Description

Compass Diversified Holdings (CODI) is a “public private equity” company focused on middle market companies.  CODI generally competes with smaller private equity firms for portfolio acquisitions versus the BX, KKR, APOs of the world.  CODI was written-up originally in 2007 and then again in 2021 – both write-ups are worth a quick review for some background information at different points in time.  CODI owns 7 different consumer businesses and 3 niche industrial businesses – I will not detail each business but instead highlight a couple of key points about select subsidiaries.  Additionally, the company has excellent disclosure in its annual report and on its website; for those interested, I would highly recommend CODI’s  “financial history” excel sheet which is available on the website  - this provides quarterly financials on every current and former subsidiary.  I have owned CODI at various points over the past ~10-12 years; I last was involved in CODI’s Series A and Series B preferred which sold off during COVID and also purchased a smaller position in the equity.  On a side note, I think the various preferreds are interesting should another group of retail investors puke out shares during a period of market turmoil.  

CODI has a solid track record of buying/selling various subsidiaries over the years, helped in part by a structure that didn’t force liquidations at the end of a fund life.  CODI has had a few duds with its subsidiary acquisitions (HALO, Tridien, and AFM) but only HALO was a true loss ($0.3 million) with the others producing small gains and these were more than offset by some of COD’s big winners (FOX, Manitoba Harvest and Clean Earth).  CODI’s win/loss record on bolt-on deals is difficult to precisely quantify from the outside but growth CAGRs suggest more winners than losers (with the notable exception of Ergobaby where bolt-on deals have performed poorly), albeit at significantly lower levels of total capital deployed versus subsidiary acquisitions.  Historically, CODI has had a mix of slower growing/cash flowing businesses and a couple of faster growing subsidiaries.  To his credit, CEO Elias Sabo has monetized some of the slower growing businesses and bought businesses with better growth characteristics at still reasonable to outright cheap multiples.  The recent selloff in CODI’s equity has occurred despite the business quality being far better than at any point in the company’s history.    

CODI came public in 2006 as a Delaware trust, was originally sponsored by the Teekay shipping family and had/has a third-party management team.  The funky structure along with the presence of Teekay’s charitable foundation (supported by CODI dividends) necessitated a larger yield to attract investors.  CODI paid dividends of $1.36-1.44 annually from the IPO until 2021 when it converted to a C corporation – a $0.88 special dividend was paid in 2021 to offset the taxable capital gain passed to shareholders as a result of the conversion.  Over its history, CODI has distributed nearly $23 of dividends.   As part of its conversion to a C corporation, CODI reset the dividend to $1.00 per share which continues today.  

CODI’s historically outsized dividend has always been a bit of a mixed blessing for CODI.  On the positive side, the dividend attracted a loyal group of shareholders and produced a large portion of the company’s market beating returns.  That said, the dividend was always a challenge for the company. CODI endured periods where the dividend was not fully covered and there was pressure to improve its cash available for distribution (CAD) to demonstrate sustainability.  Historically, the company was more reliant on equity financing and therefore it was forced to do secondaries for new acquisitions and these extra shares required more dividend mouths to feed.  Since the company became public, all 3 CEOs privately expressed a preference for a reduced dividend (especially given CODI’s successful track record buying/selling businesses) but acknowledged the institutional pressure to maintain the payment.  The C corporation conversion finally allowed for a dividend reset opportunity, and I suspect CODI will look for further reset opportunities in future years.  

Over the last five years, CODI has executed well on a couple of fronts:

• CODI transformed its capital structure with a better mix of cheaper debt and preferred equity.  After first accessing the high yield market in 2018, CODI refinanced into $1 billion of 8-year unsecured bonds (5.25%) and $300mm of 10-year 5% unsecured bonds in 2021.  CODI has 3 classes of preferred equity totaling $315 million issued between 2017-2019. 

