How long will the spin around textile stocks last?

Have you heard of the three brothers — KP Ramasamy, KPD Sigamani and P Nataraj? Most likely not. But those hailing from the textile town of Tirupur would know the trio since they run one of India’s biggest integrated textile units, KPR Mill. Eldest of the three, 71-year-old KPR started out as a powerloom fabric manufacturer in 1971 and with the help of his brothers, went on to create a textile giant straddling the entire value chain of yarn, fabric and garments. 

The company hasn’t had an impressive market history though — its debut in 2007 was a disaster. Its stock listed at Rs. 201, 10% lower than its issue price of Rs. 225. Post the global crisis of 2007-08, the slide continued and it fell to a low of Rs. 25 in 2009. It finally managed to climb above its issue price only in early 2014.

But FY21 was a watershed year in the company’s history as the stock more than quadrupled to Rs. 1,523 (as of June 30). The brothers emerged as newly minted dollar billionaires with their collective stake (74.72%) worth Rs. 77.20 billion on a market cap of Rs. 104.74 billion.

However, it’s not just KPR. Even other spinners and integrated players with a market cap of over Rs. 2 billion saw a good run with their stocks surging anywhere between 2x and 6x from March 2020 (See: Make that double) on the back of robust domestic and export demand that helped end FY21 on a positive note.

What’s impressive about the performance is that it came in a year ravaged by a pandemic and when other businesses were struggling to stay afloat. The turnaround couldn’t have come at a more fortuitous time for the sector which was facing growth pangs of its own making.

Threadbare
For an industry that has been the biggest source of employment in the country, the past decade was a rollercoaster. While China is the world’s leading producer and exporter of raw textiles and garments, India is the second-largest textile manufacturer, accounting for more than 6% of the global production. But it has had to contend with intense competition. “In recent years, Bangladesh, Indonesia, Cambodia and Thailand have emerged as major textile-producing nations with cheap labour, and industry-friendly rules and regulations,” mentions Dheeraj Manwani, analyst at Finarthaa Research & Advisory. 

While India has been an exporter of yarns and garments, Bangladesh, Pakistan and Vietnam have stolen India’s thunder since they have entered into free trade agreements (FTAs) with the European Union (EU) that India opted out of as it would have meant compromising on every other manufacturing segment. While the other Asian countries face zero duty on their exports, India has to pay 9% as it isn’t part of the FTAs. In 2000, India’s share in the global textile market was 3% as compared to Bangladesh’s 2.6%. Since then, India’s share has grown by a mere 1.1 percentage points while Bangladesh’s has more than doubled. “For India, textile is one of the several industries, while for Bangladesh, it was ‘the’ industry. Everybody else had a better story than India, even the Chinese started investing in Cambodia and Vietnam, so they were a better option than us,” says SK Sundararaman, managing director, Shiva Texyarn, whose revenue is split equally between cotton yarn and technical textiles such as coated fabric for artists’ canvas or those meant for use by the defence forces. 

Meanwhile, in January 2016, the government amended the Technology Upgradation Fund Scheme, making it effective for a period of 7 years till March 2022. For the first time, it allowed units to take advantage of credit-linked subsidy under the central scheme in addition to benefits availed from state governments. States such as Gujarat, Rajasthan, Punjab and others had introduced incentives for industries beginning 2009. This resulted in a lot of crowding in the spinning industry. Dinesh Nolkha, managing director, Nitin Spinners, explains: “From 2013-14, a lot of players have joined hands to set up small-sized units to cater specifically to China. Given that banks were charging an interest of 11% and states were giving a 5% interest subsidy, the net cost of doing business was just 5%. So, their assumption was that given the actual cost of funding was 5% [bank interest rate less the interest subsidy], the business could easily generate returns which will not only cover the interest cost but also fetch higher profit.” 

But their hopes were dashed after demonetisation in 2016 and the launch of the Goods & Services Tax (GST) in 2017.  Since a majority of these smaller players were from the unorganised sector, they couldn’t handle the supply chain disruption, the sudden fund squeeze in the system and the transition to GST.

Exports got further impacted after the US-China trade war since the unorganised smaller Indian companies exporting to China started dumping yarn back home. Abhishek Rathi, analyst at India Ratings & Research, says, “Between July 2019 and January 2020, the gross margin of yarn players came down to the lowest at Rs. 25-30/kg which was around Rs. 100/kg before the trade war and around Rs. 120-130/kg before demonetisation. Since India exports 25-30% of its yarn production and since 15-20% of the export consignment was being dumped, prices crashed.” Over 5% of the spinning capacity had gone out of business by FY20.

But things changed when the pandemic struck. Not just domestic demand, even exports showed a resurgence (See: Happy shipping).

