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Arvind Ltd
A long-term growth story – initiate with BUY
We initiate coverage on Arvind (ARVND) with a BUY rating and a
December ’12 price target of Rs 96, an upside of 70% from current levels. We
are bullish on the Indian textiles space given the rapid shift from the
unorganised to the organised sector and the growing demand for branded
products. By virtue of its operational scale and early investments in brands,
Arvind is best positioned amongst peers to benefit from this structural shift in
the industry. The contribution of higher-margin and more capital-efficient
segments is increasing and we see return ratios settling at levels much higher
than those reported in the recent past.
The stock is trading at an attractive one-year forward EV/EBITDA multiple of
5.9x and one-year forward P/E multiple of 10.3x. We see a strong case for a rerating
going ahead. Considering the high levels of debt on the books, we have
used the EV/EBITDA method, valuing the stock at 7x one-year forward (implied
P/E of 13.2x).
Structural shift in the domestic textiles industry: According to Technopak, the
organised component of the Indian textiles sector will increase its market share
from the current 17% to 40% by 2020. This implies a growth rate of over 20%
over the next 10 years. Thanks to rising aspiration levels and higher disposable
incomes, the market share of branded products is also expected to increase
considerably in the coming years.
Advantage Arvind: Arvind is uniquely positioned to benefit from this opportunity.
The company made early investments in design, sales & distribution and
branding, and today boasts of strong network relationships and an impressive
bouquet of established brands developed over the last couple of years. These
brands, some of which have been made private labels, also give its value retail
initiative, Megamart, a strong competitive advantage over other retailers in
the segment.
High operational leverage: Propelled by healthy demand, we expect high
utilisation levels in most of the segments going ahead. There is scope for
significant operating leverage and we expect consistent improvement in margins
as well as return ratios. We forecast a 200bps expansion in EBITDA margin
between FY10 and FY13, with ROCE improving from 5.7% to 8.8% during the
same period. Higher cash flows will help reduce the company’s financial risk.
We see the interest coverage ratio going up from 1.12x presently to 1.97x by
FY13. All the above bodes well for a structural re-rating of the stock going ahead.
Investment rationale
Structural changes in the Indian Textiles Industry
Unorganised to Organised
According to a study by Technopak, the domestic textiles industry is expected to grow
from Rs 3,680bn in 2010E to Rs 10,320bn by 2020, which implies a CAGR of over
10.8% for the sector. Indian textiles exports are expected to clock a CAGR of ~12% and
should reach Rs 3,760bn from the current Rs 1,220bn. The organised component,
however, is expected to grow much faster.
The textiles sector in India has traditionally been dominated by SMEs because of various
regulatory restrictions on scale and also incentives given to smaller enterprises by the
Indian government. With reduced regulation, fast-changing consumer tastes and, finally,
increasing competition, business is shifting from the unorganised to the organised sector.
According to Technopak, the organised sector which has a 17% market share will grow
to 40% of the domestic market by 2020—a CAGR of over 20% in the coming decade.
Increasing share of branded products
The consumer in India was traditionally value-driven and hence, buyers interested in
branded goods constituted a minority in proportion to the size of the market. But this has
changed considerably over the years—with higher disposable incomes, rising aspiration
levels and increasing awareness about global brands, more and more consumers are
willing to pay a premium for branded products. The market is also seeing demand
graduating from lower-end to higher-end brands to match the rising aspiration levels.
Arvind better positioned than peers
Advantages of scale
Arvind is the largest cotton textiles manufacturer in the industry and hence enjoys a
considerable advantage of scale over its competitors. Incremental capacity additions are
underway with minimal overhead cost increases. Also, since the company has
integrated spinning facilities, it is in a better position to counter the threat of rising
cotton yarn prices. Due to in-house production of yarn, the company has been able to
source yarn at a 20% cheaper rate than its peers who procure the same from the market.
Early mover advantage
The global textiles value chain has undergone various changes over time and is highly
evolved as compared to the Indian textiles industry. Of the multiple components in the
value chain, only in the research, designing, marketing and logistics segments have
players been able to differentiate themselves in the long run. Manufacturing, on the
other hand, has become highly commoditised with scale (read access to cheap capital
and resources) as the only differentiator between players.
