EQUUS TOTAL RETURN, INC. - Quarter Report: 2003 September (Form 10-Q)

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2003

OR

For the transition period                      to                     

Commission File Number 0-19509

EQUUS II INCORPORATED

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (713) 529-0900

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x    No  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in 12b-2 of the Exchange Act).  Yes  ¨    No  x

There were 6,233,021 shares of the registrant’s common stock, $.001 par value, outstanding, as of November 12, 2003. The net asset value of a share at September 30, 2003 was $12.48.

EQUUS II INCORPORATED

(A Delaware Corporation)

INDEX

EQUUS II INCORPORATED

BALANCE SHEETS

SEPTEMBER 30, 2003 AND DECEMBER 31, 2002

(Unaudited)

The accompanying notes are an

integral part of these financial statements.

1

EQUUS II INCORPORATED

STATEMENTS OF OPERATIONS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002

(Unaudited)

The accompanying notes are an

integral part of these financial statements.

2

EQUUS II INCORPORATED

STATEMENTS OF OPERATIONS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002

(Unaudited)

The accompanying notes are an

integral part of these financial statements.

3

EQUUS II INCORPORATED

STATEMENTS OF CHANGES IN NET ASSETS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002

(Unaudited)

The accompanying notes are an

integral part of these financial statements.

4

EQUUS II INCORPORATED

STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002

(Unaudited)

The accompanying notes are an

integral part of these financial statements.

5

EQUUS II INCORPORATED

STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002

(Unaudited)

(Continued)

The accompanying notes are an

integral part of these financial statements.

6

EQUUS II INCORPORATED

SUPPLEMENTAL INFORMATION – SELECTED PER SHARE DATA AND RATIOS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002

(Unaudited)

The accompanying notes are an

integral part of these financial statements.

7

EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

SEPTEMBER 30, 2003

(Unaudited)

The accompanying notes are an

integral part of these financial statements.

8

EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

SEPTEMBER 30, 2003

Unaudited)

(Continued)

The accompanying notes are an

integral part of these financial statements.

9

EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

SEPTEMBER 30, 2003

(Unaudited)

(Continued)

The accompanying notes are an

integral part of these financial statements.

10

EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

SEPTEMBER 30, 2003

(Unaudited)

(Continued)

The accompanying notes are an

integral part of these financial statements.

11

EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

SEPTEMBER 30, 2003

(Unaudited)

(Continued)

Substantially all of the Fund’s portfolio securities are restricted from public sale without prior registration under the Securities Act of 1933. The Fund negotiates certain aspects of the method and timing of the disposition of the Fund’s investment in each portfolio company, including registration rights and related costs.

In connection with the investments in American Trenchless Technology, Inc., Champion Window Holdings, Inc., Container Acquisition, Inc., The Drilltec Corporation, Jones Industrial Services, Inc., Sovereign Business Forms, Inc., Strategic Holdings, Inc. and Turfgrass America, Inc., rights have been obtained to demand the registration of such securities under the Securities Act of 1933, providing certain conditions are met. The Fund does not expect to incur significant costs, including costs of any such registration, in connection with the future disposition of its portfolio securities.

As defined in the Investment Company Act of 1940, at September 30, 2003, the Fund was considered to have a controlling interest in Champion Window Holdings, Inc., Container Acquisition, Inc., The Drilltec Corporation, Equicom, Inc., PalletOne, Inc., Reliant Window Holdings, LLC, Sovereign Business Forms, Inc., Spectrum Management LLC, and Strategic Holdings, Inc. The fair value of the Fund’s investment in ENGlobal, Inc. includes a discount of $1,552,547 from the closing market price to reflect the estimated effect of restrictions on the sale of such securities at September 30, 2003.

Income was earned in the amount of $4,993,897 and $1,725,576 for the nine months ended September 30, 2003 and 2002, respectively, on portfolio securities of companies in which the Fund has a controlling interest. Income was earned in the amount of $873,267 and $1,062,749 for the nine months ended September 30, 2003 and 2002, respectively, on portfolio securities of companies that are affiliates of the Fund but are not controlled by the Fund.