• The company monetized Manitoba Harvest & Clean Earth at a combined 19x multiple in 2019, giving CODI valuable dry power just as COVID hit.  CODI then sold out of slower grower Liberty Safe in 2021.  

• Most recently, CODI has made a series of potentially company changing acquisitions:

  • Dial-based fit systems BOA (used in skiing/snowboarding/running/others) 

  • Baseball/softball equipment provider Marucci in 2020 

  • High-end (average price $238,000 per piece) diamond manufacturer/marketer Lugano Diamonds in 2021 

  • Synthetic insulation (think fibers in coats) PrimaLoft (Prima) in 2022  

While the jury is still out on Prima, BOA, Marucci and Lugano have already performed well and likely would fetch far higher multiples if sold today.  These businesses along with apparel provider 5.11   --  5.11 filed for a $100 million IPO in November 2021 but the plan was withdrawn in October 2022 – generate ~65 percent of pre-corporate, pro-forma EBITDA.  According to the company, BOA ($82 million of 2022 EBITDA) is the business with the most potential – CODI believes the business could eventually do over $250 million of EBITDA and CODI suggest that it would not be a seller unless an offer was closer to 4-4.5x its $454 million purchase price.  

While the multi-year outlook looks promising, CODI is suffering from some near-term headwinds.  CODI has guided towards flattish subsidiary EBITDA growth in 2023 as two of its strongest businesses (BOA and PrimaLoft) have been hurt from inventory destocking by retail clients.  BOA will likely show a decline in 2023 EBITDA and PrimaLoft will only post modest growth.  Additionally, CODI took on floating rate debt to acquire PrimaLoft and took its leverage ratio to ~3.9x, above the company’s 3-3.5x guidance (CODI looks at leverage excluding corporate expense which is primarily comprised of management fees).  These two developments are likely primary factors behind CODI’s recent stock weakness.  Additionally, BOA/Prima’s diminished 2023 outlook has likely caused investors to wonder whether the gaudy growth posted by the two businesses could potentially have been attributed to a COVID pull forwards.  CODI is quick to note that growth was strong in the pre-covid periods for both businesses and, in the case of BOA, measured model count is expected to grow 10 percent in the fall/winter of 2024.  CODI’s management team has also noted how multiple large brand partners are actively trying to collaborate with BOA to integrate the company’s technology into products.  Furthermore, BOA/Prima end products are selling well, and demand remains robust. CODI has also mentioned that its direct-to-consumer businesses 5.11 and Lugano are showing no falloff in demand, offering further evidence that 2023 weakness is a result of temporary retailer inventory issues for BOA/Prima.  It is also worth noting that both BOA and Prima have small market shares in large addressable markets, and CODI’s team remains highly confident both businesses have distinct competitive advantages and are multi-year growers (with substantial reacceleration likely in 2024).  

Time will tell if the degree of CODI’s enthusiasm is warranted.  Prior to its sale(s), Fox enjoyed multiple years of robust growth despite continued naysayers doubting its sustainability.  Marucci had a sluggish start during CODI’s ownership because of the COVID impact but growth quickly reaccelerated once restrictions on baseball/softball ended.  By contrast, Ergobaby posted robust growth when first acquired but EBITDA remains far below prior year levels despite multiple bolt-on deals (which did not go well).  While there is certainly a range of outcomes for their future growth trajectory, it seems clear that BOA and Prima’s margin and growth profile are far better than recently sold businesses.  

Pro-forma Revenue/EBITDA (show results prior to acquisition for the recent acquisitions), historical growth rates and total acquisition costs/follow-on investment multiples relative to 2022 EBITDA are shown below.

