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[LOGO]
SOURCE CAPITAL, INC.
FIRST QUARTER REPORT
March 31, 1998
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OFFICERS AND DIRECTORS
[LOGO]
SOURCE CAPITAL, INC.
DIRECTORS
Willard H. Altman
Wesley E. Bellwood
Julio J. de Puzo, Jr.
David Rees
Robert L. Rodriguez
Lawrence J. Sheehan
Charles W. Stanton
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 (201) 329-8660
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:
INVESTMENT RESULTS
Source Capital's total net assets increased to $453,756,612 from $425,490,107
at year-end. Net asset value per Common share increased to $53.82 at March 31,
1998 from $50.20 at year-end. In addition, a distribution of $1.00 was paid on
the Common shares during the quarter.
During this quarter, Source Capital's net asset value per share of Common Stock
increased 9.3% while total net assets rose 8.4%, with both figures reflecting
reinvestment of dividends and distributions paid during the period. These
changes compare with a 10.3% increase during the quarter for the Russell 2500
Index, also on a reinvested basis.
NET INVESTMENT INCOME
Net investment income increased during the quarter to $2,008,371 from
$1,976,386 in the first quarter of 1997. After providing for Preferred
dividends, net investment income per Common share amounted to $0.11 in the first
quarter of both the current and the prior year.
DISTRIBUTIONS TO COMMON SHAREHOLDERS
A regular quarterly distribution at the rate of $1.00 per share was paid on
March 15, 1998 to shareholders of record on February 20, 1998. 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. Most recently,
an increase in the distribution rate was approved by the Board of Directors on
May 4, 1998, raising the annualized rate to $4.20 for the distribution payable
June 15, 1998. 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 $4.20 Common distribution rate is dependent upon
achieving total investment results which will sustain a net asset value of
approximately $42.00.
PREFERRED DIVIDENDS
The regular Preferred dividend of $0.60 per share was paid on March 15, 1998 to
shareholders of record on February 20, 1998. The increase in the Company's total
net assets so far this year has led to an increase in the Preferred shares'
asset coverage from 786% at year-end 1997 to 838% at March 31, 1998. The rise in
net investment income in the first quarter increased Preferred dividend coverage
to 170% compared to 167% in the first quarter of 1997.
MARKET PRICE OF SOURCE CAPITAL SHARES
The market price of Source Capital Common Stock increased during the quarter
from $51 1/16 at year-end 1997 to $55 3/8 at March 31, 1998. As this $4.31
increase in market price was more than the $3.62 rise in net asset value during
the period, the market premium to net asset value of 1.7% at year-end 1997
increased to 2.9% at March 31, 1998. The market price of Source Capital
Preferred Stock also increased during the quarter from $29 to $29 11/16.
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COMMENTARY
Three companies in Source's portfolio have been the subject of takeovers in
recent months. Two of these have been completed, while one is still in progress.
While all have been helpful to portfolio performance, as well as providing some
outside confirmation of the merits of our selections, we view these transactions
with mixed feelings. Each of these companies had been owned for some time, all
were doing well, and we would have been happy to continue to hold each of them
in the Source portfolio.
The acquisition of TRIMAS by MascoTech was announced last December, and closed
in mid-January. TriMas is a manufacturer of diverse industrial and consumer
products--its most important offerings are trailer hitches and related
accessories, specialty industrial and aerospace fasteners, and gas cylinders and
closures for industrial containers. Our initial investment in TriMas in the
second half of 1995 was in its convertible debentures. As our confidence in
TriMas' management and understanding of its business increased, we switched from
the convertible to common stock. We bought more shares during 1996 and early
1997, ending up with about a 2% portfolio position purchased at an average cost
of $23 per share.
TriMas' price at the time the deal was announced was about $31 per share.
Although the acquisition price of $34 1/2 was only a modest premium, it
represented about 20 times TriMas' expected 1997 earnings per share of $1.75, a
rich price by historical standards. In addition, since MascoTech already owned
37% of TriMas there was little chance of a competing offer. We believe the
purchase was motivated by MascoTech's wish to diversify away from its auto
industry customer base and to simplify the two companies' ownership structure.
ARBOR DRUGS was acquired at the end of March, 1998 by CVS, a rapidly growing
regional drug store chain with national aspirations. Arbor Drugs gives it a
dominant share in the important Detroit area, a market in which it had no prior
presence. The strategic nature of the purchase, as well as CVS's own high-priced
stock, may help to explain why it was willing to pay 37 times trailing earnings
for Arbor Drugs, a valuation we find difficult to justify.
Source first invested in Arbor Drugs in 1995 (at a split-adjusted price of
about $7 per share), attracted by its high returns on capital, efficient
operations, rapid market share growth, and impeccable balance sheet. The reader
may recall that we discussed Arbor in detail in the Source semi-annual report
published in mid-1997. At that time, we bemoaned the fact that the increasingly
high valuation which the market was putting on Arbor and other high-quality
stocks in Source's portfolio created a dilemma--we felt we should trim back
these positions, but replacement ideas were hard to find.