As defined in the Investment Company Act of 1940, all of the Fund’s investments are in eligible portfolio companies except Sternhill Partners I, L.P. and Vanguard VII, L.P. The Fund provides significant managerial assistance to all of the portfolio companies in which it has invested, except Doane PetCare Enterprises, Inc. (“Doane”), Equipment Support Services, Inc., Sternhill Partners I, L.P., and Vanguard VII, L.P. The Fund provides significant managerial assistance to portfolio companies that comprise 96% of the total value of the investments in portfolio companies at September 30, 2003.

The accompanying notes are an

integral part of these financial statements.

12

EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

JUNE 30, 2003

(Unaudited)

(Continued)

The investments in portfolio securities held by the Fund are not geographically diversified. All of the Fund’s portfolio companies (except for Doane, PalletOne, Inc. and certain investments in the venture capital funds) are headquartered in Texas, although several have significant operations in other states.

The Fund’s investments in portfolio securities consist of the following types of securities at September 30, 2003:

The following is a summary by industry of the Fund’s investments as of September 30, 2003:

The accompanying notes are an

integral part of these financial statements.

13

EQUUS II INCORPORATED

NOTES TO FINANCIAL STATEMENTS

SEPTEMBER 30, 2003 AND 2002

(Unaudited)

Equus II Incorporated (the “Fund”), a Delaware corporation, was formed by Equus Investments II, L.P. (the “Partnership”) on August 16, 1991. On July 1, 1992, the Partnership was reorganized and all of the assets and liabilities of the Partnership were transferred to the Fund in exchange for shares of common stock of the Fund. The shares of the Fund trade on the New York Stock Exchange under the symbol EQS.

The Fund seeks to achieve capital appreciation by making investments in equity and equity-oriented securities issued by privately-owned companies in transactions negotiated directly with such companies. The Fund seeks to invest primarily in companies which intend to grow either by acquiring other businesses, including leveraged buyouts, or internally. The Fund may also invest in recapitalizations of existing businesses or special situations from time to time. The Fund’s investments in Portfolio Companies consist principally of equity securities such as common and preferred stock, but also include other equity-oriented securities such as debt convertible into common or preferred stock or debt combined with warrants, options or other rights to acquire common or preferred stock. The Fund elected to be treated as a business development company under the Investment Company Act of 1940. For tax purposes, the Fund has elected to be treated as a regulated investment company (“RIC”). The Fund has entered into a management agreement with Equus Capital Management Corporation, a Delaware corporation (the “Management Company”).

Liquidity and Revolving Line of Credit – The Fund has a $10,000,000 revolving line of credit with Bank of America, N.A. that expires on November 30, 2003. The Fund uses its revolving line of credit for liquidity to pay operating expenses of the Fund and for new and follow-on investments in portfolio securities. The Fund had $9,065,000 outstanding under this line of credit at September 30, 2003, which is collateralized by the Fund’s investments in portfolio securities. As of November 12, 2003, the Fund’s availability under the revolving line of credit is approximately $240,000.

The line of credit, as amended, provides that any proceeds received from the sale of portfolio securities or from repayments by Portfolio Companies of the principal amount of loans must be used to pay down the line of credit. As such payments are made, the Fund’s availability under the facility is reduced by a corresponding amount. The lender has asked the Fund to take steps to pay off the line of credit. Accordingly, the Fund has been in discussions with interested parties regarding the sale of certain portfolio securities. Due to the Fund’s limited cash resources currently available, the Fund may be required to obtain borrowings from other parties and refinance its existing line of credit in order to maintain liquidity. Subsequent to September 30, 2003, the Fund entered into a contract, subject to certain conditions, to sell its investment in Strategic Holdings, Inc (“SHI”). The proceeds from this sale, if consummated, should enable the Fund to pay its line of credit in full. The lender indicated it will extend the line of credit to January 31, 2004, release certain collateral and permit additional secured borrowings from other parties during such period, but no definitive agreement has been executed. The Fund is also pursuing arrangements to refinance the line of credit with other lenders. There can be no assurance that the Fund can sell securities sufficient to pay off the line of credit, extend the existing line of credit, obtain additional third party financing, or obtain a replacement facility. Should the Fund be unable to do so, the

14

Fund may be required to sell portfolio securities at values that could be materially less than the Management Company’s estimates of fair value.

