Quick note: I’ll be in Midtown NYC from December 5-7. I’d be happy to meet up with anyone interested in knowing more about Alluvial’s soon-to-be-launched private partnership, or any blog reader. Get in touch.
I believe shares of Coats Group Plc, traded in London, are attractive. Coats Group’s operating business is valuable and the holding company is significantly over-capitalized. Once the company settles its legacy pension issues, I believe the company will return capital to shareholders.
Coats Group Plc has a storied history. Founded in Scotland in 1755, it predates even the famed Scottish Widows Fund. Coats actually invented cotton thread as a wartime substitute for silken thread. Coats was floated on the London Stock Exchange in 1890 and underwent a series of mergers before being bought by Guinness Peat Group in 2003. Guinness Peat Group itself has an esteemed history, with roots stretching back hundreds of years to the famed Guinness family of Ireland. Guinness Peat once held dozens upon dozens of investments around the world (and actually succeeded in scuppering the proposed merger between the London Stock Exchange and Deutsche Boerse), but has spent years divesting these holdings. Following the final round of divestments, Guinness Peat Group renamed itself after its sole remaining operating business, Coats Group.
Today, Coats is one of the world’s largest manufacturers of sewing threads and fasteners. These range from ordinary crafting yarns to high-specification fiber-optic and heat-resistant threads. Coats is the world’s second-largest supplier of zippers behind YKK. It’s a global business, and its a pretty good one. For the twelve months ended June 30, Coats reported adjusted operating income of $154 million on revenues of $1.46 billion. (Coats reports in USD, though it trades in GBP.) Results for the six months ended June 30 showed excellent improvement in adjusted operating income, as Coats has taken steps to close down loss-making operations and invest in higher-margin, faster-growing segments.
Before we can get closer to determining a value for Coats, we must consider a very significant confounding factor: legacy pensions. Though Coats (remember, formerly Guinness Peat) owns only one business, it remains responsible for multiple pension plans. Turns out these plans are rather under-funded. This finding by the British government put a halt to Coats’ plans to return its holding company-level cash to shareholders. Here’s a graphic from Coats most recent report showing the deficits at each legacy pension.
Coats Group’s three major legacy pension plans are Brunel, Staveley, and Coats UK. Brunel is 68% funded. Staveley is 91% funded, and Coats UK sits at 84%. You might be thinking “by American standards, these really aren’t bad.” However, the UK pensions regulator doesn’t see it that way. In 2015, Coats agreed to contribute £55 million to the Brunel plan over 10 years. In June, Coats agreed to contribute £74 million to the Staveley plan.
Investigations into the funding status of all three pensions continue. For now, Coats has agreed not to distribute any of its holding company cash to shareholders and to use its substantial cash balance to support the pensions. The company continues to negotiate a settlement with the regulators. In its last report, the company indicated it would proceed to court hearings if a settlement could not be reached. No update has been provided, but I believe it is very likely the parties will arrive at an agreement, court-arranged or otherwise, before the end of 2017.
I believe any settlement will provide Coats with substantial leeway to return capital to shareholders. Coats actually holds enough cash (in GBP) at the holding company level to eliminate its pension obligations in their entirety. But there is no reason to assume the regulator will force Coats to bring its pensions to 100% funded status immediately. That would be absolutely unprecedented. Rather, the regulatory body and Coats will almost definitely agree on a plan in which Coats contributes a lump sum to the plans and commits to annual contributions.
Back to the operating business. As I mentioned earlier, Coats is producing normalized operating income of $154 million. This figure should rise in 2017 as Coats exits its unprofitable UK crafts business and benefits from strategic investments in high-performance threads and a promising software business. Long-term, Coats should be able to grow its top-line revenues slightly faster than world GDP growth. People will always need clothing, and Coats high-specification specialty threads should see growing demand.
I would be perfectly comfortable buying Coats for 10-12x EBIT. Assuming Coats can produce $160 million in operating income in 2017, that values the operating business at $1,600-$1,920 million. The operating company has net debt of $337 million for net value of $1,263-$1,583 million. Now, Coats does not own 100% of all of its operating subsidaries. Specifically, the Bangladeshi and Vietnamese subsidiaries are very profitable but not 100% owned. For the twelve trailing months, income attributable to minority interests was $12 million. When considering Coats Group’s valuation, these minority interests must be capitalized. I think a 12x multiple of income is reasonable for minority interests in emerging markets ventures.
At the holding company level, Coats has $396 million in cash versus combined pension deficits of $349 million. (In reality, this cash is held in Pounds. But the pensions are also GBP-denominated, so the net effect of currency movements is limited.) Just to be extra pessimistic, let’s say the regulators and Coats come to agreement to bring pension funding to 95%. Again, that would be unpredecented. But let’s go with it, because there is the possibility that the pension liabilities are under-stated. Anyway, 95% funding would require Coats to commit another $241 million of its holding company funds to the pensions. That would leave $155 million in funds available for distribution to shareholders, or for investment in the operating business.
