Compass Diversified - Q3 2022
November 3, 2022
Transcript
Operator (participant)
Good afternoon, and welcome to Compass Diversified third quarter 2022 conference call. Today's call is being recorded. All lines have been placed on mute. If you would like to ask a question at the end of the prepared remarks, please press the star key, then the number one on your touchtone phone. At this time, I would like to turn the conference over to Cody Slach of Gateway Group for introductions and the reading of the safe harbor statement. Please go ahead, sir.
Cody Slach (Senior Managing Director)
Thank you, and welcome to Compass Diversified's third quarter 2022 conference call. Representing the company today are Elias Sabo, CODI's CEO, Ryan Faulkingham, CODI's CFO, and Pat Maciariello, COO of Compass Group Management. Before we begin, I'd like to point out that the Q3 2022 press release, including the financial tables and non-GAAP financial measure reconciliations, are available at the investor relations section on the company's website at compassdiversified.com. The company also filed its Form 10-Q with the SEC today after the market closed, which includes reconciliations of certain non-GAAP financial measures discussed on this call and is also available at the investor relations section of the company's website. Please note that references to EBITDA on the following discussions refer to adjusted EBITDA as reconciled to net income or loss from continuing operations in the company's financial filings.
The company does not provide a reconciliation of its full year expected 2022 adjusted earnings or adjusted EBITDA because certain significant reconciling information is not available without unreasonable efforts. Throughout this call, we will refer to Compass Diversified as CODI or the company. Now allow me to read 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 and its subsidiaries, the impact and expected timing of acquisitions and dispositions and future operational plans such as ESG initiatives. Words such as believes, expects, anticipates, plans, 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-Q as filed with the SEC for the quarter ended September 30th, 2022, as well as in other SEC filings. In particular, the domestic and global economic environment, supply chain, labor disruptions and inflation all may have a significant impact on our subsidiary companies. Except as required by law, 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 Elias Sabo.
Elias Sabo (CEO)
Good afternoon, everyone, and thanks for joining us today on our third quarter 2022 conference call. I am pleased to report that we delivered another exceptional quarter, with third quarter revenue and pro forma combined subsidiary EBITDA increasing by 15% and 16% respectively over prior year. Q3 marked our seventh consecutive quarter of double-digit consolidated pro forma subsidiary EBITDA growth. Notwithstanding the difficult macro climate, the strength of our year-to-date operating result is enabling us to raise our 2022 outlook once again. The macro environment has created significant challenges and distortions over the past few years. The effects of the pandemic on the global economy were profound, and we continued to wrestle with headwinds stemming from the pandemic. Throughout much of 2022, we dealt with erratic supply chains, labor shortages, and inflation running at 40-year highs.
Despite these challenges, we generated record year-to-date operating results, which is a testament to the competitive positioning and management strength at our subsidiary companies. As we finish 2022 and enter 2023, we face new macro-led challenges. Supply chains are starting to normalize, but labor markets remain unbalanced and inflation continues, particularly in wages. Global demand has eased, with Europe showing significant weakness and Asia's growth becoming more erratic due to China's zero COVID policy. Domestic spending has remained strong among the more affluent consumer, but we have seen a large decline in discretionary purchases for price-sensitive shoppers. Together, these macro issues pose a difficult challenge as we finish 2022 and enter 2023. Despite these challenges, we believe CODI is positioned to outperform in both good times and bad times.
We own a collection of subsidiaries with diverse end markets, business cycles, investment cycles, and inventory cycles, among others. This diversification proved to be essential during the pandemic, where we produced growth in 2020 against a very difficult macro backdrop. As you are aware, a strategic initiative of ours has been to launch a healthcare vertical. This afternoon, we announced that effective November 1st, Kurt Roth has joined our team with responsibility over our healthcare initiative. Kurt brings a wealth of healthcare investing and transaction experience, having previously worked closely with the Compass team during his tenure at Robert W. Baird. Most recently, he spent the last seven years as Head of Corporate Development and Strategy with Sotera Health, a leading global provider of mission-critical end-to-end sterilization solutions, lab testing, and advisory services for the healthcare industry.
During his tenure, Sotera consistently grew revenue and expanded profitability while developing a successful track record of identifying, completing, and integrating strategic acquisitions. We are delighted to have Kurt join our team. Not only does he possess the skills to build our healthcare vertical, but more importantly, he aligns with our culture and values. Healthcare is an important initiative that will allow us to see a significant increase in actionable opportunities. The healthcare industry is large and growing rapidly, and we believe the acyclical nature of the industry will add to the diversification of our subsidiaries and further decrease our financial volatility. As we have also stated on prior calls, the subsidiary company transformation over the past few years has created a much faster core growth rate.
I would like to highlight that four of our subsidiaries, BOA Technology, PrimaLoft, 5.11 Tactical, and Lugano, are all rapid market share taking businesses with low penetration in industries with positive long-term macro trends. These four businesses represent over 50% of our consolidated subsidiary EBITDA, and we believe their ability to continue to take share at a rapid pace will both soften any reduction in demand while accelerating the growth rate in stronger times. Before I turn the call over to Pat, I want to discuss the recent shifts in the capital markets and the implications as we head into 2023. As we are all aware, the Federal Reserve has aggressively tightened monetary policy in an effort to ward off high inflation. This has in part caused a major correction in the stock and bond markets, with the bond market indicating the likelihood of a recession in 2023.
