Compass Diversified (CODI) Q3 2013 Earnings Report, Transcript and Summary

Good morning, and welcome to the Compass Diversified Holdings Third Quarter 2013 Earnings Conference Call. Today's call is being recorded. [Operator Instructions] At this time, I would like to turn the conference over to Mike Cimini of The IGB Group for introductions and the reading of the Safe Harbor statement. Please go ahead, sir.

Thank you, and welcome to the Compass Diversified Holdings Third Quarter 2013 Conference Call. Representing the company today are Alan Offenberg, CEO; Jim Bottiglieri, CFO; and Elias Sabo, a founding partner of Compass Group Management. Before we begin, I would like to point out that the Q3 press release, including the financial tables, is available on the company's website at www.compassdiversifiedholdings.com. The company also filed its Form 10-Q with the SEC last night. Please note that throughout this call, we will refer to Compass Diversified Holdings as CODI or the company. Now allow me to read be the following Safe Harbor statement. During this conference call, we may make certain forward-looking statements, including statements with regard to the future performance of CODI. Words such as believes, expects, projects and future or similar expressions, are intended to identify forward-looking statements. These forward-looking statements are subject to the inherent uncertainties in predicting future results and conditions. Certain factors could cause actual results to differ on a material basis from those projected in these forward-looking statements. And some of these factors are enumerated in the Risk Factor discussion in the Form 10-K as filed with the Securities and Exchange Commission for the year ended December 31, 2012, as well as in other SEC filings. In particular, the domestic and global economic environment has a significant impact on our subsidiary companies. CODI undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. At this time, I would like to turn the call over to Alan Offenberg.

Good morning. Thank you, all, for your time, and welcome to our third quarter 2013 earnings conference call. We're pleased to report third quarter results that were consistent with management's expectations. For the 3 months ended September 30, 2013, CODI generated cash flow available for distribution and reinvestment, which we refer to as cash flow or CAD, of $19.4 million. Our diverse family of leading middle-market businesses continues to focus on increasing market share in their respective industries and expanding into adjacent markets by taking advantage of their relative operating and financial strengths. For the 9 months ended September 30, 2013, our branded product businesses consisting of CamelBak, ERGObaby, Fox and Liberty, achieved both revenue and EBITDA growth on a combined basis of approximately 13% as compared to the 9 months ended September 30, 2012. These 4 businesses also recorded a combined EBITDA margin for the 9 months ended September 30, 2013 of approximately 20.2%, which is the same as compared to the 9 months ended September 30, 2012. Please note that Fox's results will continue to be consolidated with the results of our other subsidiaries until our ownership percentage drops below controlling interest. In terms of our niche industrial businesses consisting of Advanced Circuits, AFM, Arnold and Tridien, we continue to generate predictable and strong free cash flow. For the 9 months ended September 30, 2013, these 4 businesses posted combined revenue growth of approximately 4%, although EBITDA declined slightly by approximately 1% as compared to the corresponding period in the previous year. In addition, they produced a lower combined EBITDA margin of 14% as compared to 14.7% for the 9 months ended September 30, 2012. All references to combined revenue and EBITDA and EBITDA margin for our niche industrial businesses were prepared on a pro forma basis as…

Thank you, Alan. I will begin by reviewing our branded businesses. During the third quarter, our branded products businesses produced both revenue and EBITDA growth on a combined basis of approximately 12% and 10%, respectively, over the year-earlier period. The combined EBITDA margin declined slightly to 20.4% for the quarter ended September 30, 2013 from 20.8% for the quarter ended September 30, 2012 for these 4 subsidiaries on a combined basis. Liberty delivered another record performance in the third quarter, with revenue and EBITDA increasing 51% and 49%, respectively. This business has now expanded both revenue and profitability in each of the past 3 quarters, as we continue to capitalize on the robust demand for the company's premium gun and home safes, while further enhancing Liberty's scalable infrastructure. At Fox, this business posted another strong quarter, posting double-digit revenue and EBITDA growth in Q3. As Alan mentioned earlier, Fox successfully completed its IPO during the third quarter and trades under the ticker symbol, FOXF. At ERGObaby, revenues and EBITDA declined approximately 9% and 20%, respectively, in the third quarter due principally to the timing of international shipments in the back half of 2012. In 2013, the timing of shipments has been much more evenly distributed throughout the year. This has resulted in ERGObaby continuing to deliver strong year-over-year comparisons, with year-to-date revenue and EBITDA up approximately 9% and 7%, respectively. Finally, at CamelBak, this business was impacted by the fulfillment of a contract with the U.S. Marine Corps completed in the first quarter of 2013. In addition, demand for certain of the company's personal hydration systems continues to slowly recover, following the unfavorable weather conditions experienced in many of the company's markets during the second quarter of 2013. While Q3 revenue and EBITDA declined approximately 5% and 20%, respectively, we…

