Earnings Call Transcript - CODI Q4 2022

Operator, Operator

Good afternoon, and welcome to the Compass Diversified Fourth Quarter 2022 Conference Call. Today's call is being recorded. Operator instructions were given. 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, Investor Relations / Moderator

Thank you, and welcome to Compass Diversified's fourth quarter and full year 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 Q4 and full year 2022 press release, including the financial tables and non-GAAP financial measure reconciliations for adjusted EBITDA, adjusted earnings and pro forma net sales are available at the Investor Relations section on the company's website at compassdiversified.com. The company also filed its Form 10-K 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 in 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 2023 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 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 December 31, 2022, as well as in other SEC filings. In particular, the domestic and global economic environment, supply chain, labor disruptions, inflation and rising interest rates all may have a significant impact on CODI and 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. I would like to start by recognizing that 2022 was a phenomenal year for CODI. Despite persistent market headwinds driven by rapidly changing monetary policy, supply chain imbalances, and rising inflation, we produced record annual results. For the full year, our branded consumer net sales were up 14% on a pro forma basis, while the net sales of our niche industrial businesses were up 9%, helping to drive record adjusted earnings and adjusted EBITDA. These results confirm that our diversified subsidiaries combined with expert operational and financial execution can grow and take share even in a difficult market backdrop. I'd like to acknowledge our recently announced divestiture of Advanced Circuits. We are proud of our partnership and success with their team which started more than 16 years ago. CODI's permanent capital structure and support throughout this partnership has generated significant value for our shareholders and we are grateful for their contributions and look forward to their continued success. Jumping back to our 2022 performance, our subsidiaries managed the various macro challenges exceptionally well and we remain confident in their ability to continue to grow and take market share over the long term. That said, our near-term outlook is clouded by some unique crosscurrents. Our branded consumer subsidiaries with exposure to wholesale are experiencing significant inventory destocking headwinds. This is being driven by events that unfolded coming out of the pandemic. In the first half of 2022, we benefited from extremely high demand from customers who needed our product to help manage their own supply chain issues. With the pandemic winding down and some retailers reckoning with the fact that they overordered, it has created a whipsaw effect until inventory is right sized. For our brands further down the supply chain like BOA and PrimaLoft, the destocking headwinds are exacerbated. Pat will walk through specific brand performance shortly, but I will just say that we expect the first half of 2023 to reflect lower performance from some of our companies with a reacceleration anticipated in the back half as inventory is worked through and comparisons ease. On the other hand, we are seeing no signs of slowing demand with our companies that have material direct-to-consumer components to their business like 5.11 and Lugano. This gives us confidence that the balance sheet of the affluent customer to which we sell many of our products is healthy. More specifically, it tells us that rising wages and the continued imbalance in the labor market are more than offsetting inflation and rising borrowing costs. Notwithstanding the difficult macro climate and inventory headwinds, we firmly believe our subsidiaries are well positioned to achieve their long-term growth targets. To demonstrate this, I'd like to highlight one of our niche industrial businesses, Arnold Magnetics, as a case study of how we improve value for our shareholders. We acquired the business in 2012 based on Arnold's technology leadership in the permanent magnet subassemblies industry and strong growth tailwinds for the use of permanent magnets to enable the clean energy transformation. In 2016, we made the decision to replace senior management at Arnold, bringing in Dan Miller as CEO of that subsidiary. As a reminder, Arnold is a long-cycle business, and Dan was confronted with the reality of some programs going end of life while the pipeline of new opportunities was extremely weak. Restructuring and repositioning a long-cycle business is an especially challenging situation. Entering 2022, Arnold's strategic priorities have been successfully repositioned to focus on new end markets like aerospace and defense, among others, which match Arnold's high-end, high-margin, low-volume technical engineering and manufacturing capabilities. Arnold added a tech center to improve its products, advance its technology