Broadly, we have seen a reduction in new orders across our subsidiary companies. However, end market demand for the majority of our goods remains strong. We believe a period of inventory de-accumulation is taking place, first, as supply chains are normalizing and companies are moving back to more just-in-time inventory. Second, as fears of an economic slowdown are causing companies to plan inventory more carefully. Taking these factors into consideration, we are planning for a more challenging demand environment in 2023 with easing supply and inflationary pressures. Notwithstanding a weaker demand outlook, we are confident in our company's competitive positioning and market share growth, and believe we are poised to outperform our peers. With that, I will now turn the call over to Pat.
Pat Maciariello (COO)
Thanks, Elias. Throughout this presentation, when we discuss pro forma results, it will be as if we owned PrimaLoft and Lugano from January 1st, 2021. On a combined basis, revenue and pro forma adjusted EBITDA in both our branded consumer and our niche industrial business grew and continued to exceed our expectations. Once again, third quarter EBITDA growth exceeded revenue growth as our higher margin businesses outpaced the group as a whole. Before I get to our subsidiary results, I wanted to provide a high-level view of the quarter's results. As Elias alluded to, several of our companies who sell to retailers focused on mass channels continued to face pressures as their consumers remain impacted by inflation and retailers continue to focus on reducing inventories. These headwinds were most acutely felt at Sterno, Velocity, and Ergobaby.
In addition, currency headwinds increased in the third quarter and impacted several of our subsidiaries. Despite these challenges, on a consolidated basis, we were able to achieve meaningful growth in the quarter. Once again, our management teams executed well for their customers and employees, and we are proud to be their partners. Now, on to our subsidiary results. I'll begin with our niche industrial businesses. For the first nine months of 2022, revenues increased by 13.2% and adjusted EBITDA increased by 10.8% versus the year-to-date period of 2021. Arnold and Altor posted meaningful revenue and adjusted EBITDA growth. Arnold continued to show improving margins driven by technology investments made over the last several years. Additionally, the company continues to have meaningfully positive book-to-bill ratios as demand for its technology, which enable efficiency gains in numerous industries and applications, continue to increase.
As we mentioned last quarter, the company is competing against a very large defense-related order in the back half of last year, but should have solid performance in the fourth quarter. Altor once again had solid growth, partially driven by its acquisition of Plymouth Foam in the fourth quarter of 2021. Though margins remain pressured by higher raw material prices at Altor, gross margins ticked up sequentially, and we expect them to continue to improve in Q4. The Sterno Group faced some challenges in the third quarter. Though the food service portion of the business continued to return to normalcy post-pandemic, and we expect a strong fourth quarter in that segment, the company is seeing pressure in sales of its value-driven line of scented waxes. These pressures are a result of both inflation impacting end users and retailers focusing on driving down inventory levels, as discussed earlier.
We expect these pressures to continue in the near term. Turning to our consumer businesses, for the year-to-date period, revenues increased by 16.5% and pro forma adjusted EBITDA increased by 18% as compared to the same period in 2021. BOA had another very strong quarter of performance. For the year-to-date period, revenues increased by 38.5% and EBITDA by close to 50% from the same period last year. In the fourth quarter, we expect BOA to be approximately flat to last year as the company comps against a very strong Q4 2021. However, we wanna recognize that the full year of 2022 has been an exceptional year of growth and our second full year of partnering with the company.
We remain enthusiastic about BOA's expansion into adjacent categories and believe the company will continue to gain market penetration in the years ahead. Lugano's growth accelerated in the third quarter, and the company has now grown both revenue and pro forma adjusted EBITDA for the year-to-date period by close to 70%. We benefited in the quarter from both the opening of our new Houston salon and from an increase in average transaction size. Lugano is starting the fourth quarter well, and we plan on opening our new flagship Newport salon before year-end and to continue expanding geographically in 2023. We believe that Lugano possesses a disruptive business model, and we will continue to support the company with investments in inventory, people, and new salons. Marucci also had an exceptional quarter as the launch of the highly anticipated CATX line of bats was above expectations.
For the year-to-date September period, Marucci's revenue and EBITDA grew by 41.9% and 13.2% respectively. Margins improved in the quarter as the supply chain related issues we experienced in the first half of the year began to somewhat dissipate. Marucci is also having early success entering several new markets, including fielding gloves and fast pitch softball, and we are confident these adjacent categories will be drivers of further growth. Turning now to our most recent acquisition, PrimaLoft. For the year-to-date period, pro forma revenue and EBITDA increased by 25.8% and 33% respectively. For the third quarter, on a pro forma basis, revenue and EBITDA were approximately flat with 2021 levels. Due to the seasonal nature of PrimaLoft's outerwear-driven business, the second half of the year typically accounts for less than a third of full year EBITDA.
Booking and quoting trends are solid heading into 2023, and we remain pleased with the PrimaLoft acquisition and optimistic that they will continue to take market share. Touching briefly on 5.11. We're proud of the company's performance in a difficult environment for apparel businesses. For the year-to-date period, revenue and EBITDA grew by 9.2% and 3.4% respectively. Despite the headwinds in the industry, 5.11 continued to grow in the third quarter, and its direct-to-consumer comps remained meaningfully positive. We continue to be excited by the brand's potential and believe the business remains well-positioned for continued growth. As a whole, we were very pleased with the performance of our businesses in the third quarter.
As Elias mentioned, we believe there will be continued economic headwinds in the fourth quarter, but on a consolidated basis, CODI is well-positioned to weather these storms and have solid performance. I will now turn the call over to Ryan for additional comments on our financial results.
