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[SOURCE CAPITAL LOGO]
SOURCE CAPITAL, INC.
THIRD QUARTER REPORT
September 30, 2000
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OFFICERS AND DIRECTORS
[SOURCE CAPITAL LOGO]
SOURCE CAPITAL, INC.
DIRECTORS
Willard H. Altman, Jr.
Wesley E. Bellwood
Eric S. Ende
David Rees
Paul G. Schloemer
Lawrence J. Sheehan
OFFICERS
Eric S. Ende, PRESIDENT AND CHIEF
INVESTMENT OFFICER
Steven R. Geist, SENIOR VICE PRESIDENT AND
FIXED-INCOME MANAGER
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 increased to
$422,061,923 from $416,738,249 at mid-year. Net asset value per Common Share
increased to $47.20 at September 30, 2000 from $46.72 at June 30, 2000. This
increase includes payment of a $1.15 cash distribution during the quarter.
INVESTMENT RESULTS
In the most recent quarter, Source Capital's net asset value per share of
Common Stock increased 3.4% while total net assets rose 3.2% with both
comparisons reflecting reinvestment of dividends and distributions paid during
the period. In comparison, the Russell 2500 Index increased 2.4% during the
quarter, also on a reinvested basis.
For the nine months ended September 30, 2000, the net asset value of Source
Capital Common Stock decreased by 0.3% including reinvestment of distributions
paid during the period, while total net assets rose 0.5%. These changes compare
with a total positive return of 8.2% for the Russell 2500 Index.
NET INVESTMENT INCOME
Net investment income totaled $1,044,756 for the third quarter and $4,011,473
for the nine months, a decrease of 23.2% and an increase of 9.5%, respectively,
from the corresponding periods of 1999. After providing for Preferred dividends,
net investment income per Common Share amounted to $(0.02) and $0.06 for the
quarter and nine months, respectively, compared with the $0.02 and $0.01 earned
in the corresponding periods of 1999.
DISTRIBUTIONS TO COMMON SHAREHOLDERS
A regular quarterly distribution at the rate of $1.15 per share was paid on
September 15, 2000 to shareholders of record on August 25, 2000. 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 $4.60
Common distribution rate is dependent upon achieving investment results which
will sustain a net asset value of approximately $46.00.
On November 13, 2000, the Board of Directors of Source Capital declared a
regular quarterly distribution at the rate of $1.15 per share and a special
year-end distribution of $1.86 per share, payable December 15, 2000, to
shareholders of record on November 24, 2000. 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 $1.86 per share was declared because the
Company has realized substantial capital gains during 2000. 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 2000. 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,
2000 to shareholders of record on August 25, 2000. Asset coverage on the
Preferred shares was 779%
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on September 30, 2000, compared with 770% at June 30, 2000 and 821% at year-end
1999. Net investment income provided Preferred dividend coverage of 88% in the
third quarter and 113% for the nine months of the current year, compared with
115% and 103%, respectively, in the corresponding periods of 1999.
MARKET PRICE OF SOURCE CAPITAL SHARES
After increasing from $48 1/4 to $49 9/16 in the first half of 2000, the market
price of Source Capital Common Stock increased to $50 at September 30, 2000.
This $0.44 increase in market price was less than the $0.48 rise in net asset
value during the quarter. As a result, the market premium to net asset value
decreased to 5.9% at September 30, 2000 from 6.1% at mid-year. The market price
of Source Capital Preferred Stock was unchanged for the quarter at $47 13/16.
COMMENTARY
The stock market as a whole was up in the third quarter, following a weak
second quarter. Source Capital's performance also improved, with a 3.4% gain
compared to 2.4% for the Russell 2500. Source has done well for most longer
periods, with the exception of the past 12 months when the outperformance of
tech stocks has distorted relative results. It is worth noting that this period
of extraordinary performance by tech stocks seems to be ending -- the Nasdaq
Index was down 13.3% in the second quarter and another 7.4% in the third
quarter.
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<CAPTION>
PERIODS ENDED SEPTEMBER 30, 2000
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QUARTER ONE YEAR THREE YEARS* FIVE YEARS*
-------- -------- ------------ -----------
<S> <C> <C> <C> <C>
Source.................................... 3.4% 11.5% 9.5% 15.4%
Russell 2500.............................. 2.4% 29.5% 9.7% 15.5%
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* Annualized
This quarter I would like to discuss GRACO, a company which has been in Source
Capital's portfolio since the summer of 1996 and which has increased in value
sufficiently to become Source's largest position at the end of September.
