Kewal Kiran Clothing Limited - ICRA

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Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 ICRA Equity Research Service Kewal Kiran Clothing Limited Profitability indicators remain vulnerable to cotton price fluctuations; volume/margin pressures likely to ease from Q4, FY12 onwards when the decline in cotton prices will reflect for the garment retail industry KKCL, being a leading garments manufacturer, remains vulnerable to steep fluctuations in cotton prices. Raw cotton Domestic Cotton Prices (Sankar 6; prices for the Sankar-6 variety had increased from ~30,000 Rs/Candy) Rs/candy (1 candy = 355 kg) in July 2010 to ~62,000 70,000 Rs/candy (1 candy = 355 kg) in March 2011 on account of 60,000 demand revival in developed economies and production 50,000 disruptions due to adverse agro-climatic conditions in China 40,000 and Pakistan. The steep rise in cotton prices had resulted in 30,000 high cost inventories and hence constrained volume growth 20,000 as well as operating margins across the value chain until the 10,000 Q3, FY12. However, the raw cotton prices have corrected 0 significantly over the last 6-8 months to ~35,000 Rs/candy in Dec 2011 on account of deterioration in global demand outlook and healthy productions estimates for the 2011-12 cotton season globally. Source: EmergingTextiles.com; ICRA Equity Research Service Raw material costs accounts for a higher proportion of the Denim fabric costs due to higher cotton yarn usage than trouser/shirting fabrics. As a result, the denim fabric prices had risen by approximately 30-40% in the past one year while shirting fabric prices had risen by 20-25% in the same period. Faced with the twin challenge of rising input costs and excise duty hike, most players had increased their prices with KKCL increasing it by about 10-12%. Since the production cycle for branded apparel manufacturers function with a lag of about eight-nine months, the pricier garments produced from high cost fabric inventory will remain in the retail stores until Q3, FY12. This has led to some volume pressure as witnessed in slowdown in same store sales during the current season as well as margin pressure as the raw material cost increases could not be passed on completely. The lower cotton costs will start reflecting for branded apparel industry only from Q4 FY12 onwards, easing pressure on the volumes as well as operating margins of the players across the value chain. Regulatory changes a risk factor.. The company also remains vulnerable to regulatory changes like the 10% excise duty levied on all branded apparel during the last union budget, leading to a cascading effect across the value chain. After a representation from the industry participants, the government agreed to a partial rollback, imposing the duty on 45% as against the earlier 60% of the MRP. The excise duty hike complicated matters at the time when the industry was already grappling with severe cost inflation and higher raw material (cotton, polyester, etc) prices. Besides, the organized retail industry in India continues to suffer due to stringent labour laws, multiple licences and clearances (40-45 approvals) required for setting up and operating a retail stores, high stamp duties on property deals and exceptionally high property prices and lease rentals in cities due to urban land ceiling act and delays in new project approvals. Although the proposed goods and services tax (GST) is expected to reduce complexities in doing business and allowing foreign direct investments (FDI) in multi-brand retail is expected to improve efficiencies across the supply chain and give a boost to KKCL’s MBO & national chain store sales, the timelines for their implementation continue to remain uncertain. Free Trade Agreement with Bangladesh likely to result in cost efficiencies for the branded apparel companies KKCL’s strategy towards outsourcing is expected to receive a thrust after the recent Free Trade Agreement signed with Bangladesh. Earlier, there was a cap on import of garments from Bangladesh at 10 million pieces, which is now removed with effect from September, 2011. Though the Bangladeshi garment sector lacks a raw material base, it has 12
ICRA Equity Research Service Kewal Kiran Clothing Limited emerged more cost competitive than even the Chinese manufacturers owing to significant low labour cost costs, economies of scale, flexible labour laws and subsidies from the Government which makes garmenting cost effective. The recent free trade agreement is likely to create substantial cost savings for the industry and help the branded apparel industry to reduce prices after recent inflationary trends witnessed over the past one year. KKCL has also started making efforts in this direction for exploring the options of outsourcing manufacturing to Bangladesh. Proposed Goods and Services Tax (GST) could provide further fillip The implementation of the proposed goods and services tax (GST) can provide further fillip to organized retail growth by reducing complexities of doing business, improving efficiencies across the supply chain and optimizing the taxation system of the country. Currently organized retailers pay value added tax (VAT: 5% to 12.5%) which is generally evaded by the unorganized players. Besides, organized retailers pay service tax (10.3%) on lease rentals which would be completely setoff once GST is implemented. Again, Inter-state taxes like central sales tax (2%) and local octroi taxes result in retailers having multiple warehouses to reduce taxes. This results in losses due to wastage, over-investments and sub-optimal inventories, while investments in high-end warehousing and storage facilities remain restricted. GST implementation will enable efficient implementation of hub-and-spoke distribution model, help rationalize entire supply chain, optimize warehousing capacities and reduce storage, handling and transport costs for the organized retailers. Besides, GST is expected to streamline documentation and reduce multiple tax incidences from central, state and local government bodies; thereby facilitating uniform retail pricing across the country. Robust growth expected over the next three years through product/brand extensions and entry into “lifestyle” products such as bags, headgear, eyewear etc. and personal care segment The company initially mainly focused on jeans under its flagship brand, “Killer”. However, over the years, it gradually expanded into other product categories such as trousers, shirts and T-shirts under “Killer” as well as its other brands. Additionally, most of the sales were of men’s apparels until now, with little focus on women’s wear. With the increase in number of working women, rising income levels and a cultural shift in favour of western outfits, the women’s branded apparels market has seen higher growth rates where KKCL has already started tapping the opportunity. We expect the proportion of sales from women’s apparels to increase in the coming future and drive part of the growth for the company. Additionally, with rise in disposable incomes, spend on personal care products like deodorants and lifestyle accessories such as eyewear, sunglasses etc., has received a huge thrust in the past few years. With the growth the segment has seen increased competition from players such as Provogue and Titan which have launched their own stores in the past. The company has started retailing such products through its newly launched “ADDICTIONS” outlets. Currently, the concept is in the initial stage and management expects to give the segment a push once it is able to gauge the initial market response and demand. We expect “ADDICTIONS” to contribute ~9% of overall sales by FY14. Asset light franchisee model leading to low capital requirements and high return on investments Post FY08, the company had changed its retail distribution model from company owned/leased stores to franchisee owned/leased stores, where the franchisee bears all capital investments as well as the operational costs, chiefly rental and overhead costs for the stores. While the company shares considerable margins with its franchisees, distributors as well as third party manufacturers; the asset light business model facilitates rapid ramp-up in operations without substantial capital requirements. Besides, substantial outsourced production provides economies of scale while keeping the company relatively immune to demand slowdowns or labour unrest related issues. Moreover, lower capital requirements results in robust return indicators (RoCE ~36%) and strong balance sheet position with almost zero debt and free cash & cash equivalents of ~Rs. 120 crore. Currently the ratio of company owned to franchisee stores stand at 1:8; going forward we expect the company to maintain such ratio and add about 75 exclusive stores in each of the next three years ensuring strong free cash flow generation and return indicators. 13
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