Compass Diversified: Dividend Is Okay, But for How Long ?

| About: Compass Diversified (CODI)
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Compass Diversified Holdings Declares Fourth Quarter 2009 Distribution of $0.34 Per Share – Yahoo! Finance.

We track the Business Development Company [BDC] industry, but Compass Diversified Holdings (NYSE:CODI) is not a BDC but a Grantor Trust. Moreover, the Company is not a lender and investor in private companies like BDCs, but an owner. In fact, Compass is effectively a mini-conglomerate of smaller companies in a variety of unrelated industries. Nonetheless we lump CODI in with the BDC industry because both are involved in bringing finance to private companies, and both pay out regular distributions.

Today, the Company announced an unchanged dividend of $0.34 for the quarter ended December 31, 2009. As the press release points out the Company has been paying a dividend every 3 months since going public in May 2006.

Usually dividend announcements pass without much comment. Certainly this announcement was expected. CODI has been paying out 34 cents since the IIIQ of 2008. We just want to point out that the Company has a philosophy of paying out a dividend that is not directly related to current earnings. We estimate Compass is paying out in 2009 2x what it is earning in cash terms after paying all expenses, interest expense, etc.

Both the market (which has the stock pegged at $13.00 or 19X 2009 cash flow) and Compass itself are counting on earnings increasing in 2010 and beyond to make up the difference. Certainly management has been suggesting 2010 should be better than 2009. High hopes are being placed on Staffmark, CODI’s temporary help portfolio company, to contribute to the earnings growth, after under-performing this year. Then there’s all the dry powder the Company has available in undrawn Revolver capability to make add-on or new acquisitions.

That’s all very well and good and is more likely to happen than not. The unvarnished fact, though, is that Compass is still paying out half of its distribution out of capital, rather than profits. From a Liquidity standpoint that means the $46mn of cash on the balance sheet will melt away like a polar ice cap in less than two years on the current running rate of earnings.

So here’s the risk in our estimation: should CODI’s earnings fail to ignite for whatever reason, management will eventually have to cut back the dividend to equal cash generating capacity to preserve cash. What that level of earnings (and therefore the dividend) will be is anyone’s guess but if we stick with the current run rate it suggests CODI would cut its pay-out by 50%. On today’s stock price, the yield would drop to 5.2%, not disastrous but not pretty. With the market anticipating only income growth, CODI could go to well under $10 should the dividend be cut.

We’re not there yet, but such a scenario is not inconceivable in an economy that does not achieve lift-off (as some are warning). It’s a story that’s being repeated throughout the stock market as valuations are bid up on expectations of earnings being not just better than 2009, but substantially better in the years ahead. We’re not waving our Red Flag here (warning of a possible dividend cut, which all income investors hate) but pointing out that the penalty for a change in CODI’s prospects is high. We will be poring over the IVQ 2009 results with exceptional enthusiasm.

Compass Diversified Holdings Declares Fourth Quarter 2009 Distribution of $0.34 Per Share – Yahoo! Finance.

Author's Disclosure: Long CODI