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[LOGO]
SOURCE CAPITAL, INC.
THIRD QUARTER REPORT
September 30, 1999
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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
Paul G. Schloemer
Lawrence J. Sheehan
OFFICERS
Julio J. de Puzo, Jr., PRESIDENT
Eric S. Ende, SENIOR VICE PRESIDENT AND CHIEF
INVESTMENT OFFICER
Steven R. Geist, SENIOR VICE PRESIDENT AND
FIXED-INCOME MANAGER
Janet M. Pitman, 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:
During the most recent quarter, Source Capital's total net assets decreased to
$430,419,245 from $458,570,983 at mid-year. Net asset value per Common Share
decreased to $49.66 at September 30, 1999 from $53.39 at June 30, 1999. This
decrease includes payment of a $1.10 cash distribution during the quarter.
INVESTMENT RESULTS
In the most recent quarter, Source Capital's net asset value per share of
Common Stock decreased 5.0% while total net assets declined 4.1% with both
comparisons reflecting reinvestment of dividends and distributions paid during
the period. In comparison, the Russell 2500 Index decreased 6.5% during the
quarter, also on a reinvested basis.
For the nine months ended September 30, 1999, the net asset value of Source
Capital Common Stock increased by 10.1% including reinvestment of distributions
paid during the period, while total net assets rose 9.7%. These increases
compare with a total positive return of 3.7% for the Russell 2500 Index.
NET INVESTMENT INCOME
Net investment income totaled $1,360,503 for the third quarter and $3,663,914
for the nine months, decreases of 8.2% and 29.5%, respectively, from the
corresponding periods of 1998. After providing for Preferred dividends, net
investment income per Common Share amounted to $0.02 and $0.01 for the quarter
and nine months, respectively, compared with the $0.04 and $0.22 earned in the
corresponding periods of 1998.
DISTRIBUTIONS TO COMMON SHAREHOLDERS
A regular quarterly distribution at the rate of $1.10 per share was paid on
September 15, 1999 to shareholders of record on August 27, 1999. 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 $4.40
Common distribution rate is dependent upon achieving investment results which
will sustain a net asset value of approximately $44.00.
On November 8, 1999, the Board of Directors of Source Capital declared a
regular quarterly distribution at the rate of $1.10 per share and a special
year-end distribution of $3.56 per share, payable December 15, 1999, to
shareholders of record on November 26, 1999. 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 $3.56 per share was declared because the
Company has realized substantial capital gains during 1999. 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 1999. We believe we have been able to replace these
securities both by adding to existing investments at advantageous prices and by
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,
1999 to shareholders of record on August 27, 1999. Asset coverage on the
Preferred shares was 795%
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on September 30, 1999, compared with 847% at June 30, 1999 and 771% at year-end
1998. Net investment income provided Preferred dividend coverage of 115% in the
third quarter and 103% for the nine months of the current year, compared with
125% and 147%, respectively, in the corresponding periods of 1998.
MARKET PRICE OF SOURCE CAPITAL SHARES
After increasing from $49 1/16 to $49 3/8 in the first half of 1999, the market
price of Source Capital Common Stock decreased to $48 7/8 at September 30, 1999.
This $0.50 decrease in market price was less than the $3.73 decline in net asset
value during the quarter. As a result, the market discount to net asset value
decreased to 1.6% at September 30, 1999 from 7.5% at mid-year. The market price
of Source Capital Preferred Stock decreased from $28 3/16 to $27 15/16 during
the quarter.
COMMENTARY
The stock market retreated in the third quarter, following its very strong
second quarter advance, with the Russell 2500 and S&P 500 both down about
6 1/2%. For the year to date, most market indexes show modest gains, with the
exception of the Nasdaq Composite, which was up 25%. The Nasdaq is dominated by
a small number of technology companies, which have continued to perform
extremely well. Microsoft, Intel, and Cisco, which account for about one-third
of the total capitalization of the Nasdaq index, are each up between 25% and 50%
so far this year.
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<CAPTION>
1999
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THIRD QUARTER NINE MONTHS
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<S> <C> <C>
Russell 2500.................... (6.5)% 3.7%
S&P 500......................... (6.3) 5.4
Nasdaq Composite................ 2.2 25.2
</TABLE>
Source's net asset value per Common Share was down 5% for the third quarter,
but continues to show good relative performance for the first nine months, as
well as longer periods.
