There’s nothing better than finding an undervalued stock with a huge dividend. Particularly in these volatile times, dividend stocks are highly advantageous, as they provide a source of cash flow to your portfolio, even when the general direction of the market is down.
While dividend stocks are often great for retirees looking for a source of extra cash, younger investors shouldn’t ignore their importance, either. Dividends can provide some insurance against market volatility, giving an investor more cash to buy in “on the way down”; thereby boosting long-term returns. In a world where correlation among stocks and other asset classes appears to be on the rise, this can be important.
Another advantage of dividends is they are the best reaffirmation of earnings. Companies can play games with their financial statements, but it’s difficult to pay out large dividends over a long period of time unless there was a lot of truth to a company’s earnings claims.
While “BIG DIVS” aren’t my number one consideration for purchase (valuation and growth potential are much more vital), I do look upon sustainable dividend payments very favorably in my analysis. Over the past few years, I’ve invested heavily in REITs, and have also made a few MLP investments. While I still have some investments in those two realms, I have definitely been on the lookout for companies that can generate higher-than-average growth; and if they can do so while paying out a dividend, all the better. And one dividend-paying growth-oriented company I’ve become particularly interested in lately is Compass Diversified Holdings (CODI).
What Is Compass Diversified?
In a technical sense, Compass Diversified is a “grantor trust.” However, it shares a lot of attributes with a “business development company” or “BDC” as they are commonly known. A BDC is essentially is a publicly-traded private-equity firm that must distribute 90% of its earnings out to shareholders in the form of dividends.
Compass was founded based on the premise that the private equity model was flawed. Former CEO Joseph Massoud criticized misaligned incentives in the industry that not only encouraged PE funds to make poor investments, but also encouraged them to exit good investments at sub-optimal times. Compass’s goal was to create a better model; taking what PE firms have done well, while eliminating some of the misaligned incentives.
There are several major advantages to Compass’ structure. For one, it provides access to smaller investors, whereas most PE funds are only accessible by wealthier individuals and institutional investors. Another advantage is liquidity; as an investor, you can buy and sell your interest in Compass much more easily than you can a PE fund. Moreover, if you invest in a PE fund, you will normally be required to commit capital on demand, based on the terms of a long-term contract with the PE fund; you have no such worries with Compass or another BDC.
There are also advantages from Compass’ perspective, as well. As a publicly-traded company, Compass can access capital much more easily. This structure also provides Compass with more flexibility on when to enter and exit investments. For instance, a PE fund might have a 10-year time horizon, in which it has to find adequate investments, improve them, then sell the companies off, and distribute dividends back out to investors. Compass doesn’t have to worry quite as much about this; if it decides that it can continue to grow a firm for 10 years, it could chose to hold it the entire timeframe, rather than being required to sell off 3-4 years down the line because of a contractual time horizon.
Strategy and Recent History
Compass makes control investments (i.e. takes majority control) in companies with good business models and strong brands in niche industries where it doesn’t have to worry about technological obsolesce. The firm’s goal is to acquire the companies at reasonable prices, then to help the firms continue to grow over time. Once it meets its objectives, Compass might chose to sell off the firm to an outside buyer.
CODI’s stock price peaked around January ’11, when it sold as high as $18.50. Since then, the stock has gone into a marked decline, partially fueled by an announcement in mid-February that CEO Joseph Massoud would be taking a temporary leave of absence to focus on an ‘informal regulatory inquiry’ on matters ‘unrelated to Compass.’ Since then, the stock has dipped as far down as $11.50. The stock has seen a recent resurgence up to $13.50 in the past few weeks.
The Compass Thesis
Compass attracts me for several reasons:
(1) Insider confidence. Insiders have a significant ownership interest in the company and have been making significant and consistent buys over the past two years at prices between $11 - $18. The stock has traded in the $11 - $14 range in recent weeks.
(2) Improving fundamentals. In spite of the Massoud LOA, there’s really nothing to suggest that Compass can’t continue to operate successfully. Fundamentals at Compass’ controlled companies have been improving and they’ve made good moves since that time.
(3) Portfolio selection. I like CODI’s mix of businesses with exposure to furniture, baby products, home and gun safes, and circuit boards, amongst other industries.
(4) Camelbak acquisition. In particular, I’m a big fan of Compass’ recent acquisition of Camelbak. In my view, they purchased it at a very reasonable price and I believe the market is underestimating how much this firm will contribute to Compass’ future cash flows.
(5) Track record. While the firm has a relatively short history of six years, it has shown significant progress in growing revenues and operating income from its portfolio of companies.
(6) Conservative valuation. I view the market’s current valuation as being relatively conservative and implying minimal growth. I see a valuation above $14 as being more reasonable and the firm has considerable upside beyond that.
(7) High dividend yield. The firm has about an 11% dividend yield as I write this article.
Compass’ Portfolio Companies
Compass currently lists eight portfolio companies on their website. I’ll provide a brief overview of each:
(1) Advanced Circuits. A manufacturer of printed circuit boards, with customers in the US and Canada. AC Holdings is one of the first companies Compass acquired, holding it since 2006.
(2) American Furniture Manufacturing. A leading low-cost manufacturer of upholstered promotional furniture and is headquartered in Mississippi. Acquired in 2007 by Compass.
(3) Camelbak. Camelbak offers a line of hands-free hydration products including packs, water bottles, and specialized outdoor and military gear. Its products seem to be very popular with people who participate in outdoor recreational activities, such as hikers, trail runners, and cyclers. The firm was recently acquired by Compass for $258.6 million.