Thank you, Elias. Today, I will discuss our consolidated financial results for the quarter ended September 30, 2013. I will limit my comments largely to the overall results for our company, since the individual subsidiary results are detailed in our Form 10-Q for the quarter that was filed with the SEC yesterday. On a consolidated basis, revenue for the quarter ended September 30, 2013, was $265.5 million as compared to $241.2 million for the prior year period. This increase was attributable to double-digit revenue increases at Liberty, Fox and at AFM. Net income for the quarter was $78.3 million as compared to net income of $6.4 million in the year-earlier period. CODI reversed approximately $61.3 million of supplemental put expense in connection with the termination of the Supplemental Put Agreement on July 1, 2013. As a result of the supplemental put termination, CODI will no longer be accruing any supplemental put expense in its financial statements. Cash flow for the quarter ended September 30, 2013, was $19.4 million as compared to $22.8 million for the prior year period. Cash flow for the third quarter of 2013 reflects strong year-over-year growth in our Liberty and Arnold Magnetic businesses, offset by the impact on cash flow from the IPO of Fox. Subsequent to the IPO, which was completed on August 13, 2013, Fox generated cash flow of approximately $7.3 million, which was excluded from CODI's calculation of CAD for the quarter ended September 30, 2013. Although we recognized the cash flow generated by Fox on a pro rata basis for the quarter ended September 30, 2013, Fox will no longer be included in our calculation of CAD going forward. For the 9-month period ended September 30, 2013, cash flow increased slightly to $63.7 million as compared to $62.8 million for the 9…

Thank you, Jim. To close, I'd like to add some commentary on the M&A environment. Currently, acquisition activity among middle-market businesses remains modest. Valuation levels for healthy companies are relatively high due to the continued availability of low-cost debt capital combined with the prevalence of strategic and financial buyers actively seeking to deploy their capital. We remain cautiously optimistic that deal flow for higher-quality companies will increase going forward. As we have stated in the past, the timing of any acquisition can be difficult to predict. We appreciate the patience of our shareholders and will remain disciplined in our approach to acquiring companies that have a real reason to exist under favorable terms and valuations. I would like to thank, everyone, again for joining us on today's call. We'll be happy to take any questions you may have. Operator, please open the phone lines.

[Operator Instructions] And we'll first hear from Larry Solow with CJS Securities.

Wondering if you guys could maybe just discuss just on the quarterly -- the quarterly performance looks a little flat or even slightly down, if we exclude Fox year-over-year. Is that just timing related? And specifically, ERGObaby had a nice drop and Advanced Circuits as well.

Well, I mean, I think, Larry, it really does go company by company. I think, you referenced ERGO, which in the remarks, we noted some timing associated with some orders. With Advanced Circuits, it just continues to be a tough environment in one primary segment of their business, being the aerospace and defense. Conversely, Liberty had a great quarter, Arnold had a great quarter. CamelBak's quarter was a little bit off relative to what we see in prior. So, I think, it's hard to characterize its -- in total, rather, I do think that it's more appropriate to consider it on a company-by-company basis and the individual factors that impacted that company in the quarter, some of which were related to business conditions. Others were just related to, what I would call, normal fluctuations that can occur quarter to quarter.

Okay, and it does sound at least in your prepared comments, numbers were sort of in line with your expectations. So, I mean, is it fair to say that, again, just excluding Fox, which has been obviously, hitting the cover of the bowl [ph] of growth. But outside of Fox, your businesses, in general, as you look out into '14 and without giving the actual guidance, I mean, do you see them still in growth mode? Is it sort of a flat environment? And again, I realize it's hard to put them all together into one, but if you could just give a sort of a quick review, that would be great.

