Just when the spinning mills were celebrating five good quarters, soaring cotton prices are set to spoil the party. Domestic cotton prices have shot up 61% from the beginning of the last season (October 2009) till date. Spinning mills are flummoxed, as cotton accounts for nearly 70% of their total costs.

Besides, given the resistance from textile firms to buy yarn at higher levels, mills could hike prices by only 37-40%.

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This implies a squeeze on profit margins. The June quarter had seen improved performance by spinning mills after suffering huge losses during the 2008 meltdown. Leading players such as Vardhman Textiles Ltd, Alok Industries Ltd, Ambika Cotton Mills Ltd and KPR Mill Ltd posted a year-on-year (y-o-y) sales growth in excess of 25%. Operating profit margins (OPM), too, improved by 200-300 basis points, resulting in a higher net profit. One basis point is one-hundredth of a percentage point.

The story has turned grim now. Says S.P. Oswal, chairman, Vardhman group: “In June-July, when mills agreed to reduce yarn prices to Rs170 a kg, cotton was ruling at Rs29,000 a candy. Since then, cotton has shot up 27%." A candy is 355.5kg.

Further, most mills have barely a month’s stock of cotton, whereas contracts with the textile makers are of a longer duration at lower price levels.

The only glimmer of hope is for cotton prices to come down. But that seems unlikely. The International Cotton Advisory Committee has, since last month, lowered its forecast of the 2010-11 global cotton production by 1.3 million tonnes (mt). Floods in Pakistan, the world’s fourth largest producer of cotton, are the key reason. China, too, has seen a shift away from growing cotton to food crops in recent years. The only silver lining is the US, which could offset this decline as the output is expected to be 50% higher. With rising consumption, global cotton stocks are down to 1989-90 levels.

Back home, India’s cotton output could increase by around 10% to 5.7 mt. But, with no restriction on exports, attractive global prices could see one-third of the country’s output exported. Cotton traders, the biggest beneficiaries of rising prices, are fuelling it by hoarding cotton in anticipation of further hikes.

Besides, spinning is a power- and labour-intensive industry. Costs on both fronts are rising too. Unless the firms are able to pass on rising costs, the December quarter would see most companies reporting lower operating profit margins. Further, according to Sridhar Chandrasekhar, head, Crisil Research: “The spinning firms have high debt on their books, which drag down the net profit margins." On average, analysts say that the profit before interest and tax of most midsize companies is only two-three times the interest cost.

From an investor’s standpoint, therefore, the spinning firms are likely to see peak profitability in the September quarter. Thereafter, though revenues could rise, profitability would be challenged. The only game changer would be a cooling off of cotton prices.

Graphic by Naveen Kumar Saini/Mint

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