Turnaround sector

GUEST COLUMN

Mudar Patherya says you may overlook the polyester industry's prospects only at your own risk.

Writing a column implies that you possess the sesame to investor problems, that MDs share their results with you even before the quarter has ended and that your shoulder is broad enough to play Agony Uncle.

So consider the fallout of putting my email address at the bottom of this page:
"When will you, Mudarji, write about an industry that is turning around?"
"When will you help me treble my money so that I can get my son married?
"What valuable advice will enable me to recover the losses incurred over the years?"
Friends, please consider this column as a humble one-stop reply.

So read carefully on. For years, one steered clear of the POY (partially oriented yarn) industry on the grounds of over-competition and erratic profitability. From now on, you may overlook the industry's prospects only at your own risk. Reason: the turnaround has begun, manufacturers are making money hands over fist (cliché!) and investors who buy into selective stocks will stand to make handsome gains a year from now. I intend to finally buy my peace with this column.

But wait, I claim no privileged information. I have simply drawn from the most widely circulated annual report (Reliance Industries 2006-07) in India today.

This is what it states: "The ability of polyester producers across Asia to successfully pass through higher costs in 2006 gives an early indication of the emerging strength of the sector. The slowdown in the new polyester capacity expansions accompanied by increase in the demand is expected to improve the capacity utilisation in polyester operations. The industry is at an early stage of a multi-year up-cycle."

Multi-year! Reliance's argument is based on the interplay of diverse developments. First, the macro argument: Polyester production has moved from the west to Japan to Taiwan-Korea and now to China-India, billed as the polyester hubs of the world.

Secondly, as capacity addition peaked in 2003-05 and almost 12 million tonne of effective polyester capacity was added in Asia, the older players "� with higher production costs of $ 40-70 a tonne "� were edged out of the business, reflected in more than a million tonne of capacity closure from 2003 to 2007 and polyester production decline by around 1.8 million tonne in these countries.

Thirdly, only one new polyester player is expected to go on-stream in 2007 compared to an average of nine during 2003-2005 in China; correspondingly, Asian annual polyester capacity additions are projected to slow from 23 per cent in 2003 to 6 per cent in 2007 and 2008 while demand is expected to remain healthy at 10 per cent.

Fourthly, more than 10 million tonne of polyester capacity is perceived to be batch, sub-economical and outdated, awaiting closure, while only 3 to 4 million tonne of batch capacities were similarly considered during the last uptrend.

Turn to demand-side economics. The demand in Asia is estimated to grow by 2.4 million tonne or by 6 per cent in 2007 and 2008 while capacity will increase by only 1.7 million tonne. The industrialisation of Western China is strengthening the demand for textiles, with that country's domestic textile consumption share expected to jump from 65 per cent in 2005 to 73 per cent in 2008.

Relatively low inventory levels may prompt restocking. The 2008 Beijing Olympics is expected to drive enhanced Chinese demand. The removal of residual quotas in 2008 on China by the EU could harden offtake.

So much for a continental perspective. Come home. Over 55 per cent of the 4.6 million tonne of textiles produced by India in 2004-05 was from cotton fibre, a picture that could flip in 2010-11. One number to chew at: analysts expect total production of fibre to be around 12.2 million tonne three years from now; non-cotton fibre could be a high 67 per cent, creating a demand-supply gap for chips and POY well into 2010-11.

So where does one put one's money?

Reliance Industries (Rs 2567): The great thing about Reliance is that when paraxylene supplies tighten, Reliance's captive supply will translate into higher margins; when POY turns buoyant, Reliance will simply recruit more people to count the cash.

The problem: with a number of diverse businesses at play, it will be difficult for a simple POY analyst to even make a reasonable estimate of Reliance's profits. Besides, a staggering market cap of Rs 362,374 crore supporting a multi-business company means you need to know clearly what you are doing. Skip.

Filatex India (Rs 40): Reported net losses for the first three quarters of 2006-07. Turned around in the fourth with a profit after tax of Rs 2.59 crore (excluding the interest write back of Rs 1.87 crore). Then tanked to a mere Rs 1.26 crore profit in the first quarter of the current year.

That's the decoy. Because if you lost interest at that point "� understandably "� you might have missed out on the makings of an interesting play. Check the EBITDA levels across the last two announced quarters: a profit of Rs 4.63 crore and Rs 4.76 crore. A rise in interest cover from 2.48 to 3.22. Rock-steady EBITDA margin of 6 per cent.

Look ahead. The company expects to report a top line of Rs 370 crore for the current year, a financial restructuring has increased equity to Rs 17 crore in exchange for an inflow of net worth while term loan debt is expected to be completely repaid.

My calculation is a cash profit of Rs 20 crore for the current year against a market cap of a little over Rs 60 crore and if Reliance's long-term trend call is correct, then you can live off the cream of subsequent growth and read subsequent editions of this column from Bali, Hawaii or Mauritius. Only don't forget to send me a thank you post card from there.

JBF Industries (Rs 161): Engaged in the manufacture of polyester chips and partially oriented yarn. The chips are used to make yarn, resulting in integration. Besides, JBF is an industry leader in polyester chips in India (market share 55 per cent) and the third largest POY manufacturer in India. Result: volume-value business model.

Let us take a quick look at the numbers. EBITDA margin has steadied around 12 per cent across the last five quarters; EBITDA strengthened from Rs 35 crore to Rs 61 crore simply because the top line strengthened from Rs 290 crore to Rs 495 crore during this period. My inference: a buoyant industry environment.

But what excites me about JBF is not just the realisations play but its volume proposition. Its existing annual yarn and chips capacity of 150,000 tonne and 334,800 tonne will grow to 258,000 tonne and 766,000 tonne respectively (including its Middle East presence), fully reflecting in the numbers in 2008-09.

The UAE operation commenced in July 2007, attracting tax benefits, low raw material cost, lower fuel cost by 50 per cent and the absence of customs duty. By the time this translates into full-blooded numbers, you could have an attractive proposition on your hands: an EBITDA of a shade under Rs 500 crore in 2008-09 (we are still looking only at Rs 240 crore if you annualise the numbers of the first quarter of the current year) on a fully diluted equity of Rs 75 crore.

So, figures over the coming quarters might prompt you to conclude that newspapers need better proofreaders. Compare that with a prevailing market capitalisation of Rs 1230.

Mudar responds with speed at mudar@trisyscom.com.
He holds stocks in Filatex India.