Coats Group — Update 31 March 2016

In an eventful year for Coats, FY15 included its emergence as an independent company, improved profitability, M&A (both acquisition and disposal) with some progress noted on non-trading legacy matters. On the trading front, both divisions increased their contribution to group profitability despite with some adverse FX effects. After a relatively small cash outflow in the year – including sizeable exceptional items – the company retains a significant net cash position for future investment in the business and to meet potential legacy obligations.

Industrial (FY15 81% of revenue, 90% of EBIT, before pension admin costs): overall, this division generated decent mid-single digit revenue growth in local currency – modestly down in US dollar terms – with a healthy double-digit operating profit improvement. This strengthened in H2 and the EBIT margin for the year increased by 170bp to 11.2%. Against our expectations, reported revenue was marginally lower but EBIT came in slightly better than anticipated.

Within the detail, Apparel & Footwear (A&F) thread sales demonstrated stable l-f-l revenue progress, which appeared to improve slightly in H2. We understand that volume growth was strong across a number of market sectors and countries and with major brands although pricing generally was considered to be ‘challenging’. Specialty thread applications address sub-sectors offering growth rates above those for A&F. This was again visible in FY15, although weaker demand from the oil & gas sector meant that y-o-y progress was markedly slower in H2 after a strong H1 performance (noting that sales were maintained at H1 levels in absolute terms). Apart from this, progress was made by broadening the geographic exposure of existing products and introducing new higher performance thread applications (eg cable protection). It should be noted that the weaker Specialty areas saw a partial recovery before the year end. Geographically, for Industrial as a whole, demand from Asia was robust throughout the year, EMEA was broadly flat while the oil & gas effect was most pronounced in the Americas, which still achieved some CER l-f-l growth in H2.

Coats continued to invest in improving manufacturing efficiency (in equipment, people and energy usage) as well as environmental projects. It also retains a strong commitment to new product development of higher value threads and digital technology platforms to enhance customer service.

Crafts (FY15 19% of revenue, 10% of EBIT, before pension admin costs): following the disposal of EMEA Crafts in the year, revenue in this division is now substantially generated in North America, with less than 30% coming from South America and, to a lesser extent, the UK. Brazil is a significant element of this and the real depreciated by c 50% against the US dollar over the year.

In headline reported terms, full year revenue was down by 13%, in line with the y-o-y movement at the interim stage. The underlying constant currency performance was somewhat better; although
y-o-y revenue was still down (by 5%) there was an improvement in H2 driven, we believe, by mix effects. Increased revenue in H2 was certainly beneficial but the sharp pick-up seen in profitability was primarily attributable to lower input prices and cost reduction measures taken in the division following the EMEA disposal. Overall the Crafts EBIT margin rose by 90bp to 5.2%.

In Handknitting, fashion sector sales have been tailing down from a significant peak of c $30m in 2013 and this continued during FY15, impacting trading in both half years. Seasonal effects (ie H2 is typically stronger) masked this to some extent in reported numbers. Given that the H1 and FY l-f-l revenue changes were the same in Handknitting, we believe that the reduction in fashion yarns has run its course and activity levels should be relatively stable now. In Needlecraft, good growth was seen in the smaller lifestyle fabrics segment though this did not fully offset softer thread sales. The H1 and FY l-f-l changes were identical in Needlecraft, so the apparent H2 improvement in the Crafts division reflected the greater proportion of Needlecraft sales. The Crafts operating margin more than halved in H1 (to 2.1%) but recovered in H2, resulting in a 90bp increase to 5.2% for the year as a whole. Against our expectations, revenue was slightly lower but profitability was significantly better.

Coats’ reported group net cash position was c $241m at the end of FY15. It is important to note that this comprised of:

Group net cash was c US$80m lower than a year earlier. This movement comprised a $20.1m actual outflow, a c $55.8m adverse FX translation effect with the remainder being other non-cash items. The $80m reduction in the group net cash position was effectively concentrated in the parent cash holding; relative US dollar strength accounted for the adverse translation impact; and pension cash payments were also significant. Operating company net debt, in comparison, was stable.

Our expectations were for a modestly positive actual cash flow outturn for FY15 compared to the actual c $20m outflow and the primary variance was against working capital. Elsewhere, the relatively better EBITDA performance plus proceeds from asset disposals were offset by higher non-trading, tax and EBT purchase cash outflows. We now look at actual cash, distinguishing between underlying and non-underlying movements:

Underlying: company defined adjusted free cash flow (essentially relating to continuing operations, before exceptional and pension cash recovery payments) came in at $73.9m. This was c $14m below the prior year but comparable to management’s stated target of $75m pa. The primary y-o-y variances were:

An underlying cash outflow in H1 followed by an inflow in H2 is a normal seasonal trading pattern for Coats though the timing of capex plus any M&A activity influences the outcome for the group as a whole. In FY15, this seasonality was again observed (ie c $21m H1 outflow followed by a c $95m H2 inflow) with a larger H1 outflow/smaller H2 working capital inflow than in the prior year reflecting the features described above. In H2, increased EBITDA and asset disposal proceeds were sufficient to offset lower working capital inflow versus the prior year. Hence, the $14m lower y-o-y underlying cash inflow for the year was largely a H1 effect.

