Interactive Investor

Stockwatch: this mid-cap growth stock has Asia mega-potential

27th April 2021 17:53

Edmond Jackson from interactive investor

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Can this stock trend higher, or is it at a natural limit? Edmond Jackson assesses this recovery play.

Can the mid-cap shares in the world’s leading industrial threads manufacturer Coats (LSE:COA) trend higher, despite a seemingly full valuation?

Last week, three investment institutions raised their stakes, accounting for a rise from 56p to test 60p, currently sitting at 59p, which capitalises Coats at £865 million.

On a basic test of price-to-earnings (PE), cash flow, yield and asset value, the current level appears high enough. It is possible these longer-term holders are taking a ‘top down’ approach – seeking exposure to a global recovery play as (at least) the developed world emerges from Covid-19 lockdown restrictions.  

A relatively attractive play on global recovery 

Coats derived 54% of its £1.2 billion revenue from Asia and 71% of it from clothing and apparel, where Asia is also a significant exporter. Other applications for the threads – 29% of revenue is “performance materials” – include transportation, telecoms and energy.

Downside limitation may be offered by strong market positions and a promising new product pipeline, such that it may essentially be a matter of time before better revenue kicks in. 

Care is needed, however, given the table shows a lack of top line growth even in pre-pandemic years. Coats also reports in US dollars as a truly international business, so mind that if dollar weakness persists then it could take the edge off medium-term growth for sterling-based shareholders. 

Recent modest stake-building  

Completing 16 April, Mondrian Investment Partners raised its stake from 5% to near 6%. Then, on 19 April, Invesco edged up its stake by 0.2% from 5%. On 20 April, M&G suddenly appeared with over 5% - i.e. over the 3% threshold for disclosure. 

Three institutions simultaneously raising their stakes could simply mean a broker has placed a sale elsewhere. But as yet there is no indication of this, and the buyers would anyway need to be satisfied as to value. 

Chart-wise, Coats is back to a level early last November when better-than-expected news on vaccines prompted a global re-rating. It had advanced to 72.5p by mid last December only to drift back to 56p as of a week ago.

This means it has regained its pre-pandemic level in February 2020, after which it plunged to 36.5p, recovering to 72.5p last December. That was essentially the pre-pandemic level. 

The long term has suggested more a cyclical than a growth business. Coats traded at around 60p before the 2007/08 downturn, then bumped along at around 30p until summer 2016. There was then a re-rating to 85p, which persisted until spring 2019. This is why the stock was already in a modest downtrend when the hit from Covid-19 took it down to 39p at the end of March 2020. 

Sales recovery narrative within the 2020 results 

With all of Coats’ markets impacted by the pandemic, annual revenue fell 16% and earnings per share by 70% given the aspect of operational gearing.

Declines were mitigated by last November and December. The month-exit sales rate was 5% down versus 26% in the first half of 2020 and 15% for the four months to October 2020.

Given lacklustre pre-pandemic sales growth anyway, the question is whether revenue remains impaired – or could pent-up consumer demand unleash something more vigorous? 

After a 6.4% operating margin in the first half, a recovery to 12.2% happened in the second, broadly in line with previous years. With operating margins anywhere between 1-2% in construction to 20-30% in niche software licensing, Coats’ is respectably useful.

After cautious expectations management, the $111 million (£80 million) annual adjusted operating profit was described as “ahead” of them. 

It launched 22 new products over the year, generating $13 million incremental revenue “and a rich pipeline of opportunities”. Revenues rose six-fold year-on year for EcoVerde, a 100% recycled premium polyester sewing thread – said to deliver greater abrasion resistance and colour matching.  

This sounds promising, if tricky to know with a sizeable diverse group if growth areas may substitute others in decline. 

Key valuation metrics are unexciting 

Normalised earnings per share (EPS) of around 2 cents in 2020 is projected to recover to 5.4 cents this year and 6.9 cents in 2022, which after currency translation implies a 12-month forward PE of around 14x with the stock at 59p.  

The final dividend was reinstated at dividend of 1.3 cents a share versus nothing when reporting in March 2020, said due to strength of Coats’ balance sheet and confidence in the outlook. 

