Kitex Garments Limited

Stock Opportunities Not-so-Hidden Gems
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Aveek- good point on actual margins versus reported margins. 20% EBITDA ( all inclusive) actually does not sound that high for a niche exporting business.

Donald- fair point, one should not confuse hypothesis for facts. However in a dynamic game like investing the “facts” themselves keep changing. To avoid boiling the ocean I would set up this problem as follows with specific hypotheses that can be tested for validity where facts are available.

Issue- Why do Kitex’ EBITDA margins appear to be higher than industry peers? Are they sustainable long term?

Following are some of the hypotheses which come to my mind:

1). Cost superiority- Kitex has lower costs than others in the business owing to scale, efficiency in its manufacturing process and/or lower labor costs which gives it a cost advantage over peers leading to higher operating margins at similar realizations.

2). Dominant market position)- There is a paucity of large scale credible suppliers in infant clothing thus suppliers such as Kitex enjoy more bargaining power with buyers at least till the time new credible supply emerges.

3). Higher realizations)- Kitex commands better prices than peers owing to deep customer relationships, high quality products, high service standards, socially responsible image etc. This is sustainable as long as Kitex maintains its quality and service standards and the industry characteristics don’t change fundamentally.

4). Niche segment)- Kitex’ relatively high margins are due to the specific characteristics of infant wear segment where many players enjoy such margins, it has nothing specifically to do with Kitex’ operational or quality superiority. Question then becomes how much this specific niche can be scaled up before others jump in?

Important to remember that operating margins are not the be all and and all. What ultimately matters is growth in absolute profits so if Kitex does lose a few points on margin but scales up sufficiently in volumes profits will still increase.

Disclosure: invested at lower levels

Bobby

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@Donald… Presently Kitex have 3700 employees and they have taken 7% increase in current employee cost. None of this are high and doesn’t show they have problem on scaling due to labor. There AR 14 nowhere mentioned Labor Scaling as major threat. They mentioned that Transit Time delay and Forex Rate are two major threat items. Also, cost per employee is roughly Rs. 7.5K - 8K as per my estimate (all inclusive).

I know that they are sourcing labor from other states (it is there in one of the Videos I enclosed). I have seen shop floors with more than 10 K people for Youngone, Mustgarment. Dragon Sweater etc. situated in smaller geographies. But for improving productivity automation at specific areas are better and can improve margins.

Challenges for keeping people may not be related to availability but may possibly be cultural or food related or isolation or anything like that. MNREGA etc. which you mentioned earlier for labor unavailability is not relevant here.You can get good idea about problems of Indian labor market if you happen to read some reports published by Teamlease (Bangalore). GER of 12%, brutalexploitativenature of manycompanies, monocultural bias in many geographies are India’s problem in availability and mobility not MNREGA.

I do feel, scale created by people taken from different states itself may give them a huge competitive advantage as discussed earlier.

@Ricky76 … I think your points are valid. I have no better understanding than this. large players attract each other and customer stickiness is very high in this industry… Comfort level across entire value chain built over decades of work can be penetrated only with substantial cost advantage or technology advancement which I don’t think can happen very soon.

Disc. : Not invested and no immediate plan for it unless price corrects substantially (below 175/).

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@Donald,

While I agree with your view to avoid generalization and to do objective assessment of the scaling issue, Do we have any specific data to think that labour requirements will be in the scale of 20K-25K when the current is 3.7K? I also agree that increasing focus of management for automation might be an indication of labour scaling issues, but as Aveek rightly pointed out, it might be because of some major process improvement as well, where Automation may be making more sense, otherwise, I don’t really think automation really makes sense as a total replacement of manual labour. What’s the advantage of low cost labour then?

Notwithstanding any of the arguments above, I concur with you that scaling up will remain a major challenge for the management.

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We should compare Apples to Apples. Compare Jay Jay Mills Margins with Kitex. Then we will refrain from making excuses about niche and premium pricing and things like that - and attack the problem on the exact specifics.

a) As Anil Kumar has suggested - taking into account the difference in Fabric Sales being 40% in case of Jay Jay to 25% in case of Kitex

b) We should take into account - try to get a break up of Government subsidies, Export Incentives and the Dollar appreciation effect (there are other Textile companies which are approaching 20% + margins) - but then why is Jay Jay at half Kitex margins again.

c) Cost structures - Yes Bobby, this may indeed be the important differentiator - but is difficult to get a handle on Jay Jay cost structures - let me try to collect that as possible.