Non-trading: these items are described in more detail on page 6. In total, we can identify cash outflows of this nature approaching $100m in the FY15 results. We summarise them as follows:

Looking ahead, we expect Coats to generate a slightly lower adjusted free cash flow despite a small EBITDA increase (chiefly due to lower investment returns on sterling cash balances) but also reduced non-trading cash outflows (with the large discontinued cash outflow not recurring). Clearly, the latter could potentially be significantly influenced by outcomes arising from negotiations regarding the UK pension schemes and US environmental matters (with UK tPR, the US EPA and other parties respectively). Greater clarity is expected in both areas by the end of FY16 and we will incorporate any impact at the appropriate time.

At the time of announcing results, Coats’ management listed a number of corporate developments providing positive momentum for FY16 but also made some more cautionary market and macro comments. (Of these, we would highlight a stronger US dollar – Coats’ reporting currency, c 80% of revenue is generated elsewhere – as a headwind to reporting profit progression.) However, Coats current expectation is for “modest y-o-y growth in group pre-exceptional operating profit”.

Compared to our previous estimates, we have trimmed revenue expectations modestly in both divisions slightly – chiefly for Specialty in Industrials and Handknitting in Crafts – to reflect the reported FY15 base years. At the EBIT level, our estimates now include a better Crafts profit contribution, more in line with that achieved in FY15 though this is partly offset by more gradual progress from Industrial and higher UK pension administration costs. Overall, this gives EBIT estimate increases of c $3m for FY16 and c $2m for FY17 with further progress anticipated in our new FY18 forecast. Over the whole 2015-2018 period, our EBIT margins are fairly stable sitting in the 9.3%-9.6% range throughout. After taking higher finance costs and the absence of a JV contribution going forward (Philippines investment was exited in FY15), our group PBT estimates are slightly below previous levels but still show incremental progress in each year.

We have covered high level cash flow expectations in an earlier section. In FY16, we have now allowed for a higher level of non-trading cash items – specifically UK tPR investigation costs (c $6m), the Brunel scheme cash contribution (c $8m), reorganisation costs (c $10m) and residual working capital items relating to the discontinued Crafts business (c $5m). Consequently, our FY16 cash inflow is reduced by c $29m to $17m, giving expected net cash of $258m at the year end.

Pensions: Coats is currently in negotiations with the tPR with regard to three UK DB schemes (Coats, Brunel and Staveley) on which tPR has issued warning notices. During FY15, a recovery plan for the Brunel scheme was agreed with trustees (£5.5m pa until 2025, March 2013 triennial valuation) and those for Staveley (December 2013 valuation) and Coats (April 2015 valuation) are under consideration. This dialogue with the respective trustees will continue independently but Coats’ understanding is that tPR wishes its Determination Panel to review all three schemes together and expects this to take place in H216.

At the end of December 2015, the IAS19R net deficit for these three schemes was $422.5m (split: Coats UK $264m, Staveley $87m and Brunel $71.5m) on gross liabilities of $2.98bn. As far as the impact on the FY15 P&L is concerned, the total charge to PBT was $39.4m (split $16.6m normal ongoing costs, the remainder being net finance and an exceptional provision). We believe that the cash outflow relating to pensions in the year was $59.3m (including the P&L ongoing costs plus recovery payments and investigation costs). These items are summarised in Exhibit 3.

Lower Passaic River (LPR): on 7 March, Coats announced that the US EPA had determined its final Record of Decision regarding the lower (eight-mile) section of the LPR remedy to be $1.38bn on a net present value basis. While this was below a previous estimate, the inferred cost for the whole (17-mile) stretch of river is above the proposed Sustainable Remedy level ($518m or $772m on an undiscounted basis) estimated by the Cooperating Parties Group (a number of companies, including Coats, considered likely to be considered as a potentially responsible party). Coats has consistently stated that it expects its own obligation to be a de minimus share of the total. This is unchanged but in the light of the EPA decision, has elected to increase its carried provisioning by $7m ($4m after tax) in the FY15 accounts. Including this, the total net provision recorded in the FY15 Annual Report is $12.8m. Negotiations, design and implementation of the remedial plan are expected to take more than ten years. Accordingly, the remedy for the upper LPR section and allocation of costs may differ from the assumptions used by Coats and the position will continue to be monitored and reported on.

Discontinued: the intended disposal of the EMEA Crafts business was announced on 19 February 2015, following a strategic review in the prior year. The transaction completed on 31 July with a nominal final consideration c $10m below the original indicated level. Trading conditions deteriorated during the year; taking into account the July disposal. The post tax trading loss of c $6m in H1 rose to almost $13m in total on disposal. Including disposal costs, the value of net assets disposed for nil consideration and historic exchange losses, the total FY15 discontinued P&L charge was $75.5m. In cash terms, the total outflow in the year was $37m, comprising c $15m from operations and c $22m relating to the transaction and sale process. Management anticipates that there is expected to be a further c $5m outflow in FY16 relating to working capital adjustments.

Exceptional: excluding the items outlined above, Coats recorded an $11.0m net additional P&L exceptional charge in FY15. The largest component of this was c $14m reorganisation costs for changes made to the group structure after the disposal of EMEA Crafts and this was substantially offset by a c $9m property disposal profit. The remaining items were for site consolidation in Mexico ($3.3m), a loss on JV disposal ($1.5m) and a management incentive plane charge ($1.3m). We believe that the total cash outflows associated with these charges was c $10m.