“There’s always a bull market somewhere.”
One of Jim Cramer’s 25 Rules For Investing proposes that, even in the worst of times, there are opportunities for gain.
No doubt, the COVID-19 pandemic has created an economic downturn and caused market turmoil. Yet, there are companies positioned to not only survive but profit.
Because Compass Diversified Holdings (CODI) had positioned for acquisition, it’s on my list of companies positioned to survive. Whether the company will profit from this phase of turmoil will likely be determined by its next acquisition decisions.
Positioned For Acquisition
Compass Diversified invests in and operates middle-market niche businesses in both the consumer and industrial sectors. It operates similarly to a BDC (business development company) or a private equity firm.
In 2019, Compass recorded $331 million in gains on the divestitures of two of its businesses, Manitoba Harvest and Clean Earth. In the Manitoba transaction, the company received both cash and Tilray (TLRY) shares. Those shares were sold at a loss of $10.2 million.
In November 2019, Compass issued 4.6 million shares of its 7.875% Series C Cumulative offering (CODI.PC) for $115 million. The first call date is January 30, 2025.
The company used the proceeds from the divestitures and preferred stock issue to pay down long-term debt. In 2019, long-term debt dropped from almost $1.1 billion to less than $394.5 million.
At year-end, with $100 million in cash on its books, Compass Diversified had prepped its balance sheet and leverage position for acquisition.
We currently have more capital availability than at any time in our history, and our leverage remains well below our target level – at only 1.5X. (emphasis added)
As well, it seemed Compass was purposely targeting larger businesses than it had in the past. The company’s success with 5.11 Tactical, its largest acquisition to date at approximately $405 million, seemed to be fueling its future intentions.
We continue to be pleased with the performance of 5.11 and maintain our view that this business will be our fastest growing subsidiary over the long-term and has transformational potential to the entire CODI business.
Plus, the company didn’t believe the performance of 5.11 Tactical was happenstance.
5.11’s impressive growth follows our restructuring of the business in 2018 and we believe is a direct result of actions taken at the time, along with continued investments in people, systems and logistics.
Yes, it certainly appeared Compass was poised for bigger bites and bigger challenges to start the new decade.
2020 First-Quarter Results
Compass Diversified Holdings reported 2020 first-quarter results on April 30th. Sales on continuing operations were 1.6% lower at $333.4 million as compared to $338.9 million in the first quarter of 2019. In its four consumer businesses, 5.11 Tactical and Liberty Safe generated revenue gains of 8.7% and 12.4% year over year, respectively, while Ergobaby and Velocity Outdoor experienced declines of 12.5% and 2.4%, respectively. The end result was a $6.9 million gain in the consumer segment. All four industrial businesses – Advanced Circuits, Arnold Magnetics, Foam Fabricators and Sterno Products – experienced declines. The 7% decrease in the industrial businesses totaled $12.31 million.
Due to a $5.3 million decrease in the costs of sales, Compass’ gross profit was basically flat year over year. Operating expenses were also basically flat year over year, which resulted in relatively equal operating income.
Net income from 2019 to 2020 are not comparable due to the divestitures mentioned previously. As a result, the comparisons of adjusted EBITDA and CAD (cash available for distribution) are better measures. In the 2020 first quarter, adjusted EBITDA totaled $46 million, 5% lower than the 2019 first quarter. Cash available for distribution was basically flat year over year at $17.66 million in 2020 and $17.65 million in 2019.
Compass also announced an acquisition target in the first quarter of 2020, a 95% stake in Marucci Sports of Baton Rouge, Louisiana. The company was to fund the $200 million purchase by drawing on its revolving credit facility. The transaction closed in April, 2020. The company likens the Marucci brand to other highly successful brands, both previously and currently, in its portfolio. In January 2008, Compass Diversified purchased Fox Factory Holding, a manufacturer of high-performance suspension products, for $80 million. In August 2013, Fox Factory Holding (FOXF) completed an IPO. And as mentioned already, 5.11 Tactical is currently expected to be the company’s fastest-growing subsidiary.
Much like our prior subsidiary Fox Factory and 5.11, Marucci has created an aspirational brand by appealing to the top performers in its respective market.
At the end of the 2020 first quarter, Compass Diversified had $291 million in cash and equivalents. Its long-term debt obligation was $594.7 million, of which senior notes comprise $400 million. With the Marucci transaction, the company’s leverage ratio did increase to 2X. Its debt covenants allow a leverage ratio of 5X.
After the closing of the Marucci transaction, the company would have had $91 million remaining in cash and equivalents. The 2018 Credit Facility provides $600 million on a revolving credit facility, and Compass had drawn $200 million against it for the Marucci acquisition. It also has the ability to increase this revolving credit facility by $250 million. Thus, Compass Diversified had just over $650 million in credit availability.
Just days after the 2020 first quarter report, Compass announced it would offer 5 million common shares at a price of $17.60 per share. The company should gross $88 million on the offering. The proceeds are to be used to pay down debt. After this offering, Compass would have nearly $750 million in credit availability.
On May 5th, Compass Diversified announced a private add-on offering of its 8% senior notes due 2026. The offering is expected to generate $200 million. The majority of the proceeds will be used to pay down the remainder of the credit facility. The remainder of the proceeds would be used for general purposes and to fund acquisitions. After this offering, Compass would have the full $600 million in credit availability, as well as the option to upsize the facility by $250 million.
Yet again, it certainly appears the company is positioning to make larger acquisitions. At the Bank of America Merrill Lynch 2019 Leveraged Finance Conference in early December, 2019, Compass shared its motivation.
If we’re roughly $250 million of EBITDA today, it should be upwards of a $1 billion a decade from now.