<TABLE>
<CAPTION>
PERIODS ENDED SEPTEMBER 30, 1999
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THIRD QUARTER NINE MONTHS ONE YEAR THREE YEARS* FIVE YEARS*
------------- ----------- -------- ------------ -----------
<S> <C> <C> <C> <C> <C>
Source.................... (5.0)% 10.1% 34.5% 16.8% 16.6%
Russell 2500.............. (6.5) 3.7 21.8 11.0 14.7
</TABLE>
* Annualized
ZEBRA TECHNOLOGIES, purchased for the Source portfolio earlier this year, is
an excellent example of one of the investment objectives we are always striving
to achieve -- the purchase of high-quality growth companies at value prices.
Zebra is a leader in the rapidly growing manufacture of bar code printers, earns
high returns on capital with an unleveraged balance sheet, and we were able to
purchase it at an extremely attractive valuation.
The automated identification industry consists of bar code printers and
scanners. It has grown at double digit rates for many years and is now moving
from its origins in retailing to manufacturing and distribution, where it is
also stimulating dramatic gains in productivity. We believe this rapid growth
will continue, as new applications for bar codes are developed and as some of
its key markets, like small package delivery, expand rapidly.
Zebra manufactures thermal bar-code printers. It has the biggest market share,
the broadest product line, and the best technology and distribution. It earns
extremely high returns on capital and has an unleveraged balance sheet with
significant surplus cash. Over the past 10 years, its sales and earnings have
grown at better than a 20% annual rate.
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Ironically, our opportunity to purchase Zebra at a relatively cheap price came
as the result of a very attractive merger, which Zebra completed in October
1998, with Eltron. Its purchase of Eltron, a major competitor, instantly gave
Zebra a much broader product line, as Eltron was the leading producer of
low-price printers, while Zebra dominated the high end of the market. In
addition, it expanded Zebra's distributor network and OEM customer base.
These very worthwhile long-term strategic benefits came at a short-term cost,
however. Combining the two companies was a major effort, involving
rationalization of the product line, sales force, distributor relations, and
systems. The consolidation temporarily got in the way of Zebra's usual ability
to regularly increase sales and profits. The result was a very poor fourth
quarter, with sales down 2% and profits down 35%, well under Wall Street's
modest expectations.
Zebra's stock price had declined steadily during the latter part of 1998 as
analysts increasingly realized the temporary indigestion the merger was causing.
Zebra's stock had peaked at $45 in June of 1998; by early 1999 it was down to
the mid $20s. We viewed this price decline as a great opportunity -- a chance to
buy a leading participant in the rapidly growing industry at only about 12x
estimated 1999 earnings.
We were, of course, very interested in how well, or poorly, the merger
integration was proceeding, but we viewed the merger success as more a question
of WHEN than IF. The two companies were in the same business, with similar
technology, manufacturing, and customers. Thus we were confident that the merger
would eventually be successful and its major strategic benefits realized. If
Wall Street wanted to throw away the stock in the interim, we were happy to take
advantage of that.
We purchased our position in Zebra in February and March, 1999 at an average
cost of $26 per share. Zebra moved rapidly to complete the merger integration
process, and its performance reflected this success. After declining in the
fourth quarter, revenue grew 11% in the first quarter, 12% in the second, and
18% in the third. Profits have done even better, with the recently released
third quarter far above last year, as well as Wall Street expectations. Earnings
estimates for both 1999 and 2000 have been steadily increased, and Zebra's stock
price has recovered -- regaining and then exceeding its prior peak. At this
point we are continuing to hold our entire Zebra position, but are carefully
monitoring its valuation, and would not hesitate to reduce it if Wall Street
puts an excessively high valuation on the company, as it earlier in the year
gave it an excessively low one.
I am pleased to announce that on November 8, 1999, Source's Board of Directors
has named Steve Geist as a Senior Vice President of Source Capital, with the
additional title of Fixed-Income Manager. The Board wished to recognize Steve
for his continuing major contributions to the equity portfolio and the fact that
he has had the most important role in managing Source's fixed income portfolio
for several years. We enthusiastically concur with the Board's decision and
congratulate Steve on this well deserved recognition of his role in managing
Source Capital.