Graco epitomizes many of the characteristics we seek in companies -- an
industry leader, earning high returns on capital in an understandable business,
with a reasonable balance sheet, and having a modest valuation.
Graco is a worldwide leader in fluid handling systems. Its equipment moves,
measures, and dispenses viscous fluids in industrial and commercial settings.
Some specific examples are paint spray booths and adhesive application equipment
in factories, lubrication systems in quick-lube shops and fleet service centers,
and paint sprayers for architectural use by commercial contractors.
In addition to the usual reasons (market leader, high returns, modest price),
Graco seemed attractive to us because of two additional factors:
First, it had performed very respectably in the industrial recession of the
early 1990s, earning about a 10% return on equity in an environment where many
companies were losing money.
Second, it was in the midst of a major program to improve the way the company
operated, led by George Aristedes, who had become President in 1993 and Chief
Executive in 1995. This program included reductions in administrative costs with
some of the savings reinvested in marketing and product development to
accelerate sales growth; a reorganization and improvement of manufacturing; and
a rethinking of distribution strategy.
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We were impressed by George Aristedes' intelligence and intensity, and
believed that further margin improvements and the promise of future revenue
growth, combined with Graco's strong market position, would make it a profitable
investment for Source.
Since Graco in mid-1996 was trading at about $13 per share, with expected full
year earnings of $1.15 (a PE ratio of 11x), it was obvious that other investors
did not share our optimism about its prospects. These investors were most
concerned about several things:
- They worried about the cyclicity of Graco's business and especially its
auto industry exposure.
- They believed that Graco's profit improvements were mostly already
accomplished -- operating margins had increased from a recession low of
5.2% to 13.5%.
- They were skeptical about the prospects for revenue growth.
During the four years we have owned Graco, the skeptics have been mostly
proven wrong and our own assessment correct. An economic recession has not yet
been an impediment to Graco's business, other than the Asian collapse in
1998 -- which fortunately affected only a small portion of their operations. The
profitability of the business has continued to improve -- surpassing even our
most optimistic hopes. Operating margins this year have reached 22%, almost
twice the level of 1996 and more than four times the level of the early 1990s.
Only in revenue growth have the skeptics proven to be correct -- although, as we
will discuss later, this year is proving to be dramatically better. Revenue
growth from 1996-1999 has been a modest 4% per year.
A favorable, and quite unexpected, development since our purchase of Graco has
been its substantial share repurchase. In the summer of 1998, Graco was offered
the opportunity to buy back a very large block of stock, equal to 22% of shares
outstanding, from the estate of its founding Gray Family. Graco seized this
chance, but had to borrow $160 million to do it, in the process transforming its
balance sheet from completely unleveraged to highly leveraged. Fortunately, the
two years since this share repurchase, Graco's substantial cash flow has
permitted it to restore its balance sheet, while benefiting from the accretion
(improved earnings per share) resulting from the transaction.
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<CAPTION>
JUNE 1998 SEPTEMBER 1998 SEPTEMBER 2000
--------- -------------- --------------
<S> <C> <C> <C>
Total Debt (in millions).... $ 12 $153 $42
Equity (in millions)........ $178 $ (3) $93
Debt % Capital.............. 6% 102% 31%
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Graco's share price has reflected its dramatic improvement in earnings per
share since our purchase. The stock has appreciated about 150%, or 25% per year,
reflecting EPS growth from $1.37 in 1996 to an expected $3.27 in 2000.
Interestingly, this share price growth has all come from higher EPS -- Graco's
current PE is the same as it was at the time of our 1996 purchase -- about 10-11
times.
Since Graco continues to be a large position in Source's portfolio, there must
be some compelling reasons why we continue to own the stock. This is certainly
the case. First, Graco is an extraordinarily profitable business with 22%
operating margins and a 28% return on assets -- results which are 2-3 times as
good as those of typical firms. Second, Graco has finally started to generate
excellent revenue growth -- up 13% so far this year. This is the result of
excellent new product flow into its industrial and painting contractor segments,
as well as the development of a new lower-price-point paint sprayer being sold
exclusively in Home Depot, a previously unexploited distribution channel. Third,
Graco generates very large free cash flows -- about $2.50 per share annually.