The Fund has declared a dividend of its net taxable investment income for 2003, estimated to be approximately $4.5 million, payable on January 16, 2004. The dividend will be paid by issuing shares of common stock, unless shareholders of the Fund request payment in cash, by specific election. Based on historical elections, the Fund would expect approximately 40% of the Fund’s shareholders to elect to receive their dividend in cash. If the Fund is unable to complete the sale of SHI and obtain an extension of the line of credit or obtain additional financing, it may not have the funds to pay the cash portion of the dividend.

Under certain circumstances, the Fund may be called on to make follow-on investments in certain Portfolio Companies. The Fund has guaranteed obligations to financial institutions on behalf of Equicom, Inc. (“Equicom”) in the amount of $268,520. The Fund has made loans to Equicom from time to time to enable the company to service its debt, but the Management Company does not expect the Fund to advance more than $225,000 in the last quarter of 2003 for such purpose. In addition, the Fund has committed to invest up to an additional $2 million in Container Acquisition, Inc., in connection with a proposed refinancing of the company. Also, the Fund committed to invest up to $5,550,000 in the two venture capital funds in its portfolio. At September 30, 2003, $3,570,000 of such amount had been funded. The Management Company does not expect the Fund to advance more than $450,000 of its remaining commitments to the venture capital funds in the last quarter of 2003. However, if the Fund does not have sufficient funds to make follow-on investments, the Portfolio Company in need of the investment may be negatively impacted. Also, the Fund’s equity interest in and its estimated fair value of the Portfolio Company could be reduced.

The interest rate on the line of credit is currently prime + 4%. At September 30, 2003, the interest rate was 8.00%. The Fund also pays interest at the rate of ¼% per annum on the unused portion of the line of credit. The average daily balances outstanding on the Fund’s line of credit during the nine months ended September 30, 2003 and 2002 was $10,994,432 and $10,451,773, respectively. During the nine months ended September 30, 2003 and 2002, the amount of interest paid in cash was $732,214 and $398,875, respectively. The line of credit restricts the Fund’s ability to incur additional indebtedness, pay dividends, merge with another entity, dispose of assets outside the ordinary course of business and engage in certain transactions with affiliates.

RIC Borrowings, Restricted Cash and Temporary Investments – The Fund had a $100,000,000 line of credit promissory note with Bank of America N.A. through January 1, 2003, with interest payable at 1/2% over the rate earned on its money market account. Because of the nature and size of its portfolio investments, the Fund periodically borrowed money under this line of credit promissory note to make qualifying investments to maintain its tax status as a regulated investment company (“RIC”) under the Internal Revenue Code. The Fund had $58,000,000 outstanding on such note at December 31, 2002, which was collateralized by restricted temporary cash investments of $58,000,000. Pursuant to the terms of the note, the Fund was required to repay the outstanding borrowings within five business days of the initial borrowing date. The Fund repaid the outstanding quarter end borrowings within this time period. The Fund’s line of credit promissory note expired on January 1, 2003.

During September 2003, the Fund borrowed $63,990,948 to make qualifying investments to maintain its RIC status by utilizing an established margin account with a securities brokerage firm. The Fund collateralized such borrowings with restricted cash and temporary investments in U.S. Treasury bills of $64,670,715 and other portfolio securities of $3,980,000. The U.S. Treasury bills were sold, and the total amount borrowed was repaid on October 1, 2003. The Management Company believes the Fund will be able to use this financing arrangement to maintain its RIC status. However, there is no assurance that such arrangement will be available to the Fund in the future. If the Fund is unable to borrow funds in

15

the future to make qualifying investments, the Fund may no longer qualify as a RIC. Failure to continue to qualify as a RIC could be material to the Fund’s shareholders in that the Fund would be subject to corporate income tax on its net investment income and net realized gains, and any distributions to shareholders would be subject to income tax as ordinary dividends.

