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In my quest to find honest, well run and moated undervalued securities, I chanced upon the Cotton Textiles sector. I quickly realized that most of the companies (more specifically companies that spin cotton yarn and make fabrics) in this sector are trading at high single digit / low double digit PE due to commodity nature of the business.
The companies differentiating themselves in this sector see their valuation multiples expand. Companies that have commanded a premium overtime are those that have vertically integrated e.g., KPR Mills (not analyzed as of this writing), which makes apparel (including branded apparel starting 2019) from most of their own yarn and fabric.
In this sector, I looked at Ambika Cotton (disc: I have taken a small position in Ambika) and Vardhman Textiles. This writing is on Vardhman. Usually, I love getting to the point of valuing companies after I have analyzed their business and evaluated their management, but in this case I couldn’t move over to valuation. Reasons are presented below.
Business
Textile Value Chain: Spinning -> Fabric making -> Apparel making -> Apparel branding
VTL is into the spinning commodity cotton yarn (63% of FY22 sales) and fabric making (31% of FY22 sales; more or less at this level since the last 5 years) business.
In FY22, most of the spinners across the world did well and in FY23, the spinners saw their sales and margin drop due to falling demand and very high cotton prices.
Spinners like VTL are very sensitive to raw material prices and are easily replaceable (although, with increase in cotton prices the yarn prices also increase worldwide, but when Indian cotton prices are higher (than world cotton), then it puts Indian spinners in a disadvantage since Indian spinners alone will not be in a position to increase the yarn prices commensurately in the world market — this results into the business shifting outside India to countries like Vietnam). The sensitivity to raw material reduces as you move up the value chain. Spinners diversify either by producing specialty yarn, which is less sensitive to raw material (e.g., Ambika Cotton) and/or moving up the value chain (e.g., KPR Mills)
Note – American, Brazilian and Australian cotton sells typically at a $0.15 premium to NY futures and Indian cotton has a lower premium of $0.5. Although, length, touch, feel of Indian cotton is comparable (or even better) than others, but Indian cotton is contaminated because it is manually pit. Owing to this contamination, Indian cotton typically sells at a discount. However, in FY23 (and now in FY24), the Indian cotton prices are trading at par with American and that of other countries. In turn, Vietnamese yarn sells at a premium since they use American cotton. Since Indian cotton prices are high in FY23 (and now in FY24), Indian spinners are not making margins.
a. Continued focus on the commodity game
VTL has ~12 lakh spindles, which is 2% of India’s spindle Capacity (6 cr spindles). Each spindle produces ~200 kg of yarn annually. VTL plans to add 10% (i.e., 2.5 lakh spindles) of the industry’s incremental capacity addition (25 lakh spindles) over the next 3 years. While this appears as playing a commodity game, which is true, the good thing is that they use 25% of their own yarn for fabric making.
Per FY23-Q2 con call, VTL does not seem to have any plans to expand on cotton fabric (and garmenting), where in they use their own produced cotton yarn (and fabric). This is despite expressing cotton spindle expansion plans. Hence, it seems they will continue to play the commodity game without doubling down on the cotton fabrics. They do intend to expand into the synthetic fabric side, but synthetic fabric raw material is petroleum based, which means they will have to depend upon other (synthetic) yarn producers for synthetic/blended fabrics. They make only 1% of sales from garmenting, which is an area they have not expanded yet.
b. Not so much focus on captive energy i.e., operational efficiencies from existing business
VTL’s energy expense as % of sales is 8-9%, which is 2x that of Ambika Cotton, a company that produces all the power it consumes. VTL plans to add 10% (of 2.5 lakh spindles) of the industry’s incremental capacity addition (25 lakh spindles) over the next 3 years, and has not communicated on running more efficiently via captive energy consumption.
Management
a. High Incentives
- Promoter commission higher than the set limit: CMD, Mr S P Oswal received 42.44 cr in commissions in 2022. This is 2.74% of the Net Profit. However, per resolution dated 27th September, 2018, he can receive a commission “equal to 2% of net profit calculated as per Section 198 of the Companies Act, 2013 subject to total remuneration being within the limits as prescribed in Part-II of Schedule-V to the Companies Act, 2013“.
- Sticky performance incentives despite falling PAT: Per the annual report, for the JMDs Mrs. Suchita Jain (daughter of promoter Mr. SP Oswal) and Mr. Neeraj Jain (not related to the promoters), their “Performance Linked Incentives are decided by the Nomination & Remuneration Committee based on the profits calculated at the end of Financial Year. When PAT increased from 592 cr to 741 cr in 2019, their combined incentive increased from 1.28 cr to 1.62 cr. When PAT fell to 591 cr in 2020, their combined incentive fell very marginally to 1.59 cr and stayed at that level when PAT declined further to 427 cr in 2021.
- Associate company promoter commission exceeds the set limit: Mr. Sachit Jain, who was with VTL until 2018, is the JMD of Vardhman Special Steels (VSSL), which is an associate company of VTL. He is also VTL promoter Mrs. Suchita Jain’s husband. Mr. Sachit Jain’s commission is based on the VSSL’s Return on Average Net Worth: “1.5% of the Net Profit of the Company if RoANW for that year is up to 15%. 3% of the Net Profit of the Company if RoANW for that year exceeds 15%”. However, I see that Mr. Sachit Jain was paid 6.4% of Net Profit as commission i.e., Rs. 5.56 cr. in excess commission over 2021 and 2022. Moreover, when incentives amplify on crossing a threshold, it motivates clever accounting.
b. Related Party Transactions
Subsidiary Vardhman Acrylics paid a dividend of 200 cr on a net profit of 15 cr, resulting in reducing its book equity from 318 cr to 132 cr. VTL owns 70% of this subsidiary and hence, received 140 cr of this dividend. In fact, over the last 10 years Vardhman Acrylics has paid a dividend of 305 cr on a FCF of 228 cr. The 140 cr constituted 73% of the 193 cr dividends of the holding company VTL in 2022. In prior years, this subsidiary has constituted 20-25% of VTL’s dividends, but in 2022, VTL made up for its low payout by drawing 140 cr from VA at the expense of VA’s book equity. Hence, shareholders of Vardhman Acrylics compensated those of its holding company VTL.
c. Unexplained Miscellaneous Expenses
There is no explanation given regarding the “other miscellaneous expenses”. These are not small numbers. For context, these are 40% and 20% of the 2021 and 2022 capex respectively.
Summary
I am out for now because VTL is a commodity business with low moat / competitive advantages. I will consider though when they move up the value chain from spinning commodity cotton yarn to not just fabric making but garmenting. This will make them less sensitive to cotton prices. Moreover, unexplained miscellaneous expenses, high promoter incentives, related party transactions does not tick my investment checklist either.
Hope this was informative. Please feel free to write to me if you have any questions
Disc: I have a small position in Ambika Cotton. I have no position in Vardhman Textiles and KPR Mills as of this writing.