Compass Diversified Holdings changes its tax status. It is an opportunity for investors.

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Traders working on the New York Stock Exchange

NYSE


Compass Diversified Holdings

shareholders approved a conversion of the company’s tax classification this month, a technical measure that is expected to simplify stock ownership, broaden its appeal to more investors, and reward stocks with a multiple of higher profits.

Compass (symbol: CODI) looks like a publicly traded private equity fund: it buys, sells and operates a portfolio of companies in consumer and industrial end markets, but has permanent capital rather than raised funds. periodically and for a defined period.

Compass raises funds through equity and debt at the holding company level, allowing its current nine subsidiaries to obtain financing for less than they would on their own. The company’s consumer-focused holdings are focused on tactical clothing and products, baseball bats, ski boot buckles, helmets and other sports equipment. Its industrial subsidiaries manufacture candles and other heating tools for catering, custom packaging, high-tech magnets and printed circuits.

This is a model that has been successful in the 15 years since the Compass IPO. Including an annual distribution of $ 1.44 per share – paid from the cash flows of the company’s subsidiaries – the stock has earned nearly 14% per year since 2006, compared to 9% for the


Russell 2000 Index

small cap stocks. Barron recommended buying the stock in 2019, and Compass has returned around 110% since then, roughly double the small-cap index.

Citing high valuations in the market, Compass has been in divestment mode lately, CEO Elias Sabo said. It closed a sale of Liberty Safe for $ 127 million on August 3 and filed an S-1 prospectus for 5.11 Tactical, its largest consumer-focused company. This could lead to an initial public offering for 5.11, a similar path that Compass took with the former subsidiary.


Fox Factory Holding

(FOXF).

Compass was structured as a publicly traded partnership, but not for very long. Some 98% of Compass shareholders representing 57% of the outstanding shares voted on August 3 to approve management’s plans to reclassify the company as C-Corp for tax purposes. This conversion will take place on September 1.

Shareholders of a partnership must pay their share of the company’s profits each year as part of their personal taxes. A C-Corp, on the other hand, pays corporation tax directly and is taxed separately from its shareholders. This is how the vast majority of US stocks are classified.

Some mutual funds, retirement accounts, and other investment advisers shy away from partnership stocks due to the increased complexity of tax season. And partnerships are often not eligible for inclusion in the index, which means their stocks don’t see the demand to buy exchange-traded index funds.

All other things being equal, removing these overhangs and making Compass stocks easier for investors to own should lead to increased demand for the stock and increase its earnings multiple.

“Upgrading to C-corp should help lower Compass’s cost of capital, support a more flexible capital structure (i.e. use stocks as a more efficient source of capital for growth) and make CODI shares easier to own, ”William Blair wrote. analyst Cristopher Kennedy in a recent report. “In addition, this should position CODI stocks to be included in the indices and could help to [credit] rating agencies.

Kennedy quotes


KKR

(KKR),


Carlyle Group

(CG),


black stone

(BX), and


Arès management

(ARES) as past examples of private equity firms that exchanged their tax status from a partnership to become C-Corps. All four saw their price-to-earnings ratios increase dramatically after the conversion, and he sees the potential for Compass to move in the same direction.

Society Teleprinter Conversion date Average multiple P / E before conversion Multiple P / E average post-conversion
KKR KKR Jul 2018 8.2 15.3
Carlyle Group CG Jan 2020 9.3 14.4
black stone BX Jul 2019 9.17 19.8
Arès management ARES november 2018 10.4 18.0

Sources: William Blair, FactSet

(If you cannot view the above table, please click here.)

Kennedy values ​​Compass’s stock at the equivalent of Buy. It calculates a sum of parts value of $ 32.20 per share for the current subsidiaries of the company, before any significant multiple expansion after the conversion.

There are a few more moving parts that investors should consider.

Compass will reduce its quarterly distribution to 25 cents per share from 36 cents, effective January 2022. This dividend payment will be made after corporate taxes have been paid by Compass.

The C-Corp conversion will also create a new tax payable in 2021 for shareholders while increasing the cost base of Compass subsidiaries by the same amount, thereby reducing future taxes. Compass’s board of directors has approved a special distribution of 88 cents to offset the new cost which is payable on September 7 to shareholders of record on August 31, the day before the conversion. Proceeds from the sale of Liberty Safe will cover this distribution.

Investors who want to avoid having to deal with the tax complications of a partnership for their 2021 taxes can start buying Compass shares on September 1. Compass will pay an additional dividend of 36 cents in October before the new rate goes into effect, giving it a regular dividend yield over time of around 4%. FTSE Russell rebalances its indices each spring, when Compass may become eligible for inclusion.

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