Multiple follow-on investments at archery/airgun maker Velocity distort its historical growth rates.  Additionally, this business got a big bump during COVID as consumers experimented with arrows and guns (or something like that).  This COVID bump has not proven sustainable and future demand is more uncertain – Velocity is likely CODI’s weakest business.  Demand for Sterno’s heat warming systems used in the foodservice industry was hit hard during COVID.  While the business has partially rebounded, there is unlikely to be breakout growth.  CODI’s team seems more enthusiastic about the brand strength of baby carrier/stroller manufacturer Ergobaby, but, as previously noted, the business generates less than 50 percent of the EBITDA it did 5 years ago. A slowdown in birth rates, weakness in international markets and poor results from bolt-on deals all have negatively impacted results.  Velocity, Sterno and Ergo are unlikely to produce meaningful gains.  

CODI’s two other industrial businesses (Altor and Arnold – Sterno is the last after the sale of Advanced Circuits) have produced steady results, albeit at slower levels than some of the consumer facing businesses.  Arnold (Designed/Manufacturer of electric motor and magnetic solutions for a variety of applications) is a bit of turnaround story.  CODI replaced the entire management team and financed an acquisition that allowed the company to enter the electric motor space.  CODI has hinted that both Altor and Arnold will be sold as CODI moves into its new healthcare services vertical which be led by new hire Kurt Roth.  CODI is looking for recurring revenue healthcare service companies which it believes can offer slightly faster growth with less economic sensitivity.  While there is always a risk moving into a new space, my sense is that CODI views the potential space as offering a better risk/reward than the existing industrial businesses while simultaneously allowing an offset to the more economically sensitive consumer franchises.   

When CODI first became a public company, sellside reports often showed sum-of-the-parts valuations given the limited number of subsidiaries and the large amounts of available disclosure.  Prior to becoming a C corporation, CODI also showed a cash available for distribution (CAD) metric which was primarily used as a way to judge dividend stability.  Now, with 10 subsidiaries, the sum of the parts becomes a bit more challenging.  While the multiples assumed for each of the businesses are subjective, this is still the purest way to value the company.  As a C Corporation, CODI now provides an “adjusted earnings” metric that is not unreasonable but likely overstates truly available cashflow because it excludes working capital investments as well as stock compensation (the latter is given to subsidiary employees).  CODI’s management team doesn’t disagree that adjusted earnings should be tweaked for working capital spend and stock compensation – they simply note that both are difficult to forecast.  Adjusted earnings captures maintenance capex (depreciation not added back) but not growth capex.  Future capex is expected to split roughly 50/50 between maintenance and growth capex.

With all the caveats about the subjectivity of the exact sale multiple to use -- not to mention the various working capital and transactional adjustments that I may not be fully capturing -- here is the best guess on a likely conservative sum-of-parts value adjusted for taxes/minority interests.  

CODI has something of a “hidden tax asset” as there was a step-up in basis for the company’s preferred/common when it converted into C corporation.  This asset (~$500 million according to the company) is proportionately allocated to the subsidiaries (I used proportional equity to allocate) but cannot be shown until a sale occurs (thus it does not show on CODI’s balance sheet).  If full tax payment (at 26%) on gains was required, total value would drop to ~$24.60 in the valuation above.  CODI’s value disproportionately skews towards the most recent acquisitions and 5.11 – Ergobaby selling for 6x or 8x doesn’t move the needle.  I show Prima at the same purchase price but obviously CODI would not consider selling near current levels.   I suspect that Lugano, BOA and Prima could be worth vastly more than what is shown below and therefore the below is likely overly conservative.  As mentioned earlier, management mentioned that BOA would require a price closer to $2 billion today before they would sell.

