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Edited Transcript of COA.L earnings conference call or presentation 5-Mar-20 8:30am GMT

Full Year 2019 Coats Group PLC Earnings Call

Mar 28, 2020 (Thomson StreetEvents) -- Edited Transcript of Coats Group PLC earnings conference call or presentation Thursday, March 5, 2020 at 8:30:00am GMT

TEXT version of Transcript

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Corporate Participants

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* Rajiv Sharma

Coats Group plc - Group Chief Executive & Executive Director

* Rob Mann

Coats Group plc - Head of IR

* Simon Boddie

Coats Group plc - CFO & Executive Director

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Conference Call Participants

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* Anthony William Plom

Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst

* Charles Hall

Peel Hunt LLP, Research Division - Head of Research

* Charles Mortimer

Citigroup Inc, Research Division - Senior Associate

* James Edward Zaremba

Barclays Bank PLC, Research Division - Research Analyst

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Presentation

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Rob Mann, Coats Group plc - Head of IR [1]

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Good morning, ladies and gentlemen. And first of all, sorry for the slight delay in starting today's call. Welcome to the Coats 2019 Full Year Results Presentation. I am Rob Mann, Head of IR at Coats. The presentation today will be hosted by Rajiv Sharma, our CEO; and Simon Boddie, our CFO. Once this is done, we will open up for Q&A.

With that, I will hand over to Rajiv.

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Rajiv Sharma, Coats Group plc - Group Chief Executive & Executive Director [2]

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Thank you. Thank you very much, Rob. Good morning, ladies and gentlemen. Welcome to the 2019 full year results presentation. In terms of the running order for today's call, I will take you through the headlines for the year. Simon will follow with an overview of the financials, after which I will give a review of the business. As always, we will wrap up with the outlook followed by Q&A.

2019 has been another year of growth in our key financial metrics and progress on our strategic priorities and Slide 4 sets this out. In 2019, we experienced macro headwinds, such as lower level of retail activity in the developed markets, U.S.-China trade tensions causing uncertainty in the supply chain and pause in telecom's infrastructure investments in Europe. This resulted in a sales growth of 1%. Despite lower sales growth, we delivered 5% growth in profits, a 50 basis points improvement in margin and 11% growth in free cash flow.

We completed the disposal of North America Crafts. With that, Coats is a focused, global industrial B2B manufacturing leader serving 40,000 customers in over 100 countries. We announced the acquisition of Pharr HP in the U.S., which makes us the market leader in the Personal Protection segment. We continue with our focus on controlling the controllables and self-help programs. This included the completion of our Connecting for Growth program that delivered $28 million of net savings. We are progressively reinvesting in the business to build capability and capacity in innovation, sustainability, digital and new talent. The business today is fitter, faster and more agile.

In 2019, we released our sustainability strategy with targets. We have also signed up to be part of the UN Global Compact. We are upper quartile with 2 ESG rating agencies and very close to being upper quartile with the third agency. Sustainability is core to Coats and a source of competitive advantage and commercial gains. We have a strong balance sheet that gives us optionality to continue funding attractive organic growth opportunities and acquisitions. I will talk about these more later.

With that, let me hand over to Simon to present the financials.

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Simon Boddie, Coats Group plc - CFO & Executive Director [3]

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Thank you very much, Rajiv. I would now like to take you through the key details of the results for 2019, which is set out on Slide 6. And we have specifically highlighted the performance of our financial KPIs.

Organic sales growth for the period was 1% with continued revenue growth in both our Apparel and Footwear and Performance Materials businesses, which are both in line with performance that we reported at our November trading update. At a reported level, revenues were down 2%, reflecting the same first half-weighted foreign exchange translation headwinds that we previously referred to. Foreign exchange translation headwinds were minimal in the second half of 2019. And at current exchange rates, we expect a broadly neutral impact in 2020. It is pleasing to see the good growth in our adjusted operating profit, which grew by 6% organically. And I will come on to explain the drivers behind that performance in the next slide.

At an adjusted earnings per share level, there was a 1% increase in the year, which is at reported rates, so includes the year-on-year foreign exchange translation headwinds mentioned earlier. Cash generation continued to be strong with adjusted free cash flow in the year of $107 million, an increase of 11% year-on-year. Our return on capital employed remains high at 42% as the increase in our adjusted operating profits were in line with our well-controlled asset base. Lastly, we proposed a full year dividend of $0.0185 per share, which is 11% growth on last year. This strong growth reflects our Board's collective confidence in the strategy and the future.

On Slide 7, you can see the details of the operating performance of the business, which culminated in a healthy progression in organic operating margins of 60 basis points. Overall, sales growth on a constant exchange organic basis was 1%, as I mentioned earlier. This was driven by 3% growth across our key Asia region, where our large Apparel and Footwear markets continued to see solid growth. In particular, alongside the U.S.-China trade tensions that were well-publicized in 2019, we saw a good performance in many of our markets outside China in the region, which are and will continue to be a beneficiary of the brands moving volumes away from the China market.

In Americas, we saw a 5% decline largely due to ongoing tough trading conditions in our Latin American Crafts business, although this has shown an improving trend in the second half. There were also lower transportation sales linked to lower production activity. We were pleased to see an improvement in the performance of our U.S. consumer durables business in the second half of the year as we established our key account team. In EMEA region, we saw 4% growth as the Apparel and Footwear market saw consistent low single-digit growth. The main driver of the strong performance in the region was Performance Materials, where in particular the Telecoms and Energy business saw good growth, albeit with a slower half 2, which Rajiv will cover later.

