Compass Diversified Sells Largest Subsidiary

| About: Compass Diversified (CODI)

On October 17, after the market close, Compass Diversified (NYSE:CODI) made a surprise announcement: the sale of its largest subsidiary and previous IPO candidate: Staffmark Holdings. Compass Diversified owns a portfolio of operating businesses, all held as separate subsidiaries. CODI has been called a mini-conglomerate or a mini-Berkshire Hathaway (NYSE:BRK.A). The Company is also a regular dividend payer. At the BDC Reporter we typically track Business Development Companies ("BDCs") but we do also follow a few related companies like Compass Diversified because - like BDCs - it is invested in private middle market companies, and pays a sizable and regular dividend.

Anyway, the press release said CODI sold Staffmark to a Japanese company in the same business for $295mn. Compass does not own all the shares of Staffmark, so the proceeds to the Company were $220mn. Also notable is that Compass no longer has to post nearly $70mn in letters of credit for its subsidiary to support workmen’s comp insurance. This ends the Staffmark saga, one of the longest held investments in the ever-increasing Compass company portfolio. Just a few months ago, Staffmark was going to go public, but then the economic winds changed direction and we heard nothing more until yesterday’s announcement.

Impact Of Staffmark Sale

We thought it might be useful to analyze what the Staffmark sale might mean for the company and the shareholders. Compass has been down this path before. Periodically the Company has sold portfolio companies for a sizable gain, used the proceeds to pay down debt and continue the permanent hunt for new acquisition opportunities. As the press release boasts, the Company now has about $185mn in realized gains from such dispositions , with Staffmark accounting for nearly half of the amount.

Balance Sheet Impact

From a balance sheet point of view the proceeds from the sale are going to “substantially repay” all of the the Company’s Revolver outstandings with Madison Capital, its lender. The latest 10-Q from June shows only $15mn in Revolver outstandings. It’s hard to tell, but we’d guess Compass will have at least two hundred million post-Staffmark in borrowing base capability under its nominal $340mn Revolver to use for acquisitions and other purposes (see below). There is a Term loan with $73mn outstanding. We’d have expected management to say that was being paid off too, but no word. Maybe management intends to keep any net proceeds in cash. In any case, Compass will be virtually un-leveraged after all the dust settles. The manager of Compass will be making $11-$15mn on the deal, already accrued for on the books.

Cash Flow Outlook

From a cash flow viewpoint there is no guidance from Compass. We reviewed the latest 10-Q and that seems to suggest that the “adjusted” EBITDA contribution to the consolidated $57mn CODI earned in the first 6 months of 2011 was just under 20.0% (see page 44 if you want to see for yourself). That’s a sizable hit to cash flow in the short term, especially as we don’t know if American Furniture - Compass Diversified’s under-performing albatross - is going to need cash rather than contribute any. Also, another subidiary - Tridien - has been on the downswing. Plus, we don’t know how the change of economic sentiment has affected the Compass portfolio generally. It seems certain,though, that the Company’s own metric for cash generation called Cash Available for Distribution (“CAD”) will go down in the short term. Given that CAD was not quite covering the dividend liability even before the Staffmark sale, Compass won’t be generating enough cash from its medley of businesses going forward to cover its pay-out.

Outlook For The Dividend

Will shareholders be in the ironic position of earning a big capital gain on one side and having the dividend cut on the other ? We don’t think so, although Compass has not explicitly promised to maintain the current dividend level. Instead, we have this ambivalent statement from the CEO in the press release:

As in the past, we intend to utilize the proceeds from the sale of Staffmark to further strengthen our balance sheet and take advantage of both internal and external opportunities, while maintaining the ability to provide attractive distributions to our owners.

You be the judge of what that means. “Attractive dividend opportunities” is not necessarily unchanged dividends. Anyway, if history is any guide, we expect Compass management will make up any shortfall in CAD by using cash and borrowing base capacity on the Revolver to maintain the current dividend. Down the road, though, we expect Compass to find additional acquisition opportunities and as the press release suggests the new deals may as readily come from add-on opportunities in the 8 remaining businesses as from a de novo purchase.

Disclosure: I am long CODI.

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