Sure Kitex has other levers for growth in high Asset Turns and Capital Turns as compared to other Textile companies. That is a good thing to have - no dissecting needed there. What we are trying to dissect is the sustainability of Margins - why or why not? In order to be able to quiz the Management properly.

What will help us do the job better - is to focus on key specifics and equipping us with underlying data. Re-iterating all the good things about the Kitex story isn’t helping much. Please take my comments in that perspective.

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@ Aksh

No specific data point on the labour requirement right now. Except that Kitex has ambitions of growing very fast - At 11 L/day by FY16 they aim to be near double the capacity of the next competitor (KCL+KGL). Even growing at 25%-30% CAGR implies doubling between every 2-3 years.

So if you stretch out the horizon to 8-10 years - and call it a really sustainable growth story - what is the main challenge in execution - scaling labourforce to 8k, 16k and 32 K in 3, 6 and 9 years. That is certainly a line to probe with Management, isn’t it?

Rather than dismissing labour scale up as not a problem, we like to throw these questions at Management and see what their current thinking is and what their plans are. Instead of taking a high-level automation/robotics spend as the answer to above, we like to probe deeper, where will automation have the biggest impact - in Dyeing (unlikely), in Knitting Or in Garmenting (high labour engagement) - and then put a dimension to each - to arrive at likely estimates/contours of the puzzle.

Urge everyone to think more on specifics like these on the Kitex puzzle.

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@ricky76

Your hypotheses make sense. I should agree with you that only OPM is not important. Higher growth in top line and bottom line is key.

OPM for Page industries is stable since 2007(between 20 to 21) but in that last 5yr 35% CAGR growth in sales, profit is ultimately value creator for Page investors. Sowe shall better look at sales, profit growth more than OPM. It is equally important that OPM must not swing heavily.

@Aveek Mitra

Labor issues can be sorted out with right mix technology and operational excellency by management. Kitex is doing right here. Mayur Uni is a great case study for alltextile manufacturing cos for “how to achieve highest level of operational excellency”. Mayur hired best consultants to improve cycles, turn over ratios. Constantimprovement in manufacturing process and smart backend integration are key take away.

Your wish of dream entry level at 175 demands 35% correction at CMP! I checked Point & Figure charting. It suggests extremely strong support at 215 to 230 level.Rather than getting truck load of Kitex at 215 or 175, why not think to add Kitex at various milestone levels. This way we can improve our convictions and betterallocation decision is made. So invest as story unfolds

@Donald

We have valid questions for management regarding labor, automations scaleup to understand their strategies. We can ask some specific questions like plan for creatingown brand and its marketing strategies, how will it impact OPM, potential growth in own brand, competitor threat, customer bargain power, etc

Disc : Still not invested : (

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Trying to solve few puzzles…

10% EBITDA levels is the norm. â Even Jay Jay mills reported average EBITDA margins for 2009-12 were around 15% [without any adjustments, taking reported nos by Care, one can download care reports from care websites]. Kitex reported margins were much higher than this. Yes 2013 margins fallen steeply, reported margins at 11%, but this could be due to increase in overheads or some company specific issue. So 10% EBITDA margins WERE NORM BEFORE 2008, if at all, when both JJ and Kitex were purchasing majority of processed RM from outside

EBITDA margins improved due to INR depreciation: This is little tricky. Kitex processing plant begin functioning to full capacity from FY2008 end and in 2010 new capacity garment capacity and processing plant became functional. Company had been repeating from 2007-08 that once processing plant becomes functional, their margins will improve drastically. Processing charges which were above 15% for FY08 & 09 declined drastically to low single digit by FY12 & 13.

Further note that during FY05-08/09, emp cost increase by 3x, but during FY09-14 emp cost increased only at a CAGR of 7%, during same time garment sales increased at 11% CAGR. Emp cost as a % of sales declined by 200 to 300 basis point during FY11-14 compared to FY05-10.