With consensus looking for a total 1.8 pay-out cents this year and 2.1 cents in 2022, the prospective yield is barely over 2% - i.e. unlikely to attract income-seekers and no real prop should markets fall.  

Moreover, since the end-2020 balance sheet had $289 million intangible assets in context of $319 million net assets net tangible assets per share only equate to 1.5p a share equivalent. 

That would suggest the stock is high enough and you would await more evidence given Coats’ slack historic revenues. Cost-cutting and streamlining can only go so far, revenue growth is a chief driver of investment value. (The possible exception for income-seekers, being a mature business throwing off so much cash it gets substantially distributed and you are looking at a 5%+ yield.)  

Coats - financial summary
Year end 31 Dec

  2015 2016 2017 2018 2019 2020
Turnover (£ million) 1,473 1,457 1,356 1,415 1,389 1,163
Operating profit (£m) 112 153 154 147 191 103
Operating margin (%) 7.6 10.5 11.4 10.4 13.8 8.9
Net profit (£m) -50.6 59.3 80.8 39.2 95.7 26.4
Reported earnings/share (p) 1.8 4.5 4.9 3.8 6.6 1.8
Normalised earnings/share (p) 4.0 4.8 5.2 7.3 6.9 2.0
PE ratio (x)           29.5
Operating cashflow/share (p) 3.2 0.5 -16.2 7.0 9.9 4.5
Capital expenditure/share (p) 2.3 2.8 3.5 3.2 2.7 0.8
Free cashflow/share (p) 0.9 -2.3 -19.7 3.8 7.2 3.7
Dividend per share (p) 0.0 0.8 1.4 1.7 0.6 1.3
Covered by earnings (x)   5.4 3.4 2.3 12.0 1.4
Return on capital employed (%) 8.5 16.4 16.2 16.3 21.0 12.1
Return on equity (%)   32.1 39.1 19.7 32.5 8.6
Cash (£m) 650 477 119 136 178 72
Net debt (£m) -241 -78.4 241 222 215 247
Net assets (£m) 329 68.5 286 271 321 291
Net assets per share (p) 23.7 5.0 20.5 19.2 22.5 20.1

Source: historic company REFS and company accounts

Market sentiment still favours global recovery plays 

Coats is the kind of stock with global revenues, potentially attractive as a means to play the aftermath of Covid-19. Global infections continue to rise but monetary expansion has contributed to excess risk capital seeking a home, it may well continue to do before companies actually report better growth. 

Unless stocks destabilise on inflation/interest rate worries, Covid-19 variants outwitting vaccines or nationalist aggression by China or Russia, Coats may remain well-bid. While less likely to become a momentum stock it meets aspects of current investor needs. 

In its main apparel and footwear side, a demand shift from West to East is under way with the domestic China market expected to outgrow both Western Europe and the US by 2024.  

Europe, the Middle East and Africa – EMEA – already constitutes just 19% of Coats’ sales and the Americas 27%, hence strong Asia Pacific positioning bodes well to capitalise on the trend. 

And in terms of Asian manufacturing, a state-of-art automated pilot project at a Chinese facility is due to complete this June. 

The CEO’s outlook statement remains “cautious around the recovery profile of our various global end markets and inflationary pressures within the supply chain”. Notwithstanding this uncertainty, “the board expects to see continued recovery through 2021”.

Over 90% of net assets constitute intangibles 

Be aware of this, within an allegedly “strong” balance sheet. Net debt has also risen within from $150 million to $181 million after cash fell 59% to $72 million. Otherwise, long-term debt is down 19% to $230 million and short-term debt by 48% to $23 million.

Net finance costs of $24.8 million took 22% of normalised operating profit versus 14% in 2019 albeit when profit was higher. In due respect, trade payables are broadly in line with trade receivables (no delaying on payment to suppliers) and there is an £11.4 million pension surplus.

Coats’ balance sheet therefore has respectable elements. This is not a strong conviction stock but can have a role within a diversified global portfolio – according to your situation. Buy.  

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

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