Valuation of Investments – Portfolio investments are carried at fair value with the net change in unrealized appreciation or depreciation included in the determination of net assets. Valuations of portfolio securities are performed in accordance with accounting principles generally accepted in the United States and the financial reporting policies of the Securities and Exchange Commission (“SEC”). The applicable methods prescribed by such principles and policies are described below:

Publicly-traded portfolio securities – Investments in companies whose securities are publicly traded are valued at their quoted market price at the close of business on the valuation date, less a discount to reflect the estimated effects of restrictions on the sale of such securities (“Valuation Discount”), if applicable.

Privately-held portfolio securities – The fair value of investments for which no market exists (including 95% of the investments of the Fund at September 30, 2003) is determined on the basis of procedures established in good faith by the Board of Directors of the Fund. As a general principle, the current “fair value” of an investment is the amount the Fund might reasonably expect to receive for it upon its current sale, in an orderly manner. Appraisal valuations are necessarily subjective and the Management Company’s estimate of values may differ materially from amounts actually received upon the disposition of portfolio securities.

Generally, cost is the primary factor used to determine fair value until significant developments affecting the Portfolio Company (such as results of operations or changes in general market conditions) provide a basis for use of an appraisal valuation. Thereafter, portfolio investments are carried at appraised values as determined quarterly by the Management Company, subject to the approval of the Board of Directors. Appraisal valuations are based upon such factors as a Portfolio Company’s earnings, cash flow and net worth, the market prices for similar securities of comparable companies, an assessment of the company’s current and future financial prospects and various other factors and assumptions. In the case of unsuccessful operations, the appraisal may be based upon liquidation value.

Most of the Fund’s common equity investments are appraised at a multiple of historical free cash flow generated by the Portfolio Company in its most recent fiscal year, less outstanding funded indebtedness and other senior securities such as preferred stock. Projections of current year free cash flow may be utilized and adjustments for non-recurring items are considered. Multiples utilized are estimated based on the Management Company’s experience in the private company marketplace, and are necessarily subjective in nature. Most of the Portfolio Companies utilize a high degree of leverage. The banking environment currently has resulted in pressure on several of these Portfolio Companies to reduce the amount of leverage in order to maintain such financing. From time to time, Portfolio Companies are in default of certain covenants in their loan agreements. When the Management Company has a reasonable belief that the Portfolio Company will be able to restructure the loan agreements to adjust for any defaults, the Portfolio Company’s securities continue to be valued assuming that the company is a going concern. In the event a Portfolio Company cannot generate adequate cash flow to meet the principal and interest payments on such indebtedness or is not successful in refinancing the debt upon its maturity, the Fund’s investment could be reduced or eliminated through foreclosure on the Portfolio Company’s assets or the Portfolio Company’s reorganization or bankruptcy.

16

The Fund may also use, when available, third-party transactions in a Portfolio Company’s securities as the basis of valuation (the “private market method”). The private market method will be used only with respect to completed transactions or firm offers made by sophisticated, independent investors.

The fair values of debt securities, which are generally held to maturity, are determined on the basis of the terms of the debt securities and the financial conditions of the issuer. Certificates of deposit purchased by the Fund generally will be valued at their face value, plus interest accrued to the date of valuation.

Because of the inherent uncertainty of the valuation of portfolio securities which do not have readily ascertainable market values, amounting to $78,769,052 (including $5,095,306 in publicly-traded securities, net of a $1,552,547 Valuation Discount) and $82,653,260 (including $1,230,650 in publicly-traded securities, net of a $228,003 Valuation Discount) at September 30, 2003 and December 31, 2002, respectively, the Fund’s estimate of fair value may materially differ from the value that would have been used had a ready market existed for the securities. Appraised values do not reflect brokers’ fees or other normal selling costs which might become payable on disposition of such investments.

On a daily basis, the Fund adjusts its net asset value for the changes in the value of its publicly held securities and material changes in the value of its private securities and reports those amounts to Lipper Analytical Services, Inc. Weekly and daily net asset values appear in various publications, including Barron’s and The Wall Street Journal.