Sure. Larry, as you know, I don't think I could really tell you what we're thinking about on a company-by-company basis for 2014, but I will say, we're really pleased with the performance of the companies. We've commented on our outlook for the balance of this year which really hasn't changed. We think all of our companies are going to continue to perform in line with what we communicated with you in the past, in the context of 2013. And I think there are -- again, on a company-by-company basis, when you even just look at 2013, we have a composition of companies, some of which have higher growth profiles than others. I don't think the nature of the growth profile of any of our subsidiaries has changed, is one way that I would look at it. So I think that many of them continue to invest -- all of them, I should say, really continue to invest in their future and in their growth and we continue to work with them to pursue growth initiatives both organic and acquisition related. And so, I think it's early for us to give you an outlook on 2014, but I'm very confident in telling you that I don't think that the growth profile of our companies have changed and that they all remain extremely well positioned to continue to capitalize on future opportunities and build their businesses and build their cash flow.

And next, we'll move to Ben O'Shea [ph] with Raymond James.

I'm just looking at Tridien here, and think you said that you missed [ph] on the R&D or the EBITDA decline due to that. Do you have sort of annual numbers on what R&D you'd expect to be going forward, percentage of revenue, maybe?

Well, look, as we've talked about in the past, then I'll ask Elias to maybe add some comments. This is a year where Tridien invested heavily in R&D beyond what they've done traditionally and so I don't anticipate that this year's level of R&D would be the level of R&D that we would anticipate going forward. Again, I'll ask Elias. I would expect probably future R&D to be more consistent with historical levels of R&D as opposed to this year's, but Elias, anything you would add to that?

Yes. We don't give out specific numbers in terms of R&D percentage of revenues, but just in general, we have spoken about the increased emphasis on new product development and launches and how that's going to be meaningful for the company going forward and important in terms of kind of getting some of these new products out into the market. One, I think, in general in 2013, there's really been a couple of things that have been happening. First, we've significantly increased our spend as we bring out new products. Second, we have been launching and in launch mode in some products and I think it's reflected in relatively strong revenue growth that we've experienced thus far this year and in the quarter. And the launch of certain of those products just has a lower profitable profile during the launch phase. I mean, these things are relatively complex to assemble and build and as a result of that, as most manufacturing companies when they come up the curve on launching a new product, there's some excess costs that get incurred during that period. I think it's a little broader in 2013. I think it's both the R&D expenses, which are very heavy. We've been investing in the infrastructure for this business to really move forward. It's also been some launch -- initial launch quantities of some products that have started to drive sales, but the profitability on those products is lower while we're in the launch phase. And so we think we've set up pretty well for 2014, but it's really those 2 factors that contributed to kind of the EBITDA margin degradation we've seen.

Okay. And just for CamelBak, could you talk a little bit about the headwinds with the weather and the government budget, maybe, which was more so of a headwind or...?

Yes. I think that for CamelBak, as well as, if you were to do a little research and take a look at outdoor-oriented retail over the course of this year, it's just been a tough year and the weather which is never something I like to have to point to when commenting on a business' performance, but it's just the reality in this case. It was hard -- it was very difficult. It was cold and wet in many parts of the country and it really impacted the business. I would say that, that was just a headwind that is hard to do anything about. I think the company did everything it could to position with good products in the marketplace and continued innovation, but that was just a reality [ph], in particular, in the spring season as it relates to CamelBak's business. The government budget and the defense impact, I think is certainly an issue for CamelBak as well, as we commented on in the past. Their packs and related products are sold primarily on base -- military base retail, so they're not necessarily subject to Department of Defense budget spending other than some of these onetime products that CamelBak will get from time to time. But with reduction in troop activity that was anticipated even when we made our initial investment in CamelBak, that reduced level of deployment certainly impacts the sales of CamelBak products at the base level retail. So they're both headwinds. I would say that with respect to this specific year, as we entered it, we're obviously expecting impacts of sequestration and expecting impacts associated with troop production that the more unforeseen headwind was the weather. And so that probably had a bigger impact, at least relative to our expectations on the business more so than the other, only because it was not something that we could have anticipated or predicted as we headed into 2013.