The 6% organic operating profit growth was driven by pricing, productivity and procurement gains, continued tight control -- cost control as well as the incremental year-on-year savings from the Connecting for Growth program of $13 million. These benefits were partially offset by the continued structural inflation, which we faced in many of our markets, in particular the impact of rising oil prices and energy costs as well as some adverse manufacturing variances due to the lower activity levels in some territories. The group organic operating margin increased by 60 basis points to 14.3%.

On Slide 8, we set out the performance of the business across the new operating segments that we have started reporting on this year: Apparel and Footwear and Performance Materials. As we previously set out, we see significant scale benefits in our business in our market-leading Apparel and Footwear business. And this has continued to deliver strong margin progression in the period of 110 basis points to 14.7% and profit growth of 9%. In Performance Materials, there's less scale than in Apparel and Footwear business today. However, the margins in this business benefit from the specialization of the product solutions we develop for customers.

It's key to note that because of the size of the Performance Materials business as well as the higher average order value, we can expect to see financial results sometimes impacted by specific items. In 2019, the Performance Materials margins were impacted by lower sales growth. There was also the impact of some of the initial operating costs in the new innovation hubs that were opened in the year. Largely as a result of these impacts, Performance Materials profits declined by 6% and margins were down 100 basis points to 12.8%.

The Pharr High Performance Yarns business that we acquired in February currently has lower operating margins than our existing Performance Materials business. While overall, Performance Materials operating margins will be diluted by this impact in 2020, we expect Performance Materials margins going forward to benefit from our plans to increase the margins in Pharr, along with the anticipated return to higher growth rates for the existing business.

Turning now to Slide 9. We show the bottom half of the profit and loss account at reported currency rates. I've already explained the drivers of the increase in adjusted operating profit, so I'll focus on the items below this. Exceptional and acquisition-related items have decreased significantly versus 2018. The exceptional charge in 2019 primarily relates to the remaining $8 million budgeted reorganization spend on the Connecting for Growth program, which is now completed. Finance costs were higher than last year. And this was essentially due to the nonoperational items that I alluded to earlier. These include an increase in pension charge of $1.7 million and the $3.7 million impact from the new leasing standard.

These nonoperational impacts, which are noncash, were offset to some extent by the lower interest on borrowings following the strong cash generation during the year. On tax, we saw the underlying rate continue to trend down from 31% in 2018 to 29% this year. This was due to a number of factors, including a reduction in overseas withholding taxes and the lower Indian corporation tax rate that came in during the year. As a result of the factors referred to earlier and the first half foreign exchange headwinds, at an adjusted earnings per share level, we saw a 1% increase year-on-year.

Turning to Slide 10. You can see that free cash flow for the year increased by 11% to $107 million. This was driven by our increasing operating profits, controlled net working capital and whilst maintaining capital expenditure at a level that is above depreciation. We also saw lower cash spend year-on-year on both interest and tax, although the latter was partly due to timing. On the right-hand side, you can see our balance sheet remains in a strong position with leverage at 0.6x, which was 0.4x lower at the end of 2018. Adjusting for the capitalized assets and associated liabilities as a result of the new leasing standard, IFRS 16, we see an increase in net debt of $65 million from the previous basis of $150 million to a closing net debt position at December 31 of $215 million.

Now before I wrap up on the financials, we, of course, want to update you on the current global emergency in relation to COVID-19, the coronavirus outbreak, and what this means for Coats. We're monitoring this situation very closely. And first and foremost, our priorities are the safety of our workforce, initiating relevant business continuity procedures and supporting our global customers who, of course, are also affected. To date, the impact of this outbreak for Coats is in relation to our China business, which accounts for around 12% of our group sales and 4 of our 50 manufacturing sites. We are pleased that all of these sites are now back operating, following the enforced government closures. And we expect them to reach full capacity by the end of March. Because of these temporary shutdowns, our China sales have been impacted to the extent of $8 million year-on-year in January and February combined. The local team have done a superb job of minimizing this short-term impact.

In terms of the wider apparel and footwear industry, China remains important, producing around 40% of the world's garments and footwear. What remains uncertain at this time is the impact that this will have on the industry supply chain inside and outside of China. We will monitor this situation closely and respond as necessary. What is very important to note for Coats is that whilst this is a very serious situation, our global footprint puts us uniquely placed to support our global brands and manufacturers at difficult times like this. China has already seen incremental volumes moving out to other markets in recent years, for example, the recent U.S.-China trade wars uncertainty, and we continue (sic) [expect] this trend to continue.

Now with that important latest update, let me wrap up on the financials. As you can see on Slide 12, it's worth reflecting that despite the uncontrollable macro uncertainties we and others are faced with, our financial delivery remains robust. We've delivered ongoing operating margin expansion and increased cash generation. We have a strong balance sheet and are generating high levels of returns. The financial platform we've built enables to service all our capital needs. We have funds to reinvest selectively in the most attractive, value-adding opportunities, both organically and inorganically. And alongside this, we have announced a healthy dividend increase of 11%.

