INITIATING COVERAGE ARVND IN EQUITY July 11, 2016 …reports.ambitcapital.com/reports/Ambit_Arvind_Initiation_Theyarn... · Arvind’s cyclical textile business generated steady cash

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The yarn can spin only so much

Arvind’s cyclical textile business generated steady cash flows (FY10-16 CFO CAGR of 15%) and helped brands business grow to the second-largest branded menswear company. Opportunity to grow in the US$40bn apparel market (men/women) is high but track record is less than ideal (4 successes, 30 launches). Reluctance to fold up failures, insatiable hunger for brand additions (rather than extensions) and weak positioning of new hopes (GAP/Aeropostale to revered Zara/ H&M) drive our fears of underwhelming cash generation. We build 21% revenue and 34% EBITDA CAGR (FY16-19E) in brands (yet negative CFO) and steadiness in the textile business. Implied valuation (19x FY18E EBITDA) of the brand business is at marginal discount to ABFRL brand business despite latter’s materially better execution/portfolio/RoCE. The much awaited turnaround of Megamart/Unlimited is the key risk.

Competitive position: MODERATE Changes to this position: STABLE How long can the funding engine run? Textile division with CFO/EBITDA ratio of 80% over FY11-16 has funded its own and Brands capex. Arvind has done a credible job in re-aligning the textile portfolio using outsourcing, premiumisation and vertical integration. Quality, consistency and cost structure drive client relationships but limited reinvestments in the past constrain future growth; this and inherent cyclicality keep cash generation visibility limited and, hence, valuations also 5x EBITDA.

Brands: Good processes, adventurism and faulty perseverance Power brands’ (Arrow, USPA, Flying Machine and Tommy Hilfiger) success is built around brand extensions and proposition-price combination which are missing in 12 failed brands and yet to be seen in others. Cash from these falls short to fund continuing adventurism (Billabong, NEXT) and unnecessary perseverance (Megamart [21 years!], Newport, Excalibur). This has translated to lower asset turns (2.7x FY16 asset turns) and margins than peers. We expect 150bps improvement in brands EBITDA margin to 8% by FY18E but there are risks. Too early to be hopeful of Specialty retail

Sephora faces limited threat but other licensed brands such as GAP/ Aeropostale face insurmountable threats from Zara/H&M which are investing from deep pockets and are already profitable using low prices (15-20% cheaper) and fast fashion. Meeting `15bn revenues by FY21E will require bettering Zara’s 3x asset turns or more cash investments. We expect RoCE (post-tax) of 8%/11% in FY18E/19E and 16% in FY22E, thus limiting implied valuations. A better fit at lower price points Capital allocation and business mix have improved over the last decade but current valuations leave no room for negative surprises. We value brands business at `200/share (SOTP-based valuation: `311). Upside to our brands valuation (19x FY18E EBITDA) can only emerge from EBITDA growth higher than lofty 40%; brand launches without clear strategy will pull this lower.

INITIATING COVERAGE ARVND IN EQUITY July 11, 2016

Arvind LtdSELL

Retail

Recommendation Mcap (bn): `88/US$1.3 6M ADV (mn): `619/US$9.2 CMP: `332 TP (12 mths): `311 Downside (%): 6

Flags Accounting: AMBER Predictability: AMBER Earnings Momentum: RED

Catalyst

Brand additions will cap brand margins at 8% FY18E due to higher brandex.

Cash burn on ecommerce of `2.1bn over FY17E and FY18E.

Specialty retail will miss guidance in the face of competition from global chains.

Performance (%)

Source: Bloomberg, Ambit Capital Research

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6 ARVND IN SENSEX

Research Analysts

Abhishek Ranganathan, CFA +91 22 3043 3085 [email protected]

Mayank Porwal

+91 22 3043 3214 [email protected]

Girisha Saraf

+91 22 3043 3211 [email protected]

Key financials

FY15 FY16 FY17E FY18E FY19E

Revenue (` mn) 78,514 84,504 95,073 108,459 120,228

EBITDA (` mn) 10,129 10,651 11,890 14,271 15,815

RoCE (%) 11% 9% 9% 11% 11%

RoE (%) 14% 13% 14% 15% 16%

EPS 13.2 14.0 15.8 21.9 26.3

P/E (x) 25.1 23.6 21.0 15.1 12.6

EV/EBITDA (x) 14.5 14.1 10.1 8.2 7.2

Source: Company, Ambit Capital research

Arvind Ltd

July 11, 2016 Ambit Capital Pvt. Ltd. Page 2

Snapshot of Company Financials Profit and Loss Company Background Year to Mar (` mn) FY16 FY17E FY18E

Net revenues 84,504 95,073 108,459

EBITDA 10,651 11,890 14,271

Depreciation 2,559 2,949 3,352

Interest expense 3,811 4,266 4,269

Adjusted PBT 5,165 5,844 8,089

Tax 1,517 1,753 2,427

Adjusted net profit 3,648 4,091 5,662

Reported net profit 3,648 4,091 5,662

Profit and Loss Ratios

EBITDA Margin (%) 12.6% 12.5% 13.2%

Net profit margin (%) 4.3% 4.3% 5.2%

EV/ EBITDA (x) 14.1 10.1 8.2

P/E on adjusted basis (x) 23.6 21.0 15.1

EV/Sales (x) 1.8 1.3 1.1

Forayed into textiles in 1930 by setting up a mill with 1,122 looms.