Ryan Faulkingham (CFO)
Thank you, Pat. On to our consolidated financial results for the quarter ended September 30th, 2022. I'll limit my comments largely to the overall results for CODI, since the individual subsidiary results are detailed in our Form 10-Q that was filed with the SEC earlier today. On a consolidated basis, third quarter revenue was up 22% to $597.6 million, compared to $488.2 million in the prior year period. This increase reflects the company's acquisition of PrimaLoft in July 2022, as well as the strong double-digit revenue growth from BOA, Lugano, Marucci, 5.11, and Altor. On a pro forma basis, assuming we had acquired Lugano and PrimaLoft on January 1st, 2021, net sales were up 15% compared to the prior year period.
Consolidated net income for the quarter was $2.6 million, down from $90.1 million in the comparable year ago quarter. As a reminder, Q3 last year included a $72.7 million gain on the sale of Liberty Safe. As introduced earlier this year, we believe adjusted earnings, a non-GAAP financial metric, will allow investors to assess our operating performance in a more meaningful and transparent way. Adjusted earnings for the quarter was $46 million, up $10.1 million, or 28% from the year ago quarter. Our adjusted earnings generated during the quarter were above our expectations for the reasons previously highlighted by Elias and Pat. In addition, our adjusted earnings were positively impacted by a $3.5 million income tax benefit at PrimaLoft, primarily due to the acquisition costs expensed during the quarter.
I'll provide an update on our adjusted earnings guidance shortly. Before I get to our balance sheet metrics, in this rising interest rate environment, I wanna highlight how fortunate we are to have placed $1.3 billion of bonds on our balance sheet in 2021 at a blended fixed rate of 5.2%, representing 70% of our total outstanding debt and with maturities of 2029 and beyond. Now to the balance sheet. As of September 30th, 2022, we had approximately $61 million in cash, $113 million drawn down on our revolver, $397 million in term loans, and total leverage of approximately 3.9x. We had $485 million available on our revolver, and we have the ability to upsize our revolver capacity by an additional $250 million.
With this substantial liquidity and capital, we continue to be well-positioned to provide our subsidiaries with the financial support they need, invest in subsidiary growth opportunities, and act on compelling acquisition opportunities as they present themselves. Turning now to cash flow. During the third quarter of 2022, we used $4.6 million of cash flow from operations. Our cash earnings during the quarter were able to fund our working capital needs, which were primarily directed towards our strategic inventory investment at Lugano. In addition, many of our consumer companies experienced strong revenue growth, which required working capital investments. While this is a seasonally high point for inventory levels, our management teams are closely monitoring their inventory to ensure we meet consumer demand without a negative financial impact. Finally, turning to capital expenditures.
During the third quarter, we incurred $15.1 million of CapEx for our existing businesses, compared to $11.4 million in the prior year period. The increase was primarily a result of the continued retail store expansion at our Lugano and 5.11 subsidiaries. For the full year of 2022, we anticipate total CapEx investments of between $50 million and $60 million. The capital expenditure spend in the fourth quarter will be primarily for Lugano's new expanded headquarters in Newport Beach. In addition, we will continue to support 5.11's retail store expansion from its current 107 stores. Now on to our adjusted EBITDA and adjusted earnings guidance. Despite our excellent performance in the third quarter, we remain in uncertain times, driven by market volatility, inflationary pressures impacting consumer behavior, and labor shortages, among others.
However, as a result of our company's strong performance in the third quarter that exceeded our expectations and our current view of the economy, we are once again raising our 2022 full year consolidated subsidiary adjusted EBITDA outlook. Our previous range was $445 million-$470 million. Our revised range is $460 million-$470 million. At the midpoint, this implies year-over-year growth in subsidiary adjusted EBITDA from 2021 on a pro forma basis to include PrimaLoft of 12%. Next, I'd like to discuss adjusted earnings. As Pat mentioned earlier, PrimaLoft generates its strongest earnings in Q1 and Q2, given seasonality of ordering for the outerwear industry.
Further, because of a significant income tax benefit at PrimaLoft that I mentioned earlier, coupled with strong performance across our subsidiaries, our Q3 adjusted earnings were significantly above expectations. As a result of these items, our revised full year adjusted earnings guidance range will move from our previous range of $130 million-$145 million, upwards to $145 million-$155 million. The midpoint of our adjusted earnings range implies a 10% increase from the prior year. We anticipate our fourth quarter adjusted earnings will be down from prior year, primarily as a result of PrimaLoft's seasonality, as well as higher interest costs from funding the PrimaLoft acquisition and increasing rates on our term loan and revolver credit facilities. With that, I will now turn the call back over to Elias.
Elias Sabo (CEO)
Thank you, Ryan. I would like to close by briefly providing an update on the M&A market and our strategic initiatives. M&A activity remains significantly below historic levels. Potential sellers remain hesitant to begin processes given the economic headwinds and the macro backdrop. We anticipate the remainder of this year to be extremely slow, with a gradual increase occurring in 2023 if economic headwinds start to moderate. Strategically, we continue to focus our internal efforts on the development and implementation of our ESG strategy. During the third quarter, we spent a significant amount of time working with our subsidiaries to understand how our overarching ESG framework will be implemented into our companies.