And next, we'll move on to Troy Ward with KBW. Troy L. Ward - Keefe, Bruyette, & Woods, Inc., Research Division: Real quick -- couple of questions. First, regarding the supplemental put. We do understand that because of changes in the regulatory requirement, you can't use this kind of as your tracking mechanism for the management's carry on the portfolio. But this is something we find very useful because it really provided us kind of an insight in the movements of fair value of the portfolio. Will this be something that your permitted to continue to communicate to us in the filings, despite not being able to use it as an expense mechanism?

Troy, we actually work with the SEC on the accounting for the termination of supplemental put, and basically that's their concurrence on our accounting treatment. As part of that the accounting obviously was completed as of July 1, and this basically -- the disclosures are no longer permitted under that -- as part of the termination process. We will try to work with the SEC, but -- to see if we can provide that in some different pattern or different area outside of our financial statements. But as of right now, I'm not sure that we'll be able to do it. Troy L. Ward - Keefe, Bruyette, & Woods, Inc., Research Division: Okay, great. And then on a specific -- a few questions on businesses here. With Arnold, the 10-Q provided that 75% of the sales from third quarter came from the PMAG division, which is about $24 million of the $32 million of sales. What were the sales kind of roughly for the Flex and the Rolled Product divisions?

Let us just make sure we give you an accurate answer here. Give us just one second. Troy L. Ward - Keefe, Bruyette, & Woods, Inc., Research Division: Okay, you can come back to that. Alan, I'll move on to one on kind of the acquisition environment.

Sure. Yes

Historically, your purchase multiples have been between maybe 5, 6x but, however, given your obvious success with growth companies like Fox in the branded segments, is there an expectation that in the current environment, or maybe even, for a long time going forward, that 6 and 7 multiples on quality growth companies just isn't going to exist? How do you think about that compared to the current market environment?

Yes. Well, your point is an interesting one in the context of valuations in the current environment. I think that if we were to go back and look at our companies that we've acquired since inception, I think you might be giving us too much credit. I think our average multiple might be a little bit higher than that, that you referenced here. But that being said, we certainly historically have been able to acquire high-quality companies at valuations whether it's 6 to 7-ish times, some a little lower, some we reached up higher to. And I think that right now, I do not expect that we would be able to acquire a company in this environment of the size and quality that we would like and that our shareholders have become accustomed to for 6x cash flow. It's just not, I think, realistic, to expect that. I think we have -- in our experience, both as a public company and prior to being a public company, have grown to appreciate that while maintaining a value orientation, which I believe, is core to our structure and core to how we operate our business, I think that we believe that there are companies that we would certainly pay more for, whether that's 7, 8 even 9x cash flow for a company that had the type of characteristics that make it worth that, that still can in my mind and the mind of our team here, represent compelling values. So Troy, I think you are correct in assuming that acquisitions of the types of companies we see, particularly in this environment, are very unlikely to occur at a multiple that looks like 6x and far more likely to occur at a multiple that looks like 8x. Troy L. Ward - Keefe, Bruyette, & Woods, Inc., Research Division: Okay, that's helpful. And then on Liberty, you referenced that non-dealer sales were up strong in the quarter, attributed to 2 large accounts. And then in the past and even in your 10-Q, you mentioned Cabela's by name. And I assume that that's one of the 2 accounts. Can you tell us what the other large customer is, just so we can get a feel for maybe how the expansion of that franchise can impact Liberty?