INR depreciation/ Appreciation: From above, aleast we can say that entire increase in EBITDA margin post 2009 is NOT DUE TO INR DEPRECIATION. There must be some benefit without doubt, but not entirely. Letâs see what happened when INR appreciated to INR 41-42 during FY07-09. EBITA margin remained flat and there was NO decline in gross margins.

Steep increase in cotton prices in FY 11 lead to 31% decline in garment sales [i.e excluding fabric sales]. Despite such a massive decline in garment sales, there was no pressure on Gross & EBITA margins. Ofcourse, FY11 was period in which company was getting advantage of its additional processing plant and reduction in processing charges, but it does indicate company has weathered turbulence in its operations well.

EBITDA margins sustainability Vs JJ mills: For the time being letâs not get stuck with comparison with Jay Jay mills. As highlighted earlier they have 40% fabric sales as exports, we do not know whether these sales are at breakeven levels, loss or at premium. My GUESS is IT COULD BE AT LOSS, as in India there are no tax benefits to textile companies. [ JJ mills standalone profits is merely 6 crs but consolidated profits are 29crs for FY13, which indicates much higher profits at subsidiary levels. Thanks to Vinod, for highlighting higher subsidiary profits]

Better way to think about sustainability could be to think what could put pressure on margins. Two things 1) First pressure on ASP 2) company not able to pass on the RM price hike. I highlighted earlier that despite, massive increase in cotton prices during 2011, there was no pressure on margins. Company, probably took decision to take hit on sales rather than cutting margins. Secondly regarding pressure on ASP, we should note that company is running on full capacity for most of the time in last 5-7 yrs, except for may be in 2011.

In my view most imp. variable to track and understand is the China capacity and ability of other Indian/Asian countries to quickly add capacity. Even if some one start from today, it will take atleast 3-4 years to match Kitex capacity [Kitex took 20 yrs to come to this level]… and Yes we need to understand about labour, because if something could break this story, it WILL BE LABOUR.

Automation: Donald as already talked in detail about this and I broadly agree with him. Mgt is saying no labour, but even if we assume 100% labour there wonât be any impact on margins, but YES the issue remains on AVAILABLITY OF LABOUR and if FULL AUTOMATION IS REALLY POSSIBLE, then why western countries need to depend on Asian countries, or is it a Mix OF AUTOMATION AND LABOUR.

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See below article from the Wall Street Journal. Lower cotton prices (Check out the cotton price 10 year chart from Bloomberg to get a sense of where we are in the cycle)in the foreseeable future are likely to provide a strong tailwind for garment players provided they are NOT locked into long term contracts with the mills.

Does anyone know how Kitex procures cotton? is it through long term supplies or short term contracts? Does it hedge through the futures market?

Bobby

Cotton Price Unravels as Supplies Rise

By

ALEXANDRA WEXLER

July 27, 2014 2:07 p.m. ET

Cotton prices have retreated to the lowest level in nearly five years as investors worry that global production could overwhelm demand for the fiber.

The U.S., the world’s biggest cotton exporter, is expected to produce a large crop in the season that begins Aug. 1. But global demand is likely to fall short, especially with top importer and consumer China wrapping up a 2-year stockpiling program. U.S. government forecasters predict the amount of cotton left over in warehouses world-wide when the next season ends will reach an all-time high of 105.7 million bales.

“That’s going to weigh heavily on world supplies,” said John Flanagan,presidentof brokerage Flanagan Trading Corp. in Fuquay Varina, N.C. “Prices are on their way down to the 50-cent level.”

Cotton prices last traded around 50 cents a pound in April 2009. On Friday, cotton for delivery in December, the most actively traded contract on the ICE Futures U.S. exchange, fell 1.1%, to 65.35 cents a pound. It was the lowest closing price since Oct. 12, 2009, and down 3.5% for the week. The front-month contract, for October delivery, ended down 1.9%, at 65.16 cents a pound.

“We’ve had great weather and that’s got everyone on the run,” said John Payne, market strategist at Daniels Trading in Chicago, referring to growing conditions in Texas, the top U.S. cotton-producing state.

