Prudent capex funding key to yarn mills’ profitability

Prudent capex funding key to yarn mills’ profitability

The going has been good for yarn mills for the past five quarters: Resurgent demand for yarn from the garments industry has helped them bounce back from the throes of global recession, despite soaring cotton prices. Most yarn mills are operating at high utilization rates of at least 90%.

Besides, industry estimates indicate a 10-11% increase in demand for cotton yarn over the next couple of years. Together, these signal a coming capacity expansion.

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A report by rating agency Crisil Ltd that covered 156 spinning units accounting for around 30% of the country’s total capacity says, “Capital expenditure (capex) may be necessitated because operating rates in the industry are already high, and current capacities may not be sufficient to meet expected demand."

For example, integrated textile company Alok Industries Ltd added around 68,000 spindles taking its total capacity to 4.2 lakh spindles per annum. More recently, south-based KPR Mill Ltd announced an addition of 1.5 lakh spindles to its existing capacity of 2.2 lakh spindles per annum.

This augurs well for cotton yarn spinners. Still, history has taught them lessons that merit a relook. After most companies added capacity in mid-2000s, they were hit by an unexpected global recession that saw their operating profit margins (OPMs) dropping by around 300-400 basis points year-on-year (y-o-y) to an average of around 13% in fiscal 2009. Debt-funded expansions compounded the problem. Despite getting a 5% interest subsidy, rising interest costs increased the debt-equity ratio of most firms. Interest costs as a percentage of sales rose, hurting profits.

As revenues bounced back in fiscal 2010, textile firms such as Vardhman Textiles Ltd saw their net profit margin (NPM) jump to 9% from 6% in the previous year. In contrast, those such as Alok with higher interest burden registered a dip in NPM to 6% from 9% despite robust revenue expansion.

Hence, it may be prudent for firms to take a cautious approach on capital structures given the cyclicality of the textile industry.

“Firms that plough back internal accruals and follow a judicious mix of debt and equity to fund capex could see improvement in credit risk profiles," says Gurpreet Chhatwal, director, Crisil Ratings.

The agency’s report further adds that the financial risk profiles of the firms under its coverage may deteriorate in the short-term. The sector’s average interest coverage ratio (the ratio of profit to interest payout) dropped to 1.7 in fiscal 2009 from peak levels of 3 in fiscal 2007.

Meanwhile, the government has also levied a cap on both exports of raw cotton and yarn for the year at 5.5 million bales and 720 million tonnes respectively which, in turn, could soften domestic prices. Analysts expect the OPM of yarn spinners to moderate from the present 16% to around 14% in the near term. Other factors, such as buyers’ resistance to higher yarn prices, power costs and currency exchange rates could affect profitability too.

Graphics by Yogesh Kumar/Mint

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