And with that, I'll hand you back to Rajiv to take you through a review of the business performance in 2019 in some more detail.

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Rajiv Sharma, Coats Group plc - Group Chief Executive & Executive Director [4]

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Thank you very much, Simon. Let me now talk a little bit more about the business here. Coats has been on a journey to reshape its portfolio in the recent past and Slide 14 sets out the new Coats.

5 years back, Coats had a crafts division and an industrial division. Crafts was primarily a consumer business and accounted for 1/4 of the group sales. We have sold the crafts division. We have further simplified the group by exiting or changing the business model in several small, nonstrategic tail markets with minimal impact to global customers. Today, Coats is a B2B industrial manufacturing world leader with sales of $1.4 billion to 40,000 customers in 100 countries. Our global footprint gives us the edge to better serve global customers looking for optionality in sourcing countries.

We have 2 businesses. Apparel and Footwear accounts for 75% of group sales and Performance Materials accounts for the balance 25%. In just over 4 years, we have made 6 bolt-on acquisitions in line with our strategy. We are the world's largest producer of industrial thread to the apparel and footwear industry. We also provide complementary products like zips, trims and software solutions to the same customers. Performance Materials was created by leveraging our expertise in manufacturing and materials to make products for other industries, such as automotive, oil and gas, telecom and personal protection. Performance Materials has nearly doubled in size in the last 5 years with the acquisition of Pharr HP.

Since taking over as CEO, we have been working on 4 priorities to get Coats fit for the future. They are digital, innovation, sustainability and acquisitions. We have completed a 2-year transformation program to reduce unwanted complexity and cost. Coats today is fitter, faster, agile and better prepared for the future. With that context, let me give you further details on the 2 businesses.

Slide 15 sets out our $1 billion Apparel and Footwear business in more details. 85% of this division relates to our threads business, where we are the unrivaled global market leader. Thread is a critical component in garment and shoe production. It accounts for only 1% or 2% of the total cost. In a highly complex supply chain, we are the go-to global supplier of thread, delivering speed, quality, product range, world-class customer service, compliance and ESG for our global customers. This value proposition offers peace of mind for our customers. In the past 8 years, we have increased our global market share from 17% to 21%.

Going forward, I expect global brands to insist on strong sustainability and ESG credentials from the suppliers. And this would be considered as a license to operate with them. The threads market has a long tail, and this is starting to collapse or consolidate. The strong will get stronger. The market is also moving to more premium and sustainable products, all of which will benefit Coats over the medium term.

Coats Digital is a $12 million business. It is strategically important and growing double digits. We have built it through 3 complementary acquisitions, and it continues to be a focus area for future acquisitions. This business provides software solutions to drive overall productivity and agility for garment factories. We also have $100 million zips and trims business, which has had flat sales in recent years. This is in line with our strategy to change customer and product mix through conscious rationalization actions to achieve better profit and cash. Lastly, we have a $40 million Latin American Crafts business. This has been impacted by certain macro issues in Brazil and Argentina. We intend to return this to growth.

Slide 16 sets out the Apparel and Footwear performance in 2019. But let me start with the industry and macro picture first. Apparel and Footwear retail sales grew 1%, which is down from 1.7% in 2018. Collectively, retail markets in the developed countries were flat. China and India domestic markets accounted for majority of this 1% retail sales growth. The U.S.-China trade tensions resulted in a 3% decline of exports from China. We saw some business migrating to Vietnam and Bangladesh. Sportswear, activewear, outerwear and athleisure did well in 2019. Mid-market apparel, denim and casual wear were slightly down. The mass market end of retail grew in volume terms, especially in emerging markets and with the growth in online shopping.

At a headline level, we delivered 1% sales growth, in line with what was reported at the November trading update. This headline growth would have been 2%, had it not been for conscious management decisions to exit nonstrategic, less profitable tail markets and the portfolio rationalization actions in zips. Thread account for 85% of this $1 billion business and grew 2% with 1% coming from volume and 1% from price. Our premium threads, which account for half of that, grew at 5%. We were particularly strong in the footwear space due to our market position, favorable fashion trends and overall customer buoyancy. Our overall thread market share increased by 30 basis points to 21%.

Macroeconomic challenges in Latin America, coupled with internal portfolio actions, as mentioned earlier, have had an impact on our zips and crafts business. Last year, we launched the world's first 100% premium recycled sewing thread called EcoVerde. Demand has far exceeded supply. From a small base, I expect this product to grow 10x in 2020. Global brands are increasingly more focused on sustainability and ESG. As the industry raises the bar and enforces these standards, we expect more commercial gains for Coats.

Let's turn our attention to Performance Materials on Slide 17, which is 25% of the group. This business supplies thread and yarn products that go into a variety of industrial and recreational uses. At the half year, we showed the Performance Materials business in 5 discrete end-use segments shown on the slide. This was well received. So let me provide some perspective here. In Personal Protection and Telecoms and Energy collectively, we are 3x bigger when compared to 2015, strong organic growth and 3 acquisitions account for this expansion. Both these segments are expected to grow attractively in the future and remain a key focus for M&A opportunities. I will touch upon these segments in the next few slides.

