In the 80’s getting a new dress is an ordeal task. You go to the store and buy a piece of cloth for shirt and a matching cloth for pant. This piece of cloth is called as a fabric which is obtained by weaving a fibre like cotton. Then you take this fabric to a tailor who stitches it according to your measurement. This stitched fabric is called as a garment that we wear as a new dress. The entire process took a month in the 80’s.
Things are very different today. I take my kids to Kohl’s and buy them ready made garments. The entire process takes less than one hour and I buy it at a very low price. This drastic improvement happened because of better technology, mass production, and specialization. The infant garments that Kohl’s sells are supplied by Kitex Garments which is the topic of this post.
Kitex Garments is in the business of manufacturing and exporting infant wear garments. It was incorporated in the year 1992 and it runs its operations from Kochi, Kerala. The company generates 80% of its revenue from exports and the remaining 20% comes from domestic sales. Majority of its customers are in the US. Its customers include Babies-R-us, Carter, Kohl’s, The Children Place, and Walmart. It sells both fabric and garments to its customers. Around 70% of its sales and 100% of profits comes from selling garments. Kitex is the 3rd largest infant wear supplier in the world with a capacity of producing 5.5 lakh pieces every day. The management is confident that they will become the leading manufacturer in the world before the end of 2015.
Textile industry is a highly fragmented, competitive, and a commodity business. You have to fight tooth and nail with domestic players and also with other low cost producing countries like Bangladesh, China, Pakistan, Sri Lanka, and Vietnam. In 2014, the domestic textile industry as a whole cranked out 14% return on capital employed. Compared to this, Kitex generated 38% return on capital employed. How did Kitex manage to achieve superior returns against the low base rate returns of the industry? In order to answer this question we need to know (1) what assets are needed to produce a garment (2) how much profits the company keeps in its coffers by selling these garments. For answering the first question let us look at the balance sheet.
From the table given below we can see that Kitex employs around 75% of its capital in fixed assets and the remaining 25% in working capital. It’s fixed assets include land, building, and machinery. The company has its own processing plant in a single location which enables it to produce better quality garments at a very low price due to scale advantages. Its working capital assets includes (1) inventories; mostly cotton (2) majority of its customers are big retailers and it has around 12% of sales as accounts receivable (3) accounts payable; payments that it needs to make to its suppliers.
From the income statement, I extracted sales and pre-tax operating income for the last eight years. Looking at the table few questions came to my mind (1) in 2009 the world went into a great recession. But Kitex’s sales did not go down during that period. Why? (2) in the last eight years the company compounded its sales at 14.25%. But its pretax operating profit compounded at 46.05%. How can operating profit grow faster than sales? (3) sales grew at double digits only in 4 out of 7 periods. Why?
Before answering these questions, let us look at its return on capital employed (ROCE). In the last eight years, Kitex improved its ROCE from 5% to 60%. These are phenomenal returns and it achieved this by improving both its asset turn over and operating margins. It improved its asset turn over by better fixed and working capital management. From the chart given below, you can see that its investment in fixed capital has gone down over the years for producing Rs 1 in sales.
Its operating margins improved because of its investment in better machinery and technology which increased efficiency, reduced wastage, and man power. In the latest conference call, the management told that its technological investments resulted in increasing the number of stitches per minute from 6,000 to 9,000. Also low cotton prices helped its margins. Around 80% of its cost goes towards raw materials and labor. From the chart given below you can see that the company was able to drastically reduce both these expenses.
Now it’s time to answer some of the questions that I asked earlier. Even during 2009 recession its sales did not go down. This shows that infant wear products are recession proof. Parents will cut down their own expenses in order to provide food, clothing, and shelter for their infants. So sales not dipping during recession should not surprise anyone.
Whenever you find operating profits growing faster than sales you should look for operating leverage. This measures the sensitivity of operating income to changes in sales. In order to understand this concept you need to know about two kinds of costs (1) fixed cost; these costs don’t change as sales change. Some examples are depreciation, administrative expenses, and some percentage of labor costs (2) variable cost; these costs change as sales change. Some examples are material costs and large percentage of labor costs.
Take a look at the table given below. Sales grew by 100% but profits went up by 140%. This is because of the existence of operating leverage of 1.4. The calculations of how I arrived at 1.4 is given below. Operating leverage is a powerful force which magnifies profits (up and down). Mr. Market sometimes does not account for this and misprices the stock. If you keep your eyes open for operating leverage then you can find some multi baggers.
Contribution Margin is the difference between sales and variable costs. This is the amount that is left over to cover fixed costs and provides profits. Contribution Margin = (Sales - Variable costs) Contribution Margin2013 = (100 - 30) Contribution Margin2013 = 70 Operating Leverage2013 = Contribution Margin2013 / Profit2013 Operating Leverage2013 = 70 / 50 Operating Leverage2013 = 1.4 %Change in profit2014 = Operating Leverage * %Change in sales2013 to 2014 %Change in profit2014 = 1.4 * 100% %Change in profit2014 = 140% [ Profit increase from 50 to 120 is 140% ]
By looking at the income statement of Kitex, we can’t differentiate between fixed and variable costs. But that doesn’t preclude us from seeing the presence of operating leverage. All you need to do is divide the percent change in operating profits by percent change in sales. The chart given below show the existence of operating leverage.
