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Arvind Mills: There it goes, again! - Views on News from Equitymaster
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Arvind Mills: There it goes, again!
Jul 27, 2006

Performance summary
Arvind Mills declared results for the first quarter of FY07. Lower volumes and realisations in denim and forex losses have severely drained the company’s bottomline. The fall in operating margins by nearly 500 basis points is poorer than our expectations. Even the possibilities of lower input costs in terms of cotton and power have not fructified. The management’s outlook with regard to higher growth in its garment and branding businesses also seems to have not filtered in.

Standalone financials
(Rs m) 1QFY06 1QFY07 Change
Net sales 4,230 3,900 -7.8%
Expenditure 3,120 3,060 -1.9%
Operating profit (EBDITA) 1,110 840 -24.3%
EBDITA margin (%) 26.2% 21.5%  
Other income 70 50 -28.6%
Interest 340 350 2.9%
Depreciation 390 380 -2.6%
Foreign exchange (gain) / loss (40) 90  
Profit before tax 490 70 -85.7%
Tax 40 -  
Profit after tax/(loss) 450 70 -84.4%
Net profit margin (%) 10.6% 1.8%  
No. of shares (m) 195.4 209.4  
Diluted earnings per share (Rs)* 9.2 1.3  
Price to earnings ratio (x)   42.6  
(* trailing 12 months)

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 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 1QFY07?
Segmental breakup…
  1QFY06 1QFY07 Change
Denim      
Sales (Rs m) 2,642.6 1,855.8 -29.8%
% total turnover 63.4% 52.3%  
Volume (mm) 25.7 20.4 -20.6%
Avg Price (Rs/mt) 103 91 -11.3%
Shirting      
Sales (Rs m) 773.0 656.0 -15.1%
% total turnover 18.6% 18.5%  
Volume (mm) 6.0 5.2 -13.3%
Avg Price (Rs/mt) 128 125 -2.3%
Garments      
Sales (Rs m) 386.0 605.0 56.7%
% total turnover 9.3% 17.1%  
Volume (m Pcs) 1.3 2.0 53.8%
Knit Fabric      
Sales (Rs m) 89.0 68.7 -22.8%
% total turnover 2.1% 1.9%  
Grey Fabric      
Sales (Rs m) 2.9 8.7 200.0%
% total turnover 0.1% 0.2%  
Others      
Sales (Rs m) 271.2 351.7 29.7%
% total turnover 6.5% 9.9%  
Denim & Shirting lag: Despite a fall in the proportionate contribution of denim to the company’s topline from 63% in 1QFY07 to 52% in 1QFY06, the segment continues to remain a major cause for the company’s poor performance. The 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 the prices of the premium segments. As a result, the company continues to suffer setbacks on both volume and realisation fronts. Arvind Mills also believes that the near term outlook for denim does not look very promising, as it will be significantly long time before the domestic demand supply balance is re-established.

As far as the shirting segment is concerned, despite a fall in volumes and realisations, the contribution to topline has remained consistent. While the sale to internal garment factory continues to be stable (with the shirts garmenting business growing by almost 27% YoY), the sale to outside converters has come down. The realizations, which had dropped during 4QFY06, have once again improved in this quarter (due to improved product mix), although lower than that of 1QFY06.

The contribution of the garment segment to the topline has nearly doubled with the completion of the first full year of operation of the Bangalore plant. The factory has achieved capacity utilisation of 60%. The company is now expanding its capacity by 100% and taking up the total installed capacity to 8 m pieces by FY07 (at an outlay of about Rs 200 m). The order book for the Jeans plant is full till January 2007. We expect this segment to contribute incrementally going forward.

Costs – Not in control: Although Arvind continues to leverage on the cotton inventory held by it in the wake of rising costs of cotton, the costs for the company have risen from Rs 37 per kg in 1QFY06 to Rs 40 per kg in 1QFY07. The company expects the current cotton cost to hold good for the entire year, as it holds inventory, which will last till April 2007.

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 1QFY06 1QFY07 % change
Raw material cost 1,480 1,170 -20.9%
% sales 35.0% 30.0%  
Power & fuel 370 380 2.7%
% sales 8.7% 9.7%  
Staff cost 340 360 5.9%
% sales 8.0% 9.2%  
Stores 460 430 -6.5%
% sales 10.9% 11.0%  
Others 400 360 -10.0%
% sales 9.5% 9.2%  

Arvind Brands: In absence of a viable distribution network for the mid and the low priced segments, the revenues of Arvind Brands have suffered significant reverses. The company has now opted for a viable model to distribute the low priced brands through the recently launched hyper-markets (e.g. Ruf N Tuf, being exclusively sold through ‘Big Bazaar,’ has shown the maximum growth). The company is in negotiations with other large players for a similar deal. This business has been proposed to be merged with the company with effect from 1st April 2006, and may prove to be benign for its 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 remain volatile.

Forex plunge: Besides the operating anomalies, loss on the forex side is another factor that has been cause of worry for the company for sometime now. In fact, in 1QFY07, the company’s other income has got completely wiped out by the forex losses. This is largely on account of dollar denominated long-term borrowing of about US$ 90 m and some working capital borrowing against shipments made. Although we had projected some of these in our estimates, the loss incurred on this count has been much higher. We expect this to continue with the Rupee depreciation in the coming quarters.

What to expect?
At the current price of Rs 57, the stock is trading at 43 times trailing 12 months earnings. The company does not expect the revenue and earnings to look up significantly in the next 12 to 15 months, until the downstream investments starts contributing significantly to its earnings. While the continuity of downside in denim cycle and losses on the forex side are unpredictable, we believe that the de-risking strategies will prove to be benign to the company in the longer run. The benefits of capacity expansion will also filter in, in the forthcoming fiscals. We shall soon revisit our projections for the company.

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