We believe that the environmental, social, and governance standards that we use to build our framework will allow us over time to deploy capital in a different way than many in the marketplace in a way that we think reflects risk more appropriately. We believe implementation of our ESG framework requires board involvement and oversight. In the last quarter, our board has undergone training regarding proposed climate disclosure, reporting regulations, and we continue to build out and enhance the learning process so that our board understands the risks and opportunities. In our most recent board meeting, we presented our ESG framework, and we received buy-in from our directors as we proceed to implementation. Finally, we believe health and wellbeing should be a priority for all.
In line with the World Health Organization objective to raise awareness of mental health, we have adopted a health and well-being month during the month of November, which will become an annual event. This campaign aligns with one of our key ESG imperatives of future-proofing for our people and planet, specifically our focus on health and well-being and attracting and retaining the best talent. In conclusion, it was another great quarter for CODI. Relative to our expectations, our performance was once again outstanding. Our management teams and employees continue to put forth incredible effort, and I'd like to give thanks and recognition to all of them. Before turning over to Q&A, I'd like to briefly mention that we will be hosting our Investor and Analyst Day in New York City on January 19th, 2023.
We will be highlighting each of our consumer companies with a more detailed showcase of PrimaLoft's products, including a presentation from Mike Joyce, PrimaLoft's CEO. More details to follow in the coming weeks, but we hope to see you all there. With that, operator, please open up the lines for Q&A.
Operator (participant)
At this time, I would like to remind everyone in order to ask a question, press star then the number one on your telephone keypad. Your first question comes from the line of Larry Solow with CJS Securities. Larry Solow, your line is now open.
Larry Solow (Managing Director)
Great. Thank you. Thank you very much. Good evening. Good afternoon or good evening, guys. Elias, you mentioned supply chains issues starting to improve a little bit, but there's still obviously a lot of some disjointed stuff and sounds like labor market's still very difficult. How about for you guys specifically? Are there any companies that are disproportionately any of your subsidiaries still feeling the you know the supply chain impact you know or challenges more so than you know than the average of you know? Obviously labor costs are higher, but have you guys been able to for the most part hire you know a satisfied amount of people or do you have a lot of shortages across many of your companies?
Elias Sabo (CEO)
Yeah. I'll let Pat talk about supply chain by company. I would say in terms of, you know, labor markets, Larry, they continue to remain out of balance. I think it's one of the, you know, bigger issues clearly on the macro level. You know, wage inflation is running extremely high. I think we all saw the JOLTS data the other day and ADP with, you know, almost 8% wage inflation year-on-year. You know, it's quite troubling, I would say, you know, when we see this kind of imbalance. There's been some additional hiring that we've been able to. I would say it's company by company experience. It's not broadly and universal. There's still a lot of openings.
There's still a lot of overtime that, you know, is being asked, which is really inefficient from both a cost and productivity standpoint. I would say, you know, it's not only wage inflation that is problematic here, but the fact that there's just not enough labor for the available spots continues to be an issue. You know, I think there's been some marginal improvement on labor availability, but it's not material. In terms of supply chain, Pat, you know, what are we seeing in terms of companies that are struggling still, more so than the average?
Pat Maciariello (COO)
Yeah. I mean, it's everybody's still struggling and it is, you know, getting better. It's definitely getting better, you know, everywhere at each of our 11 businesses, though there's challenges at each of the 11. A couple I would point to that, you know, may have had higher revenues if not for the supply chain issues though would be Velocity, where, you know, we manufacture a lot of sporting goods equipment. Oftentimes you have 99% of the product done, but you're waiting on one piece and that cost us, you know, some revenue this quarter, as we just didn't have that one final piece to assemble it. I would also say at Advanced Circuits we have a large assembly business where, you know, we assemble componentry for our clients.
Again, you have, you know, hundreds of pieces on a product and you have 99% of those in, but you don't have the hundredth, and so you can't ship the product. Those are two, you know, things that stand out as where we probably, you know, missed out on a little bit of revenue, this quarter if that's helpful, Larry.
Elias Sabo (CEO)
In general, Larry-
Larry Solow (Managing Director)
Yeah, absolutely.
Elias Sabo (CEO)
Supply chains are easing and shipping costs have come back to pre-pandemic levels. Port congestion has really been reduced and we're getting a good flow, you know, coming out of the ports and getting into our warehouses. You know, yeah, are there a couple of continuing, you know, minor issues that are experienced in the third quarter? Yes. Could there even be a little bit of, you know, problems existing in the fourth? Probably, but even less so. You know, I think the point to take is that supply chains are clearly normalizing and, you know, I think now on the other side, it's probably allowing companies to deaccumulate inventory a little bit because supply chains are normalizing.
I think those two things go hand in hand and that's likely, you know, gonna put system-wide some pressure down on order demand, you know, as companies are able to work down some of that inventory and manage more just in time based on a more efficient supply chain again.
Larry Solow (Managing Director)
Got it. Great. Just one more quick follow-up on a sincere question on BOA. Obviously, really impressive growth this year. I think it's close to $70 million year-to-date EBITDA. Seems like your visibility, you know, is pretty strong, multi-year strong visibility. I mean, I guess the growth may slow next year. I don't expect it to double again, but it sounds like, you know, you guys feel like, maybe this was an outsized year, but it doesn't feel like we're gonna contract or anything next year, right? Maybe just growth may slow a little bit. Is that sort of fair?
