Compass Diversified Q3 FY2024 earnings call

Management Statement and Operational Highlights

• Strategy and Economic Outlook: Discussed the CODI Momentum Index, which stood at 1.04 as of late, indicating a stable economic outlook. Noted ongoing economic and geopolitical uncertainty but positive trends in the North American consumer market, especially the affluent segment.
• Value Creation: Emphasized collaboration with subsidiary management teams, internal audit team improving financial processes at subsidiaries, and raising $17 million of preferred stock capital in Q3 to lower long-term cost of capital.
• Acquisitions and Divestitures: Altor completed acquisition of Lifoam, and a new $100 million repurchase program for common shares was announced, indicating confidence in the company's value.
• Subsidiary Investments: Altor's acquisition of Lifoam accelerates its long-term strategy, and Arnold's plant relocation to a new state-of-the-art location to facilitate growth.

Segment Performance

• Branded Consumer: Year-to-date pro forma revenues increased by 10.3% and pro forma adjusted EBITDA increased by 27% versus the prior year period. Segments like Lugano, BOA, PrimaLoft, and Honeypot delivered double-digit growth. Lugano, BOA, PrimaLoft, and Honeypot all saw strong performance, with Honeypot having a robust third quarter though expecting to invest in marketing in Q4.
• Industrial: Year-to-date revenues declined by 4% and adjusted EBITDA declined by 6.1%. Altor faced challenges at cold chain distribution partners but acquisition of Lifoam is expected to drive growth. Arnold had onetime move costs related to plant relocation, with $7M expected in Q4 excluding capital investments.

Guidance

• Raised full-year 2024 guidance: Consolidated pro forma subsidiary adjusted EBITDA expected between $510 million and $525 million. Adjusted earnings expected between $155 million and $165 million. Branded consumer vertical expected to deliver adjusted EBITDA between $390 million and $400 million, and industrial vertical between $120 million and $125 million.

Risks

• Political and economic uncertainties, including domestic and global political and economic environment, disruption in global supply chain, labor disruptions, inflation, risks from natural disasters or social unrest, and changing interest rates.

Question and Answer

• Q: On the guidance, narrowed up and then raise a little bit as well. It looks like on the industrial piece, just tweaked upwards a little bit. I guess that's primarily for the Lifoam acquisition. And then on the branded side, is that mostly Lugano or any thoughts on that?

A: Yes, Larry, it's Elias. On the consumer side, -- it's a little bit broader than Lugano. I would say the guide includes BOA performing better than anticipated. Honeypot had a really strong third quarter. We do anticipate investing substantially in marketing in the fourth quarter, but it's still going to expect it to deliver year-over-year growth. So that is kind of on track and where we expect. PrimaLoft is turned and doing a little better than expectations. So it's broader than just Lugano and your point on industrial is correct. That is due to Lifoam.

• Q: I like the momentum index, I usually kind of ask you a question in those words, and you've kind of quantified it now, which is kind of fun. I guess the question I have 1 or 2 and then it was -- so it's a little bit up now. I guess, was there somewhat of a downturn at some point this year? Has that kind of just trending in the last few weeks of that number in the last couple of months kind of just be a little bit back up? Maybe a little bit of semantics, but just curious that there's been any movement in between January 1 and recent.

A: Yes, Larry, it's interesting because on the consumer side, it's held relatively stable throughout the year, which I think it indicates what we were talking about the consumer, especially the more affluent consumer that we touch has held up remarkably well. . We have seen a little bouncing around on the industrial. I would say there was a general trending down over the first 6 months of the year, 6, 7 months. Somehow miraculously in August and September, we saw that take almost a V-shaped turn back up. And then the industrial business has sort of weakened back a little bit. And so it's gyrated a little bit around. It did correlate to a lot of the better economic readings we saw over that time in late Q3. It has ticked down a little bit in October. So it feels like there was a little bit of momentum maybe around interest rate cuts, maybe that freed up some order flow that happened, especially on the industrial side of the economy. Now that feels like it's sort of rein back in a little bit.

• Q: Just wanted to start off with Lugano. Maybe any way to unpack the kind of the key drivers of growth there? I mean just continues to sort of defy expectations on the top line? And I have a question on the margins that I'll get to. But curious if maybe you could just parse out or help us understand qualitatively like existing salon growth versus what you're seeing from the new salons in terms of contribution? Anything to call out on like average order values that could be helping you there? Just kind of wanted to get a better sense of the drivers there.

