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Eastern Silk: Our updated view
Jul 22, 2008

With significant changes in the global economic outlook and demand supply dynamics, the prospects of several sectors and companies therein have warranted a re-orientation. The high-growth sensitive textile sector being one amongst them. With highly leveraged balance sheets, capacity expansions and falling realisations, these companies are one of the hardest hit in times of slowdown. Eastern Silk, though not being a typical textile company, with the virtue of being one of the largest silk product exporters in India and having one of the lowest leverage ratio, has also seen difficult times in FY08. These are partly attributable to the sectoral trends are partly to the company’s own mistakes.

Less getting rich, rich getting less richer
Globally, the growth of silk fabric industry is largely influenced by the health of the US and European economies, its principal consumers (65% of consumption). Apart from these two economic heavyweights, the hotel industry, which is amongst the largest corporate consumers of silk, had also driven the demand for silk due over the past few years in light of the capacity expansions. In the domestic market, strong economic growth and higher disposable incomes have leveraged incremental home buying and furnishing, which in turn has increased the consumption of high-end home furnishing fabrics. The fact that the demand pattern for high-end silk-based fabrics and yarns does not exhibit much seasonal fluctuation makes its case stronger vis-à-vis its lower-end peers such as cotton and wool.

However, the recent slowdown in economic growth across the globe and with high inflation rates eating into discretionary spending, the demand for the ‘non-necessary’ product has seen a slump. Not willing to lose market share in its export destinations and compromise heavily on volumes, the company has had to partially compromise on the realisations of its high-value products as well.

Forex risks: Eastern Silk enjoys a natural hedge against currency risks due to two reasons. Firstly, outsourced yarn requirement is entirely imported and secondly, nearly 70% of the company's turnover is derived from exports. Also, to protect itself from currency fluctuations, the company has a dollar denominated bank account, which helps it meet the foreign currency liabilities with minimum forex risk. However, it entered into some derivative contracts in FY08 that led to losses with the sharp appreciation of the rupee against the US dollar. The company has provided for mark-to-market (MTM) loss of Rs 51 m on forex derivatives in FY08. The mark to market loss in derivative contracts at the end of FY08 was Rs 230 m (due for expiry beyond FY09). We have written off the entire MTM losses in our next three years’ projections for the company.

Nonetheless, there are a couple of factors that offer Eastern Silk some upsides and an edge over other textile players in the longer term.

Design capabilities: In the global silk industry, the supplier's ability to provide superior design followed by timely service and technical support are the key parameters for the buyers' selection. Thus, despite India being the second largest producer of silk, it enjoys an upper hand over China with respect to silk exports to the US and European markets. Further Indian manufacturers have flexibility as they can manufacture as small order as 7 metres per colour as compared to Chinese capacities of order sizes not less than 700-800 metres per colour.

Eastern Silk produces 500 designs every year (has a team of 14 qualified designers) out of which 13% are selected every year for samples in 20 colours. For selectivity, only 15% to 20% of the samples are identified for weaving and scaled as per customer needs. In FY08, 9% of the company’s revenues were from new designs and we expect this segment to help the company sustain growth.

Better product mix: Eastern Silk has consistently made an effort to enhance the proportion of value added products in its product mix since FY00. Apart from increasing its reliance on in-house powerloom fabrics, the company has also forayed into higher margin embroidered fabrics and made-ups. The proportion of value added products (furnishing fabrics and made ups) in its product portfolio has increased from 52% in FY05 to 64% in FY08. This has helped the company increase its average realisations by approximately US$ 4 to US$ 5 per metre. Since the cost of conversion of fabric into a value-added product is less than 50% of the incremental realisation, it makes a significant contribution to the company's bottomline

Shift from outsourcing to in-house production: The mix of the company's in-house to outsourced production, which was largely skewed towards the former earlier, has considerably reduced due to the capacities acquired during the merger and the commissioning of fabric capacity at Anekal and the commissioning of the made-ups capacity in Bangalore. With this, the proportion of in-house fabrics that is currently being consumed for production of made-ups has increase from 25% to 60% over the past three years.

Wider reach: Although the export markets of the US and Europe still account for 65% of Eastern Silk's revenue, the company is represented globally by over 30 agents in the EU, US and East Asian markets. Also, what gives it an edge in logistics is the fact that the company transports 70% of its products by air from Bangalore.

What has changed in our assumptions?

  • Firstly, we have had to adopt a more conservative stance with regards to our topline projections for the company. We have reduced our topline growth estimates from a compounded annual rate of 14.2% between the years FY05 to FY08 to 9.6% between the years FY09 to FY11.

  • Secondly, we have assumed a drop in the company’s operating margins in FY09, given the pressure on realisations and have moderated the growth in it thereafter. The company had operating margins of 19.6% in FY08 against our projected EBIDTA margin of 20.7% for this fiscal.

  • Thirdly, we have factored in the risk of having to write off entire mark to market loss on its derivative portfolio (Rs 60 m each in FY09, FY10 and FY11), which was not a risk that had been envisaged earlier, due to the company’s natural hedge.

  • Finally, the company exercised a stock split in the ratio of 5:1 in FY09 and has also received board approval for raising capital to the tune of US$ 100 m by way of ADR, GDR or FCCB in FY09 for its expansion and acquisition plans. The capital raising will lead to further dilution that we have so far not factored in.

Our view
We had recommended a ‘Buy’ on the stock in May 2006 with March 2008 target price of Rs 80 (adjusted for 5:1 stock spilt). The stock touched a high of Rs 70 in July 2007 before correcting to the current levels due to overall market weakness. While the relatively muted growth prospects of the company in the wake of a global economic slowdown cannot be denied, we believe that the company continues to be better placed than most other Indian textile companies. We recommend investors with a high-risk appetite a long-term investment horizon to buy the stock with March 2011 target price of Rs 48, offering compounded annual returns of 57%.

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