(4) ERGObaby. Designer and distributor of babywear products and accessories, including baby carriers. Compass acquired the firm in 2010.
(5) FOX Racing Shox. Designer and manufacturer of high-end suspension products for mountain bikes, ATVs, snowmobiles, and other off-road vehicles. Compass acquired FOX in 2008.
(6) HALO Branded Solutions. A leading distributor of customized promotional products. Acquired by CODI in 2007.
(7) Liberty Safe. Designer and manufacturer of home and gun safes in North America; headquartered in Utah. Compass acquired the firm in 2010.
(8) Tridien Medical. Manufacturer of medical therapeutic support surfaces and patient positioning devices. Products are primarily designed to prevent and treat pressure wounds on patients with limited mobility. The firm was acquired by CODI in 2006.
There are a few things I like about this mix. First off, I can understand the operations of all the companies in CODI’s portfolio. Personally, I prefer to shy away from a lot of industries such as high-tech and biopharmaceutical because I find that it’s difficult to understand them unless you’ve developed a large base of knowledge through education and career in those fields. All the companies above can be easily understood by anyone who makes a reasonable effort to learn about them.
While there are some companies in this mix I like more than others, I don’t view any of them as particularly bad companies to be involved with. And I particularly like the more recent acquisitions such as Liberty Safe, ERGObaby, and Camelbak; which are all strong brands with good growth potential. I also believe American high-end manufacturing may experience a bit of a revival this decade, and this is a good mix to play that thesis.
Now that I’ve laid out what Compass does and what I like about the firm, let’s take a look at the firm’s balance sheet.
What you can tell from the balance sheet is that a lot of Compass’ assets are of an intangible nature. In order to try to come up with a valuation for CODI’s operating assets, we need to look at their operations history. The chart below provides income statement and cash flow metrics for the past six years. Note that 2011 data is based on the first three quarters and not a full year:
Unfortunately, I’m not totally satisfied with the above measure of EBITDA. Note that I calculated it by taking operating income and adding amortization and impairments shown on the income statement. However, the cash flow statement suggests that depreciation and amortization is higher. Here’s an adjusted EBITDA using cash flow statement numbers:
Including the above EBITDA measures, I came up with four major profitability measures and annualized the results, based on information from the first three quarters of 2011.
Using the EBITDA – CapEx measure, I take an 8% cap rate in order to try to value the operating properties of Compass. That will allow me to back my way into a valuation, as seen below:
In the last line, you can see the valuation per share of $14.90 in this scenario. For fun, we can also do that with a slightly higher 9% cap rate:
Here, we come up with a slightly lower valuation of $13.30 per share. Of course, we can play around with these numbers quite a bit to change our valuations, but for any realistic scenarios, I come up with valuations between $11 - $16, using an assumption of relatively low growth. And keep in mind, this is essentially a growth PE fund, operating as a publicly-traded company. Therefore, my 3% - 4% growth rates may be extremely conservative. Moreover, I’m of the view that my valuation of Camelbak (at acquisition cost) is likewise conservative.
In Compass’ latest 10-Q, we can find the revenues, operating income, and net income for Camelbak for the first three quarters of 2010 and 2011. You can see that information below
Likewise, some balance sheet items are included
From what I can see here, Compass acquired Camelbak at a very low price/sales ratio, in the range of 0.13 – 0.15. That may be justified given Camelbak’s poor results in 2010 and their extremely low margins in 2011. In fact, Camelbak produced an operating margin of a mere 3.5% in 2011 and a profit margin of only 1.7%.
However, Camelbak is a very strong brand with a lot of potential, so I can see a ton of room for upside here. Even based on 2011 results, this would not appear to be an expensive acquisition, at something close to 4x operating income and 8x earnings.
So I really like this acquisition and believe there’s a lot of upside, particularly for a firm like Compass that can hold onto this company for a much longer-term timeframe than a traditional private equity firm. If Compass can grow the top-line and improve the margins, it’s not unrealistic to expect Camelbak to start producing profits that are at least 100% - 200% over the current level.
Criticism and Other Resources
The only major criticism of CODI that I am aware of is that some view its dividend as unsustainable. Certainly, it’s difficult to disagree with the contention that Compass’ dividend is aggressive; but I do not view its dividend as unsustainable, based on the analysis of cash flows above. This is not to say it's impossible to envision a scenario where the dividend is temporarily reduced over the next year, but over the long-term, I expect the dividend to grow, rather than shrink.
As for other resources, Debra Fiakas penned an article in June, offering a good overview of Compass. Other pieces I’d recommend related to Compass include BDC Reviews’ “New Criteria for Ranking Dividend Darlings” and Nicholas Marshi’s article on the implications of the Staffmark IPO.
With an 11% dividend, Compass provides a very sizable dividend stream that should be attractive to many investors. At the same time, the firm’s primary focus is finding small and middle-market firms and growing them, so this is not necessarily a low-growth value stock; even though the market appears to be pricing it as one. So buying into Compass right now, you get growth potential, without actually paying for the growth. That’s what I like to see as an investor!
I started buying into CODI in the $11.50 - $12.25 range. Unfortunately, the writers’ curse took over and as soon as I started penning the article, it took off to the $13.50 price level! All the same, I still view it as attractive at these levels. Even based on conservative valuations with low growth assumptions, the firm should be worth about $11 - $15. Yet, with some attractive acquisitions and a team that can help grow their managed firms more rapidly, there is a considerable amount of upside here. Don’t be surprised if the dividend stream continues to grow at a good clip over the next few years. I have made this one of my larger holdings over the past month.