Yes, Troy, I think that it's -- I'd would prefer not to be talking about company's customers by name. I think that it's fair to say that Liberty is extremely active in the non-dealer market with a variety of growing and national retailers that focus on the outdoorsman, the sporting and shooting enthusiast. And I think there is a list of those companies that are pretty evident and I think that it's fair to say that Liberty is doing business with the ones you would expect them to do business with. I think that the -- what I would say is one of the things that really distinguishes Liberty in that marketplace is their ability to not only provide a full suite of products to these retailers at a variety of price points, but to also really work with them in managing the category and truly adding value with respect to inventory assortment, replenishment, promotions, marketing and really helping these retailers learn how to optimize their footprint and sale of safes to their customers. So, I think that -- I'm sorry, that I'd prefer not to answer that question as directly as you would like, but I hope that gives you some guidance. The other thing I'd say about these retailers is that many of them are growing -- they're growing aggressively in terms of new store openings and they look to Liberty to be their ongoing supplier to support the company's growth, which is completely consistent with our investment in Liberty's manufacturing infrastructure. So I think that I'm very pleased with Liberty's partnership with some important non-dealers as well as dealers, to support their growth and be able to provide them products going forward. So it's -- hopefully, that gives you some color, if not we... Troy L. Ward - Keefe, Bruyette, & Woods, Inc., Research Division: That's fine, I understand. And then one last kind of further on Liberty. As you think about the very rapid growth you see over the last -- definitely 2013 but even into 2012. Obviously, there's been some events, tragic events that have brought the focus on guns and that has helped sales to the fact that -- fearful of legislation that impacts the ability for people to buy new guns, but also, I know Liberty started doing some much more aggressive marketing during 2013. So how would you view the strength in Liberty, kind of thinking about external factors outside the company but also internal factors and how can that propel growth going forward?

Yes. This is something that we talk a lot when we consider Liberty and talk with the Liberty management about it. It's very hard to peel back the impact of the marketing from the impact of the events, a try to quantify the impact of both. I think I can say without any hesitation or reservation, that Liberty's marketing efforts have absolutely been effective in promoting both the brand, as well as the category. However, I think that the external events, which led to discussions about gun legislation and led to incredible levels of gun-purchasing activity, are undoubtedly largely responsible for the enormous growth that we've seen in Liberty. And that's not to discount the impact of the marketing, but if you were to ask me, which do I think had a greater impact on these very recent results, it will be hard not to attribute it more to the external events than the marketing. I do think that marketing, however, will be a real difference maker for Liberty in the context of its business going forward, particularly due to the inevitable, I think, slowdown in some gun purchasing activity relative to recent levels. And so I think that Liberty is certainly poised to be a long-term grower, but I do think, I believe I've mentioned in the past that it's very difficult to anticipate Liberty will just simply be able to maintain this level of performance, because I do think that the permitting data that we track associated with people registering to purchase firearms, when you combine the month with the prior year month, it seems some declines over the last several months, although this most recent several month was a positive. But it just gives us a little pause as we look at expectations for Liberty going forward.…

Troy, you were looking for the absolute numbers for Arnold for the quarter? Was that -- that your question was for the different segments of the business? Troy L. Ward - Keefe, Bruyette, & Woods, Inc., Research Division: Right. Just to understand how kind of Flex and the Rolled segment are doing?

Yes. In total, the business did $32.3 million of revenue, which PMAG was $23.9 million, Flex is $6.6 million and Rolled Products was $1.8 million for the quarter.

[Operator Instructions] Next, we'll move to Vernon Plack with BB&T Capital Markets. Vernon C. Plack - BB&T Capital Markets, Research Division: This is just one question. Most of my questions have been answered. But on Advanced Circuits, I know some maintenance CapEx went up a lot. Could you help me understand why?

Yes. Elias will comment on that, Vernon.

Yes. So Vernon, it's really just a timing issue. Our first and second quarters, we had relatively low maintenance CapEx and it was budgeted for the year. We look at Advanced Circuits now, given the size of the business with 3 facilities around the U.S. as having kind of a $2 million to $3 million maintenance CapEx spend a year and so I think, this is consistent with that. It was just truly timing where it came into the third quarter with a big maintenance CapEx spike, but I don't think anybody should draw that, this is an annualized level of maintenance CapEx. I think for the profitability of the business, it still runs incredibly efficiently in terms of capital utilization and so we are very pleased with the business, still, but that would be the reason for the Q3 and I think it will normalize. And when you look at it on kind of an annual basis, it will be consistent with what our expectations are.

And Vernon, that was also consistent with our expectations. Even the previous quarter, we thought that maintenance capital expenses would come in between $11 million and $13 million and we anticipated those expenditures and that's why we still believe it's going to come in between $11 million and $13 million.

And we'll take a question from J.T. Rogers with Janney Capital Markets.

I had a question on AFM, saw a big sequential increase in sales there. You had a decline in gross margins. I know margins were up year-over-year, but just given the changes you've made there to your distribution, just wondering why we saw that sequential decline?

