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Arvind Mills: Win some lose some
Oct 27, 2007

Performance summary
  • Topline grows 14% YoY on the back of appreciable performance of the branded apparel and retail business.
  • EBIDTA margins contract from 17.0% in 2QFY07 to 13.9% in 2QFY08 due to cost pressures; higher cotton and power costs to exert pressure on profitability in the coming quarters.

  • Net margins improve from 1.0% in 2QFY07 to 1.9% in 2QFY08 due to lower interest and depreciation costs.

  • Acquires 59% stake in an erstwhile BIFR company, Anup Engineering (engaged in engineering and fabrication business).

Standalone financials
(Rs m) 2QFY07 2QFY08 Change 1HFY07 1QFY08 Change
Net sales 4,930 5,637 14.3% 9,139 10,785 18.0%
Expenditure 4,094 4,855 18.6% 7,470 9,237 23.7%
Operating profit (EBDITA) 836 782 -6.5% 1,669 1,548 -7.2%
EBDITA margin (%) 17.0% 13.9%   18.3% 14.4%  
Other income 2 17 685.7% 55 24 -56.4%
Interest 407 337 -17.2% 836 692 -17.2%
Depreciation 380 350 -7.9% 785 705 -10.2%
Profit before tax 51 112 118.2% 103 175 69.9%
Tax 4 7 61.0% 10 11 14.0%
Profit after tax/(loss) 47 105 123.2% 93 164 75.9%
Net profit margin (%) 1.0% 1.9%   1.0% 1.5%  
No. of shares (m) 209.4 209.4   209.4 209.4  
Diluted earnings per share (Rs)**         5.8  
Price to earnings ratio (x)         12.9  
(*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 2QFY08?
Fabric
  1HFY07 1HFY08 Change
Denim      
Sales (Rs m) 3,751 3,959 5.5%
% total turnover 41.0% 36.7%  
Volume (mm) 41.4 38.7 -6.5%
Avg Price (Rs/mt) 91 102 12.9%
Shirting      
Sales (Rs m) 1,364 1,441 5.7%
% total turnover 14.9% 13.4%  
Volume (mm) 11.0 11.7 6.4%
Avg Price (Rs/mt) 124 123 -0.6%
Knit fabric      
Sales (Rs m) 184 224 21.8%
% total turnover 2.0% 2.1%  
Grey fabric      
Sales (Rs m) 25 39 55.6%
% total turnover 0.3% 0.4%  
Others      
Sales (Rs m) 707 708 0.2%
% total turnover 7.7% 6.6%  
mm-million metres; mt-metre
Fabric – Price volume trade off: Arvind Mills has managed to consolidate the gains made in the denim realisations in the first half of this fiscal, after the same having bottomed out in the past few quarters. On the volumes front, however, offtakes were lower by 6.5% 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 41% in 1HFY07 to 36.7% in 1HFY08.

As far as the shirting segment is concerned, the marginal improvement in volumes was set off by the fall in realisations, as a result of which its contribution to topline also 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 that became operational this quarter is expected to open up the lucrative non-iron shirts market for the company.

Garment
  1HFY07 1HFY08 Change
Shirts      
Sales (Rs m) 569 624 9.8%
% total turnover 6.2% 5.8%  
Volume (m Pcs) 1.5 1.7 15.3%
Avg Price (Rs/pc) 379 361 -4.8%
Knits      
Sales (Rs m) 391 519 32.7%
% total turnover 4.3% 4.8%  
Volume (m Pcs) 2.1 3.1 50.2%
Avg Price (Rs/pc) 187 165 -11.7%
Jeans      
Sales (Rs m) 268 684 154.9%
% total turnover 2.9% 6.3%  
Volume (m Pcs) 0.8 1.7 123.7%
Avg Price (Rs/pc) 353 402 14.0%
Domestic garment packages      
Sales (Rs m) 126 152 20.5%
% total turnover 1.4% 1.4%  
Branded garments      
Sales (Rs m) 1,713 1,742 1.7%
% total turnover 18.7% 16.2%  
Volume (m Pcs) 5.0 3.4 -32.5%
Avg Price (Rs/pc) 344 519 50.8%
m Pcs-million pieces; pc-piece
Garments - Brands add value: The garmenting business, which has been the second largest revenue generator for Arvind Mills following denim fabric, 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 – FY09, 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.

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 sales not including the figures of the VF licensed brands, which were part of the company turnover in the corresponding quarter previous financial year, has grown 36% YoY. The branded garments business despite earning 50% higher realisation continues to be pressurised on the volumes front.

Cotton costs – Not in control: Arvind Mills enjoyed 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 might impact its profits in 2HFY08 as it goes in for mid-season buying of cotton.

Cost breakup
(%) of sales 2QFY07 2QFY08 % change
Raw material cost 1,880 2,330 23.9%
% sales 38.1% 41.3%  
Power & fuel 430 470 9.3%
% sales 8.7% 8.3%  
Staff cost 500 600 20.0%
% sales 10.1% 10.6%  
Stores 480 620 29.2%
% sales 9.7% 11.0%  
Others 800 840 5.0%
% sales 16.2% 14.9%  

Powerless margins: Arvind Mills’ initiatives to de-risk its business, control costs and improve margins have not lent any stability to its operating margins, which continue to falter. 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.

Retail: The current quarter also saw the company announcing its plan for rapid retail expansion. Retail expansion will straddle several formats, as the company would like to be present across the entire spectrum of value retail, premium retail and luxury retail. The company began the process with announcing the launch of Megamart Outlet Centre, which will be 50,000 to 60,000 sq feet large format value stores. The company has already signed up prime properties in Chennai, Pune and Hyderabad for this expansion. These 3 stores will be operational during the course of this financial year. The company has an aggressive expansion plans to sign up several more properties in the coming months. Megamart plans to have up and running 25 to 30 such Megamart Outlet Centres in top 20 cities over the next 4 years.

Stake in an erstwhile BIFR company: Anup Engineering (a group company engaged in engineering and fabrication business and listed on the Ahmedabad Stock Exchange) was referred to BIFR (Board for Industrial and Financial Restructuring) in the year 2001. The BIFR passed an order in July 2007 converting the Rs 20 m advanced by Arvind Mills in past into equity. With this conversion, Arvind Mills will control 59% of the expanded equity making Anup Engineering a subsidiary of the company and the total promoter holding will be to the tune of 91%. Anup Engineering has shown a turnaround in last three years and has returned to profits. In 1HFY08, the company notched up a turnover of Rs 260 m with operating margin of 19%.

What to expect?
At the current price of Rs 77, the stock is trading at a multiple of 5.3 times and 0.9 times our estimated FY10 earnings and book value respectively. 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).

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, rising input costs coupled with appreciating rupee are playing spoilsport with the margins. Despite the relative attractiveness of the stock to its peers in terms of price to book value, especially in the light of the issue of warrants to promoters , we maintain a cautious stance on the earnings potential of the company.

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