edge, improve its partnership with its customers, and complete Arnold's transition from a products company to an engineered solutions company. We supported Arnold's acquisition of Ramco Electric Motors to offer turnkey electric motor solutions, further positioning the Arnold business for the green economy. Arnold executed well on this strategy and reported a record-breaking year for bookings and double-digit sales and EBITDA growth. Arnold ended the year with $83 million in backlog and a book-to-bill ratio of 1.13, setting it up for another strong year in 2023. The strength of this business and the long-term runway for growth underscores the power of our diversified permanent capital model, which enables us to make long-term decisions to maximize value creation for our shareholders. In 2022, we launched our first new vertical since coming public, entering into the healthcare vertical with the announcement of Kurt Roth as our leader. Kurt brings over 25 years of experience and a decade-long partnership with CODI, and we couldn't be more excited to have him at the helm. Since his joining, Kurt and his team have been working hard at developing a robust pipeline of M&A targets. Like other markets, deal activity has been suppressed by the macro environment, but we remain proactive and prepared for the inevitable turnaround. Before turning the call over to Pat, I would like to summarize our performance and outlook. 2022 was a record-breaking year despite unprecedented headwinds proving the strength and durability of our subsidiaries and the power of our permanent capital structure. As we sit here today, the majority of our businesses are performing above our expectations and we believe are well positioned to achieve their growth potential. A few of our businesses are working through the inventory shock that is making its way through the marketplace in a post-pandemic world. We believe these headwinds will be short lived and expect a recovery in the back half of the year. Our financial outlook takes into consideration these headwinds. But the power of diversification is real and implicit in this outlook. For example, we expect our niche industrial segment to have another year of robust growth in 2023. And we expect BOA, which is currently in the crosshairs of the inventory destocking headwind, to be down versus 2022, but up versus 2021, which was an extraordinary year of growth. 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 1, 2021. On a combined basis, pro forma revenue and adjusted EBITDA in both our branded consumer and our niche industrial businesses grew significantly in 2022 and exceeded our expectations. For the year, pro forma revenue grew by 12% and pro forma adjusted EBITDA grew by 13% to $467 million. Excluding Advanced Circuits, pro forma adjusted EBITDA grew by 14% in 2022. In the fourth quarter, on a consolidated basis, pro forma revenue and adjusted EBITDA growth met our expectations, growing by 4% and 3% respectively. Before I get to our subsidiary results, I want to provide a high-level view of the quarter. As Elias mentioned, in Q4 several of the businesses in our consumer segment were impacted by inventory drawdowns in the supply chain and therefore our sales of these subsidiaries lagged end-consumer demand for their products. This impact was most pronounced at our businesses that operate further down the supply chain, specifically BOA and PrimaLoft. As mentioned, we see this trend continuing in the first half of 2023. Despite the challenges in the quarter on a consolidated basis, we were able to meet our expectations. Our subsidiary management teams once again executed well in a continuously changing environment. Now, on to our subsidiary results. I'll begin with our niche industrial businesses. For 2022, revenues increased by 9% and adjusted EBITDA increased by 8% versus 2021. Excluding Advanced Circuits, revenues increased by 10% and adjusted EBITDA increased by 11% in 2022. Driving these results were meaningful revenue and adjusted EBITDA growth from Arnold and Altor. Arnold continued to show improving margins driven by technology investments made over the last several years and is benefiting from a shift in its sales mix towards higher-growth industries focused on electrification. As we mentioned last quarter, the company comped against a very large defense-related order that benefited Q4 '21, but the company's book-to-bill ratio remains very strong and we believe points to continued growth in '23. Altor once again had solid growth in the quarter. Gross margins improved both sequentially and versus Q4 '21. And we expect this trend to continue as raw material price pressures continue to abate and Altor management achieves efficiency gains. The Sterno Group was down slightly in the quarter and for '22. Though the company's food service business is benefiting from the continued return to normal levels of activities and travel and conferences, the company continued to see pressure in sales of its value-driven line of scented waxes. On a combined basis, we believe this business will be stable in '23 and likely will return to moderate growth. Turning to our consumer businesses. For 