Is Guinness Peat Group still a buy? The Coats story..

The holy grail of a deep value investment is a company that's in the process of liquidating and selling on the market for less than the amount to be realized in the liquidation.  Situations like this don't come along too often, but one did recently, Guinness Peat Group (GPG.LSE/ASX/NSX).  The difference between the Guinness Peat Group liquidation, and a usual liquidation is what happens at the end of the process.  In a normal liquidation shareholders end up with cash, for GPG shareholders they will end up with a exposure to a company called Coats.

I wrote previously about GPG with the thesis being that it was selling at too low of a price considering their assets and what Coats could potentially be worth.  In the intervening months a lot has happened for GPG and shareholders have been provided with the official liquidation plan.  The company plans on selling all of their non-Coats investments and using the cash to buy back shares.  Eventually GPG shareholders will have a pure exposure to Coats through GPG.  When I wrote about GPG in the past shares were trading below the book value of the investments, but since then they've converged, with book value decreasing and the share price increasing.  The quick gain in a few months, and the fundamental business change for GPG has led me to re-examine the situation.

Coats background

Coats is the world's largest thread manufacturer for industrial and craft uses.  They are three times the size of their next nearest competitor.  The company's threads are used in everything from shoes, to clothes, to coats, to knitting yarn.  According to the company's website 20% of all thread originates from Coats.  The company is also an industry pioneer for thread innovations.  Operations are spread out across the world, and clients are large brand name apparel manufacturers.

The company was publicly traded up until 2003 when Guinness Peat Group took them over and took the company private.  GPG paid £414m for Coats, over the ensuing decade the value of Coats has fallen with GPG internally valuing them at £320m.

The investment case

The market is valuing GPG at book value, which means Coats is being valued at £80m by the market.  GPG has an internal value for Coats of £320m which is four times more than what the market is saying they're worth.  In addition the per share value of Coats should increase as GPG sells off their investments and buys back shares.  An investment in GPG at current prices means an investor has the ability to buy Coats for £80m, the question I had was, is this a good price for Coats, and would I want to own them?

Here is a spreadsheet I put together with some historical data for Coats:

Before diving into the details of Coats I want to mention one thing regarding currency.  GPG is a New Zealand company listed in New Zealand, Australia, and the United Kingdom, they use the Pound as their functional currency, but provide figures in NZD as convenient.  Coats uses the US Dollar as their functional currency, but is a UK company, headquartered and taxed in the UK in Pounds.  Guinness Peat Group is listed in the UK, New Zealand, and Australia.  The currencies are confusing to say the least.  I take everything in the company's functional currency and convert to something else where appropriate.

The bull case has already been well established, but the results bolster it further.  The company earned $61m in 2011, and have average earnings of $20m.  Coats is trading for an effective P/E of 6x on average earnings, or a P/E of 2.2x based on last year's earnings.  The company has £77m in cash on the books too.  Coats is also attractive on an EV/EBIT basis, trading with a ratio of 2.74x.

Here are averages for the last eight years:

My concerns about Coats doesn't have anything to do with their valuation, it has to do with their debt, and their ability to earn a satisfactory return.

Coats is highly levered, at the middle of the year they had $350m in short and long term debt.  It's concerning to me that they continue to carry, and rely on short term debt as much as they do.  Short term debt is riskier than longer term debt.  If the company fails to roll over the short term debt within a year they could be in default and bankers would be deciding the fate of my investment.  In general I'm adverse to debt, but if a company prudently borrows long term I don't have as much of a concern.  I get concerned when a company continually needs to go back to their bankers, rolling forward their debt to operate, that's the position Coats is in.

Another concern I have with Coats regarding their debt is that their interest coverage isn't that high.  In their best years Coats had their interest covered 5x, but the coverage ratio isn't consistent.  At worst interest was covered less than 2x in 2009.  This year is trending to be slightly less than 3x.

My second concern is about the financial return that Coats is making on their invested capital.  I purposely didn't include ROE on my spreadsheet because it would be artificially high.  In 2011 the company earned $61m on equity of $114m for a ROE of 54%, unrealistically high.  The company was able to achieve a high ROE because they have almost no equity.  A better measure of performance is return on invested capital.  I calculate it using free cash flow dividend by the total invested capital.  If you're confused as to why I do it this way I wrote a post a while ago explaining my reasoning.  The ROIC metric tells a much different story about Coats.  Rather than having incredible earning power Coats is barely generating a return on all of the capital they have invested.

The company achieved their highest ROIC in 2009, most likely because they were working off excess inventory, and didn't re-invest as needed, generating higher than normal free cash flow.  Outside of 2009 the company earned anywhere from nothing to 8% in 2004.  Last year came in above 6%, but the company doesn't think that historic performance will be repeated.

It's confusing to consider GPG and Coats within the context of the investment liquidations and share buybacks.  I decided to consider Coats and GPG different.  I looked at Coats in isolation and asked the question, "Would I buy Coats for £80m?"  On first glance the investment is appealing, the company is clearly cheap, and they hold a leading market position.  My problem is there doesn't appear to be much of a margin of safety at these levels.  There are plenty of highly levered companies selling at low multiples, the risk is that business stays steady or grows and we avoid a downturn.  Coats issued a press release stating they believe the 2012 levels of business will be below 2011 levels.

When I initially purchased GPG there was a strong margin of safety, the company was selling below the value of their investments.  But as the price has run up, and results have come in for Coats the investment has changed.  I still think Coats is cheap, but it's more of a speculative return from here, not a safe return.  I will most likely be selling out of my Guinness Peat Group shares to buy something much safer.

Before I wrap up I do want to mention that if Coats traded for £320m, the internal value that would be a 67% gain from these levels.

Talk to Nate about Coats/GPG

Disclosure: Long GPG shares for now.