After years of drought, Texas has begun to see rain in cotton-growing areas. Government forecasters, citing the rainfall, recently increased their estimate for U.S. cotton output during the 2014-15 season by 10% to 16.5 million 480-pound bales, exceeding market expectations for a 4.7% upward revision to June’s estimate.

There are also concerns about weakening demand. The International Monetary Fund recently cut its global economic-growth forecast for this year to 3.4% from an April estimate of 3.7%, damping sentiment in the cotton market. Cotton prices are particularly sensitive to economic data, because demand for the fiber is tied to consumer spending on items such as apparel, bed sheets and towels.

China had been a major support for the market, quadrupling its stocks since it began a strategic purchasing program in late 2011. But that program is wrapping up, as China has had trouble unloading its massive stores of the fiber on the domestic market.

The recent drop in cotton prices could spark defaults from mills that contracted cotton at higher prices, said Jordan Lea, co-owner of Greenville, S.C., cotton merchant Eastern Trading Co.

After prices plunged from a post-Civil War high three years ago, a wave of defaults by mills hit balance sheets at some of the largest cotton traders, setting off a surge of legal battles, some of which are still unresolved. “It’s always the elephant in the room,” Mr. Lea said. “Anytime you get a move down like this, the risk exists.”

Fain Shaffer,presidentat Infinity Trading Corp., a brokerage in Indianapolis, expects prices to slide to 60 cents a pound in the near term. “We’ve got large production and questionable demand,” he said.

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Below is an approx cost structure ( does not include retailer/wholesaler markup) for a garment manufacturer. Key takeaway for me is that the really labor intensive part or what is called CMT ( cut, make, trim) in the industry makes up the bulk of costs and does not look like it can be automated much to save costs- need to probe management on this.

COGS SPLIT, %
Cut, Make, Trim (labor) 31
Yarn, textile manuf ( labor , energy) 23
Raw Materials 11
Supply chain overheads 8
Duty 8
Textile manuf profit 7
Other mfg costs 8
Freight 5
Source: Deutsche Bank estimates as reported in the Financial Times- May 2013


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KITEX’ US EXPORT MARKET SHARE

Some calculations based on Nikhil’s US imports data and Kitex numbers

1). As per US import data India exported 125m USD worth of babies garments in 2013

2). Kitex had a total garments revenue of Rs 350cr for FY 2014 ( pg 53 AR 2013-14) out of which 80% was to US ( as per this thread) so its exports to US in FY 2014 = ~USD 50m

3). 50m/125m= 40% market share. Does this sound right?

Other point to note is the rather slow organic US import growth of ~4-5% based on growth rate from 2012 to 2013 and ytd 2014 and 2013.

This would imply that for Kitex to majorly scale up it would need to take share from other players rather than depending on the sector itself growing fast.

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Had an excellent first discussion with someone from the Infantwear Industry in India.

These kind of discussions with industry insiders/experts are invaluable. We must get our focus right on prioritising the digging and focus all energies first on getting to industry folks:)

There is more to the story than is being put out!

1). There are lots of players who are scaling up in India. There is no big differentiator or technical superiority. Every knitting player in India can potentially match up to the technical or quality demands of any global brand. Everyone is looking to scale up vertically

You can get more on players from Apparel Export Promotion Council.

Task of the day : get insidehttp://aepcindia.com/and get us the key players scaling up in infantwear or get us a key knowledgable person contact in AEPC

Shirtings/Suitings woven players are a different kettle of fish - saying Arvind can’t or won’t to infantwear is like asking a cotton products manufacturer to start making silk products

2). On-time delivery, price competitiveness, Collections (design inputs) are the main things a global brand looks for while deciding

3). It’s a very very competitive world - Brands will move to where price is competitive

4). Huge difference between the way American Brands and European Brands operate. Americans its a volume game. European brands are much nimbler and under big profitability pressures/targets and work with much smaller volumes

These are the main new insights into the business/industry. Will try to summarise over next week as we look to identify and speak to more people and more players in this very industry.