Elias Sabo (CEO)
Yeah, Larry, I think when you think about BOA and we really wanted to highlight for everyone not only BOA but, you know, PrimaLoft, 5.11 and Lugano. We put all three of those into companies that have relatively low market share in their respective industries but also are really fast market share takers. Take BOA, you know, as an example. BOA's market share is under 5% today but it's got disruptive technology. You know, when people experience using the product in a category, if you're a golfer and you use a BOA product and then you go do a Peloton ride, you're probably likely to want the product for a Peloton as well. As we get into more of these categories, you know, there's a huge TAM that's out there.
The product is, as I said, you know, a really exceptional and people love it and, it's very disruptive to the hundred-year-old, you know, kind of non-innovative lace industry. It may be an easy target that we're going after. But when you have those kind of dynamics of a disruptive product with low market share. Your gains in market share are allowing you to have accelerated revenue gain at the company well in excess of what the industry is, right? I mean, the industry isn't growing 20%-30% like BOA is. All of that growth is being enabled by market share. It's hard when you look and say, "Well, with sub-5%, you know, should growth start to really wane?" We just are still so, you know, kind of under-penetrated relative to our potential.
You know, we think there's really good legs for long-term accelerated growth in this business. Now, if I want to take a much more narrow view at Q4 or the first half of 2023 or even all of 2023, look, it's hard to tell what our partners are gonna do. It's hard for us to know how much inventory they brought in and what they need to work down through the supply chain. Clearly, inventory, you know, deaccumulation can negatively, in the short term, impact the strength of growth. I would say there's no view that BOA or any of those four businesses that we mentioned, which represent over half of our EBITDA, there's no view that these companies aren't taking market share and going to continue to take market share at a rapid pace.
You know, we may have a year or a period of time or six months, whatever it may be, where, you know, there are some factors that hold that growth back somewhat. The intermediate to long-term growth trends, you know, for BOA and the other three remain absolutely intact. There's nothing that makes us less excited about that company as we stand today or the other three, or any of our companies, to be honest with you. There's nothing that makes us less excited about BOA, you know, right now than where we were three months ago, a year ago, or upon the acquisition. I mean, this is a great company, and we believe it has accelerated revenue and EBITDA growth potential for years to come.
Larry Solow (Managing Director)
Excellent. Appreciate all that color, Elias. Thanks.
Elias Sabo (CEO)
Thank you, Larry.
Operator (participant)
Your next question comes from the line of Chris Kennedy with William Blair. Chris Kennedy, your line is now open.
Chris Kennedy (Senior Equity Research Analyst)
Yeah. Good afternoon, and thanks for taking the question. Can you talk a little bit about the healthcare strategy, kind of what areas is Kurt going to be focused on and kind of the timing of his onboarding and when we might see something within that area?
Elias Sabo (CEO)
Sure. Thank you, Chris. Kurt is here with us today. He joined on November 1st, two days ago. You know, as I mentioned in the prepared remarks, we've worked with Kurt for a number of years, so we know him. I think it's really great when you can work with someone who you know fits culturally in with what you are doing. When we think about the healthcare, you know, kind of vertical and industry, you know, one, we talk about actionable opportunities. I think in 2021 there was, you know, north of, yeah, there was 1,700. I don't know if that's exact, but let's say north of 1,500, you know, kind of controlled transactions that occurred, which is really an incredible number.
We think at the top of the funnel, there's the ability to have a lot more opportunities to be seen. As you know, we have a pretty tight lens and filter in terms of what can make it down through to an opportunity that we wanna, you know, ultimately close on. This, you know, industry, I think, serves up enough opportunities for us to be able to meet our criteria and still be quite active. In terms of what we're looking for, I can tell you pretty definitively what we don't want to do, and that is we don't want to take binary risk in anything. We're not going to go into biopharmaceutical development or medical device where you either hit it and it's a home run or it's a zero. That's not what we're set up and established to do.
That's much more venture capital than us. When you take out all of sort of that drug development, medical development, you know, kind of, area, that obviously is gonna narrow down kind of the view that we look at. It really leaves sort of a broad area of services that we would like to be focused on. I would say, you know, within the service space, it's a huge area. There are a lot of essential services that are done on behalf of whether it be hospitals, outpatient centers, pharmaceutical companies, medical device companies. There are essential services that, you know, exist out there that are continuing to grow and are not subject broadly to government reimbursement.
We think those are the type of companies that really lend themselves well for, you know, the control transaction and investment like we would, you know, typically consider.
Chris Kennedy (Senior Equity Research Analyst)
I appreciate that.
Elias Sabo (CEO)
In terms of your question on when we can expect to put capital to work and have something, I mean, Kurt just joined two days ago, so I think it's a little premature to be thinking about that. Obviously, we have a team here. He'll be drawing from a lot of the resources that we have. We have a business development team that, you know, will be making a lot of contacts and has been already, you know, working in the healthcare area. You know, the bankers and the, you know, other deal intermediaries know that we're going to be active here. I would say in terms of, you know, a deal, it's gonna take a little bit of time in order for, you know, us to get fully up to speed and running. I would hope that, you know, happens in 2023.
As we said earlier, the M&A market is frozen shut right now. We are seeing virtually nothing come through from the sell side. We can't create something out of nothing, clearly. The longer we stay in an M&A freeze, you know, the longer delayed we will be before we're able to, you know, kind of put money to work in the healthcare vertical, and that's a little bit outside of our control. I think we need to probably see, you know, the Federal Reserve pause or at least become less aggressive in monetary policy. We need to see, you know, how that's gonna impact the economy, and then I think deals will, you know, start to open up and come to market, and we'll be in position when that happens.