Let’s compare Coats Group’s present valuation against the value of the operating subsidiary and the example excess holding company cash. Coats has a market capitalization of £528 million, or $668 million at current exchange rates. To that we must add the capitalized minority interest, which I’d put at $144 million. Total market capitalization: $812 million. There’s $337 million in operating company net debt, plus my very rough and conservative estimate of $155 million in excess holding company cash. That’s ultimate net debt of $182 million for an enterprise value of $994 million.
For your $994 million, you get $160 million or so in operating income for a multiple of 6.2x EBIT. That strikes me as extremely cheap for a reasonably good business producing high levels of free cash flow, albeit with only moderate growth potential. If my estimate of the value of the operating business is anywhere close to accurate, then shares of Coats should be worth nearly twice the current trading price. I think my valuation is supported by Coats Group’s free cash flow yield, which exceeds 10%.
Why so cheap? I think it all comes down to uncertainty. The market is fearful that the UK pensions regulator could proclaim the pension deficit is larger than anticipated or could call for onerous contributions. Brexit still weight heavily, then there is the fact that Coats Group is a small company despite its once mightly stature. Still, I think the current price represents a good value for investors willing to look past the next few quarters.
Alluvial Capital Management, LLC does not hold shares of Coats Group Plc for client accounts. Alluvial may buy or sell Coat Group Plc shares at any time.
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So why don’t you own it?
Because it’s cheap, but I think that other stuff I own is cheaper on a risk-adjusted basis. Plus, I have enough foreign currency exposure for now. It’s certainly on the watchlist.
Using your numbers, if the $ 160 in EBIT is capitalized at 12 times, you $1920. Subtract net debt of $182, gives an equity value of $1738. Subtracting the capitalized value of the minority interest leaves the shares being worth $1594. There are 1407.5 fully diluted shares, so on a per share basis, the stock is worth $1.13 (actually a bit more). Using a 1.25 $/pound conversion rate leaves a stock price in GBP of 0.904 pounds compared to a current price 0.375 pounds, so a lot more than a double. I agree that Coats is worth more than its current price, but not 0.904. What am I missing? Thanks again for calling attention to an undervalued, off the beaten track stock. BTW, there are some interesting large holders including Soros and Michael Dell (through his family investment company.
Interesting write-up. Not to be too engrossed in macro issues but the GBP being near a recent history (at least) low to the dollar is certainly something to be excited about. The potential to add 20+% to the end of any return should be exciting… But Americans, like me, are such homebodies when it comes to investments. I even think twice about Canadian stocks lol.
Nice write up.
With regard to pensions one word of caution: The UK regulators don’t only look at the IFRS pension deficits but also at the actuarial ones. The actuarial deficit as a rule of thumb adds 10-20% to the liabilities (Adjustments are made for “real life” like age, interest rates atc.).
In general you should also include the pension deficit in your EV/EBIT multiple, otherwise you end up with a lot of “cheap ” companies with large pension deficits. Pension liabilities are financial debt, in the UK even with significant covenants.
I haven’t looked deeply into Coats, but follwoing a couple of scandals in the UK, I don’t think that they can easily distribute their holding cash.
Definitely agree with including pension deficits in enterprise value. Only reason I did not here is because of the holding company/subsidiary structure. You’re right that the actuarial deficit will be larger than than the IFRS figure, which is why I used really aggressive funding requirements to estimate how much excess cash Coats really holds.
Having just spoken with a UK actuary:
1. Currently pension regulators have no actual legal power to force much – but given the BHS scandal there is political pressure and they don’t want to be seen continuing to nap at the wheel (nor do the scheme trustees).
2. Deficits of 85 – 95% are not unusual on an actuarial basis – in fact companies will try to run at that level because these are prudent estimates and once the money is in, it can’t be gotten back out, so 95% is kinda like fully funded, whereas 100% may well be over-funded.
3. Funding plans are usually about 10 years (well the BHS one was for 25 years, which is why the regulators and trustees could be called comatose, not just napping, apparently).
Maybe the above helps you to estimate a likely contribution they will need to make.
Thanks for your thoughts. I definitely think a substantial portion of the corporate cash balance will be available for dividends, and this reinforces that belief.
Interesting post and thanks for the blog. Although zippers are going to be around for a while, isn’t this a business that lacks a moat? It reminds me of the original Berkshire textile business.
Probably little risk of going obsolete here. Coats does produce some bulk commodity thread products, but more and more it produces specialized fibers. Also they are well-diversified around the world so there is little risk of trouble from adverse pricing or costs in any particular region. That’s what did in the New England and Carolinas textile industry: a commoditized product where margins were crushed by lower-cost imports.
went up 100% 1 month after your post. Good find!!!
Is Sky Group PLC related to your business? If not why are we getting an e-mail soliciting business?
No, they are not at all. That was a spam comment that made it through the filter. I will remove it and block them.