2022, pro forma revenues increased by 14% and pro forma adjusted EBITDA increased by 15% as compared to 2021. BOA had a very strong '22 and finished the year with 26% and 38% growth in revenue and adjusted EBITDA respectively. For the fourth quarter, however, revenue declined slightly and EBITDA was approximately flat due to the factors we discussed. We believe these supply chain pressures will continue in the first half of 2023, with part of the company returning to growth in the back half of the year. To put what we are seeing at BOA in context, CODI purchased the company in late 2020 and in that year BOA produced slightly over $30 million of EBITDA. Due to significant market share gains and strong consumer demand for products incorporating BOA's technology, the company grew to over $60 million in adjusted EBITDA in 2021 and most recently over $82 million in 2022. We believe the inventory destocking headwinds discussed will lead to a short-term decline in financial performance in 2023, but we believe performance will be above 2021 levels. We are also confident that the company will then return to growth as these pressures abate. Headwinds notwithstanding, BOA is making significant strides in market share and expansion of its technologies measured by its model count on which BOA products are used. The fall/winter 2023 season will see growth of close to 10% which is expected to accelerate further in fall/winter 2024 based on initial discussions with brand partners. In addition, we saw early market receptance to BOA's Alpine ski technology as four of the company's brand partners recently pre-launched Alpine ski boots integrating the BOA system, giving skiers improved fit and performance. The quantities are limited until the official launch this fall for the 2023-2024 ski season. The excitement is significant, and we believe that with its brand partners BOA has the opportunity to improve fit in the industry. Lugano's growth continued in the fourth quarter and for the year as both revenue and EBITDA grew by over 45% and 60% respectively. In the quarter, we benefited from the recent openings of Lugano's Houston salon and its flagship salon at Fashion Island in Newport Beach. In addition, the company continued to benefit from increases in average transaction size. In 2023, the company will open locations in Washington, D.C. and Greenwich, Connecticut and is considering other avenues for geographic expansion and additional new flagship salons. Marucci continued its strong run of quarters as sell-through and reorders of its CATX line of bats were above expectations and the company continued growing in new markets. For the year, Marucci's revenue and EBITDA grew by 40% and 27% respectively. Marucci's margins remained strong in the quarter as supply chain-related issues continue to improve. Marucci continued to diversify its product mix and enter new markets in 2022. The company saw significant growth in its apparel and fueling glove categories and made significant inroads geographically through opening its Japanese operations. 2023 represents a year without a major CATX bat launch. The company is launching several new products and its growth in adjacent categories and geographies drives optimism for the year. 5.11 continued to buck the trend of struggling apparel brands and in 2022 grew revenue and EBITDA by 9% and 6% respectively. We remain proud of the company's performance in a difficult environment. In the fourth quarter, EBITDA growth outpaced revenue growth and the company's DTC comps remained positive led by strong e-commerce sales. 5.11 is having a solid start to 2023 and we believe it will be another year of growth for the company. Turning now to PrimaLoft. In 2022 pro forma revenue and EBITDA increased by 21% and 24% respectively. In the fourth quarter, on a pro forma basis, revenue growth was modest and EBITDA declined slightly from 2021 as the company's price increases did not take effect until the end of 2022 and several extraneous factors led to higher margins in Q4 of 2021. Despite facing similar challenges as BOA given its position in the supply chain and inventory levels within the channel, we believe PrimaLoft will fuel growth this year and remain confident in the medium- and long-term outlook for the business. Velocity Outdoor continued to struggle in the fourth quarter as inventory levels at retail and its archery business remained high and sell-through remains challenged in both segments following COVID-related surges in outdoor activities. We're working diligently with management to rationalize the company's cost structure to this new environment, while remaining focused on innovation. We expect a challenging first half of 2023 for this business as we proceed down this path, but are confident in the outcome. As a whole, we are very pleased with the performance of our businesses in 2022. Though the fourth quarter was challenging for several subsidiaries and the outlook for the first half of the year is mixed in several places, we are confident in the positioning of our businesses and the outlook for CODI. I will now turn the call over to Ryan for additional comments on our financial results.