I think everybody should know, you know, the near-term outlook for M&A, whether it's in healthcare, consumer or industrial, you know, it's quite limited right now.
Chris Kennedy (Senior Equity Research Analyst)
Understood. Just a quick follow-up. In terms of strategic add-ons, is that still frozen as well, or are there still opportunities happening? Thanks for taking the questions.
Elias Sabo (CEO)
I mean, we're always looking for add-ons, but unfortunately, the same dynamics that are affecting the platform M&A market is affecting the add-on market. I think the add-on market, because it's smaller and it's, you know, so entrepreneurial, typically can be a little different than the platform market. There is some marginally better activity levels there. You know, even sellers in the add-on, you know, potential add-ons, they understand that, you know, the stock market's down 20% year-to-date, the bond market isn't accommodating financing. Granted, they might not be, you know, big enough to achieve bond financing. I think you can see the headlines, you can see the macro. Just broadly, sellers are, you know, hesitant to come and initiate a process right now, even an add-on process.
Chris Kennedy (Senior Equity Research Analyst)
Very clear. Thank you.
Elias Sabo (CEO)
Thank you.
Operator (participant)
Ladies and gentlemen, as a reminder, should you have a question, please press the star followed by the number one. Your next question comes from Matt Koranda with Roth Capital. Matt-
Elias Sabo (CEO)
Matt.
Operator (participant)
Matt Koranda, your line is now open.
Matt Koranda (Managing Director and Senior Research Analyst)
Hey, guys. Good afternoon. Just wanted to follow up on some of the comments that Elias made earlier. I guess what I was curious about with the inventory destocking that you mentioned is just how are you preparing your subsidiaries for sort of inventory destocking at their customers? Who's most prepared at the moment in the subsidiary landscape, and then who may need a little bit of work on that front? I had a follow-up as well.
Elias Sabo (CEO)
Sure. I'll let Pat handle that.
Pat Maciariello (COO)
Yeah. I mean, we've broadly looked at the length of the supply chain, for each subsidiary, again, by subsidiary, right? Figured out sort of what that meant. You know, if it's a business that's characterized by a lot of overseas, and there's a lot of overseas, just think about what that would be as far as a headwind. I think I'm gonna touch on each of our subsidiaries is better prepared than their competitors in the space. We, you know, focus hard on it, and we have focused hard on it, and we'll continue to focus on it as we go into budgeting season. I'm not gonna comment sort of on the specifics.
Elias Sabo (CEO)
I think just overall, Matt, what we're seeing is, and as we've talked to our subsidiary companies, we just have to be prepared for whatever, you know, comes in the back half of 2022 here and into 2023. It's quite uncertain. We think inventory destocking is happening now. We know in some of our companies where we get point of sale versus what ours are, and we see a divergence of those. So we already know in some businesses that we're seeing a, you know, a certain amount of destocking happening in Q3 and Q4, and that could bleed into early 2023. I would say, you know, end demand continues to remain relatively strong. Now, there are pockets of weakness. Europe is weak. Asia is relatively weak. You know, the more price-sensitive shopper is weak.
Where the vast majority of our products go, which are domestic consumption by a more affluent customer, that end demand has stayed really strong and probably will continue to stay strong. If you think, you know, that consumer also has a job. Jobs are really plentiful. Wages are going up a lot. You know, their wage growth is higher than the inflation that they are experiencing, so there's no need to reduce discretionary spending. That's sort of where we stand today. As we look into early 2023, you know, none of us know any better than, you know, you guys on the call what this experiment of the government printing trillions of dollars, pumping it into the economy, creating massive inflation, and then having to reverse course, what that's gonna bring.
We have to be really cautious, and we have to be ready to move quickly. I would say, you know, the bigger picture, and when you say, "How are your companies dealing with this inventory deaccumulation?" it really is a question of how are our companies preparing for a potential reduction in demand, that could result either from inventory destocking or a hard landing driven by the policies of the Federal Reserve.
As we did in 2020 and in the prior recessions, you know, in the financial crisis in 2009, you know, we move quickly and try to be proactive with our companies to say, "Look, we need to pull back quickly on spending if we see that our demand isn't materializing." There are certain things that, you know, our companies like to do for more intermediate and long term. You know, those are the things that start to get pulled back to the extent you have demand weakening.
I would say right now, end market demand for our products, I wanna get this across again, you know, at the, you know, at the expense of maybe being redundant, end market demand for the majority of our products is really good. We're being cautious, and we're not saying to our companies, you know, now and with our management teams, "Now is the time you need to start pulling back," but you need to be watching everything really closely, and we need to be prepared to pull back and manage costs more tightly if demand starts to slow down, which the markets are suggesting. Even though we're not seeing it, the markets are suggesting that.
I would just say, you know, we as a management team and our subsidiary management teams are all committed, you know, to being on, you know, very vigilant and on high alert right now to see which direction the economy is gonna go, you know, based on macro policies that are being implemented principally by the Federal Reserve.
Matt Koranda (Managing Director and Senior Research Analyst)
Makes a lot of sense. Thanks for all the detail, Les. Just was curious about your willingness or posture toward doing any opportunistic divestitures to sort of de-lever the balance sheet in the near term or set yourself up for some of the incremental acquisitions that may come from the medical side. Any update to your leverage targets, just given the higher rate environment and the incremental loan on revolver is gonna be a little bit more expensive on a go-forward basis. Any updates to sort of how we should be thinking about leverage and willingness to go higher on lower on leverage in a higher rate environment?
