Compass Diversified Holdings CODI
March 19, 2008 - 5:17pm EST by
oliver1216
2008 2009
Price: 11.90 EPS
Shares Out. (in M): 0 P/E
Market Cap (in M): 376 P/FCF
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT

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Description

Compass Diversified Holdings (CODI) is a misunderstood publicly traded private equity fund which invests in middle market companies (annual cash flows of $7mm to $40mm). Following a harsh sell-off, the stock now trades at 7.1x trailing and 6.4x 2008E free cash flow (FCF), pays an 11% dividend which it is more than earning and which we expect will be increased later this year, and is under-levered (net debt+min interest/pf 2007 ebitda is 2.2x).  The company is run by a disciplined management team which generated IRRs of 39% from 1998 – 2006 in their previous entity and insiders own over 30% of the company’s stock, including the $30 mm investment they made last May at $16 per share (nearly 40% higher than the stock’s current price).  Unlike many other private equity firms, CODI management is highly disciplined and does not have empire-building aspirations nor does it face pressure from LPs to put money to work. Furthermore, CODI’s management does more than just financially re-engineer companies’ balance sheets; they create value by working closely with portfolio companies to maximize long term cash flows (Cash flow at all of CODI’s holdings have increased organically since their acquisition).  Unlike most other financial companies, CODI is actually benefiting from the current turmoil in the debt market since the company has committed financing which enables it to make accretive acquisitions at highly attractive prices (sellers often will take CODI’s lower bid because of the certainty CODI will close on the acquisition).  Pro forma for all acquisitions, CODI has $275 mm of undrawn, committed bank debt which it can use to opportunistically make accretive acquisitions.  CODI provides full transparency on its investments which is atypical for private equity firms, but allows CODI shareholders to really know what they own.  CODI has a collection of easy-to-understand businesses, some of which are very interesting (e.g. high-tech coatings) and some that are boring (e.g. staffing); however, even the “boring” businesses have very interesting competitive dynamics.
We believe CODI is misunderstood and undervalued for the following reasons:
1)       The company’s “reported” financials are not fully reflective of the company’s current business.  Over the past year, the company has made several highly accretive acquisitions that are not fully reflected in its trailing numbers.  In fact, two of these acquisitions, totaling $215mm in enterprise value and having closed after year end, aren’t accounted for in the trailing numbers at all, but will contribute meaningfully to free cash flow in 2008.
2)       The company’s reported income statement distorts the company’s true free cash flows as a result of the significant non-cash charges the company incurs as a result of the its acquisitions (D&A is meaningfully higher than maintenance cap ex).
3)       CODI’s legal structure is similar to that of a Business Development Company (BDC) and the stock is generally followed by the sell-side analysts who cover BDCs.  In sympathy with the financial sector, BDCs have traded down significantly over the past year.  But in reality CODI is quite different from most BDCs and private equity firms because CODI:
a.       Makes equity, not mezzanine or debt investments
b.       Provides financials for all its portfolio companies
c.       Is more than earning its dividend
d.       Will not need to raise equity in the foreseeable future
e.       Insiders own significant equity in the company
f.         Is fully financed and thus benefits from the turmoil in the debt markets
4)       A fire at American Furniture Manufacturing, CODI’s third largest holding, has caused the market to worry about the potential financial impact of the incident.  However, as discussed later, we believe the company’s insurance will cover almost all of its PP&E and business interruption damage.
5)       The company has been able to step-up the value of recently acquired assets for tax purposes, so its cash tax rate is lower than book.
 
 
Below is the company’s valuation.  Analysts and CODI use the term Cash Available for Distribution (“CAD”), which is essentially free cash flow (the term that we prefer to use) and is defined as operating cash flow less maintenance cap ex.  Below we have shown CODI’s total EBITDA as well as its portfolio-level EBITDA (excluding corporate SGA and management fees) to illustrate the undervaluation of the underlying assets (in case the company were to be split up and sold).  We are not suggesting that the company will be split up anytime soon; however, management has indicated it has received bids for one or more of their portfolio companies.  We believe that, over time, if the stock does not trade to a more appropriate value that management, being major shareholders themselves, will break up the company.  (As discussed below, management has already sold one portfolio for a big profit.)  The minority interest arises because one of the way management incentivizes its portfolio companies is by having portfolio management own stock in the portfolio company.  The supplemental put is an accrued carry that would be paid to management upon realization of gains on the portfolio.  The 2008 figures assume no additional acquisitions; however, given the company’s limited leverage and disciplined acquisition strategy, any additional acquisitions would be highly accretive.
 
VALUATION
 
 
 
Stock Price
 $11.92
 
 
Shares Out
31.5
 
 
Equity Cap
375.8
 
 
PF Debt
205.0
 
 
Supplemental Put Obligation
34.0
 
 
PF Minority Interest
39.7
 
 
Less: PF Cash
-14.4
 
 
PF Enterprise Value
640.1
 
 
 
 
 
 
Total
Amounts
Multiples
 PF 2007 EBITDA
$103.7
6.2
x EV/EBITDA
 2008E EBITDA
$96.8
6.6
x EV/EBITDA
 2007A FCF / Share
$1.68
7.1
x P/FCF
 2008E FCF / Share
$1.87
6.4
x P/FCF
 
 
 
 
Portfolio-Level:
Amounts
Multiples
 PF 2007 EBITDA
$126.7
5.1
x EV/EBITDA
 2008E EBITDA
$112.8
5.7
x EV/EBITDA
 2007A FCF / Share
$2.22
5.4
x P/FCF
 2008E FCF / Share
$2.20
5.4
x P/FCF
 
