Compass Diversified Holdings Is No Dinosaur

| About: Compass Diversified (CODI)

A panel of senior executives holds forth from a dais to a room packed with investment bankers anxious to hear the fortunes of a collection of businesses owned by a parent company. Their sonorous tones about revenue growth and profits echo off the walnut paneled walls of the plush hotel hosting the event. If it were it not for the steady tap-tapping of analysts sending messages on their smartphones it could be the 1960s, when the holding company was the corporate structure de jour for its unique ability to hedge business risk.

The occasion was actually an analyst day held recently by Compass Diversified Holdings (NYSE:CODI) at New York's Palace Hotel. Compass is a modern-day holding company and proud of it. It is the controlling owner in eight business operations ranging from Fox Racing Shox, a producer of advance shock absorbers and related equipment, to Advanced Circuits, the largest independent quick-turn printed circuit board manufacturer in the U.S. Add in American Furniture Manufacturing, with its sofas and recliners, and ERGO Baby, a producer of baby carriers and tummy packs, it appears to be an odd collection.

To Compass management, its far flung holdings make a great deal of business sense. The portfolio of eight investments is the fruit of a dogged search for middle market businesses with niche product lines and growth prospects. Compass looks for basic businesses with "solid reasons to exist" and little risk of obsolescence with time. A key ingredient is also strong, empowered management teams who have signed on for the long-haul. However, the most critical element in all potential acquisitions is the ability to generate cash.

Cash there is. The Compass eight collectively turned 3% of their sales into cash in the last five years. Cash resources are ample for working capital and capital investment to support and grow operations. Even though there is apparently a comfort level among Compass' creditors to lever the balance sheet by as much as three times equity, with all that cash around to spend, Compass debt remains less than a quarter that level.

The rest of the cash has gone out the door to shareholders in the form of dividends - over $200 million over the past five years. Compass is currently paying a $0.36 quarterly dividend that translates into a yield over 9.0% at the current stock price. This makes Compass shares, which have traded on the New York Stock Exchange since the company's initial public offering in 2006, as much a distribution story as it is a holding company making good.

Conspicuously absent from the gathering at the Palace Hotel was Joe Massoud, chief executive officer of the Compass parent. In February 2011, the company announced Massoud would take a temporary leave of absence, citing nothing more than the need for Massoud to focus his time on an "informal regulatory inquiry" unrelated to Compass. Apparently, little more has been heard from Massoud since and, despite prodding from the audience, Compass leadership at the Palace stayed tight lipped on the subject. Massoud is no longer a member of the Compass board of directors but remains a director of Teekay Group, LLC, the general manager of NYSE-listed Teekay LNG Partners (NYSE:TGP).

Compass shares fell dramatically following Massoud's abrupt departure, turning the stock into a value story as well as a dividend play. The stock has failed to fully recover and now trades at a modest 8.0 times forward earnings. The average of estimates published by analysts following suggests the Street is expecting growth in excess of 10% this year - a growth rate that may justify a higher earnings multiple.

Aside from the drama in the Compass executive suite, there is little excitement in the Compass basket of shock absorbers, furniture and circuit boards. What is more, there is quite a bit of heavy lifting for any investor considering a position in Compass. Indeed, the holding company structure nearly went the way of the dinosaur because investors were put off by the need to evaluate the performance of each operation in the holding company structure as well as critique the merits of the parent's balance sheet, acquisition strategy and management track record.

Given the apparent value in CODI, establishing a long position in Compass may be well worth the extra effort. In addition to getting a stock on the cheap, shareholders are paid a handsome dividend while they sift through the holding company financial reports.

Top priority in all that sifting has to be the Compass cash flow statement. The string of recent net losses may give some investors some trepidation over the sustainability of the impressive dividend. Consistent positive cash flow generation should boost investor confidence. Depreciation and amortization are significant adjustments to the bottom line in all periods. Working capital accounts provided the significant portion of the $39.8 million in cash generated in the first quarter 2011. Combined operations pumped up cash with $23.4 million in new payables in that quarter, a feat that cannot be repeated too often. The mark-up and mark-down of the contingent liability associated with a put option given Compass' managing entity -- an element of the holding company arrangement.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.