Coats is back in fashion

Uxbridge-headquartered Coats (COA) might not be a household name, but it is the world’s leading manufacturer of threads, yarns, zips and trims. In the world of apparel and footwear, it has a 23 per cent market share, and is estimated to be over twice the size of its nearest thread competitor.  

Its smaller ‘performance materials’ arm – which produces thread for an eclectic range of purposes, including personal protection, telecoms, and transportation – also has a chunky market share of around 14 per cent. 

Coats’ size and history is crucial to its investment case. The group has been around since 1755, boasts well-established manufacturing processes, and counts on long-standing customer relationships, meaning new entrants to the market are unlikely to prove a threat. 

Its broad portfolio also shelters it from the volatility of fashion retail. Its apparel and footwear division targets a variety of markets including premium lifestyle, fast fashion, mid-market, and luxury attire. Because of this, fickle consumer taste – often the downfall of retail brands – has little impact on demand for its products.

But it hasn’t all been plain sailing. Coats had a difficult lockdown, when profits were hit by a drop in demand and additional coronavirus costs. However, the group bounced back well in 2021, when sales and cash exceeded pre-pandemic levels, and operating profit edged toward past highs. Momentum also seems to be building. The final two months of 2021 saw sales up 20 per cent versus 2019 in both divisions, compared with 1 per cent in the first half of the year.

Opportunities in Asia

Over the past decade, Coats’ customer base has shifted away from Europe and into Asia. Asian countries – particularly India and China – are now expected to drive sales. In its latest annual report, the group said that sewing thread markets are due to grow by low single-digit percentages globally in the medium term. However, growth in Asia is expected to be faster, as consumers become wealthier and urbanisation increases demand for products such as fibre optic cables, which Coats’ performance materials division also specialises in.

“Not only will Asian consumers demand more garments, but more affluent consumers will demand higher-end garments, so we expect regional sales from our factories in Asia to increase over time,” management said in 2020.

Vietnam is also an important player. The country is a key end market for Coats as many of its clients have factories there. A series of strict Covid lockdowns resulted in serious operational disruption, particularly in 2021, when Coats had to temporarily shut its Vietnam site. The situation seems to have improved since then, although other shut-downs in Asia cannot be ruled out.

Sustainable sewing 

Geography is not the only thing working in Coats’ favour. The group is also tapping into sustainability trends. As flagged in our recent Alpha report on the company, the apparel and footwear industry is a major polluter and retailers are under pressure to go green. Historically, synthetic threads have been an oil byproduct, so eco alternatives are likely to have a competitive advantage. 

At the moment, this side of Coats’ business is small. Its ‘EcoVerde’ range – which is made from recycled plastic bottles – contributed just 6 per cent to group revenue in 2021. However, it’s growing fast: sales are up 159 per cent compared with 2020, and management wants all of its premium polyester threads to be made exclusively from recycled material by 2024. This would equate to around a third of sales. 

The group has also repurposed its Asian ‘innovation hub’ to focus on new biomaterials, and launched a new product in 2021 made from sustainably sourced wood pulp.

As well as ticking the ESG box, this is an exciting opportunity to grow margins and market share. Analysts at Jefferies say Coats’ focus on sustainability is “core to [its] positive thesis”, and believe it will help to raise higher absolute profit per unit.

Efficiency drive

It might sound unduly optimistic to discuss margin improvements against a backdrop of inflation, tight labour markets and supply chain chaos. Coats is far from immune from these pressures, as the decline in its PM division’s operating margins since 2019 shows. This is largely due to its US operations, which are dogged by worker shortages and rising wages. 

Management seems to have a plan, however. In early March, Coats announced a cost-saving scheme which promises to deliver incremental adjusted operating profit of $50mn by 2024. How exactly it will achieve this is a little hazy – the group refers simply to “strategic projects” that will optimise the business’s portfolio and footprint. However, broker Peel Hunt suspects Coats will focus on performance materials and – in a move straight out of the modern manufacturer’s playbook – increase production from lower-cost locations, such as Mexico or further afield.

This does not come without its own risks. Part of the strength of Coats’ business model is its global footprint, and the flexibility of its supply chain. Many of the group’s performance materials customers are based in the US, which has so far prevented significant offshoring. It is hard to shake the sense, therefore, that management’s hand has been forced. 

However, analysts are excited by the cost-saving possibilities. While the efficiency drive is expected to incur a one-off cash cost of $35mn, Jefferies expects it to boost consensus earnings before interest, tax, depreciation and amortisation by 9 per cent in 2023 and 2024, and result in margin accretion of two percentage points.

Decent valuation

For some investors, a question mark hangs over the profits that will flow to shareholders. The shares have jumped by around a third since the end of February, driven by a strong set of annual results. But the stock sits on less than 13 times forward consensus earnings, and sentiment still remains tainted by historic issues with its group pension arrangements. 

While the words ‘defined benefit scheme’ often cause investors to break out in a cold sweat, in the case of Coats things aren’t too bad. The group moved from a deficit of $226mn to a surplus of $21mn in 2021, largely due to higher discount rates and employer contributions. 

Future contributions will remain at the previously agreed level of £22mn a year, meaning that the deficit should be paid down by 2028.

These contributions will inevitably impact Coats’ cash position. However, the end is well in sight and the group generated an impressive amount of cash in 2021, despite having to catch up on some payments it deferred at the start of the pandemic. As such, it managed to reduce its net debt (excluding lease liabilities) by almost $35mn, and increase its dividend.

Coats seems to offer an attractive combination of value and growth, therefore – and its performance this year suggests that industrial thread is firmly back in fashion.