Coined company’s philosophy (Reno vision) in 1986 and in the process established first denim manufacturing plant.

Entered into retail in 1994 by obtaining licensing rights of Arrow and inaugurated Megamart in 1995.

Undertook debt funded expansion in 1997 to setup a 120mn capacity plant and consequently ended up with a debt of ` 27bn (D/E of 5.7) at FY01 end.

Resorted to debt restructuring in 2001 and successfully de-leveraged its balance sheet.

Entered into JV in 2004 with Murjani Brands for licensing Tommy Hilfiger.

J. Suresh, CEO- Brands, initiates revamp of the brand and retail portfolio in 2007

Launched The Arvind store in 2010 for bespoke tailoring.

Acquires 49% stake in CK India by entering into JV.

Adds GAP to its kitty of rich brands in 2015 (specialty retail).

Balance Sheet Cash flow Year to Mar (` mn) FY16 FY17E FY18E

Total Assets 85,718 88,515 95,793

Fixed Assets 34,595 37,146 36,609

Current Assets 43,083 44,068 51,457

Investments 691 691 691

Total Liabilities 85,718 88,515 95,793

Total networth 29,117 32,424 37,361

Total debt 14,917 14,453 14,647

Current liabilities 39,794 39,881 41,955

Deferred tax liability 699 699 699

Balance Sheet ratios

RoCE 9% 9% 11%

RoE 13% 14% 15%

Gross Debt/Equity (x) 1.2 1.1 0.9

Net debt (cash)/ Eq (x) 1.2 1.0 0.8

P/B (x) 2.9 2.6 2.3

Year to March (` mn) FY16 FY17E FY18E

PBT 5,165 5,844 8,089

Depreciation 2,559 2,949 3,352

Tax 1,225 1,753 2,427

Net Working Capital (768) (1,375) (3,041)

CFO 8,992 8,762 8,804

Capital Expenditure 6,206 5,500 2,814

Interest received 412 1,168 1,438

CFI (4,977) (2,827) (1,376)

Issuance of Equity - - -

Inc/Dec in Borrowings 1,494 292 (242)

Net Dividends 784 784 725

Interest paid 3,801 4,266 4,269

CFF (4,093) (4,758) (5,235)

Net change in cash (78) 1,177 2,192

Closing cash balance 3,442 3,262 5,989

Brands & Retail business will continue to be funded by textiles Arvind’s branded portfolio has a few successes

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Arvind Ltd


From yarn to brands – work in progress From a local maker of saris and dhotis, Arvind transformed into a leading manufacturer of denim and high quality fabrics for shirts and trousers in the early 1990s. The company expanded its capabilities on the premise that exports from India would get more competitive with the depreciation of the currency. In the late 1990s, the company got into retailing brands through Megamart and thereafter steadily built a portfolio of brands – own as well as franchised – with latest being GAP and Aeropostale. The journey has been an eventful one, from facing bankruptcy in FY2000 to creating one of the fastest growing (25% CAGR FY07-16) branded apparel businesses.

Exhibit 1: A snapshot of Arvind’s various businesses and growth trends

Format Description Capacity/Stores FY16 RoCE

FY16 Capital Employed

(` mn)

Revenue CAGR

FY11-16

EBIT CAGR FY11-16

Competition

Textiles

Largest denim player in India and second-largest player in the woven’s segment in India; boasts a clientele of renowned international brands like Zara, CK, etc.

Denim – 108mn metres Wovens – 132 mn metres Garments – 23 mn pieces Voiles – 38mn metres Knits – 20mn metres

28% 30,631 12% 19% Vardhaman Textiles, Nandan Denim, Sangam

Brands & Retail

Has various international brands under its umbrella like Tommy Hilfiger, CK, Arrow, US Polo, etc. whose revenues have grown at a CAGR of 33% over FY11-16. Also, operates Megamart which has been repositioned as Unlimited from a discount retailer earlier.

EBOs-871 stores Megamart-92 stores

6% 15,046 22% 9%

Aditya Birla Fashion and Retail, Raymond Apparel

Others

Includes technical textiles, construction and project activity with more than 50% of revenues coming from technical textiles.