A: Sure. So I'm only going to say that all salons did increase year-over-year. I'm not going to kind of touch on kind of salon by salon or area by area where the growth was. But the organic -- or the existing salons continue to grow and performed really well. We do continue to see a march up in sort of our average transaction value. which is driving a decent chunk of growth. We also see an increase in our number of transactions per quarter. So it's a little of each, if that makes sense. And I'm sorry, I can't be more in-depth than that. But it's a little of each. And really, it goes to -- we believe Lugano fundamentally has a different business model, and we believe it's disruptive. I mean we are offering more value to the consumers than are any of Lugano's competitors. And we believe that that's important, whether you're dealing with whether you're dealing with people any demographic, right? And so that's important for people of the highest demographic as well. We're creating long-term relationships and we're really allowing them to look at jewelry as more of a store of wealth., So we think it's a combination of all those things, right? And clearly, you see our investments in inventory. You need to have diamonds in order to sell diamonds, right? And that's part of what we're doing as well. And we're getting turns on that, and we're getting a very good return on our investment. But it's really a combination of all of those, Matt.

• Q: And then just on the incremental margins, I think historically, you guys have spoken to $1 of growth gets you $0.30-plus of incremental margin on the EBITDA line at Lugano. Maybe this quarter was quite a bit in excess of that. I'm just curious if there was anything unique about the third quarter that drove the profitability there at Lugano or anything else to call out so we can understand sort of the incremental margins on a go-forward basis?

A: Yes. I mean as we grow and as we get more scale and as we add more capabilities and more talent and management, we're clearly buying at least as effectively, if not more effectively, number one. And number two, I'm not sure if this quarter. I would not want to take this quarter's margin to sort of straight line them over the next 4 quarters, right? This could have been slightly higher than average, not materially, but slightly higher than we'd expect going forward. And I will just point out Q4, we think, is going to be a great quarter. There are marketing events as well in Q4, but we think we'll grow well beyond any increase in costs.

• Q: Could you talk about just the VoIP and supply chain impact on various portfolio companies? And when that might sort of unwind and become a tailwind just in terms of the destocking trends that we've seen?

A: Sure. This is Pat. I don't know as to whether or not when it will become a tailwind per se. I will say or if it will. I mean, I don't -- sometimes you don't want to have too much of a tailwind from where you are now because that means you're overstocking at retail and that sets you up for -- that sets you up for issues in the future. . Portfolio-wide, we think we're kind of an equilibrium now if that makes sense. We don't think we're overbuilding. We don't think we're kind of draining supply within the channel. Portfolio-wide, I would say we generally feel like we are in those sort of early supply chain businesses, we generally feel like we are sort of producing in a manner that's roughly equal to consumer demand.

• Q: And then could you just talk about how you're thinking about the dividend at this point? Obviously, leverage has been fairly consistent, and you're out earning it by a large margin, but just how you're thinking about dividend payments going forward?

A: Yes. As we've said publicly in the past, our Board makes our decision on the dividend. We paid a dividend since coming public every quarter that we've been public, and that is the current position of the company is that we are a dividend payer, and we will be, unless there is some change in strategic plan, which is not being considered right now.

• Q: Going back to that -- the M&A landscape kind of issue. I mean maybe a CODI M&A optimism index question. I mean rather than like over the next quarter, has been very muted. I'm hearing the same thing like pipelines are building, et cetera. But what's your level of optimism over say, the next 12 months you think the market's going to be conducive to you finding the kind of deals you want? I mean going into an auction process for a highly competitive health care company might not be ideal for you, right, because that's not the kind of business as you approach you normally take. But what's your view on over an extended period the market is going to be conduced to something happen.

A: We're very optimistic right now, Rob. We think the M&A markets, which have been subdued, as I said for a couple of years, really can only stay there for so long. Eventually, people do need to move on. There's a state planning for entrepreneurs and tax planning that ends up occurring. There's private equity fund lives that end up coming into a kind of a situation for them or there's just the desire for them to exit so that they can have realizations to move forward. That -- so I think there is going to be a lot of forces for why sellers should be starting to come back into the market. Everybody has been really hesitant because nobody wants to bring an A plus asset to market and be the first one with price discovery and fall flat on your face. So it's created a catatonic kind of seller market right now. With interest rates coming down, that first 50 basis point move, I think helps. If the fed is continuing to move monetary policy looser that's going to help these type of assets. We're already seeing lending start to come back and the leverage multiples start to come back in the marketplace. So the ingredients are in place that give us a lot of optimism, Robert, that next year is going to be a pretty good bounce back, and we should be able to transact against the company of the ilk that we want to buy.

