I - Business and History
GPG’s only operating asset is Coats PLC. Coats is the largest global manufacturer and distributor of sewing thread, embroidery thread and technical thread. Coats also makes zips (OPTI). The thread is spun from natural and synthetic fibers such as cotton and wool.
Manufacturers of apparel, automotive materials, home furnishings, medical supplies and footwear rely on Coats’ thread to manufacture their products.
The history of Coats spans four centuries, six continents and a couple of planets. The company is the undisputed leader in this business with revenue of £1 billion. Coats supplies its threads and zips to companies such as Adidas, Marks and Spencer, Nike and Abercrombie and Fitch. NASA used Coats’ threads for parachutes and airbags on the Mars Rover mission. Edison used Coats's thread to make lightbulbs.
Until Cartwright invented the power loom in 1785, spinning, weaving, knitting and sewing had been cottage industries for millennia. These were highly fragmented and labor intensive activities. Cartwright’s invention led to the industrialisation of the weaving process.
Some of the best looms could be found in the Scottish town of Paisley where the popular pattern with multi-colored twisted teardrops was produced. By 1860, Paisley’s weavers could produce patterns in 15 colours. They were far ahead of the competition, and Paisley became an important center for the textile industry.
As looms became faster and more complex, inventors had to find ways for the spinners to keep up. When the Napoleonic Wars interrupted supply of silk to the UK, James and Patrick Clark developed a way to produce cotton thread in large quantities. The two brothers opened a mill at Seedhill. Another manufacturer, James Coats, opened a similar mill at nearby Ferguslie.
Coats expanded internationally, particularly to the U.S. In 1890, Coats listed on the London Stock Exchange with a market cap of £5.7 million. The Coats and Clark companies amalgamated in 1896.
The production of threads, a process which hadn’t changed much for thousands of years, has come a long way since those days. Interestingly, the apparel industry, which processes the threads and textiles into garments, has not. The apparel industry is still very labor intensive and fragmented. More than two centuries after Cartwrights' invention, millions of tailors and seamstresses are still trying to figure out how to keep up with the increasingly automated spinners and weavers.
Technology is more easily applied to the spinning and weaving industry due to the uniformity of the production process. Unlike the apparel industry, with labor constituting a relatively small share of total production costs, the spinning industry has remained competitive even in countries with high labor costs.
After many decades of industry consolidation, Coats is now wholly owned by Guinness Peat Group (GPG). GPG is a New Zealand conglomerate listed in Australia, New Zealand and the UK. For U.S. investors, there is the option of buying OTC shares (GPGRF).
Two months ago, Guinness Peat Group sold the last of its investments, leaving Coats as its only operating asset. Management has announced plans to return capital to shareholders and rebrand the former conglomerate as Coats. Both the timing and amount the return of capital depend on a review by the UK’s Pensions Regulator of GPG’s obligations.
II - Competitive Advantages
Setting up a spinning mill does not require a lot of capital, propreitary technology or skilled labor. Up until the nineties, labor was the key cost. Today it is yield. In fact, for a modern spinning mill, wasted fiber and energy used are a much greater component of cost than labor. Roughly 70% of the cost of yarn is raw material (fiber) and up to 15% of that is wasted.
Anyone can spin a good yarn from high quality (long) fibers. For natural fibers though, supply is never steady. The best mills will be able to mix and match different lots of fiber to get a consistent quality yarn at the lowest cost. When cotton and wool are cheap, anyone can produce good thread. It’s when prices of the raw material go up that the mediocre players are forced to shut down their operation... for a while.
In short, on the supply side, there are no barriers to entry.
On the demand side, there is a little bit of pricing power. When talking about thread or zips, these items account for around 5% of the cost of a garment, but they’re absolutely critical in terms of the garment's quality. Next time you don your $50 pair of trousers, take a few seconds to notice the zip. There’s a fair chance it’s labeled “opti.” Opti is one of Coats’ brands. It takes a fair amout of labor to affix that zip to the garment and subsequently get that garment in the shop on its way to your closet. All that labor is much more expensive than the cost of the zip. Having said that, people who pay $50 for a pair of trousers expect that zip to function perfectly even after its been in the washing machine a hundred times.