- 3% 5,807 9% -15% Welspun India

Unallocated - - - 12,489 - Negative

EBIT -


Exhibit 2: Arvind’s brand adventurism has not only been wide but also long…

Source: Ambit Capital research, Indicates Bridge to Luxury, Indicates Premium, Indicates Specialty Retail, Indicates failures

Arvind Ltd


Exhibit 3: ...hence Arvind’s branded portfolio has a few successes

Source: Ambit Capital research

Exhibit 4: Arvind has grown the fastest but is more capex-intensive

Madura Arvind Raymond

Existence of brands since

1989

1993

1986

Brand portfolio - number of brands

9 of which 4 are

core brands

30 out of which 4 are power brands

5 of which 2 are materially large

Capex intensity

Madura’s peak asset turns at 12x (net block) due to higher capex intensity

Arvind’s peak asset turns at 7.8x (net block) due to higher capex intensity

Capex intensity has been low at 4x as

most stores were franchised

10-year revenue CAGR (FY05-15)

24%

Led by product extensions

27%

Led by brand additions

14%

No major brand extensions or brand additions

RoCE- average of last 5 years

39%

Superior asset turns and brand extensions resulted lower brandex and

higher margins

7%

Lower asset turns, addition of brands and perseverance with non-performing

formats impacted RoCE

6.30%

Plagued by inventory issues, which affected margins and asset turns

Capital employed turnover

6.3x - High due to asset

light distribution and low working capital (working capital turns - 8x)

2.0x - Due to higher capex requirements and high working capital needs (working

capital turns - 3.4x)

2.8x -

Due to working capital turns at 2x

Reach - no of EBOs and area (mn sq ft)

1797 stores / 2.6mn sq ft

957 stores / 1.7mn sq ft

1,017 stores /

1.9mn sq ft

Key brands

Louis Phillipe Arrow Park Avenue

Van Heusen US Polo ColorPlus

Allen Solly Tommy Hilfiger Raymond Premium Apparel

Peter England Flying Machine Parx

The Collective Hackett

Key distribution points

Planet Fashion Large format Stores The Raymond Shop

EBOS EBOS Large format Stores

Large format Stores Megamart EBOS

MBOS MBOS


Arvind Ltd


Textiles – vertically integrated company Arvind is the largest denim and second-largest woven player in India. It has a strong institutional clientele base across the world and India for its denim products. After the learnings from heavy capex and downturn in the denim market in FY97-00, the company diversified into vertically aligned categories. Its wovens business has become as large as denims followed by garmenting. Consequently, Arvind has become one of the few vertically integrated textiles players in India.

Exhibit 5: Wovens has become a significant part of Arvind’s textiles division


Exhibit 6: Porter’s analysis of the textiles industry


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Denims Wovens (Shirting / Khakis) Garments Voiles Knits

Bargaining power of suppliers (deteriorating)

Low

Low switching costs due to overcapacity in spinning.

Backward integration by manufacturers can eliminate any distinct advantage suppliers possess.

Bargaining power of buyers

High

Customers (Brands) have bargaining power because of the sheer number of players crowding the industry which converts to zero switching costs.

Minimal product differentiation adds to the suppliers’ woes.

Competitive intensity

High

Surplus capacity and frequent capacity additions in Denim by domestic players.

Increasing international competition in garmenting from countries in like Bangladesh and Vietnam where labor cheaper than that in India.

Free trade agreements such as TPP put players in Bangladesh, Africa, and Vietnam at an advantage as they enjoy duty free exports to USA and EU.

Barriers to entry

Low

100% FDI is allowed in textiles and low capital (due to government subsidy under TUF scheme) makes it easy for new players to enter.

Large unorganised domestic market of buyers attracts small scale denim manufacturers.

Exhaustion on the product differentiation front and economies of scale for existing

players deter entry.

Threat of substitution

Moderate

Ancestrally set up unorganised sector continues to pose a threat.

3D Printing is a potential threat to conventional textile manufacturers as conventional modes of manufacturing lose relevance.

Unchanged Improving Deteriorating

Arvind Ltd


Denims - value addition and gateway to brands Denims have evolved from a volume business to a value-added offering. Consequently, there have been conscious cuts in capacity (reduction of 36mn metres over FY05-09) and focus on realisation (8% CAGR FY07-16). The company plans to continue pursuing this strategy. Its association with brands such as Lee, Wrangler, CK and GAP has led Arvind to becoming a licensee of these brands in India.

Focus has shifted from volumes to premium products

Over the years, the company made a conscious strategy to shift towards value-added products. The longstanding relationship with brands and learning curve from over 25 years of operations has helped it move up the value chain.

Exhibit 7: Denim volumes and realisations


Competitive dynamics

There quite a few large players in India and overseas which manufacture denim, with most of them vertically integrated into spinning, but only a few are into garmenting. Arvind is among the few which have garmenting as well as related products such as wovens. Most of its customers in denim are large foreign brands that are trend-setters in terms of design and seek suppliers who offer product innovation.

