Mini-conglomerate Compass Diversified (NYSE:CODI) has acquired two companies in just a few days, and reassured us about the safety of its dividend. At the same time, we’re wondering if the Company may be raising more equity in the near term.
We wrote a back on January 13, 2010 sharing our concerns about the sustainability of the Company’s dividend, should existing portfolio companies not be able to increase their excess cash generation or should management fail to make additional acquisitions. At the time, we estimated that earnings were running at only 50% of the generous dividend Compass was paying. However, Compass had the capital resources to grow by acquisition due to considerable firepower gained from selling off portfolio companies at the height of the market, raising capital in 2009 and from unused debt capability.
Since then we’ve had encouraging, but not decisive, IVQ 2009 financial results . The Company wrote-off goodwill on one of its subsidiaries, and quarterly earnings were up over the prior year quarter but were still substantially down on a 12 month basis. Some investors were frustrated by the Company’s inability to find one or more suitable acquisitions, despite having plenty of money to spend.
The turning point, though, was the announcement on March 11, 2010 of the first acquisition by CODI’s circuit board subsidiary subsidiary, Advanced Circuits, which acquired Circuit Express, Inc. for a purchase price of $15.6 million.
Quoting from the press release for anyone who missed it:
Based in Tempe, Arizona and founded in 1987, CEI focuses on quick-turn manufacturing of prototype and low-volume quantities of rigid printed circuit boards (PCBs), primarily for aerospace and defense related customers. While its standard production lead time is five days, CEI specializes in expedited delivery in as fast as 24 hours. The company’s three facilities total 35,000 square feet, and are designed for the sole purpose of producing PCBs. For the year ended December 31, 2009, CEI reported revenue of approximately $16.4 million. The purchase price was funded largely in cash from CODI’s balance sheet.
Commenting on the transaction, Joe Massoud, CEO of Compass Diversified Holdings, said, “We are pleased to announce the strategic acquisition of Circuit Express. With this transaction, we have expanded ACI’s core capabilities to include advanced aerospace and defense driven products, while strengthening its leadership position in the quick-turn manufacturing niche. We expect this acquisition to be highly accretive to cash flows. Going forward, we expect to capitalize on our financial strength by consummating attractive acquisitions of new platform businesses or further add-ons to our existing subsidiaries.”
Then today, Compass announced a new portfolio addition: Liberty Safe and Security Products for a purchase price of $70mn. The new company has revenues of $74mn. We mention that to demonstrate this is a significant addition to the conglomerate as CODI’s total sales across 6 existing portfolio companies was just over $320mn last year.
We were further reassured by the following comment from CEO Joe Massoud: “We expect the acquisition of Liberty to immediately provide our owners with ten to fifteen cents per share of cash flow accretion on a full year basis”.
That suggests incremental Cash Available for Distribution of up to $5.5mn. (By the way, Cash Available For Distribution or CAD is the metric the Company uses to determine the amount of excess earnings generated which do not have to be re-invested in the business and are nominally available to pay-out to shareholders).
So what’s a reasonable Cash Available For Distribution number to assume on an ongoing basis? We don’t have specific guidance from CODI on the add-on acquisition, but we’re going to assume a $3.2 mn contribution. (This is partly based on a comment made by CEO Massoud on the last Conference Call saying add-on acquisitions could occasionally be closed at low EBITDA multiples). Here we are assuming a 20% contribution as a percentage of the purchase price.
The key, though, to whether CODI’s CAD can cover its $50mn a year dividend liability is the prospective growth in earnings from the existing portfolio. CODI has already announced in its Earnings Report for the fourth quarter of 2009 that it expects 2010 CAD to exceed the $37mn achieved in 2009:
” For 2010, we expect to achieve significant year-over-year growth in CAD, excluding the impact of any new platform businesses we may acquire, and are already beginning to see these trends in the first quarter”.
However, management also warned (if I heard correctly) that it did not expect the historic 6 original businesses to generate enough incremental CAD to cover the dividend by themselves. That suggests CODI is not expecting the 35% increase in cash generation that would be necessary to achieve that goal in 2010. However, with the pro-forma contributions from the two new deals, CODI will need only an 11% increase in its core CAD to get aggregate CAD up to $50mn. That seems eminently attainable given the strengthening economy, and underscores why we’re more confident than we were just 3 short months ago about CODI’s ability to generate enough Cash Available for Distribution to pay its current dividend. We wouldn’t be surprised, when the dust settles, that Compass earns CAD of $50-$55mn, or up to $1.50 a share.
Of course, we shouldn’t get carried away with earnings alone. The Great Recession showed that you have to maintain a strong balance sheet at all times. Compass has been conservative in this area in recent years and shareholders have benefited as a result. Certainly, we feel that CODI will have no problem absorbing these two acquisitions with no great difficulty. The Circuit Express deal was bought with cash sitting on the balance sheet. The Liberty deal is being funded from the unused Revolver, which had $137mn in availability at year end 2009. The Liberty assets will presumably increase the borrowing base. We’re assuming $35mn of additional borrowable against assets, which would take the borrowing base close to $175mn. Net of the $70mn Liberty purchase that still leaves CODI with $100mn in availability under its Revolver. (The Revolver has a nominal limit of $340mn but real availability, though, depends on collateral available).
Debt to equity was at 64% at year end 2009. These new deals should still leave Compass at well below a 1:1 liabilities to equity. Still, the stock price has been dropping (after rising in the preceding days) , despite a generally rising market for BDCs. Maybe the market presumes Compass will be raising additional equity, which usually causes a short term drop in the stock price ?
CEO Massoud suggested in today’s press release that there are more deals likely to come down the pike:
“Furthermore, we are optimistic that in the current environment, we will have additional opportunities to acquire businesses attractively on behalf of our shareholders.”
Given CODI’s conservative balance sheet approach in the past, the prospect of further acquisitions in the near term could result in management raising more equity to keep the balance sheet super-strong.
Disclosure: Long CODI