Transportation has had a tough 2019 due to lower global car production. However, this segment is underpinned by expectations that each car in the future will have more seatbelts and more airbags. This means more thread consumption per car. Lightweighting of cars and electric vehicles are key priorities for the automotive industry. To address lightweighting, we have an innovative composite offering that can replace steel parts. We have been in trials for 3 years to prove the technology. I'm pleased to report that we have received our first order for a pilot program. On the right-hand side of the slide are 2 traditional end-use segments of Household and Recreation and Other Industrial Applications. These are both mature markets, broadly flat and have recently shown encouraging trends as we are focused more on customer service levels here.

Slide 18 sets out further detail on our Personal Protection business, which over the last 5 years has more than doubled in size organically. Patrick Yarns and Pharr HP are now included in this segment. We estimate the addressable market in Personal Protection to be $1 billion and growing. We currently have 10% market share. And this will double to 20% with the Pharr HP acquisition. The combined business gives us operating scale and a complete range of products in the Personal Protection segment. Increasing standards, better enforcement and legislation around personal safety will drive future growth in this segment.

Today, Coats has a full range of yarns, which include thermal, flame, cut, abrasion and electrical protection properties. We can also combine protection with comfort in our products. While Pharr HP margins are currently low and will temporarily dampen group margins, we see a route to increase these margins by leveraging Coats Group commercial and operational expertise over the next 3 years. Personal Protection continues to be an attractive segment for future acquisitions.

Slide 19 elaborates on the Telecoms and Energy segment, which has grown fivefold in the past 5 years. This includes the acquisition of Gotex. We estimate the addressable market to be $400 million and growing. Our current market share is 14%. The drivers underpinning this market are linked to infrastructure and maintenance CapEx from the large telecom and energy companies. 5G rollout and fiber to home will drive growth in the use of fiber optic cables. Our products are particularly suited to strengthen and protect fiber optic cables. Another growth driver will be the progressive shift from gel-based fiber optic cables to dry cables, which have lower life cycle cost and lower environmental impact. Gas distribution companies are starting to replace steel pipes with reinforced thermoplastic pipes. The main reason here is lower life cycle cost, much faster to install and lower environmental impact. We manufacture composite tapes that are used to strengthen these pipes.

In H2 2019, 5G rollout in Europe was paused. This caused a slowdown in the purchase of fiber optic cables. We expect this to pick up in H2 2020 as 5G rollout restarts. Fiber-to-home cable installations will continue during 2020. Both the telco and oil and gas sectors for us are influenced by the CapEx cycles in the industry. Hence, the orders are usually lumpy. We do see a retrofit market, where old copper and steel cables and pipes will continue being replaced by fiber optic cables and composite pipes. We expect to deliver ongoing organic growth and market share gains. This segment continues to be attractive for future acquisitions.

Slide 20 outlines our journey in innovation. We opened our Asian and European innovation hubs in Q1. Along with the Americas innovation hub, this completes our network of 3 innovation hubs. Last year, we had 180 visits from customers, suppliers and researchers to these innovation hubs. They are in high demand with customers who are quite impressed with the quality and speed of innovation from these hubs. These hubs are staffed by specialists and technical talent. We are also building an ecosystem around each hub that includes startups, universities and industry specialists.

In 2019, $121 million of sales came from products that were launched in the last 5 years. Of this, $16 million of sales came from products launched in 2019. Our pipeline of 160 development projects is getting stronger. I'm confident that future sales from products launched on a rolling 5-year basis will continue to increase. Last year, we spent roughly $12 million in CapEx and OpEx for these innovation hubs. We launched FlamePro Splash Protect, a lightweight yarn used to make protective fabric that's especially engineered to be safe, soft, flexible and long-lasting. It protects the operator from molten metal splash. And this was the highest selling new product that we launched last year.

Last year, I spoke about an emerging opportunity in automotive to replace steel parts with our proprietary composites. Over the past 3 years, we worked hard to prove the value proposition and technology with automotive OEMs and Tier 1s. During this period, we have filed 9 provisional patents. I'm pleased to report that we have received our first order of 10,000 units for a part that goes into the suspension of a car. This is a small-sized order to test our ability to meet customer specifications in a manufacturing mode.

Let me now talk about sustainability and ESG on Slide 21. These topics are becoming progressively mainstream with our customers, and compliance in this area is almost becoming a license to do business with them. I expect sustainability and ESG to be an increasing driver of share protection and share gains for Coats. It's been a year since we released our sustainability strategy and targets for 2020. Last year was mostly about putting in foundations to ensure we have a glide path to reach our targets.

During 2019, we have moved up to the top quartile of 2 ESG rating agencies and are close to reaching the upper quartile for the third rating agency. We have made progress in absolute and relative ranking. In 2019, Coats has signed up to be part of the UN Global Compact. Our values, strategy and business practices fit very well with a number of the UN Sustainable Development Goals. This year, we have added specific sustainability objectives for the executive team. And a part of the bonus is conditional upon delivering these targets. We have some impactful videos on our progress in sustainability at coats.com, and I welcome all of you to visit our website and check out these videos.

