Ind-Ra: Denim Industry Reels Under Cost Pressure; Credit Negative

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Ind-Ra: Denim Industry Reels Under Cost Pressure; Credit Negative

The Indian denim industry is likely to face deterioration in credit profile in the absence of improvements in realisations in FY18, says India Ratings and Research (Ind-Ra). The sectors operating margins are expected to fall to 10-11% in FY18 (9MFY17; 12.6%) due to cost inflation amid surplus capacity in denim standard products which have low cotton content.

Ind-Ra estimates prices to moderate in 2HFY18, highlighted in the report 'Stable Input Prices, Fiscal Incentives to Support Textile and Cotton in FY18'. However the denim surplus situation and inventory losses are likely to pressurise margins. Moreover, the man-made industry demands a level playing field for the taxation of cotton, which is exempt from indirect taxation. If cotton is brought under the Goods and Services Tax (GST) then cotton fabrics including denim sector's profitability may come under pressure in the transitory period.

The agencies denim peer set average EBITDA margins deteriorated in 9MFY17 to 12.6% from FY16's 13.2%. The fall in margins is on account of players' inability to completely pass on the increase in cotton prices, on the back of high competitive pressure, similar to the situation in FY14. Raw cotton prices have increased by 32.8% yoy in March 2017 and Ind-Ra expects it to remain elevated until 1HFY18.

For denim manufacturers' cotton forms more than 35-40% of the total raw material requirement. The agency notes that for many of the basic denim fabric manufacturers catering to domestic consumption, average realisations remained steady, despite higher cotton prices in 9MFY17. However, some of them have been able to increase realisations for 4QFY17 partly passing the cost inflation with a lag. Denim garment players are likely to perform better than fabric players, as the retail margins may sustain as fabric prices remain under pressure.

Ind-Ra expects the denim sector to post robust volume growth of over 10-15% in line with the past trend along with rising disposable incomes, rapid growth of the retail sector, westernisation trend, young population demographics, and versatility of denim as a fabric. However, Ind-Ra views that the capacity addition is growing at a faster rate. Moreover, the existing capacities will face competition from new-age cost efficient plants.

The denim fabric industry is cyclical in nature and is characterised by periods of excess capacity followed by narrowing the demand-supply gap. The apparent short project pay-back has encouraged a number of denim fabric manufacturers to put up additional capacity, higher than the estimated demand growth.

Further capacity additions are likely to keep the domestic competitive pressures heightened. As per CMIE data, a moderate level of new capacity ramp-up is underway in FY18. This includes capital expenditure for expansion and backward integration by a few companies namely, Nandan Denim Limited, Raymond Uco Denim Pvt Limited and RSWM Limited.

Overall, the credit profile for most players has come under pressure also due to the stretched working capital cycle and debt-led capacity expansion in the backdrop of operating margin pressure. Aggregate peer set net leverage (Net Debt/EBITDA) increased to 4.59x in 1HFY17 compared to 2.83x in FY16. The working capital cycle has got stretched to 61 days in 1HFY17compared to 54 days in FY16, on account of the high credit period and inventory holding for the new capacity ramp-up.

Increased competition in the international arena and higher receivable days will impact the exports profitability. However, Ind-Ra believes the credit profile of value-add export-oriented manufacturers will remain robust. Industry players with diversified revenue lines with a mix of man-made textile products are better placed than the pure denim players. Also, companies with strong liquidity, low leverage and short working capital cycle are better placed to face the challenging times.

Ind-Ra's rated portfolio includes Sangam (India) Ltd. (SIL; 'IND A+'/Stable), Aarvee Denims Limited, ('IND tA-'/Negative), RSWM Limited and Ultra Denim Private Ltd ('IND BB-'/Stable). Financials of Nandan Denim Ltd, Jindal Worldwide Limited and KG Denim Limited also formed part of the peer set for this study.