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Arvind Mills: Denim blues - Views on News from Equitymaster
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Arvind Mills: Denim blues
Jan 27, 2006

Performance summary
Despite a noticeable decline in denim volumes and prices in 3QFY06, Arvind Mills reported a 7% rise in operating profit on the back of lower raw material cost apart from the control over other key expense heads. While denim division posted poor results, the shirtings division witnessed higher volume sales, thus partly negating the negative impact of the denim division on the overall performance. Excluding foreign exchange-related adjustments in the both the quarters, net profit has actually increased by 37% YoY in 3QFY06.

Standalone financials…
(Rs m) 3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
Net sales 4,073 3,902 -4.2% 12,163 12,343 1.5%
Expenditure 3,122 2,888 -7.5% 9,435 9,181 -2.7%
Operating profit (EBDITA) 950 1,014 6.7% 2,727 3,162 15.9%
EBDITA margin (%) 23.3% 26.0%   22.4% 25.6%  
Other income 7 21 224.6% 26 165 537.8%
Interest 281 296 5.3% 851 970 13.9%
Depreciation 370 385 4.1% 1,109 1,157 4.4%
Profit before tax 305 354 15.9% 793 1,200 51.3%
Extraordinary items 120 (96) - 30 (36) -
Tax 65 24 -63.1% 80 107 34.5%
Profit after tax/(loss) 361 234 -35.1% 744 1,057 42.2%
Net profit margin (%) 8.9% 6.0%   6.1% 8.6%  
No. of shares (m) 195.4 209.4   195.4 209.4  
Diluted earnings per share (Rs)*         7.2  
Price to earnings ratio (x)         12.7  
(*trailing twelve month earnings)            

What is the company's business?
Arvind Mills is India’s largest denim manufacturer and exporter, with a total capacity of 120 mm, after taking into account the recent 10 mm expansion at Santej. The company also ranks among the top three denim producers worldwide. It manufactures and sells textiles and ready to wear garments as well. The total fabric production capacity at 34 mm is big, even by world standards. While the company has been hitherto been focusing on fabric and denim production, it has aggressively entered the garmenting and knits businesses. In a very important step, through a GDR issue, the company has acquired ICICI Venture’s stake in Arvind Brands. After this, the company hopes to grow its readymade branded garments business significantly in the next three years, given that the company is now fully under its control.

What has influenced performance in 3QFY06?
Denim blues: Denim volume sales in 3QFY06 were lower by 6.7% YoY. As per the company, the reasons include lower offtake in key customer markets and increased competition from Pakistan and Turkey as alternate suppliers. With volumes under pressure, it is not surprising that price realisations have also been lower. To put things in perspective, average denim realisation in 3QFY06 was Rs 97 per meter, which is 2.1% lower than 2QFY06 (down 7.4% YoY). Denim prices have also come under pressure in the domestic market, which could be attributed to the fact that the total domestic denim capacity was at 350 mm in FY05 as compared to Rs 200 mm before five years. For the first nine months of the fiscal year, denim volumes were higher by 7.6%. We have factored in a 12% growth in denim volume sales with average realisation of Rs 99 per meter (down 3% YoY), which in our view, requires downward revision.

On the other hand, shirting volumes in 3QFY06 increased at a robust pace of 14.1% YoY, with price realisation more or less maintained at the same level as the previous year. As far as the garments division is concerned, while knits posted a 40% YoY growth in volumes during 3QFY06, shirting volumes were higher by 33% YoY. Our estimates on the knits and the garments side for FY06 were conservative as compared to the 9mFY06 performance.

Advance cotton purchases boosts margins: Even as the topline growth was negative, operating profit increased in 3QFY06 on account of two factors i.e., absolute decline in raw material costs and lower power cost. Even though cotton prices were firm during the quarter, the company has been carrying substantial inventory of cotton at lower prices, which is expected to last until July 2006. Apart from this, the company's ability to use inferior cotton whilst maintaing product quality (patented) has also helped matters. As far as the decline in power costs is concerned, towards the end of FY05, Arvind Mills shifted to natural gas and the benefit is reflected in terms of lower power cost to sales over the last three quarters. We have considered a gradual decline in operating margins beyond FY06 on the back of higher cotton prices and lower denim realisations. While we have been fairly in line with respect to the raw material side, the decline in denim prices has been faster than expected.

The cost side…
(%) of sales 3QFY05 3QFY06 % change 9mFY05 9mFY06 % change
Raw material cost 1,382 1,114 -19.4% 4,556 3,827 -16.0%
% sales 33.9% 28.5%   37.5% 31.0%  
Power & fuel 501 318 -36.5% 1,450 1,066 -26.5%
% sales 12.3% 8.1%   11.9% 8.6%  
Staff cost 299 309 3.4% 894 1,015 13.5%
% sales 7.3% 7.9%   7.4% 8.2%  
Stores 361 380 5.3% 1,041 1,294 24.2%
% sales 8.9% 9.7%   8.6% 10.5%  
Others 542 510 -5.9% 1,482 1,642 10.7%
% sales 13.3% 13.1%   12.2% 13.3%  

Exchange loss blow: While PBT increased in 3QFY06, owing to foreign exchange loss in this quarter as compared to a gain in 3QFY05, net profit fell by 35%. The company has attributed the same to restating of foreign exchange loss and short-term borrowings against exports. Excluding the same, net profit in 3QFY06 and 9mFY06 have risen by 37% YoY and 53% YoY respectively. In our view, we expect a 8% to 10% downgrade in our FY06 earnings estimate, excluding the foreign exchange losses that are unpredictable.

Over the last few quarters: As is evident from the graph, operating margins, on a standalone basis, have been on a the rise on account of lower cotton prices and the cost restructuring exercise. But with denim prices showing signs of weakness and cotton prices trading firm, we expect operating margins to decline further going forward.

What to expect?
At Rs 92, the stock is trading at a price to earnings multiple of 12 times our estimated FY06 earnings. In our calculation, every Re 1 decline in denim realisation results in operating margins falling by 30 basis points (0.3%), assuming other things remaining the same. While we do not underestimate the importance of the denim division to the overall performance of the company, the company also has plans to ramp up its garmenting and branded garments business significantly in the next three years, which we as positives. We will update our subscribers with our view on Arvind Mills after the conference call with the company next week.

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