This alone should produce a 7-8%
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return to shareholders. When combined with the strong revenue growth now being
achieved, we expect that continuing to hold Graco shares should produce a
rewarding return.
The table below shows some of Graco's financial metrics compared with the
Source portfolio and the average for the Russell 2500.
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<CAPTION>
GRACO SOURCE PORTFOLIO RUSSELL 2500
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<S> <C> <C> <C>
Return on Equity................. 75% 22% 13%
Return on Assets................. 28% 10% 5%
Operating Margin................. 22% 13% 10%
10 Year EPS Growth............... 17% 19% 10%
Debt % Capital................... 30% 31% 42%
PE............................... 10x 14x 25x
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These data illustrate both the attractiveness of Graco, and of the Source
portfolio as a whole. We remain optimistic that a portfolio of companies which
combine superior business performance with modest stock valuations will produce
gratifying long-term returns to our shareholders.
Respectfully submitted,
/s/ Eric S. Ende
-----------------------------------
Eric S. Ende
President and
Chief Investment Officer
November 14, 2000
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MAJOR PORTFOLIO CHANGES
Quarter Ended September 30, 2000
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<CAPTION>
Ownership at
Shares September 30, 2000
--------------- -------------------
<S> <C> <C>
NET PURCHASES
COMMON STOCKS
Circuit City Stores, Inc......................... 88,400 shs. 440,000 shs.
Manitowoc Company, Inc., The..................... 162,500 shs. 500,000 shs.
National Commerce Bancorporation................. 235,300 shs. 530,000 shs.
NET SALES
COMMON STOCKS
Brown & Brown, Inc............................... 141,000 shs. 377,700 shs.
DENTSPLY International Inc....................... 62,100 shs. 337,000 shs.
Expeditors International of Washington, Inc...... 58,200 shs. --0--
JLK Direct Distribution Inc. (Class A)........... 50,000 shs. 680,700 shs.
Methode Electronics, Inc. (Class A).............. 78,200 shs. 260,000 shs.
OM Group, Inc.................................... 23,200 shs. 389,300 shs.
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COMPOSITION OF TOTAL NET ASSETS*
September 30, 2000
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<S> <C>
Investment securities (cost $355,737,349):
Common stocks............................................ $361,677,223
Convertible securities................................... 44,208,587
Non-convertible securities............................... 12,434,861
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$418,320,671
Cash, receivables, short-term corporate notes, less
liabilities.............................................. 3,741,252
------------
Total Net Assets at September 30, 2000..................... $422,061,923
============
Assets applicable to Preferred Stock at a liquidation
preference
of $27.50 per share (asset coverage 779%)................ $ 54,153,330
============
Net Assets applicable to Common Stock -- $47.20 per
share.................................................... $367,908,593
============
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SUMMARY FINANCIAL INFORMATION*
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<CAPTION>
For the Periods Ended September 30, 2000
---------------------------------------------
Nine Months Three Months
--------------------- ---------------------
Total Per Total Per
Net Common Net Common
Assets Share Assets Share
------------ ------ ------------ ------
<S> <C> <C> <C> <C>
Beginning of period......... $444,388,091 $50.70 $416,738,249 $46.72
Net gain (loss) on
investments, realized and
unrealized................ (1,343,434) (0.16) 12,679,598 1.65
Income available to
Common shareholders....... 466,892 0.06 (136,771) (0.02)
Quarterly distributions to
Common shareholders....... (26,275,629) (3.40) (8,924,238) (1.15)
Proceeds from shares issued
for distributions
reinvested by
shareholders.............. 4,826,003 -- 1,705,085 --
------------ ------ ------------ ------
Net changes during period... $(22,326,168) $(3.50) $ 5,323,674 $ 0.48
------------ ------ ------------ ------
End of period............... $422,061,923 $47.20 $422,061,923 $47.20
============ ====== ============ ======
</TABLE>
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<CAPTION>
Sept. 30, 2000 June 30, 2000 Dec. 31, 1999
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<S> <C> <C> <C>
Common market price per share....... 50 49 9/16 48 1/4
Common market premium (discount) to
net asset value................... 5.9% 6.1% (4.8)%
Preferred asset coverage............ 779% 770 % 821 %
Preferred market price per share.... 27 13/16 28 13/16 28
</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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