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Arvind Mills: Arduous restructuring! - Views on News from Equitymaster
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Arvind Mills: Arduous restructuring!
Nov 1, 2006

Performance summary
Arvind Mills declared another disappointing set of numbers for the second quarter and first half of FY07, which in the company’s own words were, impacted by the arduous process of strategic and internal restructuring. The company also acknowledged the absence of any ‘quick fix solutions’ to the challenges posed in front of the company. Despite better offtake in garment volumes, lower volume and realisations in denim and shirting businesses, besides the forex losses have continued to drain the company’s bottomline.

Standalone financials
(Rs m) 2QFY06 2QFY07 Change 1HFY06 1HFY07 Change
Net sales 4,270 3,930 -8.0% 8,440 7,480 -11.4%
Expenditure 3,220 3,070 -4.7% 6,270 5,780 -7.8%
Operating profit (EBDITA) 1,050 860 -18.1% 2,170 1,700 -21.7%
EBDITA margin (%) 24.6% 21.9%   25.7% 22.7%  
Other income 50 - -100.0% 120 50 -58.3%
Interest 330 380 15.2% 670 730 9.0%
Depreciation 390 380 -2.6% 780 750 -3.8%
Foreign exchange (gain) / loss (20) 50   (60) 140  
Profit before tax 400 50 -87.5% 900 130 -85.6%
Tax 40 -   80 -  
Profit after tax/(loss) 360 50 -86.1% 820 130 -84.1%
Net profit margin (%) 8.4% 1.3%   9.7% 1.7%  
No. of shares (m) 209.4 209.4   209.4 209.4  
Diluted earnings per share (Rs)* 6.9 1.0   7.8 1.2  
Price to earnings ratio (x)         49.1  
(* 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 2QFY07?
Segmental breakup…
  2QFY06 2QFY07 Change
Denim
Sales (Rs m) 2,626.7 1,946.8 -25.9%
% total turnover 61.3% 49.5%  
Volume (mm) 26.3 21.6 -17.9%
Avg Price (Rs/mt) 99.8 90.2 -9.6%
Shirting
Sales (Rs m) 769.3 726.1 -5.6%
% total turnover 17.9% 18.5%  
Volume (mm) 6.0 5.9 -1.7%
Avg Price (Rs/mt) 127.7 123.6 -3.2%
Garments
Sales (Rs m) 450.4 751.2 66.8%
% total turnover 10.5% 19.1%  
Volume (m Pcs) 1.6 2.7 68.8%
Knit Fabric
Sales (Rs m) 90.9 116.0 27.6%
% total turnover 2.1% 3.0%  
Grey Fabric
Sales (Rs m) 20.4 29.9 46.6%
% total turnover 0.5% 0.8%  
Others
Sales (Rs m) 329.0 362.0 10.0%
% total turnover 7.7% 9.2%  
Denim & shirting – Domestic blues: The contribution of the denim business to the company’s topline continued to pare in the quarter under review from 61% in 2QFY06 to 50% in 2QFY07. 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. As a result, the company continues to suffer setbacks on both volume and realisation fronts. In 2QFY07 however, 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 said quarter, export prices had improved by about 5%, but the drop in the domestic prices had led to overall average coming down by about Rs 0.8 per metre. 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.

As far as the shirting segment is concerned, despite a fall in volumes and realisations, the contribution to topline marginally improved, largely due to the 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 realizations, which had dropped during 4QFY06, have once again improved in this quarter (due to improved product mix), although lower than that of 2QFY06.

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 April 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, costs have risen from Rs 37 per kg in 2QFY06 to Rs 40 per kg in 2QFY07. The current inventory of the cotton will suffice company’s requirement till August 2007. The company holds inventory at an average landed duty paid cost of Rs 42.5 per kg and the consumption is likely to be at an average cost of Rs 42 per kg.

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 2QFY06 2QFY07 % change
Raw material cost 1,650 1,410 -14.5%
% sales 38.6% 35.9%  
Power & fuel 370 410 10.8%
% sales 8.7% 10.4%  
Staff cost 370 390 5.4%
% sales 8.7% 9.9%  
Stores 460 470 2.2%
% sales 10.8% 12.0%  
Others 370 400 8.1%
% sales 8.7% 10.2%  

Repositioning Arvind Brands: In 2QFY07, Arvind Brands, the wholly owned subsidiary of Arvind Mills, formed a joint venture with VF Corporation (USA) 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 in the new company. The figures reported in the current quarter therefore reflect the sales and earnings of VF brands for two months of July and August.

In absence of a viable distribution network for the mid and the low priced segments, revenues of Arvind Brands have suffered significant reverses. As per the company, under the JV structure, Arvind brands along with the VF brands will be managed separately and will now primarily focus on growing its own brands. The own brands business 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.

  Sales (Rs m) No. of stores
1HFY06 1HFY07 Growth 1HFY06 1HFY07 Growth
International brands 600 670 11.7% 52 62 19.2%
Own brands 360 340 -5.6% 29 68 134.5%

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.

Forex woes to continue: 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 2QFY07, 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 to impact the company’s margins in the coming quarters.

What to expect?
At the current price of Rs 61, the stock is trading at 49 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 longer term.

In April 2006, we had recommended a ‘BUY’ on the stock with a FY08 target price of Rs 143. The same was inferred based on our estimations of the consolidated EPS numbers, factoring in the numbers projected by the company for Arvind Brands and considering stability in garment realisations and lower power costs. As we have highlighted in our results analysis, the company has failed to deliver on each of these parameters for the past several quarters thus grossly under-performing our estimations. The huge forex losses booked by the company (which we were unable to take call on) have further acted as dampeners to our EPS estimations. Given the fact that the company itself acknowledges to continue to remain in the ‘restructuring phase’ over the next 12- 15 months, and the continued volatility in rupee-dollar rates, there is little visibility for the company in the medium term. We would therefore advise investors who do not wish to hold on to the stock for the longer term to pare losses on the stock.

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