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Arvind Mills: Bringing little cheer - Views on News from Equitymaster

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Arvind Mills: Bringing little cheer
May 14, 2007

Performance summary
Arvind Mills declared results for the fourth quarter and fiscal ended March 2007 leaving investors with very little to cheer about other than the extraordinary profits and forex gains in this fiscal. Despite better offtake in the branded garment volumes, lower volume and realisations in denim and shirting businesses pared the company’s operating margins by nearly 800 basis points. Excluding the extraordinary profits, the bottomline for the fourth quarter and full year have fallen by 43% YoY and 78% YoY respectively.

Standalone financials
(Rs m) 4QFY06 4QFY07 Change FY06 FY07 Change
Net sales 3,579 4,831 35.0% 15,887 18,449 16.1%
Expenditure 2,663 4,159 56.2% 11,844 15,398 30.0%
Operating profit (EBDITA) 916 672 -26.6% 4,043 3,051 -24.5%
EBDITA margin (%) 25.6% 13.9%   25.4% 16.5%  
Other income 60 81 35.0% 225 163 -27.6%
Interest 330 407 23.3% 1,300 1,579 21.5%
Depreciation 394 302 -23.3% 1,551 1,433 -7.6%
Foreign exchange (gain) / loss 53 (83)   55 (77)  
Extraordinary items* - (68)   - 943  
Profit before tax 199 59 -70.6% 1,362 1,222 -10.3%
Tax (15) 4   93    
Profit after tax/(loss) 214 54 -74.6% 1,270 1,222 -3.8%
Net profit margin (%) 6.0% 1.1%   8.0% 6.6%  
No. of shares (m) 209.4 209.4   209.4 209.4  
Diluted earnings per share (Rs)** 4.1 1.0   6.1 5.8  
Price to earnings ratio (x)         7.7  
(** trailing 12 months)
* Extraordinary item refers to profit on sale of stake in Arvind Brands to VF Corp and a one-time Cenvat reversal

On the path to vertical integration…
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 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 4QFY07?

Segmental breakup…
  FY06 FY07 Change
Denim      
Sales (Rs m) 9,486 7,616 -19.7%
% total turnover 59.7% 41.3%  
Volume (mm) 96.2 81.3 -15.5%
Avg Price (Rs/mt) 98.6 93.6 -5.1%
Shirting      
Sales (Rs m) 2,996 2,651 -11.5%
% total turnover 18.9% 14.4%  
Volume (mm) 23.9 21.9 -8.4%
Avg Price (Rs/mt) 125.3 120.9 -3.5%
Garments      
Sales (Rs m) 1,607 2,751 71.2%
% total turnover 10.1% 14.9%  
Volume (m Pcs) 5.4 9.3 72.2%
Branded garments      
Sales (Rs m) - 3,328  
% total turnover 0.0% 18.0%  
Knit Fabric      
Sales (Rs m) 330.0 345.0 4.5%
% total turnover 2.1% 1.9%  
Others      
Sales (Rs m) 1,469 1,759 19.7%
% total turnover 9.2% 9.5%  
Denim & shirting – Domestic blues: Although denim business continues to be the mainstay of Arvind Mills, the contribution of this business to the company’s topline declined further in this fiscal – from 60% in FY06 to 41% in FY07. Denim supply in the domestic market has increased by over 100% in the last 12 months, leading to a drop in overall realisations and significant erosion in prices.

While Arvind Mills continues to suffer setbacks on both denim volume and realisation fronts, in 2HFY07 the company witnessed some recovery in export volumes and prices, which unfortunately, were more than offset by the continuing slide in the domestic market. In the fourth quarter, the average global denim prices had improved by about 6% YoY, but the weak trend in domestic prices capped the upsides. It may also be noted that the denim realisations of Rs 90 per metre is an all-time low for the company. The company also estimates that its market share in the domestic market will continue to contract from the levels achieved in the past and a credible alternative for selling the surplus volumes needs to be established. The current supply glut in the domestic denim domestic market has dragged down the company’s financial performance and the management does not see it improving in the near term. Going forward, the company’s strategy would be to de-focus from the domestic mass denim market and focus on mid and premium brands in the US and EU. The company has set up a marketing unit in Europe with an initial expenditure of Rs 40 m and expects positive impact from the European team’s efforts to be reflected 3QFY08 onwards.

As far as the shirting segment is concerned, with a fall in volumes and realisations, the contribution to topline marginally declined, largely due to degrowth at the topline level. Since the sale to internal garment factory is not reflected in the reported numbers, the sales in this segment appear to have fallen. The company has pointed out that, on the contrary, while the sale of fabric to outside parties has come down by 3%, the garment volume from the shirts plant has gone up by 56% YoY. The realisations, however, after showing signs of improvement in 1QFY07 due to improved product mix, have fallen in the last three quarters (down 3% YoY), and are at a two-year low.