I have mentioned the importance of M&A on a few occasions already, and Slide 22 outlines the 6 bolt-on acquisitions we have made in 4-plus years. Gotex, Patrick Yarns and Pharr HP give us scale and new capability in Telecom and Personal Protection segments. GSD, Fast React and Threadsol give us software solutions and engineering capability to improve our productivity and agility for garment factories. We started small with our first acquisition having sales of $1 million. We have gained experience and confidence with every deal. Pharr HP is our largest acquisition so far with sales of over $100 million. Cumulatively, we have paid $120 million for these 6 acquisitions. And they will collectively deliver annualized sales of $200 million and EBIT of $15 million. All 6 were family-owned businesses with intellectual property, differentiated capability, regional presence and an innovative culture. Post completion, we plug these bolt-on acquisitions into the global network and infrastructure of Coats.

Our business case is built around sales growth and operational efficiency, not cost synergies. I'm pleased to report that M&A business cases are either delivered or on track to be delivered, even though it's early days for 2 of our acquisitions. We learn with each deal and, if required, course correct. Over the past 5 years, Coats has built strong internal M&A capability and expertise. This muscle allows us to execute our M&A strategy with confidence and clarity. Coats has been very disciplined in its pursuit of acquisitions. We have had the courage to walk away from several opportunities that either did not fit our M&A criteria or where we did not have enough confidence in delivering the incremental customer and shareholder value. We have clear focus areas for future acquisitions and a strong balance sheet that gives us optionality to explore larger bolt-on acquisitions.

Now before I wrap up, let me touch on the outlook for 2020. We enter 2020 as a lean and agile organization, having delivered significant positive strategic change through 2019. We are well placed to take advantage of the fast-paced and rapidly changing modern world by capturing the many opportunities this presents to Coats as a truly global business. Absent a material impact from COVID-19, Coats remains well placed to execute our strategy and deliver another year of growth in 2020.

Finally, let me wrap up here. 2019 was a year of delivering strong growth in profits, margin and cash despite macro headwinds. This speaks well of our business model, our team, our strategy and our ability to consistently deliver, irrespective of external conditions. Our markets remain fundamentally attractive with mega trends favorable over the medium to long term. In the coming years, I expect the strong to get stronger. Coats, being a market leader, is well positioned to continue winning. Connecting for Growth has delivered a lean, nimble and agile organization that's necessary to seize opportunities in this fast-paced and volatile world. As a management team, we focus on winning with the winners and working hard on levers we control or can influence. Our balance sheet is strong, and this gives us optionality to pursue the most attractive organic and acquisition opportunities.

And with that, let me hand over to Rob, who will manage the Q&A.

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Rob Mann, Coats Group plc - Head of IR [5]

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Great. Thank you, Rajiv. We will now open up to take questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question comes from Charles Hall from Peel Hunt.

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Charles Hall, Peel Hunt LLP, Research Division - Head of Research [2]

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Could you just give us a bit more clarity on the level of input cost inflation last year? And obviously, it's a moving target at the moment, given the oil price. But as sort of direction of traveling, what are you thinking about in terms of cost this year? And secondly, could you just say how much the OpEx cost was post the introduction of the hub and how that was split between the divisions?

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Rajiv Sharma, Coats Group plc - Group Chief Executive & Executive Director [3]

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Okay. So let me start with the second bit of your question here. So we had roughly about $12 million of total spend. OpEx was about half of it, the balance was CapEx. And 2 of the 3 hubs pretty much focus more on the Performance Materials segment, so they get -- so essentially, Performance Materials gets a slightly higher allocation of the costs for the innovation hubs here. And that is one reason why margins for PM last year were slightly down. So that's on the innovation hub here.

With respect to inflation, we had roughly $7 million of raw material inflation and roughly $14 million of non-raw material inflation. And that includes labor, energy, et cetera, et cetera. So the raw materials were reasonably high in the first half and then we started to see it tapering off as we entered the second half. And as you know, today, the oil price is down, roughly 90-plus percent of what we buy is either directly or indirectly linked to the oil price. And so we expect to be beneficiaries of lower raw material costs during 2020. Simon, would you like to build on this?

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Simon Boddie, Coats Group plc - CFO & Executive Director [4]

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No. I think that's the pace. And obviously, what we've done is moved prices during the year reflecting the raw material price increase.

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Charles Hall, Peel Hunt LLP, Research Division - Head of Research [5]

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Yes. And just on that point on Performance Materials. So the profit, excluding the cost of the hub, would have actually been slightly higher year-on-year?

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Rajiv Sharma, Coats Group plc - Group Chief Executive & Executive Director [6]

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Yes.

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Charles Hall, Peel Hunt LLP, Research Division - Head of Research [7]

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Obviously, the margin is -- came down a bit because of that extra cost. And we'll now have Pharr impacting as well. But where do you see margins going in Performance Materials over, say, the next 3 to 5 years? Do you expect them to get up to the same level as Apparel and Footwear?

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Rajiv Sharma, Coats Group plc - Group Chief Executive & Executive Director [8]

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I would expect over the next 3 to 5 years, the Performance Material margins to get very close to the group average. So the group is about 14.3%. I think we should get close to that. And the reasons why I'm saying that is we will continue to see more and more sales through new products. The new products are at higher margins. As we gain scale in the Performance Materials business, that scale will translate into higher operating efficiencies, which hopefully we should be able to sort of benefit from. And the incremental cost of innovation going forward is not going to be materially high. So now it's all about an accelerated growth trajectory and getting more products with higher margins sold.

