Coats Group PLC (COA LN) is a global manufacturer of thread, mainly for the apparel and footwear industries. As a result of two separate overhangs and a lack of investor knowledge due to its odd history, this market leading industrial company is likely trading at a double digit FCF yield which appears to be far too cheap for a company of this quality.  

As the last asset remaining from 50 company investment vehicle Guinness Peat Group (GPG), COA is remarkably little known for a global industrial company that generates $1.5bln of revenue with a history that dates back to 1755.  After GPG liquidated its other assets, the company was renamed Coats in FY 15 and is looking to delist from AUS/NZ where it was historically based.  As a result of this odd history, COA is only covered by one small UK broker and one NZ broker with no bulge bracket coverage.  

The company also suffers from two separate overhangs.  Firstly, legacy AUS/NZ shareholders have been selling as a result of the company's June 22, 2016 suspension from their exchanges.  While this transition has been occurring for the last year plus, 11% of COA shareholders in May 2016 (was 30% in May 2015) are still legacy AUS/NZ shareholders, some of whom will want to exit the position before the suspension date. This forced selling is evidenced by the fact that the NZ and AUS shares generally trade at a 3-5% discount to the UK securities despite the fact that they will be converted into the UK securities.  Also, it can be seen in the gap down on Friday June 17, when Coats was removed from the NZX 50 Index.  Furthermore, because of the arbitrage potential this delisting has likely depressed the London listing which can be seen on Friday where the NZ index deletion caused an 8.5% decline in COA NZ which then lead to a 7% decline in COA LN when  it later opened in London.  This overhang will lift this week once the delisting is complete on June 24th.

More importantly, COA suffers from an overhang caused by the UK regulators investigation 3 of its pension funds, causing significant shareholder concern about COA's ultimate liability to settle the investigation. COA consists of 3 pools of value at this point: 1) Coats Operating, 2) Parent Co cash and 3) Pension liabilities.  During the release of its Q1 results in May, COA announced that it had settled the 2nd of its legacy pension plans with the trustee with a combination of Parent Co cash upfront and ongoing cash payments from Coats operating.  While the exact structure of the third settlement remains uncertain, we can use those 1st 2 settlements as a guide to understand what post-settlement Coats looks like.

Even with a larger than expected pension payout and a downturn in COA results, downside should be protected at GBp 20.  A more normalized value on COA's business + some excess parent company cash post pension payments could support a share price of GBp 51+.  This suggests that COA's risk reward is attractive at GBp 25.375 and is quite timely with the removal of the delisting overhang this week and the potential for a Coats pension settlement in H2 16.

2. Capitalization and Valuation (******* NOTE FUNCTIONAL CURRENCY USD*********)

COA has 1,408m shares for a GBP 357mln mkt cap at GBp 25.375 or $523mln.  Coats Operating has $264mln of net debt as of 12/31/15 and has made $45mln of acquisitions (incl earnouts) in H1 16 for a total Coats Operating EV of $857.4. 2015 EBITDA was $183mln so Coats Operating is trading at 4.5x trailing EBITDA.

COA also ~$500mln of Parent Co (in GBP so exact amt in $ depends on currency) on 6/20/16 and $805mln of Technical Provision (harsher than IAS 19 of only $423m) pension liabilities.  Combining this with Coats operating suggests a total EV $1,067mln or 5.8x trailing EBITDA.

Pension (*****Note GBP used for pension discussion********)

The first critical question in this investment is what does the final pension settlement look likeWhile it is impossible to precisely predict the outcome of the Coats pension negotiation, we can use the Brunel and Staveley (B&S) agreements as a framework.  

In the May trading update, COA announced that a funding plan had been agreed with the Staveley trustee.  For its Technical Provision (TP) deficit of GBP 100mln, COA would contribute GBP 34mln of cash upfront and ongoing cash payments of GBp 4.4mln over the next 9 years or a total undiscounted payment of GBP 73.6mln.  

This follows the November 2015 agreement with the Brunel trustee where a TP deficit of GBP 94mln will be funded by 10 years of GBP 5.5mln payments or a total undiscounted amount of GBP 55mln.  

In the FY 15 annual, the company stated that they expect the Coats TP compared to IAS 19 to be similar to the relationship that existed with B&S.  Using the most recent Stavely TP valuation would imply a TP of ~GBP 300mln for Coats.  B&S had undiscounted payments of 59% and 74% of their Technical Provision deficit respectively.  At 74%, COA would have to an undiscounted funding obligation of GBP 223mln.  Combined with Brunel and Stavely that suggests a total undiscounted funding obligation of ~GBP 350mln.

These undiscounted payments are broadly similar to the Parent Co cash of GBP 342mln and its important to remember that all of the Brunel and 50% of the Stavely payments are paid over the next 9-10 years and Coats will probably be structured in similar fashion.

While we can't know precisely what the Coats pension settlement will look like, it will most likely be a combination of upfront payment and ongoing support and I believe that it is likely to be weighted more towards upfront payments as shown with the more recent Staveley settlement compared to the earlier Brunel.  Also supporting more upfront is this comment from Malcolm Weir of the Pension Protection Fund "We would like to see shorter recovery plans, if possible." (1)

Using a broad range of potential outcomes is that the GBP 223mln undiscounted liability is settled by something in the range of GBP 125-200mln upfront and 10.9-2.6mln of ongoing payments over the next 9 years.  