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Denim Volumes (mn metres) (LHS) Denim Realization (Rs/metre) (RHS) “Arvind has a 'New Product Development' team consisting of 8 people (one/two people dedicated to each segment – e.g. shirting, yarn dyed denim, etc.). This team is only responsible for product innovation and showcasing developments to clients. There is a separate 'Product Development' team of more than 30 people, which is responsible to develop products (not exactly innovation), but according to customer specifications etc." – A senior employee at Arvind

Arvind Ltd


Exhibit 8: Arvind is not only vertically integrated but also has a strong clientele

Company Capacity (annual production of denim)

Integration Other products Clients/brands Revenue

FY16 (` mn)

Arvind Limited

110mn meters

Backward: spinning

Forward: garmenting (23mn pieces) and branded retailing

Shirting and bottom weights fabric (130mn meters), knits fabric (5000 tons), knits yarn dyeing capacity (1800 tons), advanced material

Zara, Gap Inc, Patagonia, Tommy Hilfiger, Quicksilver, Calvin Klein, FCUK, Pull & Bear

54,073

Nandan Denim

110mn meters

Spinning capacity of 124 tons per day, (80% captive capacity)

Khaki: 10mn meters Shirting: 10mn meters (grey cotton fabric) Yarn dyeing facility of 20 TPD for denims (with sheet dyeing & rope dyeing technologies)

Predominantly the unorganised sector (less than 1% sales from nominated), a few brands including ColourPlus, Big Bazaar, Vishal Megamart,

10,965*

Aarvee Denim

85mn meters

Backward: cotton yarn (31500 MT) and textured polyester yarn (7500 MT) manufacturing

Forward: manufacturing 3.5mn jeans/trousers

Non-denim bottom wear (cottons and blend fabrics)

Own brands: De Extase, Fashion Wrapper & Aden Key clients: Walmart, VF Corporation

7,455*

Sudarshan Jeans

74mn meters Backward integration: yarn

spinning & dyeing facility (14500 MT)

Terry towel manufacturing (~8600 MT)

Export to countries including USA, Mexico, Bangladesh, Sri Lanka

n.a.

Etco denim 50mn meters Backward integration: yarn

spinning & indigo dyeing facility

No other textile related products; diversified into real estate and infrastructure

n.a. n.a.

Raymond UCO

47mn meters

Backward: spinning denim yarn

Forward: jeans-wear manufacturing facility ‘EverBlue Apparel Ltd’ near Bangalore

Worsted suiting fabric (38mn meters), cotton shirting fabric, manufacturing tailored shirts and suits

Own brands: Raymond, Park Avenue, Colour Plus Exporting across the world

n.a.

Bhaskar Industries

42mn meters Backward integration: yarn

spinning & dyeing facility No other related products

Exporting to Bangladesh, Sri Lanka, Nepal, EU and South America

7,796**

Oswal denims

40mn meters Forward: wide variety of

yarn spinning Specialty fabrics, performance fabrics, shirting fabrics,

Domestic clients: Allen Solly, Numero Uno, Spykar, Killer, International clients: VF Corp, Levi’s, ASDA, Own brand: Cotton County

n.a.

Sangam 40mn meters Backward: wide variety of

yarn spinning (73000 MT)

Fabric weaving (30mn meters), knitting (3000 MT); other business segments: steel, infrastructure, power & energy

Own brands: Sangam Denim, Sangam Suitings

15,115

Suryalakshmi Cotton Mills

40mn meters

Backward: yarn (cotton, polyester & blended) spinning capacity of 61000 spindles

Forward: manufacturing denim garments (1.8mn garments)

No other products Wrangler, JC Penny, UFO and other high street brands

7,050*

Source: Company, Ambit Capital research; *FY15 revenue figures and **FY14 figures

Arvind Ltd


Global competitive mapping for denims

Exhibit 9: Majority of Arvind’s competition for manufacturing of denim lies outside India; Arvind is the third-largest

Company Capacity ( annual production of denim)

Integration Other products Major customers

ISKO (Turkey) 250mn meters Backward: spinning of yarn

(using regular and organic cotton)

Holds 10 international patents, with more than 35 registered and trademarked brands, including Jeggings

Brand collaborations: Diesel, Replay, Pierre Cardin, Imps & Elfs, Topman, Guess, Esprit & others; distribution in over 60 countries

Vicunha Textil (Brazil)

230mn meters

Backward: spinning of cotton yarn

Forward integration: ready-made articles of clothing

Cotton fabrics, knit fabrics, and synthetic fibers and filaments

Calvin Klein, Diesel, DKNY, Gap, Guess, Levi’s Dockers, Liz Claiborne, and Tommy Hilfiger

Arvind Limited

110mn meters

Backward: spinning of yarn Forward: garmenting (7.2mn

pieces of jeans p.a) and branded retailing

Shirting and bottom weights fabric (65mn meters), knits fabric (5000 tons), knits yarn dyeing capacity (1800 tons), advanced material

Zara, Josepha Banks, Gap Inc, Patagonia, Tommy Hilfiger, Quicksilver, Brooks Brothers, Silver Jeans, Calvin Klein, FCUK, Pull & Bear, Jack & Jones

Weiqiao Textile Company (China)

76mn meters

Backward: spinning of cotton yarn (394,000 tons)

Grey cotton fabric (978mn meters)

ITOCHU Corporation, Texwinca Holdings Limited, Levi’s, Marubeni Corporation, Nichimen, Fountain Set(Holdings)Limited