The garmenting business, which has been the second largest revenue generator for Arvind Mills following denim, after the initial hiccups in the scale-up phase, has started showing signs of placid growth in the past fiscal. This is notwithstanding the fact that the company continues to face some pricing pressure in this segment. However, with new capacities coming on stream in phases, the company is deriving the benefits of scale. Arvind Mills is targeting a capacity of 12 m pieces in the garment business by 9mFY08 and would follow that up with an addition of 50% of the capacity over the next 3 fiscals. While we believe that the former is achievable and would come on stream by FY08, we have been conservative in our future growth estimations considering the pressure on input costs. Having said that, we also believe that the garmenting business along with the brand business would go a long way in de-risking the company's performance from the volatility in the denim market.

Costs – Not in control: Cotton costs for Arvind Mills increased from Rs 39 per kg in 4QFY06 to Rs 43 per kg in 4QFY07. This was primarily on account of the company having exhausted the low-grade cotton and is using medium grade inventory. The company also estimates that the cotton cost for the first half of the next financial year will be low because of inventory purchased in the previous cotton season. The new cotton season is expected to open higher than the current inventory holding levels and margins could be impacted in the second half.

To reduce its power costs, the company had shifted to natural gas as feed for its captive power plant in January 2006. It had entered into a long-term gas supply agreement, with a penalty clause for 80% of the contracted volume. However, owing to severe shortage of supply of gas, Gujarat Gas is offering only 80% of the requirement. In absence of an alternative, the company is consuming the expensive grid power, leading to higher power costs.

Cost breakup…
(%) of sales FY06 FY07 % change
Raw material cost 5,145 5,585 8.6%
% sales 32.4% 30.3%  
Power & fuel 1,437 1,717 19.5%
% sales 9.0% 9.3%  
Staff cost 1,357 2,043 50.6%
% sales 8.5% 11.1%  
Stores 1,711 2,132 24.6%
% sales 10.8% 11.6%  
Others 2,195 3,922 78.7%
% sales 13.8% 21.3%  

Repositioning Arvind Brands: In 2QFY07, Arvind Brands, the wholly owned subsidiary of Arvind Mills, formed a joint venture with VF Corporation (US) for marketing in India, the various brands owned by VF Corporation (Lee, Wrangler, Nautica, Jansport and Kipling). In this JV, which came into effect from 1st September 2006, Arvind holds 40% stake and VF Corporation acquired the balance 60% equity for US$ 33 m. Accounting for the carrying cost of holding, past losses and other expenses, the company has made a one time gain of Rs 1,010 m. This earning is reflected as extraordinary income in the financial statements.

The own brands business of Arvind Mills has suffered recently due to supply chain issues and achieving the correct price value equation. The company has decided to run down the current inventory in the system before re-launching the brands with better price value equation and new brand image. It is also investing in new stores for its own brands. The same is expected to improve volumes and margins going forward.

Over the past few quarters: During the past couple of quarters, Arvind Mills undertook several initiatives to de-risk its business, control costs and improve margins. This included initiating a garmenting facility in Bangalore, re-acquisition of Arvind Brands from ICICI Venture, cost control measures as mentioned earlier as well as capacity expansion in Santej, Gujarat. However, this has not lent any stability to its operating margins, which continue to shrink. The company has undertaken an asset revaluation exercise in order to reflect the true value of the fixed assets in the book. The company’s assets have been revalued in October 2006 and profits to the tune of Rs 250 m have been transferred to the revaluation reserve.

Forex woes to continue: The rupee has substantially appreciated against the US dollar in the recent past, with annual impact being as high as 9.5%. Arvind Mills is predominantly a ‘dollar revenue-rupee cost’ company, as most of its revenue is either in dollars or linked to dollars. Any erratic movement in the exchange rate has a significant impact. The company is insulated to an extent, because of a cover for its revenue earnings and has to a large extent, taken forward cover for the financial year FY08. However, this is at rates lower than the previous financial year and is therefore likely to impact revenue and earnings. As per the company, the estimated impact on margins is expected to be around 2% to 3%.

What to expect?
At the current price of Rs 46 per share, the stock is trading at a multiple of 8.5 times our estimated FY09 earnings. Given the fact that the company itself acknowledges to remain in the 'restructuring phase' over the next 12 to 15 months, and the continued volatility in rupee-dollar rates, there is little visibility in the medium term. However, with the garment and brand business showing promising signs for the future, we believe that an integrated player like Arvind Mills will see better days going ahead. Having said that, investors must note that the company will continue to witness hiccups by way of forex losses and cost pressures in the near term, due to which it will be sometime before it can yield the benefits of consolidated operational synergies. Given the relative attractiveness of the stock to its peers in valuation terms, we stand by our recommendation.

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