On a smaller scale, anyone who’s ever taken the time to knit a scarf or do a bit of lacemaking will tell you that they’ll buy quality thread. There's just no point in putting in the effort only to end up with a low-quality result because you decided to spend a bit less on the thread. It’s the same for anyone who has ever fixed a zipper. You just don’t want to spend your time and skill fixing a $1 zip only to see it fail a week later. More likely, you’ll spend an extra $1 on a zip that you think will last for many years.
That is why the brands (Nike etc.) outsource their apparel production but not the acquisition of thread and zips. The brands acquire these directly from Coats and supply the sweathouses with these materials to manufacture the garments. The brands do not want the manufacturers to shop around for the cheapest thread and zips to make an extra buck at the expense of quality.
This leaves Coats with a bit of pricing power in this otherwise dreadful business.
Coats’ superior eficiency shows up in its inventory turnover. In an industry with slim gross margins, superior inventory turnover is the way to to identify the most efficient producer. Coats PLC delivers yarn to its customers within 115 days of taking delivery of the cotton, wool and other fibers. That’s more than a month sooner than Vardhman and Gruswitz.
III - Financial Strength
GPG is one of those rare companies that has more cash than debt, a very strong balance sheet. Assuming all the cash is returned to shareholders, Coats PLC will be left with debt of 2.1 times EBITDA, well within the company’s covenants.
The company has been neglecting its recievables a bit. Days receivables outstanding is about 70 days which is about a months later than Gruswitz or Vardhman. This means the belence sheet understates the true financial strenght of the company. If Coats PLC brings its receivables in line with the industry, one month's worth of revenue shows up as cash on the balance sheet.
That’s about £100 million worth of cash that the company has been “hiding” in the coffers of its clients.
As strong as it is, the balance sheet as reported still belies the financial strength of the company.
IV - Management
Guinness Peat is controlled by a committee of vultures. On the board you’ll find some interesting people:
Waldemar Szlezak. Mr. Szlezak currently is the managing director of Soros Fund Management LLC. Through Quantum Strategic Partners Ltd., George Soros owns 133 million shares (about 10%) of the company. Slezsak doesn’t get a fee for sitting on the board.
Sir Ronald Brierley. Mr. Brierley is a well known activst from New Zealand. Not unlike Carl Icahn in the U.S., he has a long track record of stepping on people's toes and enriching fellow shareholders with his own peculiar style of value investing. Sir Ron retired as chairman of the company in 2010. He was in favor of splitting the company in two. Coats PLC would have been IPOed on the LSE, and the remaining stub would have continued as his investment vehicle.
Brierley’s plan was scuttled by investors who preferred to liquidate the group. Since then Guinness Peat has been patiently liquidated, leaving Coats PLC as its only operating asset. Brierley has founded a new investment vehicle called Mercantile Investment Co. to keep himself busy.
The directors have devised an interesting incentive plan for the executives of Coats.
The CEO of Coats is Paul Forman. Mr. Forman is the former CEO of Low & Bonar, a publicly listed industrial materials maker. He took over as Coats’ chief executive at the end of 2009. Paul Forman agreed to an incentive plan that stated that he and his fellow executives will be awarded the sum of:
(i) 1.5% of the first US$600m of the value of the Coats Group;
(ii) 10% of the value of the Coats Group greater than US$600m but less than or equal to US$900m;
(iii) 12.5% of the value of the Coats Group greater than US$900m but less than or equal to US$1,350m
(iv) 15% of the value of the Coats Group to the extent that it exceeds $1,350m.
That’s a management team that has an incentive to maximise the market value of Coats in an IPO. The delay of the IPO will cause the board to implement a different scheme. Having said that, this board has proven it can and does align the interests of management with that of current shareholders.