Artistic Fabric & Garment Industries (Pakistan)

50mn meters

Backward: Spinning all types of high quality denim yarn (27,375 tons)

Forward: garmenting (25mn pieces per annum)

No other products Europe and US based high street brands

Siddiqsons Denim Mills Limited (Pakistan)

22mn meters

Backward: spinning (ring yarns, open-end yarns - in cotton, blended and polyester); specialty yarns

Forward: ready to wear garments (5.4mn pieces per annum)

Indigo knits fabric River Island, H&M, Alcott & Next

Source: Industry, Ambit Capital research

Wovens – Periphery to substantial part of business Wovens formed 19% of Arvind’s textile revenues in FY03 but its contribution fell to 13% in FY08. However, it has since emerged as the largest division of the segment. It has grown at 16% CAGR over FY02-16 and accounted for 37% of textiles in FY16. Arvind has added capacity in wovens (19mn pieces in FY10 to 23mn in FY16) to become the second-largest wovens player in India in terms of capacity and offers an end-to-end product range (core products are shirting fabrics and khakis).

Exhibit 10: Wovens volumes have been driven by capacity addition


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Woven Volumes (mn metres) (LHS) Woven Realization (Rs/metre) (RHS)

“Arvind is known for their fabric, like a brand, across the world; quality and service/delivery are the competitive advantages. Vardhman is a close competitor, who is also known for these parameters. These two companies do not compete on price like other players do. Expanding the shirting business was easy for Arvind; they already had the client base from Denim.”- A Senior executive at Arvind

Arvind Ltd


Exhibit 11: Arvind is the second-largest player in the cotton weaving segment

Company Annual weaving capacity

Integration Other products Revenue FY16

(` mn)

Vardhman textiles

180mn meters (for both shirting, tops and bottoms)

Backward: yarn spinning (1.1mn spindles/0.2mn MT)

Forward: processing capacity (114mn meters), garmenting (1.8mn shirts)

Specialty fabrics and threads, acrylic fiber and tow (20000 MT); diversified into steel business

66,370

Arvind textiles 130mn meters Backward: spinning

Forward: garmenting (23mn pieces) and branded retailing

Denim, knits fabric (5000 tons), knits yarn dyeing capacity (1800 tons), advanced material

54,073

Sangam India 30mn meters Backward: spinning of yarn (0.2mn spindles)

Denim (40mn meters), processing (54mn meters), circular knitting (3000mn pieces), seamless knitting (3.6mn pieces)

15,115

RSWM 18mn meters (suiting fabric)

Backward: spinning of yarn (grey/dyed, melange) with total 0.36mn spindles,

Denim (26mn meters) 29,694

Source: Industry, Ambit Capital research

Garmenting – vertical integration effort The company diversified into garmenting in FY01 for vertical integration as it was a producer of denim as well as wovens. Thereon, the company has steadily added capacity in garmenting from 19mn pieces in FY10 to 23mn in FY16. Garmenting accounted for 16% of FY16 textile revenues.

Exhibit 12: Garment volumes and realisation


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Garments Volumes (mn pieces) (LHS) Garments Realization (Rs/piece) (RHS)

Arvind Ltd


Measuring competitiveness across financial parameters in Textiles The company’s focus on value-added products, vertical integration and strong relationships with brands (a measure of customer satisfaction) distinguish it from peers. Consequently, Arvind has been able to charge a premium (around 20% to peers) on denim realisations (without capacity additions). This is reflected in Arvind’s better segmental RoCEs of (23% over FY12-16) than peers (next best at 15% over FY12-16).

Cost structure aids margins Over FY13-16, Arvind’s EBITDA margin has remained fairly stable at around 15% (see exhibit 13). However, EBIT margin has expanded from 11.5% in FY13 to 13.4% in FY15 primarily on account of lower depreciation expense.

Arvind’s depreciation expense is fairly low compared to the peer set because of two reasons: (a) a larger proportion of freehold land (21% of gross block in FY15 vs 2% median for the peer set), and (b) lower depreciation expense on plant and machinery (20 years useful life, as opposed to a median of 13 years for the peer set, which largely follows the Companies Act 2013).

The ‘other manufacturing expenses’ item comprises stores consumed (8% of net sales for Arvind); it is likely that a portion of the higher gross margin can be attributed to a higher portion of raw material/consumable accounted for in ‘other manufacturing expenses’ as compared to competitors where the median for stores consumed is 3% of net sales.

Arvind’s employee expense has been the highest in the peer set (12% of net sales compared to 8% median for peers). Our channel checks suggest that there are specialised and dedicated employees for every task at Arvind, which distinguishes it from competitors. This could be the reason behind the larger number of employees and, hence, higher overall employee expenses.

