Compass Continues To Offer Some Value

| About: Compass Diversified (CODI)


Redeploying capital into acquisitions like 5.11 Tactical has reignited growth and improved distribution coverage for Compass.

ERGOBaby, Sterno, and Clean Earth have continued to make solid contributions (helped by acquisitions), while 5.11 Tactical could have above-average growth potential if it catches on with a wider audience.

Fair value looks to be around $18 to $19, and Compass should have a strong enough cash flow base in 2018 to consider raising the distribution.

It has been a while since I’ve written on Compass Diversified Holdings (NYSE:CODI), a trust that specializes in acquiring stakes in small-to-mid-sized companies, letting those management teams do their thing, and then harvesting the cash flow for distribution to shareholders and/or reinvestment in expanding the business. In the interim, CODI has basically stuck to its core model – disposing of a few assets, raising some capital, and redeploying capital into new acquisitions that should provide growing distributable cash flow into the future.

CODI shares are up about 15% since I last wrote about the business, but during that time, shareholders also collected sizable distributions (which are taxed differently than regular dividends). Although I do still have some concerns about the modest long-term growth prospects of the portfolio and the frequent quarter-to-quarter turbulence in portfolio company results, I still see enough value to make this a worthwhile name to consider for investors who want returns that are more skewed toward income. Should opportunities like 5.11 Tactical live up to their potential, though, there may be a little more growth potential than commonly appreciated.

A Diverse Mix, For Good And Bad

A lot of sell-side analysts like to harp on the “unique” qualities of Compass’s business model, and I will acknowledge that there are some special attributes here. The company is structured differently than business development companies or private equity vehicles, and the company has a long and consistent history of not reducing its distributions. While the company has, from time to time, stretched its liquidity and seen its cash flow drop below the level of its distributions as it buys or sells businesses, management has always moved relatively quickly to fix those concerns.

Compass has always operated a curious mix of businesses. Since management prioritizes owning niche businesses with low technology risk and relatively defensive characteristics and not cross-company synergies, the portfolio is a hodgepodge of retail-oriented and “niche industrial” companies.

The largest contributor to revenue (at close to one-quarter) is one of the newest businesses in the nine-company portfolio – 5.11 Tactical, which Compass acquired in 2016 in its largest-ever purchase ($400 million). Sterno and Clean Earth follow, with each contributing around 16-17% of revenue. The company’s EBITDA make-up is a little more diverse with five companies contributing double-digit percentages of adjusted EBITDA (led by Clean Earth, ERGOBaby, 5.11 Tactical, Sterno, and Advanced Circuits).

Compass’s holdings operate in businesses ranging from tactical gear and apparel (5.11 Tactical) to baby products (ERGOBaby), specialty printed circuit boards (Advanced Circuits), hazardous waste cleanup (Clean Earth), foodservice (Sterno), and several other businesses (including hemp-based foods and rare earth magnets). The good and bad of this diversification is that there’s not all that much correlation between the businesses. With that, every quarter has its outperformers and underperformers though there have been some longer-term trends – ERGOBaby, Sterno, and Clean Earth have established pretty good track records, while Arnold (magnets) has been a long-term laggard, as have Liberty (gun safes) and Advanced Circuits (though this business generates good margins and cash flow).

Will 5.11 Tactical Be The Next Big Winner?

Having followed Compass for a number of years, I’d say the company typically manages a portfolio of “okay” businesses; there hasn’t often been a lot of breakaway growth or future stars in the portfolio, but the businesses typically do what they’re acquired to do – generate cash flows that can be distributed to shareholders. From time to time, though, a business will rise above the rest. Fox Factory (FOXF) (which Compass has sold out of) was one, as was CamelBak (sold to Vista Outdoor (NYSE:VSTO) in 2015 at a nice profit). Now, it looks as though 5.11 Tactical could be the next breakout candidate.

5.11 Tactical specializes in tactical gear and equipment for law enforcement (including clothing, footwear, accessories, and breaching tools), fire/rescue, and military, but also has a growing recreational/lifestyle business. In some respects, 5.11 Tactical reminds me of businesses like Under Armor (UA) and Lululemon (LULU) that started off as high-quality suppliers to specialty segments and really took off once their products started catching fire with the broader public. While “tactical pants” and $65 shirts would probably seem to have a limited addressable market, I’d ask skeptics to look at the prices that Lululemon was able to charge during its heyday.

5.11 Tactical sells largely through other dealers/stores, but it is starting to open its own stores and more heavily promote its online/direct sales channels. Sales growth has been crimped recently by an ERP installation and some lumpy order trends, but the sales growth outlook is still relatively solid. If the business can reach that critical mass of wider popularity, sales could really ramp up, though such a ramp would likely require substantial capital re-investments to support (and I could see Compass choosing to spin it out through an IPO).

They Won’t All Be Winners

While I do think the 5.11 Tactical business is a potentially interesting one for Compass down the line, not every business Compass acquires and owns works out as planned. I’ve always been a little puzzled as to why Compass bought Manitoba Harvest, as this manufacturer and distributor of hemp-based food was less established and more speculative than what I think of as the typical Compass candidate (though it is a market leader). To be fair, though, while Manitoba Harvest’s recent performance has been erratic, there’s still double-digit growth potential here and the margins aren’t bad.

Arnold, on the other hand, has had a harder go of it. This business has seen continual sales erosion for over six years and Compass recently changed the management team. I wouldn’t say that a turnaround seems to be just around the corner, but here again this is a solidly profitable business in margin terms and isn’t hurting the company other than perhaps tying up capital that could be redeployed into a better business.

The Opportunity

Although I do think there are businesses within Compass that could/will grow nicely, I expect the overall business to grow revenue at a mid-single-digit rate. While I think both 5.11 Tactical and ERGOBaby could see some improving margin leverage as the businesses grow, I’m not looking for all that much margin leverage from the other businesses; a turnaround at Arnold should lead to better margins, but I think most of the portfolio is otherwise geared to modest margin improvement. With that, I expect FCF margins (and FCF growth) to remain in the high single-digits over the longer term.

There are multiple ways to try to value Compass, but I prefer a two-pronged approach. I try to model the free cash flow (and the distributable cash flow) that the business as a whole can generate and discount that back. I also use a sum-of-the parts valuation using comp-group EBITDA multiples. Oddly enough, this two pronged approach has often given me similar results, and I currently end up with a fair value range of $18 to $19.

Looking at distributions, management reiterated earlier this year that they wanted to build up a distributable cash cushion before raising distributions. Distributions haven’t grown since 2011 and exceeded distributable cash flow in both 2016 and 2014. Cash flow should exceed distributions this year, with a more comfortable spread in 2018 that could support a long-awaited increase in the payout (likely not until the second half).

The Bottom Line

Anybody considering Compass needs to make sure they understand the different tax treatment of the distributions and the ramifications to their own tax situation. I’m not a tax professional, and I’d strongly urge readers/investors with questions about the tax ramifications to ask an actual tax professional. Aside from that added layer of complexity, though, I believe this is a name that is still worth consideration from investors who want an income-dominant investment. Compass is never going to be the most exciting or dynamic business out there, but management has a clear plan that they follow, and that plan has generated quite a bit of capital returned to shareholders over the years.

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