At its analyst day in January, CODI noted that it believes that it can grow its pre-subsidiary EBITDA by 8-10% annually through 2028 after assuming a no-growth 2023 due to some of the inventory destocking issues mentioned earlier.  This growth profile doesn’t appear unreasonable.  Assuming some rebound in 2024, I show growth at the low-end of this range and assume all cash is used to repay debt.  Certainly, a severe recession could cause EBITDA declines versus flattish results and there is no assurance that results immediately reaccelerate in 2024.  That said, if the company is directionally correct on the business quality, growth should materially rebound once a recovery begins.  Clearly, CODI wants to purchase additional subsidiaries, so this prolonged debt paydown scenario does not reflect any realistic scenario.  That said, it does suggest that investors can see a solid path towards stock upside from discretionary free cash flow as opposed to only being dependent on a hypothetical liquidation scenario.  Taxes and working capital uses could be the two biggest wildcards in actual free cash flow.  I assume an annual tax burden of ~10% of EBITDA based on conversations with the company – there would appear to be more room to add subsidiary debt.  IRS rules on “asset stripping” limit the maximum debt that can be placed on subsidiaries but CODI likely could increase debt to 4.5-5x level at several businesses.   As for working capital, Lugano and 5.11 will be the two largest users as both businesses build out salons/stores - it is certainly possible working capital use is well above these levels if either/both continue accelerated growth paths, but such a path would likely produce growth well beyond ~8 percent levels.

Taken together, a hypothetical liquidation and a back of the envelope free cash flow forecast both suggest considerable upside for CODI from current levels and a conservative estimate of at least $30 does not seem completely unreasonable.  The conversion to a C corporation/reduction in the dividend makes a great deal of intellectual sense as this allows additional holding company deductions and opens the stock to a wider pool of possible owners.  Of course, it is very possible that investors will slap an enormous conglomerate/complexity discount on the entity given the number of subsidiaries.   As previously noted, CODI’s past dividend caused immense complications (more equity issuances, more pressure to sell a subsidiary to purchase another or to buy subsidiaries in order to maintain coverage), but it also created a loyal shareholder base and accounted for a large percentage of CODI’s market beating historical returns. While CODI has instituted a $50 million share repurchase program, the company is unlikely to be a serial repurchaser of its shares.  CODI’s long-term vision is to increase the number of subsidiaries (15+ subsidiaries with average company at >$50 million of EBITDA- CODI believes this profile would allow an investment grade rating), and it is certainly worth noting that the 2/20 fee structure encourages more acquisitions, not fewer.  Finally, it is difficult to reconcile CODI’s at-the-market equity issuance program ($84 million raised in 2022 at an average price of ~$24.70) with a share repurchase program.  

CODI’s historical actions offer some reassurance on the above concerns.  CODI’s win/loss record on all deals since 2006 is strong.  Its misses have been small, and the firm has had multiple big winners.  At various points in its history, CODI has shown a willingness to sell and then sit on its hands despite compensation incentives and dividend pressure that encouraged the opposite behavior.  CODI executed multiple deals during the uncertain COVID period, and these recent acquisitions have stronger growth profiles than past subsidiaries.  And CODI appears to have acquired most of the recent subsidiaries (Prima has yet to prove itself) at attractive prices – it is possible that one or more of these deals might end up accounting for meaningful percentage of CODI’s enterprise value, driving far higher returns than what is outlined above.  The current pullback in M&A markets may offer another favorable opportunity set and CODI’s structure/financial profile offers both a funding and “certainty to close” advantage versus other middle market private equity firms.  CODI has waived management fees on numerous occasions and the management team/Board members have been active personal buyers of CODI’s stock at various points throughout its history.   A (temporarily) leveraged, multi-industry, multi-company conglomerate with an outside management group earning a 2/20 structure is likely not a name that immediately screams “look at me now” to most investors.  It is certainly possible that shares sell off further/continue to languish.  That said, the company looks cheap from multiple perspectives and is run by a competent team with an established track record of acquisition success.  Furthermore, CODI’s portfolio of subsidiaries is the highest quality in its history, and it is likely that the company can take advantage of volatile markets to acquire attractive businesses in the years ahead.  

Risks

-Bad acquisition(s)

-Multi-year pullback in BOA/Prima growth trajectory

-Recession

-Multi-year conglomerate discount

Catalyst

-Debt paydown

-Reacceleration in BOA/Prima growth

-Compelling subsidiary sale/purchase

-Large insider purchases