Exhibit 13: Cost structure comparison with sizable textile manufacturing peers – similar EBITDA margins across

Particulars Arvind Limited Vardhman Textiles RSWM Sangam (India) Ltd

FY13 FY14 FY15 FY16 FY13 FY14 FY15 FY16 FY13 FY14 FY15 FY16 FY13 FY14 FY15 FY16

Net sales (in `.mn)

38,758 48,616 52,247 54,073 49,736 61,664 67,860 66,639 19,870 24,533 28,703 29,574 14,788 14,326 14,687 15,044

Raw Material 42% 46% 45% 41% 47% 44% 51% 48% 66% 59% 61% 58% 55% 57% 58% 55%

Employee Expenses

12% 11% 12% 12% 7% 7% 7% 8% 9% 9% 9% 11% 8% 8% 9% 9%

Power & fuel 10% 8% 9% 9% 11% 11% 11% 11% 9% 9% 8% 10% 10% 10% 11% 10%

Other manufacturing expenses

13% 13% 15% 15% 9% 9% 9% NA 4% 4% 4% NA 10% 8% 5% NA

Others 9% 8% 7% 7% 7% 7% 6% 15% 6% 6% 5% 11% 3% 3% 4% 11%

EBITDA margin 16% 16% 16% 15% 20% 24% 16% 18% 7% 13% 13% 11% 14% 13% 14% 15%

Depreciation 4% 3% 2% 3% 6% 5% 8% 6% 4% 4% 4% 5% 5% 5% 5% 5%

EBIT margin 12% 13% 13% 12% 14% 18% 9% 12% 2% 8% 9% 6% 9% 8% 9% 10%

RoCE 19% 24% 26% 28% 14% 20% 12% 13% 5% 14% 17% 14% 15% 14% 15% 15%

Source: Company, Ambit Capital research.

Note: EBIT does not include ‘other income’; Arvind’s financials are of the standalone business; Employees expense has been adjusted for items, such as wages & salary, job charges, labour charges etc., sitting in ‘other manufacturing expense’. Arvind’s RoCE is post tax. Comparable FY16 data for some line items is not available for peers.

Denim manufacturing companies, though much smaller in terms of revenue, have EBITDA margins in line with Arvind. However, there is a stark difference in gross margins (58% for Arvind as compared to 37% industry average). This can be attributed to (a) premium realisations that Arvind achieves through superior product and client mix, (b) economies of scale kicking into raw material sourcing, and (c) optimising input costs (mixing lower grades of cotton with premium cotton while maintaining quality and finishing).

Arvind Ltd


Exhibit 14: Arvind’s EBITDA margins are in line with the pure plays in denim fabric manufacturing

Particulars Nandan Denim Jindal Worldwide Aarvee Denim Suryalakshmi Cotton Mills

FY13 FY14 FY15 FY16 FY13 FY14 FY15 FY16 FY13 FY14 FY15 FY16 FY13 FY14 FY15 FY16

Net sales (in `.mn)

7,031 8,938 10,965 11,576 6,059 7,804 8,401 10,0911 7,233 6,853 7,455 8,412 7,054 7,019 7,050 7,598

Raw Material 69% 70% 69% 66% 69% 67% 62% 58% 57% 60% 62% 60% 60% 60% 58% 51%

Employee Expenses

5% 4% 5% 5% 7% 7% 9% 1% 6% 7% 8% 6% 5% 7% 8% 9%

Power & fuel 6% 6% 7% NA 6% 5% 7% NA 13% 13% 13% 12% 9% 9% 9% 8%

Other manufacturing expenses

3% 3% 3% NA 9% 11% 10% NA 4% 4% 5% NA 9% 10% 11% NA

Others 2% 2% 2% 12% 2% 1% 1% 28% 3% 5% 4% 12% 3% 4% 4% 19%

EBITDA margin

15% 15% 14% 17% 7% 9% 10% 14% 17% 11% 9% 9% 14% 10% 11% 13%

Depreciation 6% 6% 5% 6% 1% 2% 4% 5% 4% 5% 4% 4% 4% 5% 5% 4%

EBIT margin 9% 9% 9% 11% 6% 7% 7% 9% 13% 6% 5% 6% 10% 5% 6% 9%

RoCE 13% 14% 16% 18% 16% 15% 13% 14% 15% 7% 6% 6% 14% 10% 10% 11%


Superior realisations from value-added products The textile business has low asset turns given high capital intensity. After optimum capitalisation, incremental asset turns and margin can come only from pricing power. Arvind has been able to command a premium to peers due to reliability, low turnaround time and consistent adherence to client specifications.

Exhibit 15: Arvind has managed to maintain gross margins above peers


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Arvind Vardhaman RSWM Sangam Arvind/Raymond would have higher realisations than say Nandan since they cater to different markets which are not comparable. If Arvind/Raymond fetch `200 per meter on an average, Nandan would play in the `150-170 range and there are others in the `130-150 range too."- A competitor in the denim segment

Arvind Ltd


Primary data checks validate strengths Our primary data checks with various industry participants highlight ability to source and mix cotton, quality control and consistency as the key competitive advantages that have allowed Arvind to command superior pricing.