V - Value and Price
In the words of Mason Hawkins, “Guinness Peat has sold all of its investments and now holds cash and Coats.”
GPG trades around £0.30 for a market cap of £420 million.
Given that GPG has some £400 million worth of cold cash at the holding level, this implies Coats PLC, its wholly owned subsidiary, is worth less than £50 million.
That is absurd.
In 2011, Ruddick corp (Harris Teeter) sold American & Efird to KPS capital partners for $180 million. The transaction included A&E’s underfunded pension plan. A&E is the second largest player in the space and is about one-quarter of the size of Coats. A&E's gross margins are consistently lower than Coats'.
This transaction indicates Coats is worth at least £500 million. More than 10 times its current price.
Gruschwitz Textilwerke AG is publicly traded at 0.5x revenue and 10x operting income. Vardhman textiles (not a perfect comp) has a market cap of about $500 million. That company trades around 0.7x revenue and 4x operating income.
These multiples confirm Coats, with revenue of roughly £1000 million and run-rate operating income of more than £100 million, is worth at least £500 million.
The management incentive scheme also indicates the board thinks Coats is likely to fetch in excess of £500 million.
VI - Risk
Market risk. GPG’s shareholders are/were generally speculating on the IPO of GPG with no regard to the fundamentals of the business. Headlines determine the direction of the stock in the short term.
Pension liabilities. John Ralfe, an outspoken consultant who specialises in pension matters, argues that Coats' reported pension liabilities (£200 million on the balance sheet) understate the true cost. This has prompted the UK Pensions Regulator to launch an investigation. This in turn has locked up the funds at the holding level and delayed the IPO of Coats.
Interestingly, the trustees of the pension fund are not worried. GPG has agreed with trustees to double annual contributions to £14 million from the previous £7 million.
It's also worth noting that most of Coats's cash is in New Zealand. That's a long way away from English regulators.
I believe the issue is overblown. After a few centuries of operation, with ever-decreasing numbers of employees, Coats' pension plan currently pays out about £80 million annually to some 16 500 pensioners. Meanwhile, the plan has £1.4 billion worth of assets. The deficit stems not from a lack of funds but from a steady deterioration of bond yields and discount rates. This affects virtually all pension schemes in the UK and elsewhere.
As of this year, Coats offers the members of its pension plan the option of cashing out. While I have no information about the details of this offer, a member who accepts 15 years of income in return for their pension is doing investors a favour. These pensioners receive, on average, £5,000 per annum. The Coats' pension plan may not be their primary source of income.
To someone in their 70s, perhaps married to someone who has a somewhat larger pension, a one-time £75,000 payment in lieu of a monthly £450 payment may look like an interesting deal. Many members of the plan may not have been employed for a long time at the company in this cyclical and seasonal business.
VII - Catalysts
At current prices, GPG is a takeover target and/or LBO candidate.
China has implemented a tax on cotton imports (but not on thread). This policy is very good for business.
At some point, UK pension regulators will make a ruling of some sort.
VIII - Why Is This Cheap?
The income statement is a mess. I believe management is pre-loading costs to make the company look better after the IPO. Also, the company has paid some hefty (hopefully one-time) fines in recent years to settle some antitrust issues in the EU and US.
GPG has historically commanded the "conglomerate discount." It still does.
Sir Ron has been selling shares to fund Mercantile Investment Co; his new investment vehicle.
Aussie and New Zealand investors may be selling this while UK investors have yet to discover this "new" UK stock.
Taxes. Some investors may be taking a loss in one of the few stocks in their portfolio that has performed badly this year.
This is not a recommendation to buy or sell anything. At the time of writing, I had no position in any of the stocks mentioned.
Any and all questions welcome as usual.
10 year financials
KPS buys A&E
Economics of spinning mills
Chinese cotton imports and spinning mills in India
10-k of Ruddick prior to the sale of A&E
Nate Tobik talks about GPG.
Mason Hawkins talks about GPG.