Background
CODI was formed by the management of Compass Group Investments (CGI), a private buyout fund established in 1998 by the founder of TK Shipping.  During its 9 years at CGI, CODI’s management team generated IRRs of 39%.  CODI both commenced operations and came public in May 2006.  The IPO proceeds were used to purchase four portfolio companies from CGI.  Since its IPO, CODI has sold one of those four initial businesses (realizing a $36mm gain on its 8-month-old, $72mm investment), acquired five additional platform companies, and conducted four add-on acquisitions (which are merged into the platform companies).  As a reflection of CODI’s investment strategy, all portfolio companies share the following characteristics: 1) strong free cash flow generation due to limited cap ex needs, 2) dominant positions in their market niches, 3) low valuations at time of purchase and 4) talented, incentivized management teams. 
Overview of Portfolio Companies
CODI’s investment portfolio currently consists of the following (pro forma contribution to 2007 portfolio-level EBITDA given in parentheses):
·          CBS Personnel (35%), based in Cincinnati, OH is a leading provider of temporary staffing with a diverse customer base (no individual account represents more than 2% of revenue and the top 10 customers represent 15% of revenue), focusing primarily on the light industrial and clerical categories.  CBS, exclusive of a recent acquisition, ranks in the top 25 of U.S. staffing companies and has a top 10 market share in 11 of the 15 major metropolitan markets it serves, including the leading share in both Cincinnati and Dayton, OH.  CBS has 140 offices in 18 states in more than 100 cities.  No region accounts for more than 15% of total revenue with the exception of the company’s stronghold in Ohio which accounts for 25% of revenue.
Historically, CBS has maintained an edge over the competition through its longstanding relationships with customers, its multiple branch offices, and its deeper database of human resources.  These three factors have allowed CBS to offer both a higher quality and a greater mix of resources and support to its customers, and have resulted in market share gains at the expense of competitors who don’t have sufficient resources to match CBS’s service offering.  As a result, many of CBS’s competitors have either reduced their presence in CBS’s markets or exited them altogether.
CBS has continued to outperform the competition through the recent downturn in the staffing industry.  While many of its competitors have seen declines of 5% or more in domestic revenue, CBS’ same store sales declined only 2%.  (Overall, CBS’ revenue was up due to the full-year inclusion of an add-on that was acquired in late 2006.)  Margins have also held up well, declining only 50bp year/year.  CODI’s management has lived through a staffing downturn before with CBS: that period running form 2002 – 2003.  During that period, CBS sought out new customer relationships and captured new accounts while most competitors were retrenching.  As a result, CBS enhanced its market position for the eventual recovery.
CBS’s business was recently augmented by the acquisition of Staffmark, a Little Rock, AK-based light industrial staffing company with 229 offices in 18 states nationwide, most of which are complementary in geography to legacy CBS.  The add-on acquisition more than doubled the size of the combined operation to over $1 billion in revenues, and increased the company’s geographic reach from 144 offices to nearly 400.  This acquisition has several benefits; 1) provides CBS with coverage in several under-penetrated markets; 2) creates $10mm of annual cost savings; and 3) makes CBS/Staffmark large enough to eventually be spun-off (but we don’t expect that to happen until the companies have been fully integrated).
The Staffmark transaction, which is a little complicated because the sellers wanted to retain a 26% minority interest of the merged entity, valued the company’s enterprise at roughly 7.2x its 2007 EBITDA.  However, a tax-basis step-up (which will allow CODI to amortize an intangible asset over a 15-year period for tax purposes), reduces the acquisition multiple to roughly 6.2x EBITDA.  Moreover, since the acquisition will also result in back-office synergies that could approach $10mm, the acquisition multiple may be as low as 4x, pro forma for the synergies of approximately.  Given the attractive valuation, the increased geographic footprint, and the acquired talent (Staffmark’s excellent management team is locked up on a multi-year contract); Staffmark seems a very accretive deal for CODI.
As separate companies, CBS and Staffmark generated $25mm and $18mm in EBITDA, respectively for 2007.  Pro forma for cost synergies, the combined company’s EBITDA would have approached $50mm for 2007.  Analysts, however, are taking a conservative view on staffing industry for 2008, and consequently EBITDA for the new CBS is anticipated to be about $36mm in 2008. We consider that estimate to be very conservative, especially in light of the coming $10m of annual cost synergies.
·          Advanced Circuits (17%) based in Aurora, CO, is a specialized manufacturer of printed circuit boards (PCBs) focusing primarily on prototyping and quick-turn services, which are very different businesses from volume production of PCBs that most investors hate.  The company caters primarily to R&D professionals who are focused on developing new products.  Customer requirements in prototyping and quick-turn are quality, speed of delivery and support.  With the emphasis on quality of service as opposed to cost, quick-turn and prototyping generally command higher margins than volume business (the company’s EBITDA margins are 40%+ versus the industry average of less than 10%).  Moreover, since prototype work doesn’t lend itself well to off-shoring (because of the lower volume runs and shorter turnaround times), the prototyping business has enjoyed steady growth.  By contrast, domestic volume production of PCBs is down 60% since 2000 and continues to decline as production migrates to lower cost geographies.
The company has an estimated 15% of the fragmented quick-turn and prototype market with the next two competitors each holding less that a 10% share, followed by thousands of smaller companies.  The company has over 8,000 active customers and adds over 2,000 new customers per year.  No single account represents more than 2% of revenue and the top 100 represent 25% of revenue.  The company has over a 99% on-time rate and over a 98% error free rate despite the fact that 70% of orders are required within five days.  Customer retention is over 80% and nearly half of new customer referrals come from existing clients.  Advanced Circuit’s business continues to benefit from the proliferation of electronic devices and the ongoing trend to shorter and shorter product development cycles, and the closure of domestic competitors who are geared toward volume production and do not have the scale to survive on prototype and quick-turn business alone.
Advanced Circuits booked $52mm in revenue for 2007, up from $48mm in 2006, largely due to increased volumes in prototyping and quick-turn products.  Pro forma EBITDA grew to $21.6 mm, up from $20.3mm in the prior year, reflecting operating leverage on higher volumes.  Analysts project EBITDA to grow to $22.7mm on revenue of $54mm in 2008.
·          American Furniture (13%) was acquired in August 2007 for roughly 5.5x EBITDA.  The company is the leading manufacturer of promotional upholstered furniture sold to large scale distributors such as Value City, Big Lots, J.C. Penney and Bob’s.  Promotional furniture is generally sold at lower price-points ($200 – $600 range), and is offered in a limited range of available designs allowing for immediate delivery to retail customers.  Unlike most U.S furniture companies, American Furniture is largely insulated from Asian competition because of American’s low cost production model, retailers’ short-lead-time times and unwillingness to accept inventory risk.  The cost of shipping large upholstered furniture from Asia can cost up to 75% of the wholesale price of comparable domestically produced furniture, eliminating any labor savings from Asian production.  The Company has over 800 customers with the top 20 accounting for 40% of revenue.    The promotional category is anticipated to outperform the furniture industry as a whole over the next several years as a result of its growing appeal with the retail customer base.  
American Furniture produced strong results for 2007, surpassing both management’s and analysts’ expectations.  While revenues declined slightly to $157mm from $165mm in 2006, as a result of softer demand for furniture generally, pro forma EBITDA increased to $16.2mm from $15.7mm, owing to labor efficiencies and raw material cost benefits.
In February, a fire broke out at the company’s main production facility in Ecru, Mississippi.  Fortunately, no one was hurt, but there was damage to the facility and inventory.  In addition to causing the loss of assets, the incident has also set back production at American Furniture.  Even though management mobilized quickly to set up alternative facilities, allowing production to resume within three weeks of the fire, production is running at roughly 80% of pre-fire levels.  We estimate that it’ll be several quarters before operations return to 100%.  The company is fully insured.  It expects to recoup the full cost of repairing the factory and replacing inventor, except for $0.5mm.  It also expects to receive business interruption payments, but the exact amount won’t be known for a few months.  Before the fire, American Furniture was estimated to contribute $13.5mm in EBITDA for 2008; we now estimate that EBITDA will come in about $6mm, before accounting for any recovery from business interruption insurance.
 