Yes. J.T., I think that AFM really has made some positive strides and I think that the big component of the furniture industry are material costs and I think that there had been some modest increases in material costs that have impacted margins. But I also think in the quarter, perhaps, more importantly, I believe that they had...

Gross profit is actually up.

Margin, now, he is asking about?

That was $6.6 million versus $5.8 million.

Oh. Quarter-over-quarter?

Yes.

Jim, I was talking on a sequential basis, went from 7.1% gross margins in 2Q to...

In addition, the company is introducing a lot of new products and as part of that, there are some mix issues in the quarter associated with the company selling some of their older products as they transition to the new, which results in a little bit of pressure on gross margin as well. So we would expect those margin trends to improve as the company has successful new product introductions going forward. But I think that -- I don't think, J.T., that it's representative of any meaningful shift in the business or something that would impact our outlook on the 2013 financial performance for AFM. Rather, I think it's just -- I don't want to call it a timing issue, but more of a mix issue associated with where they were in the context of their year as well as the new product introductions. Troy L. Ward - Keefe, Bruyette, & Woods, Inc., Research Division: Okay. That's helpful. Have you guys seen any change, obviously, it was a big year-over-year growth. Any change in terms of end market demand? Any sense that you guys are -- any sense of that?

Yes. I think at a macro level, I would say it's fairly consistent with what we've seen recently. At a more company-specific level, I think the management team has done a great job with the new product introductions, the penetration of some additional customers, particularly new, what I'll call mid-tier furniture retailers, so getting a broader distribution and a bigger piece of the pie relative to what they had historically. However, I wouldn't say we're in a phase right now where there's a tangible or notable expansion within the pie itself. So very pleased with AFM's performance, but, at this point, don't really have any visibility towards an improvement in end-market demand at a macro level. Hopefully, that will occur going forward, but I think as we've talked about previously, the consumer that purchases ultimately a piece of AFM furniture is a consumer with less disposable income and a consumer that is still struggling with high levels of unemployment, with high levels of personal debt, high gas prices, things of that nature. And I think that while there has been obvious, at a minimum, steadying and perhaps even beyond an improvement in the economy for many, I don't think that, that has completely found its way to the consumer that ultimately buys a piece of American furniture. So until that happens, I think that the end markets are expected to stay fairly steady and that American's doing all it can to improve its slice of that market. Hopefully, and eventually, I'm sure there'll be a return to a growing demand for their products. But it's impossible for me to predict when we think that's going to occur.

Yes, sure. Understandable. That's helpful. On -- just another one question on ERGObaby, also saw some compression on gross margins there. I think in the Q, they discussed some sales discounts on baby carriers, but just wondering what's driving those sales discounts given that we're sort of, what I assume is early in the -- still in the growth stages of ERGObaby and expanding their end markets.

Sure, Elias will address that for you, J.T.

So, J.T., there was a couple of things that caused discounts in the quarter. First, we changed our packaging worldwide and in doing so, we had some of the older packaging that we needed and cleaned out a lot of that inventory. In doing so, we offered some discounts on the product. It has nothing to do with kind of longer-term, kind of demand or needing to simulate demand. It was truly just changeover in packaging on the carrier side. In terms of the stroller business, there was also some weakness there as we gave some discounts and we'll be -- and that was really due to -- and we've announced this, that we are coming out with our next-generation stroller, which is our G3 travel system, and with the G2 phasing out in advance of the G3, we're working through that inventory in the channel. That's also putting a little bit of pressure as you could imagine on sales of the existing travel system as we get ready to launch the new one in the coming year. So, it's really just managing some of the transition to both packaging on the carrier and to the new product line on the travel system. But I would say, all remains very healthy in that business and we're -- continue to be very excited about the growth prospects for ERGO this year and as we look out kind of next year and into the future. The brand remains healthy enough that we don't need to give discounts in order to stimulate demand.

And at this time, there are no further questions. I would like to turn the call back over to the company for any additional or closing remarks.

I want to thank all of you for your continued support. We appreciate it very much, and we look forward to speaking to you next quarter. Thanks.

And that will conclude today's call. We thank you for your participation.