Coats Group — Update 17 August 2016

Coats’ Industrial division delivered a solid H1 performance and although Crafts demand was relatively weak, underlying divisional profitability was maintained. Management continues to work through legacy, non-trading items, which, together with a seasonal cash outflow, reduced period-end cash to US$59.1m.

Industrial division summary: relative US dollar strength held H116 reported revenue slightly below the prior year level, but EBIT still progressed by an impressive 22% y-o-y. Three acquisitions (ie GSD in May 2015, Fast React in May 2016 and Gotex in June 2016) will have made a marginal contribution to this outturn. Underlying – at constant exchange rates (CER), like-for-like (l-f-l) – revenue and EBIT were up 3% and 27% versus H115. Operational gearing from higher volumes, process improvements and maintained pricing discipline (retaining weaker input cost benefits) more than offset other operating cost inflation. This had a positive, upward influence on reported group gross margin and resulted in a 250bp increase (at CER) in divisional EBIT margins to 13.3%.

Apparel & Footwear (A&F) saw mixed trading conditions during the first half. Volume progress in Asia, EMEA and certain Latin American markets was partly offset by weaker US demand, especially during Q2. Management believes that the division outperformed its competitors and consequently that market share increased during the period. Citing a good and rising penetration rate of a digital e-commerce platform, it appears that customer commitment to and adoption of electronic trading links (including new product development support and services) is facilitating business, building on strong relationships with major brand owners, as well as developing loyalty with new ones. Pricing was considered to be tough throughout the period and a drag on growth overall, although this was partly attributable to input price deflation, which was beneficial for achieved profitability. Overall, A&F grew CER l-f-l revenue by 3%. Speciality threads had a tougher end to FY15 owing to weaker demand from garment manufacturers servicing the oil & gas industry (affecting Coats’ sales of aramid or heat-resistant threads). During H116, it also had to contend with US channel de-stocking in consumer durable goods, although there was no further reference to oil & gas sector demand. More positively, EMEA revenues grew in excess of 5% due to geographic development of existing portfolio threads into new markets (eg South-East Asia, Latin America) and through sales of newer innovative materials into both existing (eg fibre optics) and new segments. The carbon composite segment in particular has been earmarked for significant growth, with the potential to become Coats’ largest speciality category on a five-year view. The primary end-market applications are considered to be automotive and sporting goods, where Coats already has a strong presence with some of the leading OEMs in these areas. Although regional and end-market revenue performances have been mixed, our sense is that the innovation and new product introduction programme remains very active and will be given greater prominence over time. Overall, Speciality subsector revenue grew by 3% (CER l-f-l) in H116, in line with A&F.

Crafts division: reported numbers included a contribution from a small UK Crafts operation, which was not included in the EMEA Crafts disposal in FY15 and is to be exited via closure in H216. Stripping out the revenue and trading losses from this operation, the ongoing Crafts division (now entirely serving the Americas, with c 75% in North America) experienced c 17-18% reductions in revenue and EBIT. Adjusting for the relative weakness of Latin American currencies relative to the US dollar, the underlying performance was somewhat better with 13% lower sales – comprising North America -17%, Latin America 0% – and flat profitability on a CER l-f-l basis.

Needlecrafts revenues (just under half of the division) were down slightly year-on-year with a continuation of subsector trends seen in FY15, specifically growth in lifestyle fabrics offset by weakness in thread sales. In the previous year, foundation Handknittings had been relatively resilient, but a combination of lower seasonal demand and a customer’s IT system issues contributed to a subsector revenue fall in excess of 20%. As the corporate customer base is fairly concentrated, problems at any one customer can lead to a volume hit. By the same token, once resolved, they can recover fairly quickly and management noted that this had been the case towards the period end. We believe that ongoing revenue softness for fashion Handknittings was broadly similar to foundation, although this subsector now forms a relatively small proportion of total Handknittings revenue (we estimate c 10-15%).

Coats reports divisional but not subsector profitability. Ongoing EBIT for the division overall was slightly down year-on-year at US$3.1m, but in line with H115 on a CER l-f-l basis. Implicitly, with weaker revenue, the ongoing Craft business improved its operating margin (by 40bp to 3.0%). This was largely generated from cost control including some benefit from actions taken in the previous year following the EMEA Crafts disposal.

Other P&L items: compared to prior periods, other non-trading elements created less noise in Coats’ P&L in H116. We had already seen group net bank interest costs increase significantly in H215 compared to H115 (as a result of moving parent company-level cash into lower yielding sterling deposits against actual and potential UK pension scheme liabilities) and H116 continued at a similar level. Non-bank finance costs of US$6.6m (largely unrealised losses on FX contracts) were around half the level of the prior year. The underlying tax rate of 34% on PBT norm was lower than reported in H115 and consistent with our FY16 expectation. Below this, reported exceptional items were only US$2.3m in the period, c US$1.3m relating to acquisition activity and a c US$1m charge for the expected exit from UK Crafts during H216. We have seen significantly higher provisioning in previous years (especially relating to expected pensions and environmental liabilities) and so take the absence of additional charges in these areas as a positive development.

Coats ended H116 in a US$59.1m group net cash position. This comprised US$396m cash held in the parent company (in sterling) to meet actual and prospective UK pension scheme liabilities and c US$337m net debt (c US$476m gross debt) at operating company level.