·          Fox Factory (9%) was acquired in January 2008 for $85mm, or roughly 7.5x estimated 2007 EBITDA. However, since CODI receives a tax step up, the multiple is closer to 6x. This is an exciting growth company of roughly $105mm in 2007 revenues, which dominates the market for suspension components for mountain bikes (75% of revenue), all-terrain vehicles and snowmobiles.  The company competes primarily in the market for high-end mountain bikes (retail price of $1,500+) where it has a 50% (and growing) market share and faces less competition than low-end manufacturers.  Through the introduction of innovative products, Fox has tripled its revenues over the last 5 years.  Over the next several years, the company is anticipated to grow in the mid single digits, but to grow EBITDA faster as operating leverage helps margin expansion.  However, in the near term, analysts have more conservative expectations for Fox given the overall outlook for the economy: $11.5mm in EBITDA on flat sales of $105mm.
·          Aeroglide Technologies (8%) was acquired on February 28, 2007 for $57mm and approximately 7x trailing EBITDA.  However, given rapid growth of the business (pro forma EBITDA for 2007 reached $10mm on revenues of $64mm) the forward purchase multiple of 5.7x was significantly cheaper.  The company is a manufacturer of thermal processing equipment, sold globally, that is used to both cook and dry processed food products including human food, pet food and animal feeds.  The company controls 15-20% share of the market, more than double its nearest competitor.  Aeroglide has long standing relationships (30-year average) and customers include Frito-Lay, Kellogg, Nestle, BAF and Dupont.  50% of revenue is from abroad.
Aeroglide’s business should continue to benefit from two trends that have underpinned the growth in demand for its equipment: domestic trends to healthier snacks, such as baked potato chips, which is driving increased sales of conveyor ovens; and emerging consumer markets overseas driving a boom in processed food production, particularly in China.  Aeroglide is expected to grow EBITDA to $11mm on revenues of $67mm in 2008.
·          Halo  (8%), acquired in late February 2007 (for $63 mm), is a leading provider of promotional merchandise (e.g. custom-labeled apparel and gift items) for business customers.  While promotional merchandise itself is a commodity, Halo provides the value-added service of connecting a highly fragmented customer base (in excess of 30,000 accounts) to a highly fragmented vendor base (which also numbers in the thousands).  The company has longstanding relationships with over 30,000 customers.  The top ten customers account for 15% of revenue and approximately 90% of the top 100 accounts were repeat customers over the previous year.  Halo is the largest customer for nearly 50% of its top 100 suppliers which gives it significant negotiating leverage.  Halo has only one competitor in its niche of custom merchandise distribution: Bell.  Management estimates that there is significant barrier to entry in this business, in the form of roughly $25mm on IT capital expense to support the customer and vendor database and supply chain system, as well as gathering supplier and customer accounts.  Halo is a highly seasonal business, with the substantial majority of its profits coming through in the fourth quarter.  The company’s first peak season with CODI surpassed the expectations set when the company had been acquired.  Revenues for 2007 grew to $144.3mm, up from $115.6mm in 2006, largely due to acquisitions made in both 06 and 07.  On an organic basis, revenues were up 5.5%.  Pro forma EBITDA was $9.5mm, up significantly from the $6.9mm in 2006, and ahead of the $9mm anticipated.  For 2008, we expect Halo’s performance to be roughly similar to its results in 2007.
·          Silvue (6%), acquired February 2007, is a developer and manufacturer of anti-scratch and anti-UV coatings chiefly for eyewear, but also for automotive and aerospace applications.  Silvue dominates its niche with a 70+% share.  The company is very profitable with gross margins of over 75% and EBITDA margins of over 35%.  Three quarters of its revenue come from the eye/sun glass industry, a stable market driven by increasing UV awareness, aging populations and emerging markets in India and China.  The company has a portfolio of over 80 patents covering 65% of sales made to an established customer base.  The company has 125 customers around the world with its largest customer representing 15% of revenue.  Silvue’s business lends itself to high margins and entrenched customer relationships for several reasons.  First, customers typically desire proprietary formulations of coatings in order achieve properties and characteristics that are specific for a given product or use.  While Silvue will generally sell the formulation only to the customer for which it was developed, Silvue retains the ownership rights to the product.  Second, because coating systems are highly idiosyncratic, formulations must not only meet specifications for end use but must also be compatible with the customer’s coating equipment.  Once implemented, coating systems are very costly to modify or replace.  Third, while coatings are one of the key drivers of product quality, they represent one of the smallest components of product cost. 
Silvue’s revenues grew modestly from $21.3mm in 2006 to $22.5mm in 2007, while pro forma EBITDA remained flat at $8mm vs. 2006.  We expect revenues and EBITDA to grow to $23.5mm and $9.2mm, respectively, for 2008.
·          Anodyne (4%) is a manufacturer and distributor of medical bedding products that are primarily used for the treatment and prevention of bedsores.  Anodyne was acquired in July 2006 and an add-on acquisition, Anatomic Concepts, was completed in October 2006.
The medical bedding industry is expected to benefit from favorable demographic trends and regulatory developments.  The aging of the American population, higher rates of obesity and higher life expectancies should drive increasing demand for medical bedding products in general.  Meanwhile, according to Medicare guidelines, third parties are only eligible for reimbursement for bed sores when and if the condition is diagnosed at hospital admission.  Accordingly industry analysts have forecasted bedding industry sales to nearly double from $1.6 billion in sales in 2005 to an estimated $2.9 billion by 2012.  Anodyne generated $44.2mm in revenue and $5.6mm in pro forma EBITDA for 2007.  We expect revenue and EBITDA to grow to $46mm and $6.8mm, respectively, in 2008.
Management
For a company of this size, management is very strong and very user friendly.  I’d suggest calling Joe Massoud, CEO, for additional information on the company.  The one area where management has been lacking has been in their investor relations efforts.  Being public is very different than running private money and I believe management has found being public a bit more complicated than they had anticipated.  Specifically they have HISTORICALLY done a poor job on press releases and telling their complicated story to the street.  The company, however, has recently made significant strides in doing a better job of communicating effectively with the street. 

