1997, the net asset value of Source
Capital Common Stock increased by 24.0% including reinvestment of distributions
paid during the period, while total net assets gained 21.5%. These increases
compare with a total positive return of 27.2% on the Russell 2500 Index.
NET INVESTMENT INCOME
Net investment income totaled $2,050,153 for the third quarter and $5,994,118
for the nine months, decreases of 17.0% and 14.7%, respectively, from the
corresponding period of 1996. After providing for Preferred dividends, net
investment income per Common Share amounted to $0.12 and $0.34 for the quarter
and nine months, respectively, compared with the $0.18 and $0.48 earned in the
corresponding periods of 1996.
DISTRIBUTIONS TO COMMON SHAREHOLDERS
A regular quarterly distribution at the rate of $1.00 per share was paid on
September 15, 1997 to shareholders of record on August 22, 1997. Source's 10%
Distribution Policy, adopted in 1976, calls for payments to Common shareholders
approximating 10% of the Common Stock's ongoing net asset value. Shareholders
are reminded that these payments substantially exceed the Company's net
investment income and thus represent a continuing payment of a portion of the
Company's capital. As we repeatedly point out, maintenance of the current $4.00
Common distribution rate is dependent upon achieving investment results which
will sustain a net asset value of approximately $40.00.
On November 3, 1997, the Board of Directors of Source Capital declared a
regular quarterly distribution at the rate of $1.00 per share and a special
year-end distribution of $2.23 per share, payable December 15, 1997, to
shareholders of record on November 21, 1997. The Internal Revenue Code requires
a regulated investment company to distribute substantially all of its net
investment income and net realized gains to shareholders of record on or before
December 31 in order to avoid the imposition of a federal excise tax. The
special year-end distribution of $2.23 per share was declared because the
Company has realized substantial capital gains during 1997. Capital gains are
the eventual result of successful investments. Changes in relative market
valuations as well as changing prospects of individual companies have led us to
sell certain holdings in 1997. We believe we have been able to replace these
securities both by adding to existing investments at advantageous prices and by
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making selected new investments (primarily equity investments) offering
potentially better long-term investment returns.
PREFERRED DIVIDENDS
The regular Preferred dividend of $0.60 per share was paid on September 15,
1997 to shareholders of record on August 22, 1997. Asset coverage on the
Preferred shares was 815% on September 30, 1997, compared with 763% at June 30,
1997 and 706% at year-end 1996. Net investment income provided Preferred
dividend coverage of 174% in the third quarter and 169% for the nine months of
the current year, compared with 209% and 198%, respectively, in the
corresponding periods of 1996.
MARKET PRICE OF SOURCE CAPITAL SHARES
After increasing from $45 1/2 to $47 in the first half of 1997, the market
price of Source Capital Common Stock increased to $49 3/8 at September 30, 1997.
This $2.375 increase in market price was less than the $3.79 gain in net asset
value during the quarter. As a result, the market discount from net asset value
increased to 6.8% at September 30, 1997 from 4.4% at mid-year. The market price
of Source Capital Preferred Stock increased from $28 1/2 to $28 7/8 during the
quarter.
COMMENTARY
I would like to discuss two companies in Source Capital's portfolio which
possess many of the business and financial characteristics we look for in our
investments. Each earns high returns on capital, has a well-focused business
strategy, is debt free, and has grown at a steady rate. The companies are not
well known to the general public, both because of their size, and because their
customers are mostly other businesses.
POE & BROWN is a Florida-based insurance broker which operates three closely
related businesses -- it is the largest insurance broker in Florida; it has a
growing insurance brokerage business in selected markets outside of Florida; and
it manages a national programs business, which provides property and casualty
policies specifically designed to meet the needs of various professionals, of
whom dentists and lawyers are the most significant.
Although Poe & Brown is only a fraction of the size of the largest U.S.
insurance brokers -- Marsh & McLennan and Aon Group are over twenty times as
large -- its performance is second to none. Poe & Brown's revenue growth in
recent years has averaged 10%, half from acquisitions and half internal, despite
a continued "soft" insurance market -- one in which insurance premiums, and
therefore broker commissions, have steadily declined. Poe & Brown is also much
more efficient than other brokers, with pre-tax margins approaching 25%,
compared with 12-15% for its best competitors.
Much of Poe & Brown's extraordinary performance can be attributed to the
leadership of CEO Hyatt Brown, who proudly refers to the "hunter-gatherer"
culture he has fostered at the company. He has insisted on a high level of sales
performance -- the average Poe & Brown broker earns $120,000 a year, and the
best $200,000 - $300,000, amounts far in excess of typical industry levels. In
addition, rigorous attention to cost control has produced SG&A expense levels
5-10 points lower than those of competitors.
The result is high returns on capital, a well-stocked acquisition kitty, and
steady gains in market share. Source first purchased Poe & Brown in May 1996,
paying about $24 per share. Although the business progressed steadily, the stock
moved sideways for a year until taking off five months ago. The current share
price is in the low $40s.
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The second company, LANDAUER, is the leader in personal dosimetry services --
the measurement of the amount of radiation, mostly from x-rays or radioactive
materials, to which a person is exposed on the job. This is most often done by
wearing a small rectangular badge containing a piece of photographic film which
darkens when exposed to radiation. The badge is sent back to Landauer
periodically, to determine if the radiation level has been excessive.
The business is driven by government regulation, which has become stricter
over time, meaning more business for Landauer, whose revenues have grown at
about 7-8% annually. The business has significant economies of scale, as
Landauer must manufacture, distribute, and analyze about one million badges each
month, and requires sophisticated systems. As a result, barriers to entry are
considerable, which, combined with Landauer's large market share and low cost
structure, has permitted it to earn very high, sustainable returns for a long
period of time.