Kitex sales grew in double digits in 4 out of 7 periods. Few reasons that lead to the sales growth are (1) increase in 2010 could be because of the world coming out of recession (2) increase in 2011 can be attributed to rupee depreciating against the dollar (3) increase in the last couple of years can be attributed the tragic incident that happened in Dhaka, Bangladesh in 2013. This made Western retailers to seek quality sources like Kitex.
Kitex has two sources of competitive advantage (1) low cost producer due to scale advantages (2) high switching costs for its customers. Professor Bakshi wrote about this already and you can find the excerpts given below.
It’s fully compliant, large scale operation (the company can manufacture about 250,000 pieces of infant-wear every day), its fair treatment of employees, its focus on automation, and other factors gives it a low-cost advantage over its competitors which is hard to replicate. For example, given its large business volume, the per-unit cost of social compliance for Kitex is much smaller than that of thousands of sweatshops, most of whom simply can’t afford to comply. Kitex will continue to gain market share from them because— thanks to its low cost advantage — it can charge the same price for its products than it’s non-compliant competitors and yet earn healthy profit margins. Another source of Kitex’s competitive advantage is high switching costs for its customers. Large buyers of garments spend significant amount of time and resources in selecting and approving vendors. Once a vendor has been selected and approved, then so long as it’s compliant with quality, safety, and social compliance standards, its very difficult and costly to switch to another vendor just to save some money. – Professor Bakshi
In the latest conference call, the management told that its pricing power with its customers improved a lot. By looking at the gross margins we cannot conclude if that’s the case as majority of margin improvements came from better technology. And sales increase came mostly from volume growth. So I looked at its accounts receivable days. From the chart given below we can conclude that the company is doing a good job in collecting cash from its customers. It doesn’t prove the presence of pricing power. But it shows that its customers want its products and paying cash sooner than later.
Big retail customers look for three things from the suppliers of infant wear products. They are (1) low cost (2) high quality (3) timely execution of orders. Even though this industry is extremely competitive, Kitex is the only company possessing all three qualities. This will enable the company to maintain the durability of its moat for a very long time.
The big business houses in the USA and Europe manufacturing and dealing in textiles and garments depend upon India, China and the neighboring countries, due to availability of the raw materials and skilled labour at lower prices in these countries, to get the required output at the lowest possible cost. However we perceive threats by way of competition from the neighboring countries like China, Pakistan and Sri Lanka. Although the competition is hectic we have an edge over others with our quality and timely execution of orders. – 2014 annual report
In 2008, Kitex’s total capital employed in its operations was around Rs 130 crores. In the next six years it added another Rs 112 crores as capital expenditure. Adding this together we get a total of Rs 242 crores. On this capital it produced a total pretax operating profit of around Rs 410 crores from 2009 to 2015. Every rupee invested in the business produced Rs 1.69. These are fantastic returns and it tells that the management is very efficient in capital allocation. It achieved these returns without taking any additional risks (leverage) as indicated by the reduction in debt-to-equity ratio. In the latest conference call, the management told that they will take additional orders only when they are confident about delivering it on time. This shows that the management is conservative in nature.
Sabu M. Jacob is the managing director of Kitex. From 2011 to 2014 his compensation increased from Rs 1.64 crores to Rs 4.64 crores. On average his compensation represents 4.5% of pre-tax operating profit. This is definitely on the higher side. He is a type two owner operator.
This is an owner-operator who is passionate about running the business but is in between the two extremes of being completely stakeholder oriented and operating the business for his or her own personal benefit. These managers typically receive higher compensation packages than OO1 managers. – The Investment Checklist
The company has a lot of related party transactions with enterprises owned or controlled by its directors. This is definitely a concern. But there is some good news. Kitex already appointed Ernst and Young to merge Kitex Childrenswear with Kitex Garments.
In FY2015, Kitex generated a pretax operating income of Rs 147 crores. At 10% cost-of-capital its operating assets should be worth Rs 1,470 crores. Clearly the economic value of its operating assets is much higher than its accounting value of Rs 243 crores. After paying down all its debt it will still have Rs 62 crores of cash left in its bank account.
No growth valuation of Kitex will be Rs 1,532 crores. As of this writing its market capitalization is Rs 3,159 crores. At this price the market expects the company to grow its residual operating earnings at 5.25%. If you consider Kitex stock as your savings account then at the current price you are getting a pretax yield of 4.75%. Is this high or low? In order to answer this question, we need to know the market size of infant wear.
The global infant wear market size is around $20 billion and India represents a very low single digit market share. Of this low single digit market share, Kitex controls 70% share. Kitex’s management expects to grow its top line between 20 to 25%. If we assume its top line to grow at 20% for the next ten years then in 2025, Kitex will generate a revenue of around Rs 3,164 crores (~ 527 million).
This will give Kitex around 3% global market share in 2025, which is very low for the world’s largest producer of infant ware. The company seems to have an earning power to generate pre-tax operating margins of around 25%. After paying taxes at the rate of 34% its profit after tax will be Rs 514 crores. At 20 times earnings the company will be worth Rs 10,280 crores in 2025. From the current market price the CAGR comes to 12.5%.
The company is currently having a lot of tailwind going in its favor. Some of them are (1) quality issues in Bangladesh and delayed orders in China (2) low cotton prices (3) investment in technology helped to improve efficiency and reduce wastage (4) by the end of this year it will introduce its own brands in the US. If this works out then it’s an icing on the cake and this will result in further margin improvements. If the movie unfolds as expected then odds of Kitex stock exceeding the CAGR of 12.5% is very high. As of this writing I do not own any shares of Kitex Garments.