CAD Analysis
Set forth below are projected actual 2007 results, 2007 results pro forma for all acquisitions, and our 2008 estimates which reflect a slowdown in some of CODI’s businesses resulting from a slowing economy as well as the fire damage and insurance recovery at American Furniture.
 
 
Rept'd
PF
 
EBITDA
 
2007
2007
2008E
CBS / Staffmark
 
25.4
44.4
36.0
Advanced
 
21.1
21.6
22.7
American Furniture
 
3.9
16.2
6.0
Fox Factory
 
0.0
11.3
11.5
Aeroglide
 
8.2
10.0
11.0
Halo
 
9.0
9.5
9.6
Silvue
 
7.6
8.0
9.2
Anodyne
 
5.3
5.6
6.8
Portfolio combined
 
80.4
126.7
112.8
Bus. Interruption Ins. Recovery
-
-
7.0
SG&A & Fees
 
-14.6
-23.0
-23.0
Overall EBITDA
 
65.8
103.7
96.8
Cash Int Expense
 
(1.9)
(18.0)
(18.0)
Cash Taxes
 
(12.0)
(16.0)
(13.2)
Main Cap Ex
 
(5.4)
(6.5)
(6.5)
Other
 
(0.2)
0.3
0.0
CAD
 
46.3
63.5
59.1
Wtd. Avg. Shares
 
27.6
27.6
31.5
CAD/share
 
$1.68
$2.30
$1.87
 
Below we have analyzed CODI based on a sum-of-parts analysis.  We have estimated a fair valuation multiple for each business, based on multiples of comparable companies.  Inter-company debt represents loans made by CODI, the parent, to each respective portfolio company.
 
 
Fair
 
Inter-
CODI's
Value of
Value of
 
Portfolio
PF 08E
Valuation
Total
company
Economic
CODI's
Total
 
Company
EBITDA
Multiple
EV
Debt
Stake
Equity
Investmnt
 
CBS
36.0
6.5
234.0
135.6
68.5%
67.4
203.0
 
Advanced Circuits
22.7
9.0
204.3
30.5
70.2%
122.0
152.5
 
American Furniture
13.5
6.5
87.8
68.7
93.9%
17.9
86.6
 
Aeroglide
11.5
8.0
92.0
35.1
89.0%
50.6
85.7
 
Halo
11
7.5
82.5
47.0
73.6%
26.1
73.1
 
Fox Factory
9.6
8.5
82
56
76.0%
19
75
 
Silvue
9.2
8.0
73.6
15.0
72.7%
42.6
57.6
 
Anodyne
6.8
7.5
51.0
13.0
47.3%
18.0
31.0
 
Total Portfolio:
120.3
7.5
906.8
400.9
72.0%
364.1
765.0
 
PV of Tax Step-ups
 
 
Use discount rate of:15%
 
 
28.8
 
Net External Debt
 
 
 
 
 
 
(190.6)
 
Fair Value of Equity, Gross
 
 
 
 
 
603.2
 
Supplemental Put Obligation (Carry)
 
 
 
 
(40.0)
/share
Fair Value of Equity, Net of Put
 
 
 
 
 
563.2
$17.88
Market Value
 
 
 
 
 
 
378.0
$12.00
Upside to Current Market Value
 
 
 
 
49%
49%

Catalyst

We anticipate that one or more of the following catalysts drive propel the shares of CODI higher in 2008:
• Increased investor awareness
• Easier to analyze with inclusion of recent acquisitions into reported financials
• Increased dividend later this year
• Move to high dividend-paying stocks due to Fed rate cuts
• End of selling by large shareholder(s)
• End of selling pressure on BDCs/financial stocks due to fed easing
• Additional and accretive acquisitions
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    Description