At parent company level, period-end cash was over US$100m lower than at the end of FY15. Of this movement, US$65m was accounted for by pension recovery payments, as follows:

In addition to the above payments, US$2.3m cash costs relating to the Pensions Regulator (tPR) investigations (and provided for in prior years) were incurred, taking the total parent company cash underlying outflow to c US$67m in the first half. Relative US dollar strength resulted in an adverse c US$40m translation effect on sterling balances, which we believe accounted for the remainder of the headline move in parent company cash.

By comparison, company net debt increased by c US$73m during the first half. Included within this movement was US$35.4m cash payments relating to the two H116 Industrial division acquisitions referred to earlier and US$14.1m for exceptional items (including reorganisation costs and discontinued activities), together representing two-thirds of the outflow.

Excluding the non-trading items, operating cash flow of c US$42m was an improvement from c US$28m a year earlier with increased EBITDA (+US$11m to c US$98m) and a reduced working capital outflow of US$55m both being contributory factors. An H1 working capital outflow is a normal seasonal characteristic of Coats’ trading cycle, as is a substantial inflow during H2 to the year end, partly influenced by Q4 activity levels.

Below this, net interest and tax cash outflows totalled c US$35m; we have already referenced increased interest costs above and, although the group tax rate is declining, there was a higher cash payment in H116 compared to H115 due to timing effects, which should wash through. Minority dividend payments made were over US$1m higher at almost US$8m, reflecting improved profitability in the Vietnam and Bangladesh majority-owned subsidiaries. Net capex of US$16.4m was slightly below the prior year level and no major items of expenditure were flagged in the period.

This analysis broadly matches Coats’ cash flow presentation, which noted an adjusted free cash outflow of US$15m in H1 and an inflow of US$82m for the trailing 12-month period. Both of these metrics represent an improvement compared to H115 (US$23m outflow) and the year to December 2015 (US$74m inflow).

Cash outlook: raising core profitability and exiting loss-making/cash-consumptive activities have both been a feature of the last 18 months. In FY16, we expect Coats to deliver c US$80m+ adjusted free cash for the year as a whole consistent with the recent trailing 12-month trading pattern. After factoring in acquisitions, discontinued activities, reorganisation costs and pensions-related items (non-service, chiefly recovery payments and tPR investigation costs) we expect the group cash outflow before financing to be in the order of US$45m in FY16. Pension recovery payments will obviously be ongoing and the latest Coats UK scheme triennial review, together with the tPR investigations, could have a material bearing on future cash flows. As things stand (ie without anticipating the either outcome), we would expect a similar adjusted cash flow performance in FY17 before some increase in FY18.

Coats Group is the leading global supplier of industrial thread with substantial exposure to consumer spending patterns (in Americas Crafts also) and to some more specialist industrial applications. Reviewing management outlook comments indicates that more subdued Q2 trends in the Industrial division are expected to persist for the remainder of FY16, though we estimate that acquisitions will make an incremental c US$5m-10m revenue contribution in H2. In Crafts, an expectation of a better revenue and margin performance in H216 has been flagged, partly due to seasonal factors. When reporting FY16 figures, UK Crafts and its associated trading loss will be recorded as a discontinued activity.

At the trading level, we have reduced revenue expectations for both the Industrial and Crafts divisions reflecting the H1 performance and outlook comments. A stronger margin performance in Industrial allows us to increase the EBIT contribution here while the opposite applies to Crafts. Taken together, our group margin expectation is now c 60bp higher for FY16 (at 9.8%). While future periods have also increased, we continue to expect a broadly flat group EBIT margin profile over our estimate horizon. After incorporating slightly higher net interest costs and a higher non-bank finance charge (in line with H116), our FY16 normalised PBT estimate is reduced slightly, while those for FY17 and FY18 are unchanged.

Pensions solution nearing: At the end of June, the IAS 19R aggregate net deficit for Coats’ three UK DB schemes had risen to US$465m from US$423m (or £349m and £286m, respectively) at the end of FY15. This movement and summary information for each scheme are shown in Exhibit 3.

The EU referendum result has limited operating company significance, but had clear immediate impacts on the deficit calculations, being the further reduction to already soft discount rates partly offset by marginally lower inflation expectations. All three schemes are UK based, so relative sterling weakness further reduced some of this impact in US dollar terms. Otherwise, we note the significant reduction in the Staveley deficit following the US$50m/£34m one-off cash payment under the new scheme recovery plan. The April 2015 Coats UK triennial valuation is underway and discussions with scheme trustees are ongoing. As this is the company’s largest DB scheme and deficit, the outcome will be keenly watched by investors. Owing to its importance, we see agreement here being inextricably linked with active wider negotiations with tPR covering all three schemes. This brings uncertainty as to the timing and quantum of any settlement; latest guidance from management was that a tPR hearing “is unlikely before the fourth quarter of 2016 at the earliest”. Management’s clear preference is to retain parent company cash to support the schemes with manageable future annual cash contributions. As well as providing clarity here, the outcome of the negotiations will enable greater strategic conviction on the discretionary application of funds for growth through both organic and acquisitive means and a resumption of dividend payments. Ahead of any agreement reached on the Coats UK scheme and with the tPR, the annual recovery payments currently in place are £25.9m (£16m Coats UK, £4.4m Staveley, £5.5m Brunel).

Environmental case unchanged: there were no further updates regarding the US environmental case concerning the Passaic River in New Jersey over and above that communicated to investors on 7 March and included in the 2015 Annual Report. As at 30 June, US$2.1m of a $6.8m net provision for associated legal and professional costs had been utilised and a US$9m potential remediation cost provision was unutilised. A good summary of the historical position and timeline of developments from 2014 onwards is contained in note 10 to the H116 consolidated financial statements.