Exhibit 16: Quality, innovation and brand value are the competitive advantages of Arvind’s manufacturing business Designation, Company

Comment

Marketing, Nandan Denim

"The benefit of economies of scale pertaining raw material is limited for cotton sourcing. However, large players, like Arvind, can squeeze the dyes and consumables suppliers, hence that’s where the benefit lies." "The turnaround time to get nominated by a brand (for fabric supply) is at least a year; the company (fabric manufacturer) has to showcase its products and capabilities to the potential client for at least two seasons. Only a few big players, including Arvind have been able to do this."

Production Head, Oswal Denims

"Arvind's competitive advantage lies in (a) Quality philosophy: The company has very strict quality checks and norms. Say for example, if Armani says that there can be maximum 10 defect points per 100m of fabric – Arvind would ensure the maximum level to be 7 or 8 points. Similarly, quality standards are very well defined for each customer – say 15 points for Levis and 25 for domestic clients; the company strictly adheres to these (b) Reputation: Arvind sells to the most reputed designers in the world just because of product quality (c) Logistics team: a very effective logistics team (for ensuring dispatch, booking etc.); this is as opposed to other players which have commercial teams doing many tasks, including filing tax returns

Shirting division, Arvind

“Arvind is known for their fabric, like a brand, across the world; quality and service/delivery are the competitive advantages. Vardhman is a close competitor, who is also known for these parameters. These two companies do not compete on price like other players do. Expanding the shirting business was easy for Arvind; they already had the client base from Denim.”

Production Head, Oswal Denims

A brand/client looks for the following in a fabric supplier (in order of priority): (a) the kind/characteristic of product, (b) Quality, and (c) Price." "Where most players fault is that they would take order from big/reputed clients – promising Arvind like quality. They would fulfil the first order very efficiently. Then after the next 2-3 orders, they would start pressurising the client for a price increase; on failing to get a hike they would start optimising their manufacturing abilities to increase the margins. Then lastly, they would start compromising on quality – after repeated warnings, fail and off the client list."

Senior management, Arvind’s competitor

“Sanjay Lalbhai’s instincts are far superior to anyone else; he has the mixing skills (cotton) and does it himself.” Others are not able to do this as well as him; hence Arvind is able to save costs. Employees in most companies are unable to take this bet; for such optimisation of costs – only owners can take the risk.


Arvind Ltd


Overview of the Indian branded apparel space Exhibit 17: Porter’s analysis of the branded apparel industry


Exhibit 18: SWOT analysis for Arvind Brands Strengths Weaknesses

Long retailing experience of over 20 years.

A wide portfolio of 14 international brands some of which are historically popular/known in India.

Robust supply chain of 75 vendors and a well spread out network of 957 stores with presence in over 200 cities.

Designing team consisting of 150 people control brands Arrow, US Polo and Ed Hardy.

Wide array of brands gives it bargaining power with garment suppliers and malls for rentals.

Megamart has been persevered with for over two decades despite no material and consistent returns- recording average EBITDA margin of a meagre 2% over FY11-FY16.

Too large a bouquet of brands means capital and brand ex allocation are sub-optimal- ad spend for brands as a % increased by 100 bps to 6% over FY13-15.

Tendency to create/add especially own new brands impacts profitability as they take time to scale up. Non power brand losses in FY16 were `381 mn.

Opportunities Threats

Leverage on the rich retailing experience they possess to grow the brands.

Product extension in existing brands such as Arrow, US Polo to newer categories such as footwear, inner wear etc.

Using their omni-channel platform to strengthen the franchisee and large store network of over 1,000 stores.

Growing the brands beyond the cities and acquiring rural wallet share.

Intensity of competition increasing with foreign brands having entered India.

H&M and GAP’s aggressive expansion in India at competitive price points can impact GAP and Aeropostale as they done so worldwide.

E-commerce continuing to empower the unorganised players.


Bargaining power of suppliers

Moderate

Companies source their products from various suppliers and hence, are considered to be dispensable.

With entry of foreign brands, malls have a choice of tenants to choose from and command higher rentals.

Bargaining power of buyers

High

Availability of brands especially in men’s wear across price points gives large choice to consumers.

Additionally, through ecommerce, consumers can switch for lower priced products.

Competitive intensity

High

Fiercely competitive industry fuelled further by ecommerce which gives all the brands a level playing field.

Most retailers offer similar products which shifts focus to gaining pricing advantage.

Entry of global brands such as H&M, Zara will increase competition for wallet share.

Barriers to entry

Moderate

Managing inventory and fashion cycles (design to store takes up to an year) is challenging.

Investments in stores, supply chain and branding needs capital and staying power to put up with initial phases of losses and cash outflows .

Threat of substitution

Low

Unorganised sector poses low threat of substitution to brands due to inferior shopping experience.

However, counterfeit products and their improving quality pose threat to brands.