    Compass Diversified Holdings (CODI) is a misunderstood publicly traded private equity fund which invests in middle market companies (annual cash flows of $7mm to $40mm). Following a harsh sell-off, the stock now trades at 7.1x trailing and 6.4x 2008E free cash flow (FCF), pays an 11% dividend which it is more than earning and which we expect will be increased later this year, and is under-levered (net debt+min interest/pf 2007 ebitda is 2.2x).  The company is run by a disciplined management team which generated IRRs of 39% from 1998 – 2006 in their previous entity and insiders own over 30% of the company’s stock, including the $30 mm investment they made last May at $16 per share (nearly 40% higher than the stock’s current price).  Unlike many other private equity firms, CODI management is highly disciplined and does not have empire-building aspirations nor does it face pressure from LPs to put money to work. Furthermore, CODI’s management does more than just financially re-engineer companies’ balance sheets; they create value by working closely with portfolio companies to maximize long term cash flows (Cash flow at all of CODI’s holdings have increased organically since their acquisition).  Unlike most other financial companies, CODI is actually benefiting from the current turmoil in the debt market since the company has committed financing which enables it to make accretive acquisitions at highly attractive prices (sellers often will take CODI’s lower bid because of the certainty CODI will close on the acquisition).  Pro forma for all acquisitions, CODI has $275 mm of undrawn, committed bank debt which it can use to opportunistically make accretive acquisitions.  CODI provides full transparency on its investments which is atypical for private equity firms, but allows CODI shareholders to really know what they own.  CODI has a collection of easy-to-understand businesses, some of which are very interesting (e.g. high-tech coatings) and some that are boring (e.g. staffing); however, even the “boring” businesses have very interesting competitive dynamics.
    We believe CODI is misunderstood and undervalued for the following reasons:
    1)       The company’s “reported” financials are not fully reflective of the company’s current business.  Over the past year, the company has made several highly accretive acquisitions that are not fully reflected in its trailing numbers.  In fact, two of these acquisitions, totaling $215mm in enterprise value and having closed after year end, aren’t accounted for in the trailing numbers at all, but will contribute meaningfully to free cash flow in 2008.
    2)       The company’s reported income statement distorts the company’s true free cash flows as a result of the significant non-cash charges the company incurs as a result of the its acquisitions (D&A is meaningfully higher than maintenance cap ex).
    3)       CODI’s legal structure is similar to that of a Business Development Company (BDC) and the stock is generally followed by the sell-side analysts who cover BDCs.  In sympathy with the financial sector, BDCs have traded down significantly over the past year.  But in reality CODI is quite different from most BDCs and private equity firms because CODI:
    a.       Makes equity, not mezzanine or debt investments
    b.       Provides financials for all its portfolio companies
    c.       Is more than earning its dividend
    d.       Will not need to raise equity in the foreseeable future
    e.       Insiders own significant equity in the company
    f.         Is fully financed and thus benefits from the turmoil in the debt markets
    4)       A fire at American Furniture Manufacturing, CODI’s third largest holding, has caused the market to worry about the potential financial impact of the incident.  However, as discussed later, we believe the company’s insurance will cover almost all of its PP&E and business interruption damage.
    5)       The company has been able to step-up the value of recently acquired assets for tax purposes, so its cash tax rate is lower than book.
     
     
    Below is the company’s valuation.  Analysts and CODI use the term Cash Available for Distribution (“CAD”), which is essentially free cash flow (the term that we prefer to use) and is defined as operating cash flow less maintenance cap ex.  Below we have shown CODI’s total EBITDA as well as its portfolio-level EBITDA (excluding corporate SGA and management fees) to illustrate the undervaluation of the underlying assets (in case the company were to be split up and sold).  We are not suggesting that the company will be split up anytime soon; however, management has indicated it has received bids for one or more of their portfolio companies.  We believe that, over time, if the stock does not trade to a more appropriate value that management, being major shareholders themselves, will break up the company.  (As discussed below, management has already sold one portfolio for a big profit.)  The minority interest arises because one of the way management incentivizes its portfolio companies is by having portfolio management own stock in the portfolio company.  The supplemental put is an accrued carry that would be paid to management upon realization of gains on the portfolio.  The 2008 figures assume no additional acquisitions; however, given the company’s limited leverage and disciplined acquisition strategy, any additional acquisitions would be highly accretive.
     
    VALUATION
     
     
     
    Stock Price
     $11.92
     
     
    Shares Out
    31.5
     
     
    Equity Cap
    375.8
     
     
    PF Debt
    205.0
     
     
    Supplemental Put Obligation
    34.0
     
     
    PF Minority Interest
    39.7
     
     
    Less: PF Cash
    -14.4
     
     
    PF Enterprise Value
    640.1
     
     
     
     
     
     
    Total
    Amounts
    Multiples
     PF 2007 EBITDA
    $103.7
    6.2
    x EV/EBITDA
     2008E EBITDA
    $96.8
    6.6
    x EV/EBITDA
     2007A FCF / Share
    $1.68
    7.1
    x P/FCF
     2008E FCF / Share
    $1.87
    6.4
    x P/FCF
     
     
     
     
    Portfolio-Level:
    Amounts
    Multiples
     PF 2007 EBITDA
    $126.7
    5.1
    x EV/EBITDA
     2008E EBITDA
    $112.8
    5.7
    x EV/EBITDA
     2007A FCF / Share
    $2.22
    5.4
    x P/FCF
     2008E FCF / Share
    $2.20
    5.4
    x P/FCF
     