Ryan Faulkingham, CFO

Thank you, Pat. Moving to our consolidated financial results for the quarter ended December 31, 2022, I will limit my comments largely to the overall results for CODI, since the individual subsidiary results are detailed in our Form 10-K that was filed with the SEC earlier today. As a reminder, our sale of Advanced Circuits occurred in the first quarter of 2023. ACI's results of operations are included in our fourth quarter and full year 2022 operating results. ACI will be reclassified to discontinued operations in our first quarter 2023 Form 10-Q. In addition, our 2023 guidance discussion that I'll make shortly excludes ACI's results. Now to our quarterly consolidated results. On a consolidated basis, revenue for the quarter ended December 31, 2022 was $594.9 million, up 6% compared to $559.9 million for the prior year period. This year-over-year increase primarily reflects our acquisition of PrimaLoft during the third quarter of 2022. In addition, we had strong sales growth at our branded consumer subsidiaries on a combined basis. Consolidated net loss for the fourth quarter was $11.8 million compared to net income of $25.9 million in the prior year. The decrease was primarily due to a $20.6 million impairment of our Ergobaby subsidiary in the fourth quarter and an increase in management fees and interest expense as a result of the PrimaLoft acquisition in the third quarter. Adjusted EBITDA in the fourth quarter was $87.3 million, up 5% compared to $83.3 million in the fourth quarter of 2021. For the full year, adjusted EBITDA was $369.8 million, up 20% compared to a year ago. The increase was primarily due to the strong performance at CODI's branded consumer subsidiaries and the benefit of the PrimaLoft and Lugano acquisitions. Adjusted earnings for the fourth quarter were in line with our expectations at $28.7 million, down from $37.1 million in the prior year quarter. This decline was primarily a result of financing costs for the acquisition of PrimaLoft in July ahead of its seasonally slow third and fourth quarter earnings periods. Now on to our financial outlook for 2023, which is unchanged versus the preliminary expectations we shared at our January Investor Day. However, it now excludes Advanced Circuits. For the full year 2023, we expect consolidated subsidiary adjusted EBITDA to range between $420 million and $460 million and we expect adjusted earnings to range between $105 million and $135 million. As Elias and Pat have covered well, this outlook expects a challenging first half of the year given the headwinds discussed and then a reacceleration in the second half of the year. Turning to our balance sheet as of December 31, 2022, we had approximately $61.3 million in cash, approximately $443 million available on our revolver and our leverage was 3.97 times. We have substantial liquidity and as previously communicated we have the ability to upsize our revolver capacity by an additional $250 million. Subsequent to year end, we received approximately $170 million in net proceeds from the sale of Advanced Circuits, which we used to repay our revolver balance and reduce our leverage levels. With this liquidity and capital we stand ready and able 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 fourth quarter of 2022, we received $11.6 million of cash flow from operations, primarily a result of strong operating performance. We used $29.2 million in working capital during the fourth quarter and continue to strategically increase inventory levels at Lugano to support near-term demand. We expect to produce strong consolidated cash conversion in 2023. Also of note during the fourth quarter, the manager waived 50% of the management fee owed by the company in respect of PrimaLoft. Finally, turning to capital expenditures, during the fourth quarter of 2022, we incurred $24.6 million of capital expenditures at our existing subsidiaries compared to $12.6 million in the prior year period. The increase was primarily a result of the timing of retail buildouts at Lugano and 5.11 to support their continued growth. For the full year of 2023, we anticipate total CapEx spend of between $70 million and $80 million. This spend will be in line with 2022; we continue to see strong returns on invested capital at several of our growth subsidiaries and believe they will have short payback periods. The 2023 capital expenditure spend will primarily be at Lugano for new retail salons in Washington, D.C. and Greenwich, Connecticut as well as expansion of its Palm Beach, Florida location and at 5.11 as we continue to increase its retail store count from its current 117 stores. 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 continues to be significantly below historical levels. We are hopeful that the M&A environment improves in the back half of 2023 if economic headwinds moderate. On the ESG front, we continue to advance our key initiatives and we're excited to announce that in the fourth quarter, we implemented a customized ESG technology platform for data collection, which will enable us to consider setting time-bound targets in the future. In fact, we are already preparing to collect Scope 1 and 2 emissions data for our subsidiaries. This will aid in the continued advancement of our ESG platform and ensure we are tracking the necessary metrics in order to regularly improve our ESG strategy. We also publicly released our corporate citizenship statement on our website which provides shareholders access to information on our ESG approach and a summary of our policy. In conclusion, we're proud of our 2022 results, which were significantly ahead of our expectations despite a challenging macro backdrop. I'd like to thank our management teams and employees for their continued commitment to success. With that, operator, please open up the lines for Q&A.