Arbor's price at that time was a split-adjusted $13 1/2, and its PE ratio was
24.5x trailing 12 months earnings. We continued to sell shares as the price and
valuation increased. In all, we sold about half the June 30, 1997 position, at
prices from $16 to $22 1/2. Arbor rose about 70% in the 7 months from June, 1997
to the announcement of the deal in February of this year. The acquisition was
made for CVS stock, which at the date of the closing was worth about $24 per
Arbor Drugs share. At this time, Source continues to hold its new CVS shares,
but at a price of 30x estimated 1998 earnings, its time in the portfolio may be
brief.
The third portfolio takeover is DEVON GROUP, which will be acquired by Applied
Graphics Technologies in late May, assuming a favorable vote by both companies'
shareholders. The price is approximately $60 per share, half in cash and half in
Applied Graphics stock, the
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value of which is subject to fluctuation. Applied Graphics, an aggressive and
rapidly growing company that provides pre-press and related services to a
diverse customer base, is an
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excellent strategic fit with Devon's Black Dot Division, which represents close
to two-thirds of its sales and probably a larger percent of profits.
Source first purchased Devon in 1986 at a cost of about $16 per share, and
remarkably it has been in the portfolio for longer than any other common stock.
After some missteps in the early 1990s associated with an unsuccessful venture
in financial printing, Devon has earned high returns and steadily increased its
earnings, as well as building up a fortress balance sheet--minor amounts of debt
and $7 per share in cash--while searching unsuccessfully for an appropriate
major acquisition. By arranging to be acquired by Applied Graphics, Devon
increased its stock price by 30% and gave its owners the option of continuing to
participate in the business through Applied Graphics, a company with more
extensive Wall Street coverage and much higher trading volume than Devon. As in
the case of CVS, the high valuation which the market is putting on Applied
Graphics' stock price may make it difficult for Source to hold on to its
position long term.
We will continue to search for companies like Arbor Drugs, Devon, and
TriMas--which combine high returns on capital, excellent growth prospects, and
strong balance sheets--and which also can be purchased at reasonable valuations.
We believe that such investments will provide Source shareholders with rewarding
long term returns without assuming excess risk.
Respectfully submitted,
[/S/ ERIC S. ENDE]
Eric S. Ende
Senior Vice President and
Chief Investment Officer
May 5, 1998
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MAJOR PORTFOLIO CHANGES
Quarter Ended March 31, 1998
<TABLE>
<CAPTION>
Shares or Ownership at
Principal March 31,
Amount 1998
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<S> <C> <C>
NET PURCHASES
COMMON STOCKS
Arrow Electronics, Inc............................ 42,300 shs. 265,300 shs.
Bacou USA, Inc.................................... 14,700 shs. 291,200 shs.
Channell Commercial Corporation................... 40,000 shs. 255,000 shs.
KEMET Corporation................................. 66,600 shs. 271,700 shs.
Nucor Corporation................................. 11,900 shs. 180,200 shs.
Schlumberger Limited.............................. 84,500 shs. 84,500 shs.
CONVERTIBLE SECURITY
Read-Rite Corporation -- 6 1/2% 2004.............. $500,000 $500,000
NET SALES
COMMON STOCKS
Arbor Drugs, Inc.................................. 123,900 shs. 280,200 shs.
Franklin Covey Co................................. 63,900 shs. 231,800 shs.
Graco Inc......................................... 6,600 shs. 411,000 shs.
Juno Lighting, Inc................................ 144,100 shs. --0--
Kennametal Inc.................................... 70,000 shs. --0--
Toys "R" Us, Inc.................................. 183,200 shs. --0--
TriMas Corporation................................ 264,210 shs. --0--
NON-CONVERTIBLE SECURITY
Government National Mortgage Association (REMIC)
-- 7.99125% 2010................................ $753,500 $545,800
</TABLE>
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COMPOSITION OF TOTAL NET ASSETS*
March 31, 1998
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<S> <C>
Investment securities (cost $293,839,612):
Common stocks............................................ $349,181,455
Convertible bonds, debentures and preferred stocks....... 35,259,567
Non-convertible bonds and debentures..................... 41,273,069
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$425,714,091
Cash, receivables, short-term corporate notes, less
liabilities.............................................. 28,042,521
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Total Net Assets at March 31, 1998......................... $453,756,612
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Assets applicable to Preferred Stock at a liquidation
preference
of $27.50 per share (asset coverage 838%)................ $54,153,330
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Net Assets applicable to Common Stock -- $53.82 per
share.................................................... $399,603,282
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</TABLE>
SUMMARY FINANCIAL INFORMATION*
<TABLE>
<CAPTION>
Three Months Ended March 31,
1998
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Total Per
Net Common
Assets Share
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<S> <C> <C>
Beginning of period.................................................... $ 425,490,107 $ 50.20
Net realized gain on investments....................................... 6,951,802 0.94
Increase in unrealized appreciation of investments..................... 26,401,169 3.57
Income available to Common shareholders................................ 826,844 0.11
Quarterly distribution to Common shareholders.......................... (7,397,259) (1.00)
Proceeds from shares issued for distributions reinvested............... 1,483,949 --
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Net changes during period.............................................. $ 28,266,505 $ 3.62
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End of period.......................................................... $ 453,756,612 $ 53.82
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<CAPTION>
Beginning End
of Quarter of Quarter
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<S> <C> <C>
Common market price per share.......................................... 51 1/16 55 3/8
Common market premium to net asset value............................... 1.7% 2.9%
Preferred asset coverage............................................... 786% 838%
Preferred market price per share....................................... 29 29 11/16
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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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