    Background
    CODI was formed by the management of Compass Group Investments (CGI), a private buyout fund established in 1998 by the founder of TK Shipping.  During its 9 years at CGI, CODI’s management team generated IRRs of 39%.  CODI both commenced operations and came public in May 2006.  The IPO proceeds were used to purchase four portfolio companies from CGI.  Since its IPO, CODI has sold one of those four initial businesses (realizing a $36mm gain on its 8-month-old, $72mm investment), acquired five additional platform companies, and conducted four add-on acquisitions (which are merged into the platform companies).  As a reflection of CODI’s investment strategy, all portfolio companies share the following characteristics: 1) strong free cash flow generation due to limited cap ex needs, 2) dominant positions in their market niches, 3) low valuations at time of purchase and 4) talented, incentivized management teams. 
    Overview of Portfolio Companies
    CODI’s investment portfolio currently consists of the following (pro forma contribution to 2007 portfolio-level EBITDA given in parentheses):
    ·          CBS Personnel (35%), based in Cincinnati, OH is a leading provider of temporary staffing with a diverse customer base (no individual account represents more than 2% of revenue and the top 10 customers represent 15% of revenue), focusing primarily on the light industrial and clerical categories.  CBS, exclusive of a recent acquisition, ranks in the top 25 of U.S. staffing companies and has a top 10 market share in 11 of the 15 major metropolitan markets it serves, including the leading share in both Cincinnati and Dayton, OH.  CBS has 140 offices in 18 states in more than 100 cities.  No region accounts for more than 15% of total revenue with the exception of the company’s stronghold in Ohio which accounts for 25% of revenue.
    Historically, CBS has maintained an edge over the competition through its longstanding relationships with customers, its multiple branch offices, and its deeper database of human resources.  These three factors have allowed CBS to offer both a higher quality and a greater mix of resources and support to its customers, and have resulted in market share gains at the expense of competitors who don’t have sufficient resources to match CBS’s service offering.  As a result, many of CBS’s competitors have either reduced their presence in CBS’s markets or exited them altogether.
    CBS has continued to outperform the competition through the recent downturn in the staffing industry.  While many of its competitors have seen declines of 5% or more in domestic revenue, CBS’ same store sales declined only 2%.  (Overall, CBS’ revenue was up due to the full-year inclusion of an add-on that was acquired in late 2006.)  Margins have also held up well, declining only 50bp year/year.  CODI’s management has lived through a staffing downturn before with CBS: that period running form 2002 – 2003.  During that period, CBS sought out new customer relationships and captured new accounts while most competitors were retrenching.  As a result, CBS enhanced its market position for the eventual recovery.
    CBS’s business was recently augmented by the acquisition of Staffmark, a Little Rock, AK-based light industrial staffing company with 229 offices in 18 states nationwide, most of which are complementary in geography to legacy CBS.  The add-on acquisition more than doubled the size of the combined operation to over $1 billion in revenues, and increased the company’s geographic reach from 144 offices to nearly 400.  This acquisition has several benefits; 1) provides CBS with coverage in several under-penetrated markets; 2) creates $10mm of annual cost savings; and 3) makes CBS/Staffmark large enough to eventually be spun-off (but we don’t expect that to happen until the companies have been fully integrated).
    The Staffmark transaction, which is a little complicated because the sellers wanted to retain a 26% minority interest of the merged entity, valued the company’s enterprise at roughly 7.2x its 2007 EBITDA.  However, a tax-basis step-up (which will allow CODI to amortize an intangible asset over a 15-year period for tax purposes), reduces the acquisition multiple to roughly 6.2x EBITDA.  Moreover, since the acquisition will also result in back-office synergies that could approach $10mm, the acquisition multiple may be as low as 4x, pro forma for the synergies of approximately.  Given the attractive valuation, the increased geographic footprint, and the acquired talent (Staffmark’s excellent management team is locked up on a multi-year contract); Staffmark seems a very accretive deal for CODI.
    As separate companies, CBS and Staffmark generated $25mm and $18mm in EBITDA, respectively for 2007.  Pro forma for cost synergies, the combined company’s EBITDA would have approached $50mm for 2007.  Analysts, however, are taking a conservative view on staffing industry for 2008, and consequently EBITDA for the new CBS is anticipated to be about $36mm in 2008. We consider that estimate to be very conservative, especially in light of the coming $10m of annual cost synergies.
    ·          Advanced Circuits (17%) based in Aurora, CO, is a specialized manufacturer of printed circuit boards (PCBs) focusing primarily on prototyping and quick-turn services, which are very different businesses from volume production of PCBs that most investors hate.  The company caters primarily to R&D professionals who are focused on developing new products.  Customer requirements in prototyping and quick-turn are quality, speed of delivery and support.  With the emphasis on quality of service as opposed to cost, quick-turn and prototyping generally command higher margins than volume business (the company’s EBITDA margins are 40%+ versus the industry average of less than 10%).  Moreover, since prototype work doesn’t lend itself well to off-shoring (because of the lower volume runs and shorter turnaround times), the prototyping business has enjoyed steady growth.  By contrast, domestic volume production of PCBs is down 60% since 2000 and continues to decline as production migrates to lower cost geographies.
    The company has an estimated 15% of the fragmented quick-turn and prototype market with the next two competitors each holding less that a 10% share, followed by thousands of smaller companies.  The company has over 8,000 active customers and adds over 2,000 new customers per year.  No single account represents more than 2% of revenue and the top 100 represent 25% of revenue.  The company has over a 99% on-time rate and over a 98% error free rate despite the fact that 70% of orders are required within five days.  Customer retention is over 80% and nearly half of new customer referrals come from existing clients.  Advanced Circuit’s business continues to benefit from the proliferation of electronic devices and the ongoing trend to shorter and shorter product development cycles, and the closure of domestic competitors who are geared toward volume production and do not have the scale to survive on prototype and quick-turn business alone.
    Advanced Circuits booked $52mm in revenue for 2007, up from $48mm in 2006, largely due to increased volumes in prototyping and quick-turn products.  Pro forma EBITDA grew to $21.6 mm, up from $20.3mm in the prior year, reflecting operating leverage on higher volumes.  Analysts project EBITDA to grow to $22.7mm on revenue of $54mm in 2008.
    ·          American Furniture (13%) was acquired in August 2007 for roughly 5.5x EBITDA.  The company is the leading manufacturer of promotional upholstered furniture sold to large scale distributors such as Value City, Big Lots, J.C. Penney and Bob’s.  Promotional furniture is generally sold at lower price-points ($200 – $600 range), and is offered in a limited range of available designs allowing for immediate delivery to retail customers.  Unlike most U.S furniture companies, American Furniture is largely insulated from Asian competition because of American’s low cost production model, retailers’ short-lead-time times and unwillingness to accept inventory risk.  The cost of shipping large upholstered furniture from Asia can cost up to 75% of the wholesale price of comparable domestically produced furniture, eliminating any labor savings from Asian production.  The Company has over 800 customers with the top 20 accounting for 40% of revenue.    The promotional category is anticipated to outperform the furniture industry as a whole over the next several years as a result of its growing appeal with the retail customer base.  
    American Furniture produced strong results for 2007, surpassing both management’s and analysts’ expectations.  While revenues declined slightly to $157mm from $165mm in 2006, as a result of softer demand for furniture generally, pro forma EBITDA increased to $16.2mm from $15.7mm, owing to labor efficiencies and raw material cost benefits.
    In February, a fire broke out at the company’s main production facility in Ecru, Mississippi.  Fortunately, no one was hurt, but there was damage to the facility and inventory.  In addition to causing the loss of assets, the incident has also set back production at American Furniture.  Even though management mobilized quickly to set up alternative facilities, allowing production to resume within three weeks of the fire, production is running at roughly 80% of pre-fire levels.  We estimate that it’ll be several quarters before operations return to 100%.  The company is fully insured.  It expects to recoup the full cost of repairing the factory and replacing inventor, except for $0.5mm.  It also expects to receive business interruption payments, but the exact amount won’t be known for a few months.  Before the fire, American Furniture was estimated to contribute $13.5mm in EBITDA for 2008; we now estimate that EBITDA will come in about $6mm, before accounting for any recovery from business interruption insurance.
     
