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As a growth investor I’m usually pleased when one of my potential investments has a history of dividend payments. It’s like the icing on the cake, provided that capital wasn’t required to sustain the company’s growth.
But when a company mortgages the future by paying a special dividend I get skeptical — especially if that dividend was paid for by taking on debt. And the worst-case scenario in my mind is a dividend recapitalization.
A dividend recap happens when a company takes on debt to pay a special dividend to founding partners, private investors or venture capital groups. It’s typically done as a way for these early investors to realize a gain, or as a way to remove some (or all) of their initial investment.
The dividend recap is great for these early investors who took on considerable risk. They certainly earned a reward. But it’s not great for new shareholders who want to buy stock in the company that completed the dividend recap, since the aftereffects can linger for years.
So I was somewhat dismayed when I found out a company I wanted to invest in, Fox Factory Holding (NASDAQ:FOXF), had completed a dividend recap in 2012. Fox makes high-end suspension products for mountain bikes, motocross and off-road vehicles.
Fox is a holding of Compass Diversified Holdings (NASDAQ:CODI), a private-equity-type holding company I’ve held in my 100% Letter advisory service since August 2011. We’ve done well on Compass, with total returns topping 80% to date. It pays a very attractive 8% yield.
But part of what makes CODI great as a high-yield stock – its private-equity type structure – also creates challenges for portfolio companies if and when they go public. Such is the case with Fox Factory Holdings, in which CODI bought a controlling stake for $80 million in 2008.
While perusing Fox’s pre-IPO filing I noticed that the company paid a special dividend of $67 million in 2012.
To put this in context, Fox’s net income in 2010, 2011 and 2012 totaled $38.52 million. So the special dividend in 2012 amounted to 173% of the company’s trailing-three year net income. Ouch.
To help cover the special dividend, Fox borrowed $58.4 million in the form of long-term debt from its holding company, Compass Diversified Holdings. In other words, this was a dividend recapitalization.
This dividend recap meant that Fox’s debt-to-equity ratio skyrocketed from 0.23 in 2011 to 2.0 in 2012.
Fast-forward to Aug. 8, 2013; Fox goes public via IPO. Its “take” from the IPO was around $36.2 million. Every penny of this went to pay down debt to Compass resulting from the 2012 dividend recap.
But this $36.2 million wasn’t enough, so Fox borrowed an additional $21.6 million to clear its debt to Compass.
The punch line here should be clear. Fox didn’t benefit from the dividend recap or the IPO. These events were great for shareholders of Compass (like many subscribers to 100% Letter), but they didn’t do anything to help generate growth for a small company that has plenty of opportunities out there to pursue.
And these events are a total turn-off for those who may have been interested in buying shares of Fox.
I’m going to pass on Fox for now. While the company grew revenues by 20% in 2012, that dividend recap is still a killer. I can’t look past it without wondering how the cash drain will affect future growth.
Compass still owns around 54% of Fox, so it’s not as if it wants the company to fail. And I’m not suggesting that Compass didn’t earn its return. It did.
But I won’t pull the trigger this time . . . or likely at any time in the future soon after a company has completed a dividend recap. That’s why I think it’s the worst kind of dividend out there. Instead of luring potential investors in, it drives us away.
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