Weathering the storm
The onset of the pandemic in March 2020 resulted in a complete shutdown of 35-45 days. There were large-scale supply chain disruptions. However, once the lockdown eased, demand in Q2 and Q3 proved to be a booster for the yarn industry. Jayesh Shah, director and CFO, Arvind Mills, in the Q3 earnings call told analysts: “Domestic brands and retailers, who  had sharply cut down on buying, have returned to placing  regular orders as demand has re-emerged post Diwali.” Arvind, whose Q3 revenue fell 19% to Rs. 15.14 billion, saw denim volume recover 88% from the Q3FY20’s number, woven volume recovered 77% and garment volume, 89%.

KPR, which has more than 1,200 regular domestic clients for yarn and fabric and around 60 leading international brands for garments, saw a 5.6% growth in revenue for FY21 to Rs. 35.69 billion while PAT surged 37% to Rs. 5.15 billion with a margin of 14.4%. According to Bharat Chhoda, analyst at ICICI Securities, KPR generated healthy operating cash flows worth Rs. 5.80 billion in FY21 owing to healthy profitability growth and controlled working capital cycle. While exports accounted for 35% of revenue, the remainder came from the domestic market. “Demand for cotton yarn globally in the past few months has been pretty robust, translating to significant rise in yarn realisation. Revenue from the yarn & fabric division grew robustly by 42% YoY in Q4 to Rs. 4.96 billion driven by 22% realisation growth and 17% volume growth,” mentions Chhoda in his report.

Madhav Bhageria, joint managing director and CFO, Filatex India, one of India’s top five manufacturers of polyester filament yarn, also known as man-made fibre (MMF) since it is not produced naturally from cotton, saw robust demand in both domestic and export markets. “Given that freight rates were 4x of the pre-pandemic levels, yarn imports did not make sense, resulting in higher demand for locally produced yarn. Besides, another factor was the 5-6% capacity constraint [in MMF] following fire at one of the major manufacturers’ — Bhilosha Industries’ — production facility,” explained Bhageria. Filatex, which clocked a turnover of Rs. 22.27 billion in FY21 with robust margins as the government withdrew anti-dumping duty on PTA (raw material for polyester), saw the stock rise nearly 6x over the past one year. The company saw domestic sales of Rs. 18.87 billion and exports of Rs. 3.40 billion in FY21. While sales were down, profit was up 36% to Rs. 1.66 billion. 

The strong performance in FY21 allowed the company to generate healthy cash flows, enabling it to reduce debt by Rs. 1.4 billion, resulting in a D/E of 0.8x in FY21 against 1.2x in FY20.

One reason behind better profit in the yarn business has been the increasing spread between cotton (input) and yarn (output) prices. Yarn spreads improved 17.5% in months — from Rs. 103 kg in October 2020 to Rs. 121 in March 2021 (See: Stretching it). “Lower cotton prices have helped yarn spinners show good margins and higher profit,” says Pulkit Agarwal, analyst at CARE Ratings. For integrated mill players, that’s a boon. “Players such as KPR, Welspun and Vardhman, which have higher integration, have better resilience in their operating margins,” feels Rathi.

What has also kept the yarn prices high is the ban on cotton from China’s Xinjiang Uyghur Autonomous Region (XUAR), which produces about 20% of the world’s cotton and is China’s largest textile and apparel exporter. In November 2020, major fashion brands decided to not source cotton from the province over reports of labour exploitation of Uyghur Muslims.

Neeraj Jain, joint MD of Vardhman Textiles, in the Q3 earnings call told analysts: “Export from India to China has increased. China is importing 25 to 30 million kg per month from India. Most of the garment exporters in China are looking to import yarn.” While China has diverted the use of Xinjiang cotton for domestic apparel production, it is looking to increase sourcing from India even as other garment makers are reaching out to Indian textile players directly.

Arvind’s Shah, too, mentioned in an earnings call that new enquiries have gone up. “Some customers, who were not buying from India or were sourcing from China, have started buying [from India]. We are seeing it clearly in the kind of orders we have got and you saw that, despite the fact that Europe has been significantly impacted in the last three to four months, our exports have been quite strong. This is because we have been able to add a few customers and a few product categories for our existing customers, more importantly for the US markets,” said Shah. Denim export volume for Arvind, in fact, crossed the previous year’s level. Export volume for woven has been impacted by the extended lockdown and the work-from-home trend in Arvind’s key markets and stood at 62% of last year’s volume. In Q3, without disclosing the break-up in absolute numbers, Arvind reported that the domestic market volume had recovered to 74% for denims and 81% for woven, in terms of fabric volume, and export of denim and woven had grown 108% and 62%, respectively.

Manwani believes that the pandemic has forced developed nations to think about their over-reliance on China for everything. This has pushed them to think about an alternative supply chain. “Global demand for value-added polyester product is strong and is increasing annually by 3-3.5 million tonnes, which is difficult to meet with current capacity and reduced focus on China. Hence, it provides a long-term opportunity for Indian players in the segment,” says Manwani.

While the US remains the biggest market for textiles, most Indian textile companies have exposure to the EU.