Over the coming years, revenues from branding and retailing would continue to
contribute a rising share to Arvind’s topline. The company started focusing on the
domestic retail segment a few years ago and has developed a healthy lead over its
competitors. It has 832 Shop-in-Shop (SIS) stores which focus on retailing of fabrics;
fabric retailing contributed close to 10% of the company’s revenues in FY10. Retail sales
from subsidiaries and JVs today stand at over Rs 6.5bn.
Established Brands
Arvind has a slate of owned and licenced brands which cover all the major segments
from formal to casual wear
Arrow won the “Best Iconic Brand” award from Pantaloon, one of India’s leading retail
chains. It was also awarded “Superbrands” status by the Superbrands Council of India.
US Polo, which was launched last year, has been a huge success for the company and
was awarded best “Debutant Iconic Brand” in 2009 by Pantaloon.
The company has plans to roll out several more international brands in India. The
management is also trying its hand at extension of established brands in related
segments. For example, Arrow which was earlier a men’s formal wear brand has
successfully been extended to the sports segment.
While each of the above brands enjoys high brand equity, we are bullish on the
competitive advantage of having a bouquet of such successful brands going ahead. We
believe that the share of multi-brand outlets (MBO), both in the ready-to-stitch (RTS) and
ready-to-wear (RTW) segments, will continue to increase. Hence, negotiating power is
expected to shift from the brand marketer to big MBOs, which like their global
counterparts, would try to increase the market share of their own private labels. Only
players like Arvind, which have multiple strong and established brands in their bouquet,
will continue to enjoy strong shelf space for their products. Single brand companies or
players with multiple mediocre brands will find it extremely difficult to negotiate
favourable terms with MBOs.
Differentiated strategy in value retailing
We are bullish on the future of value retailing in India. Numerous consumers are
expected to patronise value retailers as they hunt for bargain buys, before graduating to
buying branded goods at marked prices. Arvind’s strategy in its value retail business,
Megamart, is entirely different from other players in the segment such as ‘Brand Factory’
and ‘The Loot’. As against its competitors, Arvind does not have to solely rely on other
companies for its merchandise. This serves as a key advantage as the company uses
older but popular designs from its own premium brands to attract customers.
Secondly, unlike most other private labels, Arvind’s private label brands such as
Excalibur, Newport University and others already enjoy significant brand awareness.
Interestingly enough, this is primarily because the company had unsuccessfully tried to
launch these as national brands in the past. A typical value-conscious Megamart
customer, who is interested in discounted ‘known’ premium brands, also finds value in
good mid-tier ‘known’ brands. Hence, the company has a long-term competitive
advantage in this space.
Margin improvement going ahead
Operational leverage
Over the last couple of years, Arvind has made massive investments in building scale,
sales and distribution, designing, brand creation, and also in setting up its own retail
network. We believe that these investments create tremendous leverage for margin
improvement going ahead. This would include improvement in realisations, savings from
the bulk sourcing of goods and, finally, using the same network for distribution of
multiple brands.
By the end of FY11, the company is expected to have over 0.6mn sq ft of retail space in
its value retail subsidiary which, according to the management, will triple in the next
five years. With the success of Megamart, we expect a high proportion of franchisee
outlets going ahead. This would not only reduce the company’s capital requirements but
also increase the pace of the rollout.
Financial overview
Revenue mix to change considerably
We expect Arvind to report revenue CAGR of over 16% for the three years ending FY13.
While some of its business segments will grow at a rapid pace, we are not projecting
much growth in the garments and non-textiles businesses.
Strong EBITDA and PAT growth going ahead
The company is going through a phase of strong operational leverage. Hence, we expect
margin improvement at all levels in the next couple of years. We are expecting a 200
bps improvement in EBITDA margins between FY10 and FY13. The company should see
an improvement in realization because of a change in the revenue mix. This, along with
bulk procurement savings at the gross margin level should help in shaving off 70bps at
the COGS level. We expect another 130 bps improvement because of scale benefits in
employee and other S,G&A expenses.
Improving capital efficiency with reducing risk
The change in business mix towards higher capital-efficient businesses is helping Arvind
improve its risk profile. The graph below shows that the company will steadily improve
both its interest coverage as well as ROCE in the coming years.
Valuation rationale
Re-rating ahead; initiate with BUY
Most of the major players in the sector have diversified into other businesses, such as
real estate, which gives us a limited universe for comparative valuations. We therefore
look at multiples historically commanded by the company. Textiles is a cyclical sector
and because of high capital requirements and leverage in the system, Arvind has
endured various rough patches in the past, implying a limited P/E history. Also,
considering the high levels of debt on its books, we believe that valuing the company
based on a forward EV/EBITDA multiple is more appropriate than on an earnings-based
multiple.