Respectfully submitted,
/s/ Eric S. Ende
-----------------------------------
Eric S. Ende
Senior Vice President and
Chief Investment Officer
November 10, 1999
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MAJOR PORTFOLIO CHANGES
Quarter Ended September 30, 1999
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<CAPTION>
Shares or Ownership at
Principal Amount September 30, 1999
---------------- -------------------
<S> <C> <C>
NET PURCHASES
COMMON STOCKS
Clayton Homes, Inc........................ 770,500 shs. 770,500 shs.
Crane Co.................................. 177,700 shs. 487,700 shs.
Donaldson Company, Inc.................... 13,500 shs. 312,300 shs.
Office Depot, Inc......................... 250,000 shs. 538,900 shs.
O'Reilly Automotive, Inc.................. 42,300 shs. 267,900 shs.
CONVERTIBLE SECURITIES
Central Garden & Pet Co. -- 6% 2003....... $ 500,000 $ 2,500,000
Checkpoint Systems, Inc. -- 5 1/4% 2005... $ 2,000,000 $ 2,000,000
MascoTech, Inc. -- 4 1/2% 2003............ $ 2,000,000 $ 2,000,000
World Access, Inc. -- 4 1/2% 2002......... $ 1,500,000 $ 7,505,000
NON-CONVERTIBLE SECURITIES
American Telecasting, Inc. -- 14 1/2%
2004.................................... $ 600,000 $ 3,000,000
United Stationers Inc. -- 8 3/8% 2008..... $ 2,000,000 $ 2,000,000
NET SALES
COMMON STOCKS
Adobe Systems Incorporated................ 73,500 shs. 218,500 shs.
Black Box Corporation..................... 4,600 shs. 399,800 shs.
Circuit City Stores, Inc.................. 56,400 shs. 315,600 shs.
Expeditors International of Washington,
Inc..................................... 25,000 shs. 152,200 shs.
Federal Signal Corporation................ 13,500 shs. 164,700 shs.
Holophane Corporation..................... 269,100 shs. --0--
CONVERTIBLE SECURITIES
Developers Diversified Realty Corporation
-- 7% 1999.............................. $ 2,500,000 --0--
Lam Research Corporation -- 5% 2002....... $ 2,000,000 --0--
NON-CONVERTIBLE SECURITY
Pamida, Inc. -- 11 3/4% 2003.............. $ 1,330,000 --0--
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COMPOSITION OF TOTAL NET ASSETS*
September 30, 1999
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<S> <C>
Investment securities (cost $331,709,838):
Common stocks............................................ $358,625,737
Convertible securities................................... 39,478,200
Non-convertible securities............................... 15,631,866
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$413,735,803
Cash, receivables, short-term corporate notes, less
liabilities.............................................. 16,683,442
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Total Net Assets at September 30, 1999..................... $430,419,245
============
Assets applicable to Preferred Stock at a liquidation
preference
of $27.50 per share (asset coverage 795%)................ $ 54,153,330
============
Net Assets applicable to Common Stock -- $49.66 per
share.................................................... $376,265,915
============
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SUMMARY FINANCIAL INFORMATION*
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<CAPTION>
For the Periods Ended September 30, 1999
---------------------------------------------
Nine Months Three Months
--------------------- ---------------------
Total Per Total Per
Net Common Net Common
Assets Share Assets Share
------------ ------ ------------ ------
<S> <C> <C> <C> <C>
Beginning of period......... $417,776,547 $48.23 $458,570,983 $53.39
Net realized gain on
investments............... 41,053,592 5.40 14,396,925 1.90
Decrease in unrealized
appreciation of
investments............... (5,957,582) (0.79) (34,475,205) (4.55)
Income available to
Common shareholders....... 119,332 0.01 178,975 0.02
Quarterly distributions to
Common shareholders....... (24,203,565) (3.20) (8,332,630) (1.10)
Proceeds from shares issued
for distributions
reinvested by
shareholders.............. 1,630,921 0.01 80,197 --
------------ ------ ------------ ------
Net changes during period... $ 12,642,698 $1.43 $(28,151,738) $(3.73)
------------ ------ ------------ ------
End of period............... $430,419,245 $49.66 $430,419,245 $49.66
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<CAPTION>
Sept. 30, 1999 June 30, 1999 Dec. 31, 1998
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<S> <C> <C> <C>
Common market price per share....... 48 7/8 49 3/8 49 1/16
Common market premium (discount) to
net asset value................... (1.6)% (7.5)% 1.7%
Preferred asset coverage............ 795% 847 % 771 %
Preferred market price per share.... 27 15/16 28 3/16 29 13/16
</TABLE>
* 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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