Interactive Investor

Stockwatch: has this quality cyclical stock passed its low?

8th November 2022 11:09

by Edmond Jackson from interactive investor

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To decide whether it’s time to buy this £1 billion company. Analyst Edmond Jackson looks at the 2009 recession for clues. 

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Among sharp rebounds for cyclical stocks in recent weeks has been industrial threadsFTSE 250 share Coats Group (LSE:COA), up nearly 30% from 52p on 12 October to 67p currently. 

It is a pronounced example, where equities are enjoying a relief rally – both in the US and UK – after a sordid September. 

It’s unclear how much we can trust this, given the context is Coats not much changed from April 2021, when I made a “buy” case at 59p?  

Coats being the world’s leading manufacturer of threads, yarns, zips and trims made it look a useful play onglobal recovery – as the developed world emerged from Covid restrictions. 

In which case, and if the world is at high risk of entering recession - as the effects of various countries’ serially raising interest rates, manifest – then even a quality cyclical now seems an odd “buy”. 

Can we trust the forecasts? 

I did not have conviction about Coats due to a seemingly full valuation. But if forecasts are fair, then it currently trades on a forward price/earnings (PE) multiple around 8x and a price/earnings-to-growth (PEG) ratio that is a highly attractive 0.6.  

While Coats is listed in London and capitalised at just over £1 billion, as a global business it reports in US dollars – with net profit expected to rise from $69 million (£60 million) last year to $117 million this and $146 million in 2023. 

For this year at least, it is partly a response to last August’s interims guiding full-year results “moderately” ahead of expectations. 

Yes, the group made two chunky acquisitions last year, but in overall context it is targeting a significant break-out in its earnings trend – for the period when global interest rate rises will take effect on underlying economies: 

Coats - financial summary
Year end 31 Dec

201620172018201920202021
Revenue - $ million1,4571,3561,4151,3891,1631,504
Operating profit - $m153154147191103179
Operating margin - %10.511.410.413.88.911.9
Net profit - $m59.380.839.295.726.488.9
Reported EPS - cents4.54.93.86.61.86.1
Normalised EPS - c4.85.27.36.92.06.7
Operating cash flow/share - c0.5-16.27.09.94.58.8
Capital expenditure/share - c2.83.53.22.70.82.1
Free cash flow/share - c-2.3-19.73.87.23.76.7
Dividend/share - c0.81.41.70.61.32.1
Covered by earnings - x5.43.42.312.01.42.9
Return on capital employed -%16.416.216.321.012.117.0
Return on equity - %32.139.119.732.58.621.1
Cash - $m47711913617872.0107
Net debt - $m-78.4241222215247246
Net assets - $m68.5286271321291553
Net assets/share - c5.020.519.222.520.138.1

Source: historic company REFS and company accounts

Performance was mixed in 2019 and worsened in 2020, although Covid disrupted the business. 

It would bother me at the best of times, when cyclicals start to attract growth stock-type ratings, yet here we are supposedly facing perhaps the greatest downturn in living memory. 

Either some macro analysts are smoking something odd, or forecasts on industrial cyclicals need treating with caution. 

At the risk of confirmation bias, yesterday I saw a clip of Mike Wilson, Morgan Stanley’s chief equity strategist, arguing the latter – why he sees the second quarter of 2023 as when stocks are more likely to bottom out.  

While he refers primarily to the US, I suspect it will be the pied piper now that anxious times mean markets tend to move in unison.

Yet Coats has a relatively strong record from the 2009 recession 

Normalised operating profit eased barely 7% in 2009 to $96 million, despite revenue down 14% to $1,408 million.  

The company said then: “Coats’ strong operational and financial position, coming into the downturn has enabled it to withstand a downturn in global demand plus de-stocking in the supply chain, and to react quickly.” 

This time around, Coats is entering what appears a likely global downturn on a circa 12% operating margin, helping returns on capital/equity in mid-teen percentages.  

Management seeks cost savings amounting to $50 million a year by 2024, starting with $15 million in 2022. Mind a likely exceptional cost of $35 million to achieve this. 

Consensus expects margins around 14% following guidance on recent acquisitions and a continued shift towards “sustainable” polyester threads.  

Last summer, a total $355 million was spent on buying Texon and Rhenoflex, in footwear reinforcement materials, which added around $200 million revenue. This raised footwear to around 24% of group revenue versus 53% for apparel and 23% for performance materials. 

Even before these acquisitions contribute, the interim 2022 results achieved an 18.2% operating margin in apparel and footwear and 8.2% in performance materials, up from 13.8% like-for-like. That is an even better cushion than Coats had to face the 2009 recession. 

Also potentially limiting downside risk is a shift in the customer base over the last decade towards India, Vietnam and China – in support of clothing/footwear manufacture, also urbanisation which requires fibre optics, the performance materials side supplies. Asia is also involved in biomaterials such as sustainably sourced wood pulp. 

I remain a tad wary about Asia-Pacific being defensive while China’s on-off battle against Covid persists. Asia will also not be immune to a serious global recession given it supplies Western markets. 

The “sustainable” theme does however imply defensive qualities. EcoVerde, a range of threads made from recycled plastic bottles, contributed 6% of 2021 revenue but grew 159%. Management aims for all its premium polyester threads to be made from recycled material by 2024, possibly accounting for a third of group sales. 

Such factors explain how, when markets sold off abruptly a month or so ago, Coats attracted buyers.  

Going forward, the key question is whether earnings growth targeted in the high-teens percentages is exposed in 2023, and if revenue growth proves softer than around 10% as projected. Will recent acquisitions fill any slack? 

Otherwise, an implied prospective yield of 3.3% does not exactly support the stock. Nor do net tangible assets per share equivalent to 22p as of last June. Intangibles constitute 40% of net assets. 

Turnaround in the pension fund deficit 

This does argue for a better rating, having been a drag previously. A $226 million deficit moved to a $21 million surplus by end-2021, helped by higher discount rates and employer contributions. Macro trends then bolstered it to $189 million, end-of last June. 

Interim net debt excluding leases was $195 million or $284 million inclusive, hence just over $15 million net finance costs clipped 14% of operating profit.  

Yet I have seen one estimate of current net bank debt around $440 million due to the acquisitions, suggesting Coats needs to de-leverage. 

All-considered, I think the stock trades in an approximate fair value area given uncertainty about whether a growth scenario is fair for 2023/24, or if profits consolidation follows. 

Coats’ revenue profile is not radically better than $1.6 billion in 2008 and $1.4 billion in 2009, when it made normalised net profit of $32 million and $36 million respectively. 

Yet the long-term stock chart is a concern – the price hit 20p in April 2009 – if recession impacts sentiment towards cyclicals. 

Threads are potentially exposed to softer demand from apparel/footwear, although broadband upgrades should support performance materials. 

A takeover approach seems unlikely 

Coats would appear a prime example of weak sterling attracting a bid, yet with a 23% market share in its apparel/footwear market and 14% for the performance materials side, who else in such industry would buy it? 

We may see a contraction in private equity’ opportunism as interest rates rise. 

The CEO since 2017 has divested non-core segments and made small bolt-on acquisitions prior to this year’s deals. It is hard to argue any takeover on grounds of failures, yet Covid has clouded judgment on his overall progress.  

I like the company and its stock is one to have on your list. My enthusiasm is constrained by forecasts on industrial cyclicals looking as if they will get a reality check in 2023. I may be wrong, but regard Coats’ share price jump as another rally in a wider bear market. Hold.  

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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