2023-09-26 23:27:12 ET
Summary
- Compass Diversified has high levels of debt and unclear trajectory, making it a risky investment.
- The company's financial metrics have not met the minimum requirements.
- It's a pass for me until I see the metrics improve, although current investors are getting a decent dividend yield.
Investment Thesis
I wanted to take a look at Compass Diversified’s ( CODI ) financials to see if it would be a good idea to put some money into it. The company’s financial metrics are not what I look for in an investment, coupled with an unclear trajectory of where the company is going and dangerously high levels of debt, I will give this company a pass until I see efficiency and profitability metrics improve considerably.
Briefly on the company
Compass Diversified engages in acquiring controlling interests in niche middle-market businesses and actively manages them because the company believes in these businesses’ long-term prospects. This business model allows the company's investors to own a diverse group of businesses in the niche industrial and branded-consumer sectors.
Financials
As of Q2 ’23 , the company had $67.3m in cash against $1.7B in long-term debt. This is where it gets a little tricky for me. I have a certain criterion that I would like to see when it comes to debt financing. I don’t mind companies taking on debt to finance their operations as long as it is manageable. As of Q2 ’23, the company’s 6-month interest coverage ratio stood at around 1.8x meaning EBIT can cover interest expense on debt about 1.8 times over. It is a little close for comfort to me because even most analysts believe that a 2x coverage ratio is healthy, while me being on the safer side, I’d like to see at least a 5x coverage ratio. The company’s average interest rate is around 5.3% and I’m not saying the company has any issue in terms of solvency right now, but with such a low cash pile and unimpressive EBIT, the company is on the riskier side. The company can always depend on its credit revolving facility from its parent company to pay for the interest expenses, so I don’t think it will be at any risk of insolvency any time soon.
A historical look at the coverage ratio isn’t giving me any hope that it’ll turn around, however, it also means that the company has always operated under these conditions.
Looking at the company’s current ratio reveals a company that is very strong in terms of liquidity. The historical current ratio has been hovering around 2.5-3.4 in the last 5 years. This is a good ratio and a bad ratio in my opinion. It is good because the company can easily cover its short-term obligations, and it’s bad because it’s a little too high. I would like to see a ratio in the range of 1.5-2.0, which I think is a more efficient ratio. It strikes a nice balance between the ability to pay off ST obligations and being on a more active side of expansion of operations through growth initiatives. It seems that the company has a lot of inventory that keeps the working capital tied up which could be used to further the growth of the company.
In terms of efficiency and profitability, the company’s ROA and ROE have not been up to my requirements of at least 5% for ROA and 10% for ROE. The company was above my minimums in FY19, but ever since then, these have gone down considerably. It seems like the management isn’t utilizing the company’s assets and shareholder capital very efficiently.
Return on invested capital is also nothing to write home about in my opinion. I would like to see at least 10%, however, the company has been hovering around 5% in recent years, which isn’t great.
In terms of revenues, the company saw around 13% CAGR over the last decade, which is respectable in my opinion. I will approach my valuation analysis with more conservative numbers since analysts are estimating revenue growth to be 0 for FY23 and around high-single-digits for the next couple of years.
In terms of margins, there’s not much to like here. Gross margins have improved slightly over time, while the bottom line has seen better days in the past. Not much of a trend with many fluctuations.
I also do not like the fact that the shareholders have been consistently losing the value of their shares due to dilution.
Overall, the financials have left a lot to be desired in my opinion. It looks like the management isn't being very efficient with the company's assets and the company has no strong moat or competitive advantage, which is very important to me if I would consider the company for long-term investment. It also looks like the company’s performance is very erratic and no clear direction can be observed, which adds more to the risk.
Valuation
Let’s entertain the idea of what I would be willing to pay for the risks and what I think are quite mediocre metrics above. For the base case revenue growth, I went with around 6% CAGR for the next decade. My reason is that the company's not going to be producing much over the next couple of years , so I’ll be on the conservative side here. For the optimistic case, I went with around 8% CAGR, while for the conservative case, I went with around 4% CAGR to give myself a range of possible outcomes.
In terms of margins, I decided to go with adjusted numbers, even though I would prefer it if the company was not relying on non-GAAP measures to show its “true” value.
On top of these estimates, I will add a 40% margin of safety because the financials seemed a little too mediocre and the company seems to fluctuate quite a bit without a clear trajectory. With that said, CODI’s intrinsic value is $19.15 a share, which means that the company is trading at a slight discount of 3% to its fair value in my opinion.
Closing Comments
To be honest, even if the math tells me that the company’s cheap, I don’t think I would want to invest in a company that has financials like CODI. The debt is very high which is a little risky when operating income can just about cover it annually. The operating results are fluctuating too much and do not show a clear positive uptrend, except for revenues.
If I was to invest in the company, I would need a good margin of safety and I would like to see efficiency and profitability ratios improve significantly it looks like these may not improve any time soon, so I give the company a hold for now for new investors looking to add a new company to their portfolios. It is also not a sell because current investors are getting a decent dividend yield right now, which can hold them invested longer until the business becomes more attractive.
For further details see:
Compass Diversified: Need Financials To Improve Before I Invest