    ·          Fox Factory (9%) was acquired in January 2008 for $85mm, or roughly 7.5x estimated 2007 EBITDA. However, since CODI receives a tax step up, the multiple is closer to 6x. This is an exciting growth company of roughly $105mm in 2007 revenues, which dominates the market for suspension components for mountain bikes (75% of revenue), all-terrain vehicles and snowmobiles.  The company competes primarily in the market for high-end mountain bikes (retail price of $1,500+) where it has a 50% (and growing) market share and faces less competition than low-end manufacturers.  Through the introduction of innovative products, Fox has tripled its revenues over the last 5 years.  Over the next several years, the company is anticipated to grow in the mid single digits, but to grow EBITDA faster as operating leverage helps margin expansion.  However, in the near term, analysts have more conservative expectations for Fox given the overall outlook for the economy: $11.5mm in EBITDA on flat sales of $105mm.
    ·          Aeroglide Technologies (8%) was acquired on February 28, 2007 for $57mm and approximately 7x trailing EBITDA.  However, given rapid growth of the business (pro forma EBITDA for 2007 reached $10mm on revenues of $64mm) the forward purchase multiple of 5.7x was significantly cheaper.  The company is a manufacturer of thermal processing equipment, sold globally, that is used to both cook and dry processed food products including human food, pet food and animal feeds.  The company controls 15-20% share of the market, more than double its nearest competitor.  Aeroglide has long standing relationships (30-year average) and customers include Frito-Lay, Kellogg, Nestle, BAF and Dupont.  50% of revenue is from abroad.
    Aeroglide’s business should continue to benefit from two trends that have underpinned the growth in demand for its equipment: domestic trends to healthier snacks, such as baked potato chips, which is driving increased sales of conveyor ovens; and emerging consumer markets overseas driving a boom in processed food production, particularly in China.  Aeroglide is expected to grow EBITDA to $11mm on revenues of $67mm in 2008.
    ·          Halo  (8%), acquired in late February 2007 (for $63 mm), is a leading provider of promotional merchandise (e.g. custom-labeled apparel and gift items) for business customers.  While promotional merchandise itself is a commodity, Halo provides the value-added service of connecting a highly fragmented customer base (in excess of 30,000 accounts) to a highly fragmented vendor base (which also numbers in the thousands).  The company has longstanding relationships with over 30,000 customers.  The top ten customers account for 15% of revenue and approximately 90% of the top 100 accounts were repeat customers over the previous year.  Halo is the largest customer for nearly 50% of its top 100 suppliers which gives it significant negotiating leverage.  Halo has only one competitor in its niche of custom merchandise distribution: Bell.  Management estimates that there is significant barrier to entry in this business, in the form of roughly $25mm on IT capital expense to support the customer and vendor database and supply chain system, as well as gathering supplier and customer accounts.  Halo is a highly seasonal business, with the substantial majority of its profits coming through in the fourth quarter.  The company’s first peak season with CODI surpassed the expectations set when the company had been acquired.  Revenues for 2007 grew to $144.3mm, up from $115.6mm in 2006, largely due to acquisitions made in both 06 and 07.  On an organic basis, revenues were up 5.5%.  Pro forma EBITDA was $9.5mm, up significantly from the $6.9mm in 2006, and ahead of the $9mm anticipated.  For 2008, we expect Halo’s performance to be roughly similar to its results in 2007.
    ·          Silvue (6%), acquired February 2007, is a developer and manufacturer of anti-scratch and anti-UV coatings chiefly for eyewear, but also for automotive and aerospace applications.  Silvue dominates its niche with a 70+% share.  The company is very profitable with gross margins of over 75% and EBITDA margins of over 35%.  Three quarters of its revenue come from the eye/sun glass industry, a stable market driven by increasing UV awareness, aging populations and emerging markets in India and China.  The company has a portfolio of over 80 patents covering 65% of sales made to an established customer base.  The company has 125 customers around the world with its largest customer representing 15% of revenue.  Silvue’s business lends itself to high margins and entrenched customer relationships for several reasons.  First, customers typically desire proprietary formulations of coatings in order achieve properties and characteristics that are specific for a given product or use.  While Silvue will generally sell the formulation only to the customer for which it was developed, Silvue retains the ownership rights to the product.  Second, because coating systems are highly idiosyncratic, formulations must not only meet specifications for end use but must also be compatible with the customer’s coating equipment.  Once implemented, coating systems are very costly to modify or replace.  Third, while coatings are one of the key drivers of product quality, they represent one of the smallest components of product cost. 
    Silvue’s revenues grew modestly from $21.3mm in 2006 to $22.5mm in 2007, while pro forma EBITDA remained flat at $8mm vs. 2006.  We expect revenues and EBITDA to grow to $23.5mm and $9.2mm, respectively, for 2008.
    ·          Anodyne (4%) is a manufacturer and distributor of medical bedding products that are primarily used for the treatment and prevention of bedsores.  Anodyne was acquired in July 2006 and an add-on acquisition, Anatomic Concepts, was completed in October 2006.
    The medical bedding industry is expected to benefit from favorable demographic trends and regulatory developments.  The aging of the American population, higher rates of obesity and higher life expectancies should drive increasing demand for medical bedding products in general.  Meanwhile, according to Medicare guidelines, third parties are only eligible for reimbursement for bed sores when and if the condition is diagnosed at hospital admission.  Accordingly industry analysts have forecasted bedding industry sales to nearly double from $1.6 billion in sales in 2005 to an estimated $2.9 billion by 2012.  Anodyne generated $44.2mm in revenue and $5.6mm in pro forma EBITDA for 2007.  We expect revenue and EBITDA to grow to $46mm and $6.8mm, respectively, in 2008.
    Management
    For a company of this size, management is very strong and very user friendly.  I’d suggest calling Joe Massoud, CEO, for additional information on the company.  The one area where management has been lacking has been in their investor relations efforts.  Being public is very different than running private money and I believe management has found being public a bit more complicated than they had anticipated.  Specifically they have HISTORICALLY done a poor job on press releases and telling their complicated story to the street.  The company, however, has recently made significant strides in doing a better job of communicating effectively with the street. 

    CAD Analysis
    Set forth below are projected actual 2007 results, 2007 results pro forma for all acquisitions, and our 2008 estimates which reflect a slowdown in some of CODI’s businesses resulting from a slowing economy as well as the fire damage and insurance recovery at American Furniture.
     