Investment Transactions – Investment transactions are recorded on the accrual method. Realized gains and losses on investments sold are computed on a specific identification basis.

Cash Flows – For purposes of the Statements of Cash Flows, the Fund considers all highly liquid temporary cash investments purchased with an original maturity of three months or less to be cash equivalents.

Federal Income Taxes – The Fund intends to comply with the requirements of the Internal Revenue Code necessary to qualify as a regulated investment company and, as such, will not be subject to federal income taxes on otherwise taxable income (including net realized capital gains) which is distributed to shareholders. Therefore, no provision for federal income taxes is recorded in the financial statements. The Fund borrows money from time to time to maintain its tax status under the Internal Revenue Code as a RIC. See Note 2 for further discussion of the Fund’s RIC borrowings.

Reclassifications – Certain reclassifications have been made to the prior years’ amounts to conform to current year presentation.

17

Stock-Based Compensation – The Fund accounts for stock-based compensation using the intrinsic value method in accordance with the provisions of APB No. 25. Had the Fund accounted for the options using the fair value method under SFAS 123, the decrease in net assets from operations for the nine months ended September 30, 2003 and 2002, respectively, would have been:

The Fund has entered into a management agreement with the Management Company. Pursuant to such agreement, the Management Company performs certain services, including certain management and administrative services necessary for the operation of the Fund. The Management Company receives a management fee at an annual rate of 2% of the net assets of the Fund, paid quarterly in arrears. The Management Company also receives compensation for providing certain investor communication services, of which $37,500 is included in the accompanying Statements of Operations for each of the nine months ended September 30, 2003 and 2002. The management fees paid by the Fund represent the Management Company’s primary source of revenue and support. The Management Company is controlled by a privately-owned corporation.

As compensation for services provided to the Fund, each director who is not an officer of the Fund receives an annual fee of $20,000 paid quarterly in arrears, a fee of $2,000 for each meeting of the Board of Directors attended in person, a fee of $1,000 for each committee meeting attended, and reimbursement of all out-of-pocket expenses relating to attendance at such meetings. In addition, each director who is not an officer of the Fund is granted incentive stock options to purchase shares of the Fund’s stock from time to time. (See Note 8). Certain officers of the Fund serve as directors of Portfolio Companies, and may receive and retain fees, including non-employee director stock options, from such Portfolio Companies in consideration for such service. Additionally, two officers of the Management Company serve as directors of the Fund.

The Management Agreement will continue in effect until June 30, 2004, and from year-to–year thereafter provided such continuance is approved at least annually by (i) a vote of a majority of the outstanding shares of the Fund or (ii) a majority of the directors who are not “interested persons” of the Fund, at a meeting called for the purpose of voting on such approval. The Management Agreement may be terminated at any time, without the payment of any penalty, by a vote of the Board of Directors of the Fund or the holders of a majority of the Fund’s shares on 60 days’ written notice to the Management Company, and would automatically terminate in the event of its “assignment” (as defined in the Investment Company Act).

The Fund is required to make distributions of any net taxable investment income on an annual basis, and may elect to distribute or retain net taxable realized capital gains. The Internal Revenue Service approved the Fund’s request, effective October 31, 1998, to change its year-end for determining capital gains for purposes of Section 4982 of the Internal Revenue Code from December 31 to October 31.

18

The Fund was not required to make any distributions for 2002 under income tax regulations. As of December 31, 2002, the Fund had a capital loss carryforward of $2,218,000, which may be used to offset future taxable capital gains. If not utilized, the loss carryforward will expire in 2006.

The Fund declared no dividends during the nine months ended September 30, 2003 and 2002. In November 2003, the Fund declared a dividend equivalent to its net taxable investment income for 2003, estimated to be approximately $4.5 million, or $0.72 per share. The dividend is payable to the shareholders of record on November 30, 2003. The dividend will be paid by the issuance of additional shares of common stock, unless shareholders request payment in cash, by specific election. Based on historical elections, the Fund would expect approximately 40% of the Fund’s shareholders to elect to receive their dividend in cash. Payment of the dividend is expected to occur in January 2004.