• Q: Could you talk about just the VoIP and supply chain impact on various portfolio companies? And when that might sort of unwind and become a tailwind just in terms of the destocking trends that we've seen?

A: Sure. This is Pat. I don't know as to whether or not when it will become a tailwind per se. I will say or if it will. I mean, I don't -- sometimes you don't want to have too much of a tailwind from where you are now because that means you're overstocking at retail and that sets you up for -- that sets you up for issues in the future. . Portfolio-wide, we think we're kind of an equilibrium now if that makes sense. We don't think we're overbuilding. We don't think we're kind of draining supply within the channel. Portfolio-wide, I would say we generally feel like we are in those sort of early supply chain businesses, we generally feel like we are sort of producing in a manner that's roughly equal to consumer demand.

• Q: And then I got to ask the requisite Lugano question. I mean on store openings next year, I mean, what -- do you have any preliminary -- I mean it takes a while to open them, right? I mean if you're open 1 by the middle of next year, you've got to have the location already picked out, right? So what's kind of the -- any color on how many you think might be open next year? Do you think you'll do a second international? I mean London seems to be doing quite well, but nothing has been -- you can sell internationally without [Indiscernible] obviously, but do you think there's going to be more international footprint expansion and expand the potential customer base even further, right?

A: Yes. So the Board hasn't -- the Board of Lugano, and we haven't reviewed with them sort of the strategic plan for 2025. That being said, as you would expect us to and as you want us to, we always have irons in the fire. And there are several locations that we're evaluating any -- not at any point in time, but lately, and there are several locations now and one of the several is international and more than one of the several or not. Is that a good sort of summary. I'd say we -- there is room for growth. We've identified a lot of markets that we think are attractive and within that this Lugano model would fit into. And absent something happening, we would envision incremental store openings next year. Maybe two if I had to guess. I mean if I -- you want me to roll out a number, right? I mean, maybe two probably.

• Q: This is Jonathan on for Lance. Just 1 question for me. With the decreasing of rates with -- it seems to be a good quarter and the raised guidance. How are you thinking about balancing the share buybacks, potentially acquisitions in 2 as well as managing your debt? Like how do you prioritize it? Or does it change based on what's going on in the market at the time?

A: Yes. Jonathan, this is Elias. Our capital allocation is fluids. Clearly, we would like to retain capital to proceed against our strategic plan. And as we've said many times to the market, a strategic goal within our strategic plan is to hit $1 billion of EBITDA. And we think that size and breadth of subsidiaries and end markets all the diversity that comes from that, it continues with our quest to lower our cost of capital. So that is our strategic North Star that we constantly point to and internally generated capital as well as whatever we generate in the market through capital raising and through divestitures, our first goal would be to prioritize acquisitions that align with our strategic vision. Now that being said, we cannot be immune to the stock price. And as our opinion of intrinsic value starts to deviate materially from the stock price, then it's incumbent upon us to put a floor in or at least use better capital allocation to buy back those shares because the return on that buyback is on a risk-adjusted basis, better than what we think we can get in the market by deploying against our strategic plan. So I know that doesn't give you an exact answer. It's fluid. Our priority is to follow our strategic plan. That being said, at this level of discount, we are willing to step in and use a buyback and support the share price at this type of return, we think we would be getting on that capital that's being used. I also want to point out one of the comments that I made in the script is that we raised $17 million of preferred capital in the third quarter. We have also raised capital in the fourth quarter. We don't disclose how much until the following. That's preferred capital we raised in the fourth quarter so far before the window was in October. We would anticipate as long as that product is available to us at reasonable cost, which it is right now, that we would continue to raise that as a form of equity capital that can be used to either invest in Lugano, it could be used theoretically to buy back shares, right? Money is fungible. So wherever the highest return on invested capital is. I can tell you, in our opinion, right now, nothing is as attractive as investing in Lugano, because the returns that gives are really exceptional. And so that -- raising preferred can be there, I can buy back our stock. It can be part of the acquisition capital that we have to go buy new companies. That we view as a viable source or just general deleveraging. And so there is capital coming in the door through that means. And as M&A markets become more active for us on the acquisition side, we do think that there are some divestiture opportunities that we would continue to pursue as I continue to say, we march against our strategic plan.