Cheers

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92

Dear all,

Gokuldas exports are a big player in kids wear (not infant wear) exports. They had a turnover of rs.900 crs out of which 35% is from kids wear . Their ebitda is about 7%. They had cited increase in employee costs as one of major risks in their business. Appreciate if any of could comment if they had already studied gokuldas exports or check if they are worth comparing from 1) demand growth perspective 2) employee cost perspective

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I had a quick look at AR of Kitex and learned that the growth in profit in FY14 is on account of 1. Increase in income from sale of manufacturing scrap from Rs 1.6 CR in FY13 to Rs 15 Cr in FY14 and

2). Increase in forex gain Rs 2.5 Cr in FY13 to Rs 11.3 Cr in Fy14.

These 2 factors explain most of the improvement in profitability of the Company in FY14.

Cant see anything exciting in this!! Am I missing something??

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amit,

sales grew from 321 cr to 455 cr. difference is 134 cr, even after taking out 25 cr as explained by you the we still have a growth of 109 cr which is 33%

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A small video on moneycontrol.

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Hi Donald,

Thanks for sharing insights from your conversation with an industry veteran. Indeed we need to seek out more of them to get to the bottom of this sector. Do let me know if you come across any big player based out of Singapore, will try to get access. So far haven’t found any.

Today I listened to Kitex" June "14 results con-call ( available on Research Bytes) and what really struck me was the super gung-ho attitude of the CEO. A key point he made rather emphatically was that even with 500 cr one cannot replicate what Kitex has. He claimed that the infant wear industry was unique in its specific safety and security requirements and that it required years to acquire expertise that would interest major buyers. He made it sound as though Kitex had a really great moat.

This assertion though seems to contrast with the views of the industry veteran you spoke with who thinks anyone can scale up. Not sure at this point who is right.

Another important point he made was that " labor is not an issue for the next 5-10 years" reason being their access to trained labor pool across India who are happy to live in the Kitex campus and increasing levels of automation as volumes climb up.

Bobby

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Made a note based on Kitex COnference Call for Private Circulation… Sharing with VP members for their views and opinions…

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Aveek,

Thanks for the detailed notes, could barely follow the the CEO’s thick accent!

On your 3 questions, my thoughts are as follows:

1). KGL/KCL- not really a big issue with me, both will mint money as long as there is good business, CEO also categorically stated in the call that 1st preference for order fulfillment goes to KGL as long as there is sufficient capacity.

2). Infant wear growth- you can use US import data in this thread as a proxy, growth rate, it is around 4-5%, more growth will come from taking market share from existing players. This is no different from Cera and Mayur Uni taking share from the unorganized market thus growing above organic market rates.

3). Competition/moat- this is still a question mark for me. The CEO is full of bluster but we need to check this out with others in the game. Ultimately though proof is in the pudding. If Kitex delivers a couple of quarters more of solid earnings then the CEO is probably right.

Bobby

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Bobby

  1. KGL / KCL issue is a grey area … MD was clearly ambivalent in his response … My concern is not about KCL’s performance or its potential but their reluctance to merge it … I don’t think he is waiting to give KGL shareholders a wonderful merger ratio when the eventual merger happens … It is just a “red herring” for me.

  2. Yes, I know the growth rate of infant wear market but was talking about very long term… Unlike many other area, unfortunately we will have lesser kids in 0-2 years in any foreseeable future beyond next 2 - 3 years. But that’s not going to affect KGL / KCL in any way being a very small player and primarily growing by replacing other sundry smaller players. Yes, fully agree to your views.

  3. As I mentioned in the note, I don’t get visibility beyond few years for compounded growth … If margins can be as high as 30% with 30% - 40% growth in sales … somebody somewhere would wake up to it, rub his eyes and start chasing madly… !! CPSIA certification, Customer build up etc may be difficult to replicate in 2 -3 years but if the size of the pie is there with so much sugar left, somebody will surely jump and bite.

They have done a wonderful job and MD has all the reason to feel proud of it but as a minority holder I would prefer to be safe … At this price point.

Aveek

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Hey guys,

sorry for going missing but kind of been travelling a lot. I have asked a few of my friends to get me in touch with a merchandiser in Ki-Tex & Jay-Jay Mills, lets see what comes out of it.