Operator, Operator

Operator instructions were given. Your first question comes from the line of Cris Kennedy from William Blair. Cris Kennedy, please go ahead. Your line is open.

Cris Kennedy, Analyst

Yes, good afternoon and thank you for taking the questions. It's clear the first half will be a little bit more challenging relative to the second half. Can you give us an update on quarter-to-date trends and how we should think about first half performance relative to the second half, if you can? Thank you.

Elias Sabo, CEO

Sure, Cris, and thank you for the question. Yes, it is apparent to us that the first half is going to be difficult and it really is due to inventory destocking. What we're hearing in the companies that are having the biggest challenge, BOA and PrimaLoft, is that our products in the end market are actually selling really well. In 2022 the first half was abnormal due to supply chain issues that caused overordering throughout the end of 2021 and then fulfillment in 2022. So, we're comping against a very high level in 2022 and then we have to burn off some of this inventory, which masks the positioning within the companies that is much better. As Pat alluded to, BOA for example has model count growth north of 10%, which should be the best indicator of growth and market share gains, but the inventory headwinds are significant and will create near-term pressure. Initial trends we're seeing outside of BOA and PrimaLoft suggest the business is actually performing better in the first two months than we anticipated. From Investor Day to today, the companies that have direct-to-consumer exposure—5.11 and Lugano—both feel better now than they did at Investor Day. Beyond that, companies like Marucci and our entire industrial businesses are in good shape. So on the whole, most of our businesses are performing better than expectations from a month ago. On the other hand, the severity of the inventory headwinds, especially for a company like BOA which sits far down the supply chain, is notable. Take a retailer with excess product: they won't order from the shoe manufacturer, which causes customers further up the chain to pause orders until their own inventory is cleaned up. We expect it will take some time to work through this, but it's not structural to the companies' competitiveness. To be specific, we expect the first half will be down, with the first quarter likely the worst for comparisons. We expect the first quarter to be down high single digits to low double digits. The second quarter should be down but not as much, and then we expect a reversal and reacceleration in the back half of the year. The consumer strength we are seeing in our direct-to-consumer businesses and product sell-through gives us confidence that once this inventory destocking is completed, growth should revert to normalized levels.

Cris Kennedy, Analyst

That's very helpful. Thank you. And then just a quick update on the healthcare initiative, please? Thanks for taking the questions.

Elias Sabo, CEO

Sure. Kurt is engaged and working with our team to create a plan for our healthcare vertical. A lot of legwork is being done right now, meeting with investment bankers and other intermediaries that are active in the deal market. Some proprietary opportunities that we have through Kurt are also being explored and pushed forward. A positive for us is that many investment banks active in the healthcare space also work in consumer and industrial, and we have strong relationships across those banks. While we have not been in healthcare before, these relationships give us instant credibility in the vertical. There is a robust pipeline being built of potential target companies. As Pat noted, the M&A market is weak right now, including in healthcare. The market is broadly seized up across categories. We think the best path is to continue building the pipeline, make preliminary contact, and tee up opportunities for later in the year and into 2024.

Cris Kennedy, Analyst

Great. Thank you.

Operator, Operator

Your next question comes from the line of Larry Solow from CJS Securities. Larry Solow, your line is open.

Larry Solow, Analyst

Elias, just a follow-up on the acquisition question. I know you guys don't have a target leverage, but you're a little bit levered versus historical numbers, a little under 4x. Wouldn't you want to weigh it out a bit and maybe pursue some opportunistic small acquisitions? Would you be in a position today to do a large acquisition earlier this year anyhow?

Elias Sabo, CEO

Yes, Larry, the good news is there are not many opportunities to transact right now, so it's not a big issue. As of December 31, we were at the upper bounds of where we want to be in terms of leverage. That number does not include the proceeds from the sale of Advanced Circuits. We used approximately $170 million of those proceeds to repay our revolver and reduce leverage. We expect significant cash conversion in 2023 as working capital normalizes. We had to build a lot of inventory over 2021 and 2022 and we've largely slowed inventory purchases. We're monetizing inventory and reducing payables in the near term, which may cause some working capital movement, but ultimately we expect a flood of cash as inventory is monetized. Given our cash generation and the proceeds from ACI, we have the ingredients for deleveraging in place. If there were an acquisition that was incredibly compelling, we feel we would be able to act on it. The primary constraint right now is the weak M&A market rather than our financial capacity.