So far, so good
After an eventful FY21, while analysts are bullish on stocks, the management commentary seems to be rather guarded. For instance, in March 2021, Natraj of KPR, told institutional investors over a call: “It is difficult to predict the market situation because it is based on global scenario, government policies, and international policies.”

Sundararaman, too, is restrained: “Major retailers [overseas] are edgy about Indian textile players’ ability to stick to their commitments, given the second wave disruption.” Shah of Arvind, too, sounded circumspect in the Q3 earnings call: “Traction in our export markets will depend on how the second and later waves of pandemic play out. We also expect input cost pressures to continue at least for some time.”

The fear is not unfounded as India Ratings & Research’s Rathi points out that with the surge in cases along with micro lockdowns, the demand remained lacklustre at spinning mills. “Exports were also disrupted during April-May 2021 on the back of labour availability and logistical challenges. Although a continued shift in global sourcing strategy provided an opportunity for Indian players with competitive abilities and healthy balance sheet liquidity, the total exports of apparels declined by 20% to $12 billion in FY21,” says Rathi. Also, the rating agency expects near-term disruptions with the closure of retail spaces, malls, shopping centres (other than essentials) in urban areas to delay the pickup in domestic demand.

In short, while the performance has been good thus far, the future is still uncertain. While the domestic recovery was robust in FY21, post the second wave that swept the nation in April-May, the Q1 and Q2 numbers of textile companies with a focus on domestic demand will be keenly watched. Those with an export focus will have to hope that the orders keep coming.

That explains why textile stocks tend to have low P/E — the cyclicality in the business and also the impact of raw material prices. For instance, at current prices, most textile stocks are trading in the range of 5x to 13x FY23 estimated earnings (See: Cheap for a reason). “Since you have no control over cotton production and prices, textile companies always run the risk of wild swings in margin. Besides, they will have to spend free cash flow (FCF) to generate volume growth because you can’t keep increasing prices beyond a point,” explains Anoop Bhaskar, head-equity, IDFC Mutual Fund.

That’s the reason why most textile companies continue to have debt on their books (See: Till debt do us apart) as, without capacity expansion, you cannot achieve growth. For instance, in the case of Arvind, the company has debt of Rs. 20.82 billion and is looking to bring it down. During the Q3 earnings call, Shah was categorical that debt would come down as the company did not have any capex lined up.

To invest or not to invest is the million-dollar question that textile companies are now faced with. Sundararaman of Shiva Texyarn says, “If India gets 30% higher orders coming out of China, that’s phenomenal. But we may not have the capacity to do that as currently, most units are running at near fully utilisation levels. While it [FY22] will be a record year for sure, further growth will depend on whether one is confident of increasing capacity.”

Though the government has announced a PLI scheme aimed at MMF units, industry players are not enthused over the policy. “It’s a hare-brained scheme. Firstly, the minimum threshold is turnover of Rs. 1 billion and, secondly, the government wants YoY growth of 50% each year. How is that possible in a business like textiles? To grow by 50% for a Rs. 2-billion unit means investing at least Rs. 600 million to aim for Rs. 1 billion in sales next year. And what I get for achieving 50% higher sales is just 9% of incremental sales, that is, Rs. 90 million. Which entrepreneur in his senses will invest Rs. 600 million for the Rs. 90 million that the government is promising?” quips the CEO of a listed textile unit.

While the PLI scheme is yet to be notified, for now, the players are looking at incremental capacity depending on their ability to fund it.  KPR is looking to set up a new 42-million-unit garment facility and Filatex is planning capex of Rs. 1.75 billion to add 100 TPD capacity of partially oriented yarn (POY) and drawn textured yarn (DTY). Further, it is planning a capex of Rs. 1.30-1.50 billion in FY23 to add 100 TPD of recycled chips that have higher realisation and margin than normal polyester chips. “The company is constantly focusing on enhancing the share of value-added products as they yield higher margin,” mentions Chhoda.

Textiles players are not reading too much into the China+1 narrative. “It will take at least another one or two quarters to see how much [orders] is coming out from China to our country,” Nataraj told his investors. Sundararaman believes that it will be near impossible for global players to stay away from China. “Initially, the feeling was that trade would move out of China from a revenge perspective but trade doesn’t work that way. It will go where the volume and efficiencies are there and a small portion would have come to India. China has created global competencies that you can’t change overnight. Yes, the only aspect is that India will be seen as a credible alternative.”

Barring a handful of textile companies, not everyone will be in a position to cash in on the “alternative” demand. “Textile firms will only do well when they enjoy interest rate subsidy because they don’t have more than 12-13% ROCE. So, if the cost of capital is 6-7%, will you make money as a shareholder? You can’t keep funding through equity so you will have to take debt,” points out Bhaskar. 

That’s like a chicken-and-egg situation that most textile companies find themselves in. 

Not surprising, Bhaskar, who holds KPR Mill and Vardhman in his funds, is playing it by the ear. “If you get in early in the cycle, stay put. But, to buy at the current price is like a leap of faith because to make money from hereon, the companies have to deliver the numbers.”