Elias Sabo (CEO)
Yeah. First, in terms of opportunistic divestitures, you know, you know this about us, everything's for sale at the right price. If we can find, you know, the right opportunity and the right buyer that finds value, that we think is accretive for our shareholders, we are always open to that. It clearly has to be in any company that we would consider a divestiture, something that is value accretive to our shareholders over holding that business, and that's a pretty high bar. It feels like a stretch for us to be able to achieve that in an environment that is this negative and where multiples have contracted, you know, so hard.
I mean, we can look at a lot of public companies, and heck, you're seeing multiples contract, you know, 30%, 40%, 50%, 60% in a lot of businesses. I think it would be, you know, difficult to achieve sort of the valuations that we would expect for our businesses in today's environment. Not to say that that's not possible, I just would think that it's difficult to anticipate that. We're always open. I would say, you know, when markets, you know, come back, there'll be, you know, some companies that strategically we think make more sense than others. We'll always, you know, consider that, but it doesn't seem to be a likely target right now. In terms of our leverage, and I can let Ryan speak to this as well, our target remains 3.5x.
You know, understand we have over 70% of our total obligations fixed right now, which in hindsight now looks like a very good, you know, kind of move we made last year. We aren't overly exposed to higher borrowing costs. Yeah, will we have a little bit of higher borrowing costs? Of course, because on the, you know, 30% that's not fixed, those rates are going up. It was anticipated. Most of that debt was placed for the PrimaLoft acquisition, and so we feel very comfortable that, you know, PrimaLoft's earnings and earnings growth will be able to cover any additional costs, you know, that we have on that floating rate debt. But we are not changing our leverage, you know, policy.
We do remain a little bit above what our target leverage is, but given growth in the portfolio and given our cash flow that we produce now from operations, we feel comfortable with where we are. Ryan, any additional thoughts on the balance sheet?
Ryan Faulkingham (CFO)
Yeah. Just the only other thing I'd add too, you know, is just simply we've been investing, you know, pretty heavily into the growth of the subsidiaries, and that's certainly, you know, added working capital into the balance sheet. You know, that we are at a high point right now seasonally. We've got, you know, cash conversion that, you know, should occur over the next couple quarters, and at the same time, investing in businesses that continue to grow. Does that make sense? We'll have some, you know, I think, tailwind to leverage with that conversion.
Matt Koranda (Managing Director and Senior Research Analyst)
Okay. Excellent, guys. I'll jump back in queue. Thank you.
Elias Sabo (CEO)
Thank you, Matt.
Operator (participant)
Your next question comes from the line of Matthew Howlett with B. Riley. Matthew Howlett, your line is open.
Matthew Howlett (Senior Managing Director and Senior Equity Research Analyst)
Thanks for taking my question. Sorry to jump in so late. I heard the comments on Marucci, but that was really the outperformer, at least relative to my numbers. You know, I know there's some seasonality with the first half of the year. You mentioned some success, some growth in some other product categories. What can you tell us, you know, what's going on there? I mean, it looks like you have $230 million into the company. It's generating $120+ million of EBITDA. That looks like terrific. Just curious on what's going on there.
Pat Maciariello (COO)
Yeah. This is Pat. As I mentioned, and I think I mentioned it in Q2 was a little bit light because we didn't have a product launch. In Q3, we had what is kind of the big every other year launch at the Marucci brand, which is the CATX. That produced a very strong Q3. I wouldn't take kinda, you know, Q3 numbers and multiply by four and say that's what the company's doing now. We will have a good, you know, solid to good Q4. Beyond that, there's sort of momentum in sort of the other brand adjacencies that I mentioned. In fast-pitch softball and fielding gloves, which is a, you know, a large market and we're beginning to get some traction in.
Beyond that, there will be sort of, you know, incremental growth. This business is characterized, you know, on the Marucci side by, which is most of the business, by a, you know, big launch every two years, which will drive sort of, you know, again, Q3 and Q4. Then we'll have other smaller launches on the Victus side, on, you know, and with other products.
Matthew Howlett (Senior Managing Director and Senior Equity Research Analyst)
Earlier, you mentioned some supply chain issues with getting the product to shelves. That's cleared up in terms of with the recent launch, everything.
Pat Maciariello (COO)
Yeah. I mean, you'll see that the margin growth or the sort of EBITDA growth did not keep up with the revenue growth, and a lot of that was driven by this was one of those companies that was most sort of heavily impacted by having to airship a lot of products. That is starting to clear up, as Elias mentioned more broadly, but specifically to Marucci, that is starting to clear up, and we're starting to see margins return to sort of a more normal level. Now, there's some margin mix, right? As we sell, you know, Lizard Skins bat grips, and as we sell gloves, those may not have the exact same margins as aluminum bats or wood bats, but, you know, there will be mix.
The sort of big supply chain costs are, knock on wood, getting behind us.
Matthew Howlett (Senior Managing Director and Senior Equity Research Analyst)
Great. Maybe you can help me understand this a little bit more. I mean, one of the benefits of CODI is the structure, the intercompany debt that you eliminate, but it's just since you own the companies, you have the debt against them. Could you just go a little bit over? I mean, that's floating rate debt. I mean, is it? Do I think of it right where you know you're gonna be able to take cash, more cash out of the companies? I know it's for tax purposes, but do I? Am I thinking about that the right way where you could maybe fund more working capital but not obviously do anything to jeopardize the companies or pressure the companies from a debt service coverage ratio?