Meanwhile went through the Annual Report of the Company& this threadto understand the business completely so as to ask intelligent questions to who ever I got in touch. I have a few doubts…

1). Why so much cash in Currrent Accounts?? There should atleast be a FD. There is no cash yield. The limited interest accrued from fixed deposits must be from various FDs submitted to authorities as secrurity deposit.

Before going to next point, let me clarify that in a garment operation generally 40% of cost goes for the fabric. In kidswear I would expect it to be 30%, especially because the workmanship as total percentage of costs is higher and also there is presence of more embroidery / garment-printing.

2). The biggest thorn is the related party transaction.

The capacity of fabric Capacity of KGL seems to be at 40% of their of Garment revenues, then why they have to source fabric from outside? Now one may argue it is due to mismatch between processing and knitting, so to fill this process house they source grey fabric, process it and sell it to fill their capacities.

In the con-call MD said they have 5blocks. and each blocks gives revenue of $13 - 15Mn. So 5 locks * $15 Mn * 60 = 4500Mn. The actual garment turnover of the company is at 3500Mn. The company already has excess capacity.Still the company sources about 50Cr worth of fabric from outside(10Cr from Kitex Limited), which is 30% of total fabric consumption. So though I can understand Fabric sales, I completely dont understand Fabric Purchases.

Also note total fabric consumption is at 176Cr which is at 50% of revenues of 350cr from the garment division. Way too high! Would request Donald to check with his source on this front.

3). The claim of MD that fabric manufacturing is a loss giving business i utter Bulls***. Dyeing charges for fabric in Maharashtra & gujarat are in the range of Rs. 80 per Kg, the same in South(TN/Kerala/Karnataka) is in the range of 120 - 140 per kg. All due to pollution control strictness and problems in this area. In todays times fabric processing is more profitable than garment business.

Knitting is very neglible profit operation & Spinning is cyclical but gives decent profit. If some body has everything inhouse I look forward to a minimum average profit of 20%. so for the 70cr fabric they sell to KCL I would expect a profit of 15Cr and not a loss of 10Cr from fabric division(understanding transfer of stock within the company is on no-profit/no-loss basis).

Given this I dont understand why management is pushing to increase capacities in knitting and not in Sewing which is their biggest profit generator.

3). Donald raised a issue about creditor days decreasing, it is quite natural to happen that way. Earlier they must have been sourcing fabric at credit but now sourcing more of basic raw-material like cotton would lead to faster payments, mostly immediate. Though they would be getting credit on other front like excess fabric purchase, chemicals, dyes, etc…

4). For 8 lines/1 block. MD says they need 500people / workers. They have 5blocks so max. labor required is 2500. why they have 3800??

5). If KCL is 60% of KGL, why does it also have 3800 workers?? And they say the capacity in KCL is still underutilised, so the issue raised by Donald about KCL having capacities more than KGL could quite be true. There is a major possibility that capital incentive Textile business is concentrated in KGL and low-capital Garment manufacturing is concentrated in KCL.

The point that no where lack of details about capacity in terms of number of sewing machines, Dyeing Machines, No. of spindles (yarn spinning) just doesnt seem right to me. Generally companies give these details upfront on website, but here the website itself is under construction for years(That too for a export company). Very un-professional I would say.

6). In branding excercise company projects to employ $10Mn. for a increase of 400 + 400 basis points. (Mentioned in the con-call). This leads to a 40% increase in PAT. So a additional income of 28Cr. Which turns out to be 5% return P.A. completely unjustified.

Also this concept of licensing the brand from Jockey and then re-licensing to Wal-Mart to Target just doesnt make sense. If Wal-mart is intrested in licensing the brand why wouldnt it purschase directly from Jockey?

Coupled with above 2, add the fact that they have recruited a VP from Toys-R-Us as Director of Operations(USA). This says that they are facing selling pressure, doesnt seem like a suppliers market. Garment industry has never been that way.

7). MD takes salary at 6% PAT.

These are some of issues I came up with, will keep prodding and try to get in touch with people of JJ and Ki-Tex. If somebody could answer these concerns of mine, it will be great.

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