SOURCE CAPITAL /DE/ — Interim / Quarterly Report 1999

Nov 24, 1999

[LOGO] SOURCE CAPITAL, INC. THIRD QUARTER REPORT September 30, 1999 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 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% 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.

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.

• 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. 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 MAJOR PORTFOLIO CHANGES Quarter Ended September 30, 1999

COMPOSITION OF TOTAL NET ASSETS* September 30, 1999

SUMMARY FINANCIAL INFORMATION*

• 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. SOURCE CAPITAL, INC. 11400 West Olympic Boulevard, Suite 1200 Los Angeles, California 90064 BULK RATE U.S. POSTAGE PAID CMSS