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Charles Hall, Peel Hunt LLP, Research Division - Head of Research [9]

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Got it. And just lastly, obviously good that you've had your first auto composites order, albeit it's small scale. What sort of pace of conversion of your pipeline of potential business do you think? Should we start to see material orders in the next couple of years? Is that the time line?

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Rajiv Sharma, Coats Group plc - Group Chief Executive & Executive Director [10]

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Well, typically, the automotive industry operates on a 5- to 7-year approval cycle for anything new on their platforms. And if it's a new technology, it takes closer to 7 rather than closer to 5. So we have been reasonably lucky in getting approval within 3 years. I don't think this is going to be material over the next 2 years. We need to earn our stripes. We need to build confidence with the automotive OEMs that we can manufacture this product and we can meet their quality and just-in-time requirements. So I think as we build credibility with the automotive OEMs, I expect this to become material in the 5- to 10-year time frame.

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Operator [11]

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Our next question comes from Charlie Mortimer.

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Charles Mortimer, Citigroup Inc, Research Division - Senior Associate [12]

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Yes. Just a couple of questions on the acquisition strategy. I mean actually could you firstly reconfirm the leverage target? Is that still between 1 and 2x net debt? Particularly on pre-IFRS 16 numbers, it was down 0.6x now, clearly for the dividend up, which is another -- up by 10% this year and it could go up further. Firstly, could you reconfirm that? And then secondly, just regarding the acquisition, I mean you made a number of within software. You've made now with Pharr within the Performance Materials and Gotex within Performance Materials as well. Is Performance Materials the target area? Is it going to be a mixture of that software? Or are there other options? And what size might be looking at as well?

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Simon Boddie, Coats Group plc - CFO & Executive Director [13]

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So I'd kick off with the gearing target. Yes, still 1 to 2x is the target. Yes, we are below that. But we see that as an opportunity both to invest on organically, and we've guided to CapEx remaining ahead of depreciation for the next year as well, and also in terms of firepower for future acquisitions. So we recognize where we're at. But we see that as an opportunity, perhaps particularly in the current market environment.

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Rajiv Sharma, Coats Group plc - Group Chief Executive & Executive Director [14]

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Okay. And if I can take your first question in terms of the areas that we're looking at. So within Performance Materials, there are 3 segments that we continue to be focused on. One is Personal Protection, the other is Telecoms and Energy and the third one is Transportation. Within Apparel and Footwear, clearly the focus has been on the software part of it. But we are open to looking at any tactical opportunities that might come up in the future in terms of rolling up the tail and consolidating our position in the core business. So we're open to that. But the focus is on software and A&F and in the 3 sectors that I've mentioned. What we are not looking at is any acquisitions in zips, trims or crafts.

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Operator [15]

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The next question on the line comes from Anthony Plom from Berenberg.

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Anthony William Plom, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [16]

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Just a couple of questions. I thought your comment on EcoVerde was quite interesting. I think you said that it was potentially going to grow about 10x in 2020. Just looking at the segment, I think you did about $7 million of revenues in '19. So that would represent about 5% of sales in 2020, which is obviously quite a big jump. So just sort of wondering if you could give a bit more clarity on who the main customers here are. I don't know whether that's easy to do, whether it's kind of higher margin work, whether you need any sort of different manufacturing processes. Any information there would be quite interesting. And then maybe just following on Charles' comments on the automotive order, I guess sort of key question, what does that basically mean, the sort of 10,000 units? Is this on a sort of trial basis? I don't know whether you can give any kind of details on what value of the order might be.

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Rajiv Sharma, Coats Group plc - Group Chief Executive & Executive Director [17]

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Sure. Okay. So let me start with the recycled product here. So last year, we sold about 200 tonnes of recycled polyester thread. The plan is to sell about 2,700 tonnes. So my 10x refers to more of the volume rather than the value part of it, okay? So that's sort of point number one. Point number two is because this is a supply-constrained situation, we are focusing on 3 key global strategic customers for us. And that's where pretty much all this 2,700 tonnes is going to be directed towards. The demand for this is very, very high. If we had our hands on, let's say, 10,000 tonnes of recycled polyester, we could have sold it this year. So I think here, the issue is not demand, the issue is supply. And we're working pretty hard to make sure that we're able to get access to high-quality recycled polyester.

The one thing to note here is that for sewing thread, you need very, very high-quality recycled polyester. It's not the run-of-the-mill plastic that gets converted for sewing thread. So if you think of a plastic Coke bottle or a Pepsi bottle, those are the ones that can be used for sewing thread. And what's happened in the last 12 to 18 months is that these beverage companies, in order to meet their own sustainability targets, are now buying back a lot of the plastic bottles that they consume. So that's creating a little bit of a supply situation. There are new technologies that are currently being worked on to sort of offset or mitigate this issue. But that will take time. But right now, what I can say is we have access to 2,700 tonnes this year. And we will sell that completely this year.

With respect to the other question you had around the automotive composite order. So this is a trial order. This is where essentially testing our credibility as a supplier. The 10,000 units roughly equates to between $50,000 and $70,000 worth of sales. And we would get compensated a bit for some of the equipment that we might invest in. So that's -- so it's not really material in the near term. But the key thing here is that we have proof of concept. This is with a large global brand OEM. And as this concept becomes more and more sort of prevalent, we hope to build scale here.