We believe that improving operating and return ratios make Arvind a compelling story
for a re-rating going ahead. We have used a forward multiple of 7x as against the current
multiple of 5.9x to value the stock. At our target price, the stock will trade at 13.2x its
one-year forward earnings, which too isn’t expensive considering the company’s
improving risk profile.
High sensitivity to margin assumptions
We note that due to high levels of debt, the company has high sensitivity to our
assumptions of EBITDA margin improvement over the coming years. We have factored
in margin expansion of 200bps between FY10 and FY13.
Key concerns
Global or domestic slowdown
Arvind is the biggest denim exporter in the country. The company exported over 44mn
meters of denim in FY10 which was 50% of its total production for the fiscal year.
Denim demand is highly dependent on the macro-economic environment in the
developed countries as was seen in the last recession. A double dip in the global growth
would prove negative for the company. This apart, the domestic business will be the key
growth driver for the company going ahead and hence any unforeseen drop in domestic
demand would affect our estimates.
Rise in cotton Fibre prices
Raw material is the biggest component on the costs side for the company. Because of
high demand, the company has successfully been able to pass on the increase in cotton
prices over the last year to the end consumer. However, we believe that the same would
not come easily especially for the B2B segment in FY12.
Competition
We feel that the textiles sector will become more and more lucrative going ahead for
newer domestic as well as international players to enter the market. We expect to see
the launch of new domestic and international brands in India, leading to higher
competition in every category of the business. However, we believe that companies
with a single brand or multiple mediocre brands in their portfolio would not have a long
term competitive advantage in the market.
Licensed brands
Arvind markets various brands which have been licensed from its foreign owners under
a JV agreement. With increasing interest amongst international players to independently
tap the Indian market, there is an impending threat of the company losing some of these
brands. Last year, of the total sales of Rs 32bn of the company, Rs 1.06bn came from
such operations.
Company profile
Arvind is the largest cotton textiles manufacturer in the country with an installed fabric
capacity of over 200mn meters per annum. It is also one of the leading denim fabric
manufacturers in the world. The company has five major segments:
Denim
The denim division with an installed capacity of 100mn meters p.a. caters both to the
domestic as well as the export market. About 50% of the 88mn m of denim produced
last year was sold in the domestic market. The company plans to increase its capacity by
50% over the next four years with a total investment of Rs 3bn. This includes the set-up
of a 30mn m plant in Bangladesh, the first phase of which is expected to commence
operations in FY12.
Shirtings & Bottom Weights
With a manufacturing capacity of over 70mn m, Arvind is the largest producer of
shirting and khaki fabrics in the country. The company intends to ramp up capacity by
30mn m over the next three years with an investment of Rs 4bn. While it has
traditionally been servicing the B2B market, both globally and in India, it is increasing
its focus on the domestic B2C segment. The company has already opened 832
Shop-in-Shop (SIS) stores and hopes to double its revenue from fabric retailing from the
current Rs 4bn.
Arvind Retail
Arvind demerged its value retail business, Megamart, last year. The subsidiary sells
seconds and season-old inventory of major textile brands. Megamart has 0.45mn sq ft of
retail space in the form of 120 small format stores and 4 large format stores. The
initiative has been quite successful and is marginally profitable even at the PAT level.
The stores are making ~Rs 7,000/sq ft currently and are present mainly in the south of
India. The management aims to quadruple the space to 2mn sq ft in the next five years.
Given the format’s success, we expect the company to increase the number of
franchisee outlets. This would not only expedite rollouts, but also lower capital
requirements of the business.
Arvind Lifestyle
The branded apparel business registered sales of Rs 2.5bn in FY10. The segment houses
all the key brands—owned and licenced—of the company including Gant, Energie,
Izod, Arrow, US Polo, Cherokee and Flying Machine. US Polo, which was launched last
year, has been a huge success for the company and is already making double-digit
margins at the EBITDA level. Arvind plans to launch a couple more brands especially
targeting youth and women and also extend established brands to related segments.
Garments
The garments business, which recorded a topline of ~Rs 5bn in FY10 is the only lossmaking
segment for the company. The management is focusing on containing the losses
and does not plan to expand this business going ahead.
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