Larry Solow, Analyst

Got it. And then just on the guidance. You shared about six weeks ago that you expected supply and inventory concerns in the front half, and you also included continued slowdown in the economy in the back half in that outlook. It feels like you may not be as concerned about the economic impact on your company now. Is it more about inventory issues in the front half and then a rebound in the back half? Also, BOA and PrimaLoft are usually more front-end loaded—will they be less front-end loaded this year because of that? Two-pronged question.

Elias Sabo, CEO

I'll answer the macro part and then ask Pat to discuss BOA and PrimaLoft seasonality. From a macro standpoint, we do not see clear signs of a recession. Conditions are unusual: demand for labor dramatically exceeds supply, wage growth remains elevated, and many consumers still hold higher levels of savings accumulated during the pandemic. These factors support consumer spending. Inflation is coming down, but wage-driven inflation remains, which suggests rates may have more to go. On the positive side, China has reopened after zero-COVID policies, giving strength to some international operations, and Europe experienced a significant inflation shock in 2022 and may see some normalization in 2023. In short, at present we feel consumer and demand conditions are healthy. The downward pressure we expect in the first half is primarily inventory destocking and not a demand collapse. Once that inventory is worked through, we expect a reversion to normal growth. If anything, current trends suggest the back half could be better than what we have conservatively built into our guidance.

Pat Maciariello, COO

Larry, on BOA, last year results were front-end loaded relative to historical norms. This year will be more back-end loaded than last year and likely more back-end loaded than 2021. As for PrimaLoft, it will still be much stronger in the front end than the back end. What's changing is customers are ordering later because they don't have the supply chain worries they did previously. We may see some bleed into Q3 and Q3 may be proportionally a little bigger than typical, but PrimaLoft will remain largely a front-end business.

Larry Solow, Analyst

Okay. If I can slip one more question: the EBITDA dropping from $470 million to $440 million—mostly due to the sale of ACI—how does that reconcile with adjusted net income going from $160 million to $120 million? I assume higher interest expense is a factor. Also, don't you get some interest savings on the sale of ACI? I'm trying to connect those dots.

Ryan Faulkingham, CFO

Yes, Larry, the numbers you highlighted are accurate. The sale of ACI removes a meaningful adjusted earnings contributor. In addition, interest costs increased meaningfully. At year end, we had a $395 million Term A and $155 million revolver outstanding; rates have moved higher from roughly low single digits to over 4% on floating debt, which is meaningful to adjusted earnings. So corporate financing costs are a primary driver of the adjusted earnings decline. You are correct that the ACI proceeds were used to pay down revolver which reduces floating-rate interest, but timing and the overall financing costs drove the adjusted earnings impact.

Larry Solow, Analyst

Okay, I appreciate the color guys. Thanks so much.

Operator, Operator

Your next question comes from the line of Matt Koranda from ROTH. Matt Koranda, your line is now open.

Matt Koranda, Analyst

Hey, guys. Good afternoon. Thanks for taking the questions. First, I want to make sure I understood the inventory destocking commentary. It sounds like it may be more acute with OEMs versus retailers—can you parse that out? Also, you signal the destocking cycle through the first half and pickup in the back half. Any data points or order book visibility giving you comfort that things can get better in the second half?

Pat Maciariello, COO

I'll answer quickly on inventory levels. It varies by geography. In Asia, for example, there is inventory at retailers given the COVID lockdowns people experienced. In North America it's probably less at retailers, and Europe is somewhere in between. So it varies by region and supply chain dynamics.

Elias Sabo, CEO

Matt, regarding what gives us confidence for the back half: look at our direct-to-consumer businesses like Lugano and 5.11 and how well they're selling. Marucci's sell-through is strong. Our industrial businesses had a great 2022 and came out of the year even stronger in January. That covers five significant businesses and they are performing very well. Aside from Velocity, which had a COVID-driven surge and is now adjusting, most of our businesses have healthy end-market demand. We are seeing bookings pick up. January was slow, February improved and bookings have generally gotten better. Those are positive early indicators. Given how robust demand feels outside of Velocity and the inventory destocking at BOA/PrimaLoft, we believe the back half should improve. We also think we may be conservative in our guidance; current trends imply a better back half than what we built in.

