The Hindu Business Line : Spinning companies: Weave in a few

FOR investors, rock-bottom cotton prices could mean only one thing: A bumper year for spinning companies. Sluggish yarn markets notwithstanding, spinning companies turned in impressive performances in the first half of FY-06 and appear set to continue the trend in the second half as well. Over the past year, the stocks of traditional textile makers such as Mahavir Spinning, Super Spinning, Precot Mills, Ambika Cotton, GTN Textiles and Rajasthan Spinning, have outperformed the market and the likes of large, integrated players such as Raymond and Arvind Mills, which were in fancy in 2004.

As these stocks trade at 10-14 times their trailing four quarters' per-share earnings, they continue to be seen as attractive picks in the textile sector. Several spinning companies are morphing into integrated players with a presence across weaving, processed fabric and garments. Aided by low-cost loans from the Textile Upgradation Fund (TUF), they are on an aggressive expansion path. While there appears to be a strong preference for integrated players, however, the transition from a commodity-driven business to a technology- and design-led, labour-intensive business, poses a challenge for these companies.

Given the capital-intensive nature of these expansion plans, the risks are also high. Interest and depreciation costs are likely to temper earnings growth in the next couple of years, with most new capacities likely to go onstream in 2007. Moreover, cotton prices may behave less predictably in the year ahead, as global supply-demand gap narrows and supplies tighten for certain varieties of cotton.

Profitability trigger

Revenues of spinning companies in the first half of FY-06 have been flat, on the back of lower realisations of yarn prices. With preference for finished products on the rise, the export market for yarn has also stagnated, although domestic offtake has been strong.

Expenses have, however, dropped between three and five per cent, on the back of a more than 30 per cent decline in the prices of cotton — the main raw material and cost component for yarn-makers. This, coupled with low interest costs, has aided a healthy growth in profits. Margins have risen by anywhere between 200 and 500 basis points, as companies expended their cotton inventory over the year.

Cotton prices may, however, be less predictable in 2006. Although India has had a bumper crop, prices have risen from their lows. Yarn prices tend to move in the direction of cotton prices, although sometimes with a lag. This could put some pressure on margins for those who do not have adequate inventory of low-cost cotton.

A cut in global production and continuing rise in consumption would also lead to a fall in global stock levels. On the back of rising yield, India is among those countries whose production has risen this year as well. This makes textile companies relatively better placed to tap low-cost cotton. It might also trigger import of cotton and cotton yarn from China, where there has been a decline in production. Should this happen, the improvement in off take might partly compensate for pressure on margins.

On an expansion wave

The TUF scheme, which offers a five per cent interest subsidy for upgradation and modernisation of textile machinery, has had companies in the capital-intensive spinning segment expand like never before.

Mahavir Spinning, the country's largest yarn-maker, is planning to invest a whopping Rs 1,600 crore in phases over the next three years, to double its fabric processing capacity and expand and modernise its spinning and weaving capacity. Even smaller players such as Precot Mills have a Rs 90-crore expansion plan on the cards.

But, with the shortage in availability of machinery in the spinning segment, companies may be forced to import machinery at a higher cost or run the risk of delays in their expansion plans. The costs of expansion are, therefore, likely to put a strain on earnings growth in the near term.

Outlook and picks

AMONG the several spinning mills embarking on major expansion plans, those that investing in higher value segments such as fabrics, home textiles and garments are likely to command a premium in the markets.

These players would attain a higher return on their investment and be less vulnerable to the vagaries of cotton prices.

We take a positive view of companies that are already ahead in the vertical integration game. Mahavir Spinning (Rs 307), with a fabric business of Rs 300 crore, is a large player in the fragmented fabric industry, though the segment still contributes only about 15 per cent of its revenues. We re-iterate our buy on the stock, though the investment has to be viewed from a long-term perspective.

Super Spinning (Rs 411) is another stock that appears attractive from the medium-term perspective. The company has performed impressively and has a small equity base.

New capacities are set to go onstream in the first quarter of FY-07 and so the addition to revenues would be more immediate relative to other companies.

Players in blended yarn and synthetics are at a relative disadvantage to cotton textile companies, thanks to an inverted duty structure and low cotton prices. Rajasthan Spinning (Rs 124), however, merits attention.

The company is beginning to sell cotton yarn as well, which would be a hedge against pressures in the blended yarn segment.

Its foray into garments also appears to be paying off. The company is to produce trousers for UK retailer Marks & Spencers from July, which is an early indication of its competence in this segment.

Its plans to foray into the fickle denim segment are, however, a cause for concern. But investors with a one-year perspective can consider the stock.

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