In addition, Landauer's business, once established, needs very little capital
- -- there are virtually no inventories and about half of sales are paid for in
advance, like magazine subscriptions. As a result, Landauer pays out virtually
all its earnings as dividends -- current yield is about 5% -- while financing
its growth opportunities, and maintaining cash reserves equal to one-third of
assets, an extremely high level.
The table below illustrates some of the financial characteristics of Poe &
Brown and Landauer as compared to the average S&P Index Company. The differences
are impressive:
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<CAPTION>
POE & BROWN LANDAUER S&P INDEX
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<S> <C> <C> <C>
Operating Margin 23% 43% 11%
Return on Equity 30% 45% 20%
Percent of Assets
Equity 40% 61% 26%
Debt 6% --0-- 31%
Cash 24% 33% 5%
Recent Price 41 26 --
PE 19x 19x 24x
Market Cap $360 Million $220 Million $6 Billion
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We hope to keep Source's portfolio filled with companies the quality of Poe &
Brown and Landauer -- which combine high returns on capital, reasonable growth
prospects, strong competitive positions, and excellent balance sheets. Such a
collection of superior businesses should provide shareholders with rewarding
long-term returns at modest risk.
Respectfully submitted,
[/S/ ERIC S. ENDE]
Eric S. Ende
Senior Vice President and
Chief Investment Officer
November 4, 1997
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MAJOR PORTFOLIO CHANGES
Quarter Ended September 30, 1997
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<CAPTION>
Shares or Ownership at
Principal Amount September 30, 1997
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<S> <C> <C>
NET PURCHASES
COMMON STOCKS
Denison International plc................................... 332,300 shs. 332,300 shs.
Manpower Inc................................................ 50,400 shs. 208,500 shs.
Nucor Corporation........................................... 18,500 shs. 123,000 shs.
PREFERRED STOCK
Crown America Realty Trust.................................. 39,000 shs. 39,000 shs.
CONVERTIBLE SECURITIES
NovaCare, Inc. -- 5 1/2% 2000............................... $ 1,250,000 $ 5,250,000
Reptron Electronics, Inc. -- 6 3/4% 2004.................... $ 4,285,000 $ 4,285,000
NON-CONVERTIBLE SECURITY
DLJ Mortgage Acceptance Corp. (Series 1997-E Class B) --
7.5481% 2026.............................................. $ 1,000,000 $ 1,000,000
NET SALES
COMMON STOCKS
Arbor Drugs, Inc............................................ 20,300 shs. 358,600 shs.
Donaldson Company, Inc...................................... 26,200 shs. 185,000 shs.
Expeditors International of Washington, Inc................. 48,200 shs. 151,300 shs.
Horace Mann Educators Corporation........................... 80,400 shs. --0--
Leggett & Platt, Incorporated............................... 12,900 shs. 151,100 shs.
Progressive Corporation, The................................ 27,100 shs. 40,800 shs.
Unifi, Inc.................................................. 116,100 shs. --0--
NON-CONVERTIBLE SECURITY
Kidder Peabody Mortgage Assets (CMO)
-- 8.45% 2018............................................. $ 1,226,500 --0--
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COMPOSITION OF TOTAL NET ASSETS*
September 30, 1997
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<S> <C>
Investment securities (cost $299,774,311):
Common stocks................................................... $331,997,526
Convertible securities.......................................... 32,055,654
Non-convertible securities...................................... 44,663,569
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$408,716,749
Cash, receivables, short-term corporate notes, less liabilities... 32,421,229
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Total Net Assets at September 30, 1997............................ $441,137,978
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Assets applicable to Preferred Stock at a liquidation preference
of $27.50 per share (asset coverage 815%)....................... $ 54,153,330
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Net Assets applicable to Common Stock -- $52.97 per share......... $386,984,648
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SUMMARY FINANCIAL INFORMATION*
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<CAPTION>
For the Periods Ended September 30, 1997
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Nine Months Three Months
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Total Per Total Per
Net Common Net Common
Assets Share Assets Share
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<S> <C> <C> <C> <C>
Beginning of period................ $ 382,146,427 $ 45.35 $ 413,458,918 $ 49.18
Net realized gain on investments... 36,741,585 5.03 9,181,433 1.26
Increase in unrealized appreciation
of investments................... 37,246,981 5.10 24,935,294 3.41
Income available to
Common shareholders.............. 2,449,536 0.34 868,625 0.12
Quarterly distributions to
Common shareholders.............. (20,810,295) (2.85) (7,306,292) (1.00)
Proceeds from shares issued for
distributions reinvested by
shareholders..................... 3,363,744 -- -- --
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Net changes during period.......... $ 58,991,551 $ 7.62 $ 27,679,060 $ 3.79
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End of period...................... $ 441,137,978 $ 52.97 $ 441,137,978 $ 52.97
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<CAPTION>
Sept. 30, 1997 June 30, 1997 Dec. 31, 1996
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<S> <C> <C> <C>
Common market price per share................ 49 3/8 47 45 1/2
Common market premium (discount) to net asset
value...................................... (6.8)% (4.4)% 0.3%
Preferred asset coverage..................... 815 % 763 % 706 %
Preferred market price per share............. 28 7/8 28 1/2 28 5/8
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* THE FINANCIAL INFORMATION INCLUDED IN THIS REPORT HAS BEEN TAKEN FROM THE
RECORDS OF THE COMPANY WITHOUT EXAMINATION BY INDEPENDENT AUDITORS. SECURITIES
ARE CARRIED AT MARKET VALUE.
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SOURCE CAPITAL, INC.
11400 West Olympic Boulevard, Suite 1200
Los Angeles, California 90064
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