Matt Koranda, Analyst

Super helpful. Thanks, Elias. On Lugano specifically, how are you contemplating growth in 2023 within the framework of your guidance? It looks like it continues to grow aggressively and margins are ahead of expectations. How are you thinking about Lugano growth in 2023?

Elias Sabo, CEO

We generally prefer to be conservative in our forecasts. There's nothing in January and February that suggests a slowdown for Lugano. Pat can speak to exact trends, but we embedded a much more conservative growth plan for Lugano in our guidance. January was very strong and early 2023 is fine and in line with or slightly better than the prior run rate. We plan conservatively and prefer to overdeliver.

Pat Maciariello, COO

January was very strong. February and the beginning of the year are in line with exactly what Elias described, if not a little better.

Matt Koranda, Analyst

Okay. One last question: you received $170 million in proceeds from the ACI divestiture. How much debt was repaid net of fees, and what does that do to pro forma net leverage? Also, you mentioned working capital monetization—can you help shape how much inventory flush you have this year and how that contributes to cash, and where leverage could be by year-end?

Ryan Faulkingham, CFO

Matt, we used the $170 million proceeds to pay down the revolver. There will be a profit allocation payment on the gain that will be net against that amount; that calculation is in process. A couple of tenths of a turn is the effect of that paydown on leverage. At Investor Day we highlighted retained cash in the system and in 2023 expect to be at or above 2022 levels. We had about $75 million of retained cash pre-working capital at Investor Day. As we think about that and working capital coming back in, it implies north of $75 million. Last year we used about $200 million of working capital throughout the year, much of which was inventory to support growth and Lugano. A portion of that was ongoing support for growth and won't come back, but roughly a third was excess and we expect that portion to convert to cash in 2023. It's hard to put precise dollars on it, but a reasonable assumption is same retained cash plus roughly one-third of last year's inventory use returning as cash conversion in 2023.

Matt Koranda, Analyst

Okay, very helpful. I'll jump back in queue. Thank you.

Operator, Operator

Your next question comes from the line of Robert Dodd from Raymond James. Robert Dodd, your line is now open.

Robert Dodd, Analyst

Hi, guys. Some of these questions have been partially answered, but on BOA as you look toward a rebound in the second half—when would firm orders need to be coming in for that to manifest in second-half results? How much visibility do you have and when would you know it's actually happening?

Pat Maciariello, COO

Short answer: our Q1 earnings call will give a good picture of how Q2 is trending. The lead times vary industry by industry, but generally there's a four to eight week lag. We'll have a better picture around the time of our Q1 earnings call. We also listen to our OEM partners on inventory and sell-through and monitor model count. Those inputs inform our confidence.

Elias Sabo, CEO

Robert, our businesses generally can take orders and ship within four to six weeks, so lead times are short. We likely won't know definitively about the back half until June and July when we see trends in third quarter bookings and what we can ship against that. I will say bookings have improved: January was slow, February not great but better, and we've seen a general pickup already. That pickup could enable the business to recover more quickly than expected and possibly in Q2, but we need more data to be sure.

Robert Dodd, Analyst

Got it. On Lugano, that was the biggest contributor to working capital build in 2022. Are you still going to invest heavily as you grow locations? It looks like the return on that investment has been excellent—what's your plan?

Elias Sabo, CEO

Yes, Robert, we will continue to invest in Lugano. The working capital involved is not frivolous—inventory in that business converts to sales at a high rate. Historically, when we've invested $1 of inventory in Lugano it has yielded about $1 of revenue with roughly a 40% incremental margin. As long as that return on invested capital holds, we will continue to support the business with inventory and capital. Our guidance assumed a more conservative growth plan for Lugano; the business is currently running well ahead of that plan. If necessary, additional inventory investment could meaningfully increase EBITDA, and we monitor this weekly and monthly.

Robert Dodd, Analyst

Right. So embedded Lugano assumptions are subject to more revision than other businesses—that's fair?

Elias Sabo, CEO

Yes, based on current trends, Lugano has a high probability of upside revisions relative to our plan given what we've observed in January and February.

