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Arvind Mills: ‘Power’less performance - Views on News from Equitymaster

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Arvind Mills: ‘Power’less performance

Jul 31, 2007

Performance summary
  • Topline grows 21% YoY on the back of better realisations in the denim and branded garments business.

  • EBIDTA margins contract from 19.8% in 1QFY07 to 14.1% in 1QFY08 due to cost pressures; higher cotton and power costs to exert pressure on profitability in the coming quarters.

  • Net margins improve from 1.1% in 1QFY07 to 1.2% in 1QFY08 on the back of forex gains.

Standalone financials
(Rs m) 1QFY07 1QFY08 Change
Net sales 4,208 5,103 21.3%
Expenditure 3,376 4,382 29.8%
Operating profit (EBDITA) 832 721 -13.3%
EBDITA margin (%) 19.8% 14.1%  
Other income 53 52 -1.9%
Interest 372 438 17.7%
Depreciation 404 354 -12.4%
Foreign exchange (gain) / loss 56 (83) -248.2%
Profit before tax 53 64 20.8%
Tax 6 5  
Profit after tax/(loss) 47 59 25.7%
Net profit margin (%) 1.1% 1.2%  
No. of shares (m) 209.4 209.4  
Diluted earnings per share (Rs)**   5.6  
Price to earnings ratio (x)   8.6  
(*On a trailing 12-month basis)

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 driven performance in 1QFY08?
Denim & shirting – Realisations catch up: 1QFY08 saw Arvind Mills consolidate on the gains made in the denim realisations after the same having bottomed out in the past few quarters. On the volumes front, however, offtakes were lower by 6% YoY. The sales mix was further skewed in favour of exports in line with the stated strategy of the company. The company has arrested the price slide in the domestic market by offering value added products and containing the volume to be sold in the market. Arvind Mills is expecting significantly better volumes from the European market in the third quarter of FY08 along with further improvement in prices in the domestic market, as the sourcing for the festival season will be underway. The contribution of the denim business to the company’s topline declined further - from 43% in 1QFY07 to 37% in 1QFY08.

As far as the shirting segment is concerned, despite improvement in volumes and realisations, its contribution to topline declined marginally. Since the sale to internal garment factory is not reflected in the reported numbers, revenues in this segment appear to have slowed down. 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. Also, the plant to process the ‘pre-press’ (non-iron) fabric will be operational in the first week of August and it will open up the lucrative non-iron shirts market for the company.

Segmental breakup…
  1QFY07 1QFY08 Change
Denim      
Sales (Rs m) 1,806 1,910 5.8%
% total turnover 42.9% 37.4%  
Volume (mm) 19.9 18.6 -6.3%
Avg Price (Rs/mt) 91.0 102.7 12.9%
Shirting      
Sales (Rs m) 647 742 14.7%
% total turnover 15.4% 14.5%  
Volume (mm) 5.2 5.9 13.5%
Avg Price (Rs/mt) 124.4 125.8 1.1%
Garments      
Sales (Rs m) 420 970 130.9%
% total turnover 10.0% 19.0%  
Volume (m Pcs) 5.4 9.3 72.2%
Branded garments      
Sales (Rs m) 572 714 25.0%
% total turnover 13.6% 14.0%  
Knit Garments      
Sales (Rs m) 63.7 102.6 61.0%
Volume (m Pcs) 1.76 3.2 82.0%
% total turnover 1.5% 2.0%  
Others      
Sales (Rs m) 558 664 19.0%
% total turnover 13.3% 13.0%  
mm-million metres; mt-metre

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.

Cotton costs – Not in control: Arvind Mills had been enjoying two consecutive years of low cotton prices until 1HFY07. Considering the price levels at the beginning of last two seasons the company had taken very long positions. As per the company, the current inventory of cotton will last till the opening of new season for denim and will cover the current financial year in case of shirting business. The domestic cotton prices have moved up by 25% YoY and the company expects the prices to firm up further by 15% to 20% in FY08. This is likely to impact its profits in 2HFY08.

Cost breakup…
(%) of sales 1QFY07 1QFY08 % change
Raw material cost 3,870 5,030 30.0%
% sales 92.0% 98.6%  
Power & fuel 400 460 15.0%
% sales 9.5% 9.0%  
Staff cost 450 570 26.7%
% sales 10.7% 11.2%  
Stores 400 460 15.0%
% sales 9.5% 9.0%  
Others 640 730 14.1%
% sales 15.2% 14.3%  

Brands yet to add value: The performance of brands business was affected by the off season but the company is on target towards its stated goals and in terms of roll out of stores and supply chain expansion. Arvind Mills is still charging large overhead cost of creating the US and the EU sales infrastructure with some benefit coming back in the EU market, but still the full recovery is couple of quarters away.

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.

Powerless margins: 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 total requirement of about 55 to 60 MW of power. Currently about 32 MW of this power is being serviced from the natural gas powered combined cycle power plants. With the gas supply agreement due for renewal in November 2007 and with no viable alternative, Arvind Mills has stated that it may be forced to buy this 32 MW of energy from the grid. The company would be buying power at an average cost of Rs 4.4/Kwh (32 MW will be purchased at Rs 5.2/Kwh compared to cost of Rs 2.9/Kwh for generating electricity internally). The annual impact is expected to be around Rs 250 m to 300 m (x% of our estimated FY08 revenues).

Forex woes to continue: The rupee appreciated by 6% against the dollar in 1QFY08. Arvind Mills, predominantly being a ‘dollar revenue-rupee cost’ company, as most of its revenue is either in dollars or linked to the same, is reasonably exposed to such currency risk. Its forward cover on net dollar exposure is based on the average exchange of Rs 42.5 to a dollar. The near and medium term outlook on rupee being strong, the company expects the real impact of rupee on its FY08 margins to be about 4% compared to previous financial year on comparable basis.

Having said that, 50% of the company’s long-term borrowing is denominated in foreign currency and is subject to rate fluctuations and it is on this borrowings company has reported a gain of Rs 80 m in the current quarter. Around 13% of the company’s outstanding loans are under the TUF scheme. Arvind Mills is also expected to benefit from lower rate of borrowings for export (under the DEPB scheme).

What to expect?
At the current price of Rs 46, the stock is trading at a multiple of 9.7 times our estimated FY10 earnings. Given the fact that the company maintains a cautious outlook on its near term revenue and earnings, and the continued volatility in rupee-dollar rate, there is little visibility in the medium term. However, the policy of servicing the key markets with value added products and focused marketing of brands seems to be yielding positive results. Even though the company has been performing better, the rising interest costs coupled with appreciating rupee are playing spoilsport with the margins. The impending threat of higher cotton and power costs is not allowing the company to fully benefit from the operational resurgence. The margins of the company will be protected only in scenario of its rupee denominated sales going up and only avenue for doing it is the domestic apparel and retail business. Given the relative attractiveness of the stock to its peers in valuation terms, we stand by our recommendation.

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