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Anthony William Plom, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [18]

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So just to follow up on that EcoVerde point, I mean did you get better pricing with this product? Okay. I guess is there a margin story as well as the kind of the ESG story?

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Rajiv Sharma, Coats Group plc - Group Chief Executive & Executive Director [19]

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Yes. So typically, what happens is that these 3 customers that we are currently working with are reasonably flexible and giving us a slight price premium for the first couple of years until we gain scale. And then the expectation is that after that, once we have achieved scale, we should be able to normalize the pricing with the equivalent product that we have been selling in the past. We don't have any incremental investment in terms of machinery or operator training, we can pretty much use the same kit and the same workforce that we have. So that's kind of where we are. The key issue today is supply.

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Operator [20]

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(Operator Instructions) The next question comes from James Zaremba from Barclays.

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James Edward Zaremba, Barclays Bank PLC, Research Division - Research Analyst [21]

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Yes, a few questions, maybe one simple one to start. Just on the guidance, is that spur of growth at a quite organic level? Or does that include, I guess, Pharr HP?

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Simon Boddie, Coats Group plc - CFO & Executive Director [22]

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No, that's around the -- it's around the underlying growth of the business.

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James Edward Zaremba, Barclays Bank PLC, Research Division - Research Analyst [23]

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Okay. So that includes -- sorry, does that include Pharr HP or not?

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Simon Boddie, Coats Group plc - CFO & Executive Director [24]

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No, that's on top. So that's a chunky part of that -- that's quite a -- that's our biggest acquisition to date. So it's really looking in terms of, I'd say, underlying the existing business. Yes.

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James Edward Zaremba, Barclays Bank PLC, Research Division - Research Analyst [25]

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Great. And then in terms of, I guess, the bridge for that FY '20 growth, I guess if I look at this year's EBIT, which is up $3 million, I guess we had a couple of things which don't repeat next year, one of which being IFRS 16, which contributed $2 million and then, I guess, the Connecting for Growth, which contributed $13 million. So I suppose, in terms of, in a way, those $15 million doesn't repeat, would have implied this year was down $12 million. So I guess what happens next year to -- on either the cost or, I guess, revenue side to make up for that?

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Simon Boddie, Coats Group plc - CFO & Executive Director [26]

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So in terms of the Connecting for Growth program, you're right that, that one is now completed. So that's been a big program that we've done over the last couple of years. And that's gone faster than we thought and delivered greater benefits. And you see, you're right in terms of the numbers that have got there. But really looking into next year, it's around that -- the growth, the top line growth in terms of those 2 core parts of the business, the Apparel and Footwear and particularly the Performance Materials working in terms of our normal programs around productivity, procurement, those programs. And we still work through cost containment areas and the like. But those -- but not big programs as we've had on cost control. So there's a number of levers that we are looking at going into next year, but out with the big Connecting for Growth program.

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Rajiv Sharma, Coats Group plc - Group Chief Executive & Executive Director [27]

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Well, if I can just build on what Simon has said, the 2 big drivers for us in 2020 are going to be essentially volume growth, so -- as we grow top line through volume, and that's going to deliver operational efficiency, which should drop to the bottom line. And the second thing is we should be beneficiaries of lower raw material costs in 2020. So I think these 2 combined should offset the one-off gain that we had last year from essentially Connecting for Growth.

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James Edward Zaremba, Barclays Bank PLC, Research Division - Research Analyst [28]

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Great. And then on that volume point and I guess the point you made about 10x volume in terms of usage of raw materials, recycled ones, maybe not revenue, but I guess there would still be some impact there, is this, let's say, an area where you're winning market share? Or is this more just replacing a product that you would be selling with non-recycled thread?

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Rajiv Sharma, Coats Group plc - Group Chief Executive & Executive Director [29]

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No, it's actually winning market share. So when I gave you the number of $16 million of innovation sales, that $16 million is new products, new customers, where we are not cannibalizing existing products with the existing customers. So that's truly incremental. We do look at kind of replacement products, but that's not counted in the $16 million number that I gave you. So sorry, if I can just build here, the $7 million of EcoVerde products or the recycled products that we sold is not included in the $16 million because that $7 million is essentially replacing existing products.

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James Edward Zaremba, Barclays Bank PLC, Research Division - Research Analyst [30]

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Okay. Very clear. And then on the Performance Materials, I know you had, I guess, a one-off in the first half, which was, I guess, a bad debt write-down. In terms of any other loss, the kind of like inventory, was there an inventory write-down in 2H that doesn't repeat as well?

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Simon Boddie, Coats Group plc - CFO & Executive Director [31]

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Yes. There was an inventory impact at the end of -- kind of the end of the year. We normally have that, but it was bigger than we had had in the past. That's why we pulled that out and was an impact in terms of the PM margin.

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James Edward Zaremba, Barclays Bank PLC, Research Division - Research Analyst [32]

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Okay. So those are 2 things, which, I guess, help in 2020 as a comparison.

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Simon Boddie, Coats Group plc - CFO & Executive Director [33]

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Yes. We're certainly working hard in terms of the credit side and the operational side in terms of going into 2020. Yes.

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James Edward Zaremba, Barclays Bank PLC, Research Division - Research Analyst [34]

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And then finally, any comment worth in terms of, I guess, just on the working capital? I suppose, we had volumes up this year and inventory benefit and payables, I suppose, headwind? Any kind of comment to be made there?