Operator, Operator

Your next question comes from the line of Matthew Howlett from B. Riley. Matthew Howlett, your line is now open.

Matthew Howlett, Analyst

Thanks. First, on the $1 billion 2028 long-term target that contemplates about a 10% long-term growth rate—are you still comfortable with that trajectory for the subsidiaries?

Elias Sabo, CEO

Yes. The example of Arnold demonstrates that we've improved the positioning of many of our businesses. Arnold was a difficult turn-around but is now positioned in growth markets like electrification and the green economy. Across our portfolio, management teams have strengthened their businesses, improved margins, and driven revenue growth. Removing Advanced Circuits, which historically grew at about GDP, also improves consolidated growth. There's nothing to suggest our long-term growth rate shouldn't remain on track; in fact, there is a reasonable probability of exceeding it given current positioning and execution.

Matthew Howlett, Analyst

That makes sense. Regarding potential monetization or capital deployment—if markets reopen, are you considering selling businesses, IPOs for assets like 5.11, or returning capital via buybacks? What's the appetite and what are bankers saying?

Pat Maciariello, COO

We have many businesses that could be for sale, but it's all a function of price. We do not have plans to actively market any business this year. On 5.11, if the IPO market opens next year, we would consider it; the company is a strong brand and executed well through a difficult period.

Elias Sabo, CEO

Bankers are constantly in contact with us about markets and opportunities. The capital markets have been effectively shut for IPOs in 2022 and remain slow in early 2023. These conditions won't last forever. When markets reopen, high-quality companies like 5.11 could be even more attractive to public investors given their performance through a difficult cycle. We're prepared to act when markets provide fair value. On buybacks, our stock is trading at valuation levels that make a repurchase program attractive for long-term shareholders. We instituted a buyback authorization because we are prepared to act. However, we are a growth company and prefer to deploy capital into acquisitions and subsidiary investments when those opportunities provide greater long-term value. With the stock trading in the low 20s, though, the buyback is an attractive option to return capital to long-term holders and is on the table.

Matthew Howlett, Analyst

Appreciate it. Thanks.

Operator, Operator

Your next question comes from the line of Barry Haimes from Sage Asset Management. Barry Haimes, your line is now open.

Barry Haimes, Analyst

Thanks. Two questions: first, with upward pressure on inflation and rates, how are you thinking about debt and whether you'd like to raise more long-term fixed-rate debt now? Second, on Lugano—given new locations, how many potential Lugano locations do you think are possible over the next three to five years, what ROIC do you get on a new location, and how long to steady state?

Elias Sabo, CEO

Barry, the majority of our debt is locked out into the late 2020s and early 2030s. To be specific, roughly $1.5 billion of our $1.7 billion capital structure is fixed-rate bonds at mid-single-digit coupons. The remaining $400 million term loan and revolver were a smaller portion and, as you know, we repaid revolver with ACI proceeds, reducing floating-rate exposure. Approximately 75% of our debt is fixed and about 23% was floating at year end. Ideally we'd have 100% fixed, but terming out the remaining floating debt today would be costly given current market spreads compared to our prior issuances. Bond pricing today implies yields materially higher than where we issued previous tranches. Because of that, it makes more sense to be patient unless market pricing narrows. If spreads compress and we can term out that debt in the 6% range, that would be attractive. For now, we have ample liquidity, limited secured leverage and no covenant pressure. Pat, do you want to address Lugano specifics?

Pat Maciariello, COO

On Lugano, payback on new salons varies. In markets where we already have strong clientele, payback can be under 12 months. In greenfield markets or international openings it can take longer. Inventory is not strictly per-salon formulaic; we share inventory across salons and gain efficiencies. This year we're targeting a couple new locations and possibly one more, then digesting those before further expansion in 2024. We need to build the talent to support additional salons; they're highly skilled roles and require time to develop. Thus the number of ultimate locations depends on market penetration opportunities, not a simple arithmetic of one more store equals X revenue.

Barry Haimes, Analyst

Got it. That's helpful, thanks.

Operator, Operator

There are no further questions at this time. I would now like to turn the conference back over to Mr. Elias. Sir?

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 support. That concludes our call.

Operator, Operator

This concludes Compass Diversified conference call. Thank you, and have a great day.