Denims - not in fashion but made to last

SECTOR REVIEW

8.74 33.35 59.60 OPM (%)26.00400 bps

9.1#

140 bps

23.20480 bps Net Profit82.28114.80

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17.5795.00 NPM(%)9.70500 bps

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12.30440 bps P/E based on FY06E14.37

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17.20

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6.40

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 * Probit before Interest and Tax(PBIT)   # PBIT margin  Going forward, Indian denim industry should continue to do well. There are several reasons.  Firstly, India's per capita consumption of denim is really low at 0.1 meter, which is one-fifth of the global average in 2001 according to the US International Trade commission.  Changing demographics with increasing proportion of young population and changing perception of denim from simply a rugged and long lasting material to an icon of style and fashion should mean more denim sales. The growing mall mania is only likely to accelerate demand further.  According to the chairman of a leading Indian denim manufacturer, demand is continuously growing. This is because; denim is no longer restricted to only men's wear. There is greater acceptance among women and kids. In India, it is also finding wide acceptance in small cities and villages. Even more, denim is now being used for not just garments but for a variety of other products like pillow cases and upholstery.  Globally too, there has been a shift in the supplier base. This is because most of the plants in the US, the biggest producer of denim till late nineties, have closed down.  And now denim supplies are primarily from countries like China, India, Bangladesh and Sri Lanka as they enjoy low raw material as well as labour cost advantages. Asia now accounts for 50 per cent of the global denim capacity. Overall, the removal of quota restrictions and growing consumption in Asian economies is aiding higher growth for the industry.  But there is a flip side to this growth. The robust demand in the domestic market encouraged players to plan massive capacity expansions in the past couple of years.  Further, robust export demand for denims in 2004-05 much before the quotas were freed, also compelled major Indian denim exporters to hike capacities liberally. For example, Arvind Mills, which is one of the largest exporters of denim, saw its exports climb by about 42 per cent in 2004-05. Notably, the first three quarters of that fiscal still had quota restrictions.  According to industry estimates, capacity addition of around 150-200 million meters or supply growth of about 50-100 per cent is expected over next two years in the domestic market.  Domestic industry leader, Arvind mills, is adding capacity of 10 mn mtrs to increase its total capacity to 120 mn mtrs. Raymond with a capacity of 30 mn mtrs is expected to add 10 mn mtrs by March 2006. Aarvee Denim is planning to expand its capacity from current 47 mn mtrs to 100 mn mtrs by FY08.  Similarly, small player like Soma textiles is going for expansion cum modernization. The company plans to invest around Rs 55 crore and hike its denim capacities from 6 mn mtrs to 16 mn mtrs.  Suryalakshmi Cotton mills is expanding its capacity from 25 mn mtrs to 40 mn mtrs and also integrating backward for its increased yarn requirements, the benefits of which will accrue in FY07. Further there are many more unorganised denim manufacturers.  Not only this, there has been capacity additions globally as well. According to industry players, apart from massive expansion in China, there has been capacity additions in Bangladesh (40 mn mtrs), Pakistan (60 mn mtrs), Turkey (60 mn mtrs) and Indonesia.  In a nutshell, though demand is expected to remain string, industry sources expect huge supply growth as a cause for concern. According to a senior company official of leading Indian denim player, global demand for denim is expected to grow at about 5-6 per cent, however, global supply is expected to outpace demand growing at about 8 per cent.  Moreover, export demand for denim is more in the form of garments as in the post quota era the developed markets are directly importing garments rather than fabrics.  Though large players like Aarvee Denims, Arvind Mills and Raymond have garmenting facilities, they still do not have enough scale to cater to the garmenting demand. Besides, other small players have insufficient denim garment capacities for the export market, which induces them to dump the products in the domestic market.  Similarly, while domestic demand is expected to grow at 20-25 per cent, industry sources expect supply growth to be in excess of 50 per cent. All this obviously means pressure on prices and margins.  Denim makers witnessed better realisations in 2004-05 with average prices moving up by about 4.3 per cent. Going forward, industry sources expect prices to decline by 5-10 per cent due to overcapacity in the industry and competitive pressures in both the domestic and the international market.  Denim prices have been declining since the beginning of the year. For example, average realization of Arvind Mills has declined by 5 per cent, from Rs 104.7 in Q3FY05 to Rs 99 in Q2FY06.  On the other hand, prices of cotton, which is the main raw material and forms 50 per cent of net sales, are expected to rise owing to incessant rains in major cotton growing areas like Andhra Pradesh, Maharashtra and Haryana.  Global supply deficit and higher exports of Indian cotton projected at about 20 lakh bales (1 bale is 170 kg) is not helping either. Recently cotton prices have risen by 5-7 per cent. Thus margins are expected to be under pressure. Industry experts expect margins to come down by 1-2 per cent after the third quarter, though some of them expect prices to stabilise after a year or so.  Says Kapil Bagaria of Sushil Stockbroker Pvt Ltd " The players who concentrate more in the domestic market will fare better than the players who completely rely on exports. Aarvee denim is expected to be the biggest beneficiary from the margins front."  Bagaria advises investors to adopt a wait and watch policy for Arvind Mills, the largest denim maker in the country. The export markets seem tougher currently and Arvind Mills being the largest exporter faces a bigger challenge.  Arvind Mills, Raymond and Aarvee Denim are expected to trade at a forward earnings multiple of 12.2 times, 12.5 times and 4 times respectively for FY07E. Analysts feel that valuations of denim stocks look decent but one needs to take a long term view.  Says the textile analyst from BRICS, "Existing investors in denim companies are advised to hold as of now but prospective investors should wait for next two to three quarters. Investors are advised to invest in the denim stocks for long term." In the denim basket, he is bullish on Aarvee Denims.