Arvind Mills an underperformer: Macquarie

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Macquarie has recommended an under performing rating on Arvind Mills . The downside risk in denim, the primary revenue driver, gas, a significant cost are the major causes. Research house, price target has been revised down by 14% to Rs 41 to reflect the cut in earnings estimates.

 

Macquarie research report on Arvind Mills

 

Event

 

Arvind Mills reported standalone 4Q FY3/07 results on 12 May. Recurring PAT declined 85% (to Rs40m), which was >40% below consensus and our expectations

 

Impact

 

Sales grew 35% YoY as the merger with Arvind Brands introduced the branded garment segment (Rs810m). On a like-for-like basis, sales increased 12%YoY, due to 65% YoY growth in garment exports volumes (17% of sales). Denim (40% of sales) declined 4% YoY as it experienced a 9% YoY decline in volume, partially offset by 6% YoY increase in pricing (figure 3).

 

Shirt fabric division (~14% of sales) sales increased 7% YoY (to Rs687m), on back of 10% YoY increase in shirt volume and 3% YoY decline in realizations. Garment exports now contribute 17% to top line (vs. 14% in 4Q FY3/06). While the ramp-up is encouraging, the contribution is not yet significant enough to offset weak results in denim.

 

Raw material costs increased 40% YoY, which offset the 35% YoY growth in revenues resulting in 27% YoY decline in EBITDA. Power costs increased 7%YoY as margin gains from the switch to gas from naphtha (for captive power plant) were affected, due to a cut in gas availability (refer to figures 1 and 2).

 

 Reported PAT contains forex gains (Rs83m) and a one-off extraordinary loss of Rs68m. Adjusting for these, Arvind reported PAT of Rs40m (figures 1 and 2), which is >40% below our and consensus estimates.

 

We believe weakness in denim is likely to last for at least 6-9 months. We may not see a solid turnaround for at least 12-15 months. Any turnaround will likely be impacted by a surge in power costs. This is because price renegotiations during the gas supply contract renewal in November 2007 are likely to increase power costs by 9% in FY3/08E and 18% in FY3/09E.

 

Earnings revision

 

 We reduce our FY3/08E EPS estimate by 14% and FY3/09E EPS by 7% to account for the more pessimistic scenario in denim business.

 

Price catalyst

 

12-month price target: Rs 41.00 based on a DCF methodology.

 

Catalyst: Higher power costs. Continuing weakness in denim business.

 

Action and recommendation

 

We reiterate our under perform recommendation due to the downside risk in denim, the primary revenue driver, and gas, a significant cost. Our price target has been revised down by 14% to Rs 41.00 to reflect the cut in earnings estimates.

 

Greater focus on garment exports and branded retail should lead to long-term margin expansion and help reduce the over-exposure to denim. Until then, the denim business will drive profits and share price performance.