Description

Coats sells for less than 60% of NAV, carries a dividend yield of 6.9% with little debt, is in the final stages of a value-enhancing restructuring, and benefits from the involvement of a highly sophisticated and successful activist shareholder. The USD$ market cap is around $500 million so it is liquid enough for even mid-sized funds to establish a decent position, and to top it all off, Coats is very close to its multi-year low of just under 40 pence.

Coats is the world’s leading supplier of thread for the apparel and craft markets. These are relatively fragmented markets: Coats has 25% of the apparel market and 23% of the craft market, while the nearest competitors are 13% and 7% for apparel and craft, respectively. Coats is at the tail end of a multi-year restructuring whereby the company has divested its money losing non-core businesses such as Fashion Retail (Jeager & Viyella) and Bedding in order to focus on its crown jewel, which is thread. The final step of this restructuring is the sale of the bedding division (pillow cases, sheets, etc.) which should take place this year. The proceeds from these sales is nothing to write home about, but when you consider their consistent operating losses Coats is lucky to unload them and move on. When the restructuring is complete, Coats will be a pure play on the world’s leading thread manufacturer.

Thread:

Thread may sound boring, but there are three factors that make this business attractive: First, Coats is the leading player which allows it cost and distribution advantages. Second, the thread business is relatively stable. Sales of Tommy Hilfiger or other apparel brands may boom and bust as fashions change, but the number of garment units produced annually tracks global macro economic conditions and overall population growth. Each article of clothing must be held together with thread, and Coats is there to supply the apparel manufacturers. This brings me to point number 3: Thread accounts for around 1% of the cost of an article of clothing. Being an inexpensive item compared to labor and materials, thread is relatively insulated from cost cutting measures undertaken by apparel manufacturers, who are Coats’ customers.

The geographic breakdown of thread sales is as follows:

North America: 32%
UK & Europe: 35%
Asia: 23%
South America: 10%

As you might have guessed, Asia is growing to the detriment of both North America and Europe as apparel production shifts to lower cost locations. Coats is migrating production to low cost regions in tandem with its customers, which is expected to cost approximately 50 million Pounds over the next three years. As Coats completes this migration, I expect operating margins to improve from just below 8% to 10%. Management has indicated that this is achievable.

The activist shareholder is Guinness Peat Group, which is the investment vehicle of New Zealand-born Sir Ron Brierly. I would expect that some VIC members are familiar with Brierly, and if not he is an interesting person to study. Coats is GPG’s largest investment at around 17% of GPG’s net assets (GPG owns approximately 25 % of Coats’ share captial), which brings a certain focus to this situation for Brierly. GPG is represented on Coats’ board and has been a strong advocate of the company’s restructuring efforts. GPG’s record has been quite solid, but there have admittedly been some mistakes, of which one of the largest was a U.K. investment (Stavely Industries). Some people make a big deal out of Stavely insofar as it indicates that Brierly has less of a touch in the U.K. than in New Zealand or Australia. On that subject I don’t have any comment one way or the other, except that you should judge Coats on its own merits without regard to what Brierly has or hasn’t done with other investments, while recognizing that GPG is strongly motivated to get some value out of Coats in the medium term.

The Numbers:

I will focus on Thread since it is the end game in this story. The thread business had operating income of 73 million in 2001, which was reduced by operating losses at Fashion Retail and Bedding, not to mention an array of one time charges associated with the restructuring (write downs, asset sales, etc). 2002 and 2003 should see the end of these restructuring charges as Bedding is the only remaining division to be divested. My projections for Thread incorporate 1% sales growth and a 2.2% pickup in operating margins by 2004. I have presented 2001 and 2002 as if the other businesses didn’t exist for illustration, and 2003 and 2004 are free of any one time items which may or may not be the case. Numbers are in Pounds.

2001Adj. 2002E 2003E 2004E
Thread Revenue: 938 947 956 966
Thread Op. Inc.:73 74 81 96.6
Thrd. Op. Marg: 7.8% 7.8% 8.5% 10%
Interest: (10.5) (12) (13) (13)
Pretax 62.5 62 68 83.6
Tax @ 30% (18.8) (18.6) (20.4) (25.1)
Minority Int. (5) (5) (5) (5)
Net 38.7 38.4 42.6 53.5
Shares(mil): 704 704 704 704
Per Share: 5.5p 5.45p 6.05p 7.6p
Share Price: 43.5 43.5 43.5 43.5
PER 7.9x 7.9x 7.2x 5.7x
Div: 3p
Yield: 6.9%
Equity Mkt Cap: 306 million

There is one publicly traded comp in the U.S., Ruddick Corp., which is not a direct comp because most of its value is derived from a chain of grocery stores in the Southeast. Ruddick’s thread business is much smaller and less profitable with only USD$300 million in sales and $12.5 million in EBIT (versus approximately USD$1.07 billion in sales and $120 million in EBIT for Coats). Some people might think Ruddick is cheap, but they should look at Coats…

One comment on trading: For about eight weeks in late 1998 and early 1999, Coats dipped all the way to 20p. The chart is petty much a V shape for that time period. The stock rebounded very quickly and has not dipped much below 40p since then. In my opinion there are far fewer uncertainties today and the company is in much better shape now than it was then.

Catalyst

1) Winding up of the transition out of Fashion Retail and other non-core businesses, which will reveal the economics of the Thread business. Coats is cheap and getting much cheaper based on the thread business by itself.
2) Presence of major activist who will push to realize value for shareholders.
3) 6.9% dividend (in addition to low valuation) should provide some downside protection.