So when we combined the settlements with B&S I think the total pension underfunding will be settled by GBP 185-234mln upfront and ongoing payments of GBP 12-21mln (USD 18-30mln).  The upfront payments will be settled by using a portion of the GBp 342m of Parent Co cash.

It should also be noted that a 140bsp increase in the discount rate would have eliminated the Coats underfunding as of 12/31/15.

Finally, there is an argument that Coats' shift to being more normal UK PLC as opposed to being part of an NZ investment vehicle should help with in negotiations with the UK pensions regulator (2).  

The company's restructuring in February to become a standalone and UK-listed entity, moving away from its investment company past as Guinness Peat which was a New Zealand investment vehicle, could also be an important factor.

Pinsent Masons head of strategic development for pensions Robin Ellison, while not wishing to comment directly on the case, points out that TPR's usual concern about ultimate overseas companies is there could be difficulties if they fail, whereas UK-based owners tend to be less of an issue.

Upside/Downside

Thus the company should have ~GBP 108-158mln of Parent Co Cash post the upfront pension payments.  To be conservative, I also add assume another 100mln cash reserve (escrow for pensions, environmental, other) which leaves remaining parentco cash of ~GBp 0.4 to GBp 2.9 per share.

Reported FCF has been burdened by pension payments ($46mln in FY 15 comprised of pension support payments and legal expenses due to investigation), discontinued operations (sale of EMEA crafts) and reorganization costs.  Reported operating FCF was 74mln in FY 15 and 88mln in FY 14.  I have removed the investment income of 10mln in each year when considering "operating FCF" to get to a $64-$78mln for the last two years and $71mln for the average of the two.  The major difference between the two years was working capital (-15 in FY 15, +28 in FY 14).  

The company talks about $75mln of adjusted FCF and mgmt's 2016 LTIP includes a target of 220-260mln of cumulative FCF over the next 3 years (excluding pension payments).  Here is the company's calculation for FY 14&15:  

Using the average of 2014-15 of $71mln is GBp 3.56 of operating FCF per share.  Reducing that by our $18-30mln of ongoing pension support suggests equity free cash flow of $41-53mln or ~GBp 2.00-2.60 per share.  So what kind of multiple does this FCF deserve?

For the ongoing business, COA is by far the leader in thread, 3x the size of their nearest competitor and involved in the manufacture of 20% of the world's apparel and footwear (see more business info in appendix below).  The company's competitive advantage stems from its unmatched global footprint, long-tenured customer relationships (some brands specify Coats thread) and best-in-class capabilities and reputation. Coats believes it gets a 15-20% pricing premium vs local peers as  result of its advantages in speed of delivery, ability to handle complexity and value-add technical services.  While not a fast growing industry, thread should continue to grow over the long-term due to demographics and an increase of the world's middle class (people buy more apparel and footwear as their wealth increases).  The company has stable margins (ongoing EBIT margins range from 6-9% from since FY 04) and generates high returns on capital (33% PP&E + working capital, 20% if you include intangibles). Coats Operating also boasts a conservatively levered balance sheet (1.6x EBITDA post acquisitions).  FCF should grow as a result of earnings growth, accretive bolt-on M&A, and lower taxes as the company continues to improve its current inefficient tax structure (goal of low 30s vs. high 30s currently).

Given these qualitative attributes, I think it is difficult to argue that more than a 10% yield would be justified which suggests downside support at GBp ~20 given the high end of the ongoing payments and assuming zero recovery of the ~4p of excess Parent Co cash in the lower upfront/greater ongoing payment scenario.   

For the upside scenario 5% yield would support a share price of GBp 51 excluding any value for the remaining Parent Co cash.  

GBp 20 would be ~4.7x 2015 EBITP and 50p would be ~8.5x as another way to think about valuation.  Thus with ~20% downside and ~100% upside I think Coats is an attractive risk reward.

The Future

In 2017, the company should have shed its pension and delisting overhangs and should be able to act more like a normal PLC.  The elimination of the tri-listing should concentrate volumes on the UK exchange, increasing the potential for research coverage and allowing COA to be eligible for index inclusion in the UK (most likely FTSE all-share and small cap, FTSE 250 would likely require share price above 50p).  COA should also be able to pay ongoing dividends from its FCF which will increase its appeal to UK shareholders and add more bolt-on acquisitions that take advantage of its global footprint and strong customer relationships. As this normalization unfolds, investors should rerate COA as a market leading, high-return industrial company which should lead to a materially higher share price.

Risks

• Unprecedented action from the regulator pushes Coats pension settlement past H2 16 and forces company to litigate.

• The agreements so far are with the trustees of each scheme and not with the pension regulator so it is possible that they are rejected

• We are already in unprecedented territory with the regulator issuing a warning notice against an operating company so something unforeseen is certainly possible

• Significant downturn in operating business due to global macro, operating problem etc

• New apparel/footwear technologies that use less thread (printed garments etc)

Appendix- Business Info

(1) & (2)http://www.pensions-expert.com/DB-Derisking/Staveley-agrees-73.6m-recovery-plan?ct=true