Just walk me through that interplay with intercompany debt, the cash flows that come from the companies. Clearly, they're, you know, they're better to be inside CODI than they are using, you know, third-party leverage loans. Just go over that, you know, rising rates on the intercompany debt part.
Elias Sabo (CEO)
Sure. Matt-
Ryan Faulkingham (CFO)
You wanna do that, Elias? Okay. I'll take it, Elias. So I would start off by saying, Matt, high level, that in the end, whatever subsidiary earns in free cash flow, it will send to CODI. It will do that because all of the management teams, right, are equity owners of each company's individual stock, and they wanna pay their debt back off as quickly as possible. They're gonna pay, you know, interest back in principal and do so as much as possible. Now, in the case of rising rates, you know, you're correct in that there will be more interest expense paid, but what that probably means is they'll just pay a little less principal back because the interest expense is a little higher, right?
In the end, that subsidiary will send whatever cash flow, you know, it can, to CODI. I think the little benefit that we do get, though, is with, you know, some rising interest expense at the subsidiary level, which as you said, is intercompany and gets eliminated. They're all C corps, and they, in theory, will have less pre-tax income and pay some less taxes there.
Matthew Howlett (Senior Managing Director and Senior Equity Research Analyst)
Absolutely.
Ryan Faulkingham (CFO)
In theory, a little less cash goes out of the system because of that and yet stays within CODI. You know, it is really, you know, tax strategy at the subsidiary level. You're correct, it all floats. It all does eliminate. I think the key message here is in the end, every subsidiary will send, you know, as much cash as they can through whether interest expense or, you know, amortization of that interest or principal payments.
Matthew Howlett (Senior Managing Director and Senior Equity Research Analyst)
If I hear you correctly, you're indifferent from the CODI perspective, from shareholders of CODI. You know, shareholders are indifferent to how you get that cash. I mean, all in all, you know, obviously it's nice to eliminate, pay less in taxes, but in reality, you don't. I mean, you're not trying to take more money out of the companies by raising, you know, increasing higher interest expense internally.
Ryan Faulkingham (CFO)
No, that's correct. I mean, there is an income stream to CODI, which is now reclassified as a C corp. So in theory, we have higher interest income coming up to CODI, but our expenses at CODI more than offset that interest income. We actually operate on an annual basis in a NOL position, assuming we don't sell. So there's really not a whole heck of a lot of, you know, tax impact at CODI for this. You know, certainly our interest expense is rising, so that does add interest expense at, you know, up at CODI. So, you know, those are really the dynamics affecting us here with rising rates. Is that being captured?
Elias Sabo (CEO)
You know, and Matt, just, you know, it's interesting and counterintuitive. Higher interest rates because we've locked in our debt on seventy whatever, 72% of it or something is locked in. Because of that, higher interest rates likely are earnings accretive to CODI. I know that's a, you know, kind of strange concept to think about, but we only have 28% of our debt that actually has a higher interest expense out the door. Our companies have 100% of their debt owed to us with higher interest expense, which gives them a greater tax shield, and therefore has lower cash taxes. You know, if you think about the two net items to CODI, the one is, well, the companies are gonna have less cash taxes that are going out the door.
On the other side, CODI's got a little more interest expense because the debt that we locked in at CODI, the amount of interest expense going out the door is less than the amount of tax savings that we end up achieving by having our companies pay us higher interest rates. Again, I know that's counterintuitive, but our cash flow actually improves marginally in a rising interest rate. Our cash earnings improve marginally because of that, which is I know a little bit counterintuitive, but it also has to do with us having, you know, most of our debt fixed and our companies having their debt be variable.
Matthew Howlett (Senior Managing Director and Senior Equity Research Analyst)
Yeah, it's sort of an embedded inflation I said, yeah, that that I didn't really foresee at first, and now I see it. Of course, since you own the companies, I mean, there's no terms of debt service coverage. There's never, you know, they're not in, you know, obviously worried about anything you see in the broader leveraged loan market in terms of, you know, interest coverage and things like that. It's not an issue with your company. That's an interesting, dynamic. I guess with that, I mean, was there any update to the working capital, you know, the capital expenditures in Lugano, and now 5.11? I know you'd laid out some guidance. It was around $70 million last quarter. Just curious, an update there.
Lugano looks like the more money you give it, the more money it makes. I mean, any update there?
Pat Maciariello (COO)
No. I mean, it will be. You've seen us. As the company continues to grow, we'll continue to fund inventory, and we monitor it, you know, obviously very closely as it's a large investment. The company's, you know, proven to be good stewards and a lot of the sort of ratios that we look for around inventory are improving or not, at least not getting, you know, worse. They're solid and stable. As it relates to 5.11 Tactical, I think we're about to open our 107th store. The stores proved to be a great driver of growth and profit, and we believe will continue to do that next year.
Matthew Howlett (Senior Managing Director and Senior Equity Research Analyst)
Great, guys. Congratulations.
Pat Maciariello (COO)
Thank you.
Elias Sabo (CEO)
Thank you, Matt.
Operator (participant)
There are no further questions at this time. I would now like to turn the conference back over to Mr. Sabo.
Elias Sabo (CEO)
Thank you, operator. As always, I'd like to thank everyone again for joining us on today's call and for your continued interest in CODI. Thank you for your continued support. That concludes the call, operator.
Operator (participant)
This concludes Compass Diversified conference call. Thank you and have a great day.