     
    Rept'd
    PF
     
    EBITDA
     
    2007
    2007
    2008E
    CBS / Staffmark
     
    25.4
    44.4
    36.0
    Advanced
     
    21.1
    21.6
    22.7
    American Furniture
     
    3.9
    16.2
    6.0
    Fox Factory
     
    0.0
    11.3
    11.5
    Aeroglide
     
    8.2
    10.0
    11.0
    Halo
     
    9.0
    9.5
    9.6
    Silvue
     
    7.6
    8.0
    9.2
    Anodyne
     
    5.3
    5.6
    6.8
    Portfolio combined
     
    80.4
    126.7
    112.8
    Bus. Interruption Ins. Recovery
    -
    -
    7.0
    SG&A & Fees
     
    -14.6
    -23.0
    -23.0
    Overall EBITDA
     
    65.8
    103.7
    96.8
    Cash Int Expense
     
    (1.9)
    (18.0)
    (18.0)
    Cash Taxes
     
    (12.0)
    (16.0)
    (13.2)
    Main Cap Ex
     
    (5.4)
    (6.5)
    (6.5)
    Other
     
    (0.2)
    0.3
    0.0
    CAD
     
    46.3
    63.5
    59.1
    Wtd. Avg. Shares
     
    27.6
    27.6
    31.5
    CAD/share
     
    $1.68
    $2.30
    $1.87
     
    Below we have analyzed CODI based on a sum-of-parts analysis.  We have estimated a fair valuation multiple for each business, based on multiples of comparable companies.  Inter-company debt represents loans made by CODI, the parent, to each respective portfolio company.
     
     
    Fair
     
    Inter-
    CODI's
    Value of
    Value of
     
    Portfolio
    PF 08E
    Valuation
    Total
    company
    Economic
    CODI's
    Total
     
    Company
    EBITDA
    Multiple
    EV
    Debt
    Stake
    Equity
    Investmnt
     
    CBS
    36.0
    6.5
    234.0
    135.6
    68.5%
    67.4
    203.0
     
    Advanced Circuits
    22.7
    9.0
    204.3
    30.5
    70.2%
    122.0
    152.5
     
    American Furniture
    13.5
    6.5
    87.8
    68.7
    93.9%
    17.9
    86.6
     
    Aeroglide
    11.5
    8.0
    92.0
    35.1
    89.0%
    50.6
    85.7
     
    Halo
    11
    7.5
    82.5
    47.0
    73.6%
    26.1
    73.1
     
    Fox Factory
    9.6
    8.5
    82
    56
    76.0%
    19
    75
     
    Silvue
    9.2
    8.0
    73.6
    15.0
    72.7%
    42.6
    57.6
     
    Anodyne
    6.8
    7.5
    51.0
    13.0
    47.3%
    18.0
    31.0
     
    Total Portfolio:
    120.3
    7.5
    906.8
    400.9
    72.0%
    364.1
    765.0
     
    PV of Tax Step-ups
     
     
    Use discount rate of:15%
     
     
    28.8
     
    Net External Debt
     
     
     
     
     
     
    (190.6)
     
    Fair Value of Equity, Gross
     
     
     
     
     
    603.2
     
    Supplemental Put Obligation (Carry)
     
     
     
     
    (40.0)
    /share
    Fair Value of Equity, Net of Put
     
     
     
     
     
    563.2
    $17.88
    Market Value
     
     
     
     
     
     
    378.0
    $12.00
    Upside to Current Market Value
     
     
     
     
    49%
    49%

    Catalyst

    We anticipate that one or more of the following catalysts drive propel the shares of CODI higher in 2008:
    • Increased investor awareness
    • Easier to analyze with inclusion of recent acquisitions into reported financials
    • Increased dividend later this year
    • Move to high dividend-paying stocks due to Fed rate cuts
    • End of selling by large shareholder(s)
    • End of selling pressure on BDCs/financial stocks due to fed easing
    • Additional and accretive acquisitions

    Messages


    SubjectQuestions
    Entry03/20/2008 10:25 AM
    Memberdavid101
    Oliver,

    Interesting idea. Have some questions:

    1. Could you describe the differences between a Delaware statutory trust and a BDC/RIC? Are there any required distributions? Can they retain earnings?

    2. Since they pay corporate taxes, were all the 2007 dividends classified as qualified?

    3. What is the external management fee to CGI?

    4. How dependent are they upon realized gains for dividends? Does CODI receive dividends from its portfolio companies?

    David

    SubjectRE: thanks for idea
    Entry03/25/2008 04:58 PM
    Memberoliver1216
    Scrooge – CODI’s value add is that they are both financial engineers (i.e. can structure deals with asset step ups to reduce cash taxes) but, more importantly, are guys with strong operating backgrounds. They also are buying small companies where its easier to add value if you are a sophisticated buyer..unlike when kkr buys a portfolio from Carlyle, it is hard to understand what value KKR will extract that Carlyle didn’t.

    SubjectRE: Questions
    Entry03/25/2008 04:59 PM
    Memberoliver1216
    DAVID -

    1. Could you describe the differences between a Delaware statutory trust and a BDC/RIC? Are there any required distributions? Can they retain earnings?

    CODI does not need to make distributions and in fact they do not pay out all their free cash flow, or NII as BDCS use. You can refer to the 10-K filing of a BDC like Prospect Capital (PSEC) for all the details. However, in general, a BDC/RIC has ownership restrictions on how much of the portfolio assets are invested in a specific holding, how much of the portfolio can be invested in “control” situations. To be registered as a RIC (and, hence, to avoid taxation at the holding company level), RICs must distribute at least 90% of their ordinary income and net gains to shareholders. The statutory trust isn’t subject to these restrictions. Trusts generally take majority stakes in the investments they make. Another difference is that BDCs may or may not be externally managed. But stat trusts are by definition externally managed.

    2. Since they pay corporate taxes, were all the 2007 dividends classified as qualified?

    A large portion of CODI’s div is treated as a return on capital so your tax treatment is even better

    3. What is the external management fee to CGI?

    0.5% of the “adjusted net assets” of CODI on quarterly basis. See the management services agreement for all the details on how “adjusted net assets” is defined but it’s closer to gross assets than it is to stockholders’ equity.


    4. How dependent are they upon realized gains for dividends? Does CODI receive dividends from its portfolio companies?

    Not dependent at all. Their “cash available for distribution” is in excess of 1.3x the dividend and excludes any proceeds from realizations. CODI doesn’t receive dividends from its portfolio companies, per se. Instead, they funnel cash back up to the parent through the interest that they pay on intercompany loans.

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