Other Factors Influencing Acquisition
Having available cash and credit is but one factor in the acquisition equation.
In a previous earnings call, Compass Diversified explained why it hadn’t moved on potential targets.
We think that asset prices, obviously, have been very high for the last couple of years. But borrowing costs are extremely low, as we all know right now, and capital remains very plentiful. So, our view is there’s – it’s unlikely we’re going to see – unless we go into a global recession, it’s unlikely we’re going to see a material downward change in private market valuations.
In the 2020 first-quarter earnings call, Compass validated its strategy and affirmed it would not pass on the right acquisition because of economic conditions.
We believe the best opportunity to generate long-term shareholder value occurs by acquiring premium assets during market dislocations like we are currently experiencing. While we will always prioritize the financial health of the company over strategic acquisition and this time will be no different, we are constantly evaluating the best ways to enhance our portfolio. We enter the year with significant balance sheet strength and will seek to capitalize on select opportunities, while maintaining a balanced approach to risk taking. (emphasis added)
The company suspects the economic downturn created by the COVID-19 pandemic will create the type of market dislocation necessary to reset asset prices.
The cooling of asset prices due to reduced economic activity was something that we were… look, we need it, frankly, given the size of our balance sheet and the strength that we had and the inability to find assets to put money to work in. And so, although we hate the reason that asset prices are coming down due to a health pandemic, we do think that it is very much beneficial for how we are executing our strategy right now.
Furthermore, Compass believes it should be able to react more quickly than private equity firms.
And so, as prices in the public market come back and for issuers like ourselves who have seen our stock come back, our bonds trading back above par, our preferred trading back towards par, there’s an arbitrage that starts to exist where we’re starting to perform much better in our securities. But, the private markets and the buyers who would be competing are still frozen out of markets. And we think that creates sort of the ideal condition for us to be able to be active and create value for the long term for our shareholders. So this is frankly what we’ve been waiting for.
Still, the company warned there could be obstacles in closing deals.
Sellers are reluctant to, I think, right now, come to grips with the reduction in valuation that will absolutely change as markets could sort of come back.
Though Compass is positioning to create long-term shareholder value, it does not intend to capitalize on the pandemic by any and all means.
For example, because it expects earnings in the second quarter to be negatively impacted due to the economic downturn, the holding company will waive 50% of its management fee for the quarter. As well, the Board of Directors will waive 50% of its compensation for the quarter. It has also decided to defer incentive payments related to five-year anniversaries. These decisions are expected to improve cash flow by approximately $10 million for the year.
In another example, Compass Diversified does not intend to apply for certain initiatives provided by the government through the CARES Act.
I think, the PPP [Paycheck Protection Program] plan, and we’re seeing some backlash to public companies that have access to capital that are taking it. I think that was designed more for smaller, privately held companies that don’t have access to capital. Our liquidity is awesome, to be honest with you, and we feel that the earnings power of our company is, on a comparative basis, holding up extremely well. And so, we wouldn’t feel, morally, that it’s correct for us to apply for these programs that are designed for companies that need it and need it just to keep people on their payroll. And so, we have adequate capital; we have adequate resources to be able to make it through. Our companies are positioned really well and performing, to be honest with you, much better than our expectations if you had asked us four or five weeks ago. And so, we don’t feel that it would have been morally right to accept those payments, even if we were eligible.
It appears evident that Compass Diversified expects positive momentum regarding its acquisition strategy as a result of the COVID-19 pandemic. On the other hand, as a result of the COVID-19 pandemic, management also felt compelled to withdraw full-year guidance.
The company did offer a projection for adjusted EBITDA in the 2020 second quarter in a range of $28-38 million. This represents a decrease of 30-50% compared to the $52.1 million generated in the 2019 second quarter.
It did relay a glimmer of hope for the quarter.
April’s tracking a little better than expected.
Despite the many signals indicating a larger acquisition could be at hand, Compass Diversified’s CFO, Ryan Faulkingham, seemed to derail such an idea.
I think, in our minds, finding some add-ons to existing companies is a great potential use of capital in this near to intermediate term – in that three to six month period.
Thinking about a substantially large platform deal in the next three to six months is very low likelihood just given the uncertainty in the markets, uncertainty in cash flow streams, valuations et cetera.
Long-term shareholders may remember Mr. Faulkingham expressed similar hesitation in 2016.
We remain able to acquire businesses – both add-on as well as platforms. Can we buy a 5.11 size business today? No. But, could we buy $100 million to $200 million platforms? Yes. So, we are still in business. We are still looking. There are still a lot of great opportunities. And, as you know, in the past too, one of the best ways or a great way for us to deploy capital is through add-ons given their accretive nature.
Yet, the company’s CEO at the time, Alan Offenberg, was quick to counter the limitations.
And here is the yin and the yang relationship that exists between Elias and me versus Ryan. While we never take for granted the support of the debt and equity capital markets, I would go so far to say that, while Ryan is factually correct that maybe today we do not have the liquidity to acquire a 5.11-sized transaction at this moment, I can also tell you that we definitively are looking for opportunities just like that in addition to the size that Ryan referenced because we believe that if we are able to find opportunities of the quality of a 5.11, for example, and we are able to bring additional cash flow to CODI that we would hope and it would be consistent with history, that we would be able to find the support to enable us to consummate an acquisition of that size. (emphasis added)
Since then, Compass Diversified has diligently improved its capital availability. Also, Mr. Offenberg has turned the reins over to Elias Sabo. And it is actually Mr. Sabo signaling the desirability of larger acquisitions.
Disclosure: I am/we are long CODI, CODI.PA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I belong to an investment club that owns shares in CODI and CODI.PA.