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Simon Boddie, Coats Group plc - CFO & Executive Director [35]

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No. I mean I think overall, we had a reasonable control in terms of the -- continuing control in terms of working capital. And that's what we'll be looking to do going also into 2020, and I think particularly beyond that to highlight.

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Operator [36]

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We have a follow-up question from Charles Hall.

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Charles Hall, Peel Hunt LLP, Research Division - Head of Research [37]

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Yes. I'm thinking to just ask on China, what level of capacity utilization are you now running at? And when do you expect to be back at normal production? Also, what are you seeing in the broader supply chain, not necessarily just to you but throughout the industry? And what potential impact that might have? And finally, I know it's obviously very early days in terms of understanding the consumer response. But clearly, a number of companies (inaudible), Hugo Boss have been warning about their sales performance. How do you see that moving?

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Rajiv Sharma, Coats Group plc - Group Chief Executive & Executive Director [38]

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Okay. So let me just start with some facts here. Because as you know, Charles, this whole coronavirus is something which is very hard to forecast. It's sort of changing almost on a daily basis here. But if I just look at the facts, as of yesterday, we had all our 4 factories in China open. On an average, 75% of our employees are back to work. We are getting orders. We are shipping orders. A lot of our customers are up and running. I expect us to get to near full capacity by the middle of March. So that's as far as our own operations are concerned. As Simon had said China, for us, accounts for 12% of our group sales versus China accounting for 40% of the industry. So we are relatively underweight when it comes to China. And so from that standpoint, I think we are reasonably sort of well hedged.

The issue that the industry is going to face is that China is very critical in terms of fabric supply to the rest of the Asian markets. And what we have seen in February is a lot of the garment factories using existing inventory to keep the factories up and running. Typically, most garment factories in Asia that are linked to the China supply chain have between 30 and 60 days of inventory. So that's about the time it takes to ship the product from China to these countries. So currently, most customers are using existing inventory. They have orders that they have placed with the Chinese factories. The Chinese factories are slowly ramping up. So what I expect is that over the next 2, 3 months, everyone is going to be running on sort of light inventory because -- using existing inventory until the overall inventory catches up in sort of a couple of months here. What we have seen, some customers are looking at creative ways in terms of reducing a shift or maybe not working 7 days and working 5 or 6 days. So I think people are trying to balance the supply of raw materials with the existing capacity that they have.

One point to note is that this industry, the apparel and footwear industry from a supply chain, is absolutely agile and it sort of reacts very, very fast. So if I look at the one example of the global financial crisis, it was basically a V-shaped recovery in 2009. When I look at 2003, the SARS case that happened, again the impact was felt for a few months and then the supply chain reacted pretty, pretty quickly and sort of ramped up here. So compared to some of the other industries like automotive or aerospace or large chemicals, where it's hard to ramp up quickly, I think the Apparel and Footwear supply chain is very agile and nimble. So it's going to be tough for the next few months. But I think supply will catch up with demand sort of by then.

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Charles Hall, Peel Hunt LLP, Research Division - Head of Research [39]

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And do you actually see an increase in orders in some of your other markets, Vietnam or Bangladesh, to compensate China? Or is it more just the loss of sales in China that you're seeing?

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Rajiv Sharma, Coats Group plc - Group Chief Executive & Executive Director [40]

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So we have been seeing an increase in our Southeast Asia and Bangladesh markets for the last 7, 8 months anyway. So this was -- it started off with the U.S.-China trade tensions and now it's continuing with the coronavirus. So we are -- we have been seeing that some business is sort of migrating outside of China to the rest of Asia. The thing about China is China is so big in the grand scheme of things. It is the world's largest producer of garments and shoes. And even if I add the next 10 countries, it's still smaller than what China produces.

So let's say a 1% migration out of China could mean half of Bangladesh, just sort of I'm trying to give you a scale impact here. So China will continue to be big and important for the industry. I don't think there is any short-term substitute for China. China is -- has got a highly efficient, very productive, integrated supply chain, and I think the rest of Asia will continue to depend on critical components from China. But the incremental volume is being derisked from China.

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Charles Hall, Peel Hunt LLP, Research Division - Head of Research [41]

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And are you already starting to think about capacity performance outside China because of customers looking at changing their supply chain?

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Rajiv Sharma, Coats Group plc - Group Chief Executive & Executive Director [42]

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Absolutely. We are in discussion with many, many customers who are looking for optionality to put their incremental volume outside of China. So absolutely, we have seen a tick up in business in Southeast Asia. We're starting to see Eastern Europe, a little bit of the volume is coming up there, and then Mexico, Central America. So we will see this thing play out. It's not going to be sudden, Charles. It will be incremental and it will take some time. But we should end up winning in the grand scheme of things because of our global manufacturing footprint.

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Operator [43]

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It appears we have no further questions on the line. So I will hand back to Rob for any closing comments.

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Rob Mann, Coats Group plc - Head of IR [44]

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Great. Thanks, Joshua. If that is the case, I would like to thank everyone for dialing today, and wish you all a very good day. Thank you very much.

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Simon Boddie, Coats Group plc - CFO & Executive Director [45]

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Thank you.

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Rajiv Sharma, Coats Group plc - Group Chief Executive & Executive Director [46]

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Thank you, everyone. Good day.