Unchanged Improving Deteriorating

Arvind Ltd


Exhibit 19: Proportion of organised segment continues to be low in the large apparel market

Source: ABFRL, Ambit Capital research

Exhibit 20: The men’s wear market forms the bulk of the organised market

Segment (US $ mn) Total Market

size

Men Women Kids Accessories

Casual Formal Western Ethnic

Luxury and Super Premium 518 82 215 41 43 125 12

Premium & Sub premium 4,545 704 1,581 334 455 1,360 111

Value & Mass 5,200 643 1,769 370 1,159 1,181 78

10,263 1,429 3,565 745 1,657 2,666 201

Source: ABFRL, Ambit Capital research

28.8 32.545

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Arvind Ltd


Evolution of Arvind’s Brands & Retail segment Arvind forayed into the branded business in the 1990s but the business gained mass and scale from FY07. Arvind Lifestyle Brands Limited (‘ALBL’) has gone on to become one of the fastest growing apparel retailers in India (FY10-16 CAGR of 25%), contributing around 30% of the Arvind’s overall FY16 revenues. Whilst the retail division’s (Megmart) revenues and profits stagnated; the brands business has witnessed a renaissance from FY07 driven by addition of brands, growth of power brands and distribution reach (through departmental stores and multi brand outlets).

Exhibit 21: Brands & Retail revenues have increased at a CAGR of 25% over FY10-16

Source: Company, Ambit Capital research. Note: RoCE is pre-tax.

Early days The brands business, though in existence from FY94 when the Arrow license was obtained, remained a shadow of the textiles business. Moreover, it also bore the brunt of the debt restructuring which the company had to go through and in the process sell majority stake in FY04. However, with J Suresh, CEO of Arvind Brands, coming on board in FY06, the business began witnessing a remarkable turnaround.

It all began with…

Arvind forayed into Brands & Retailing by launching ‘Flying Machine’, its own denim brand in 1981. Thereafter, it took the license rights to sell the apparels under the ‘Arrow’ brand in 1993 with the aim to expand retail presence across India. Since then, Arvind has brought in international brands such as Lee, Wrangler and US Polo.

...then came Megamart

The company forayed into retail through Megamart stores in FY95. Megamart began as a discount retailer offering brands a channel to liquidate excess stock. It aggressively expanded under the format (216 stores in FY12) but later resorted to store reduction (92 stores in FY16). It is now re-branded as Unlimited.

Divestment of brands business in FY10

As a part of its debt structuring in FY04, a part of debt from ICICI was swapped with controlling stake of brand subsidiary Arvind Brands Ltd (54% stake in brands) to ICICI Emerging Sector. At that time, Arrow, Lee, Wrangler, Excalibur and Newport were its main brands. In FY05, the company bought back the stake from ICICI Emerging sector for `1060mn.

0%2%4%6%8%10%12%14%

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Brands' Revenues (Rs bn) (LHS) Retail Revenues (Rs bn) (LHS)

RoCE (%) (RHS) EBIT margins (%) (RHS)

Arvind Ltd


Parting with VF brands

Arvind entered into a licensing agreement with VF brands (Mauritius) to sell Lee (FY95) and Wrangler (FY99) in India. In FY07, Lee and Wrangler were transferred to a JV called VF Arvind Brands Private Limited. In FY12, the company sold 40% share in the JV to VF for `2.57bn at a valuation of 2x FY11 EV/sales.

Rebooting the business J Suresh, who joined in Sept 2005, is at the helm of the brand and retail division of Arvind Group and the man behind increasing the division’s contribution to revenues. From FY07-16, the Brands & Retail business has grown at a CAGR of 25%.

Building the brands business

The brands business has been built on a mix of own exclusive brand outlets (EBOs), departmental stores and MBOs. Consequently, the business has grown on the back of distribution – addition of MBOs and expansion by departmental stores even as LTL growth rate has fallen.

Exhibit 22: Revenues have grown at a healthy pace led by distribution


Exhibit 23: Arvind’s channel revenue mix is skewed towards non-EBOs


Exhibit 24: Departmental stores have played a vital role in Arvind’s branded growth


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Arvind's Brand revenues (Rs bn) (LHS) LTL growth (%) (RHS)

EBOs40%

Dept. stores30%

MBOs25%

Ecommerce5%

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Arvind has a network of 35 dedicated vendors from whom it purchases 20mn garments annually for its Brands & Retail business.

Arvind operates only 30% of the EBOs; the rest are franchised with differing terms with respect to capex, opex and inventory ownership

Arvind Ltd


Business has evolved around power brands

Approximately 60% of Brands & Retail revenues come from ‘Power brands’, which comprise Arrow, US Polo and Tommy Hilfiger (through JV with Arvind Murjani Brands Pvt. Ltd.) and Flying Machine. Arrow, is the leader in premium formalwear with a turnover of ~`6,000mn. US Polo also grew to become a `6,000mn brand in 2016 from no revenues 5 years ago. Arvind, with a brand portfolio of over 30 brands, has the advantage of being able to cater to masses as well as classes with its offerings in value, premium and luxury.

Exhibit 25: Power brands have grown rapidly on the back differentiated offerings


Introduction of Specialty brands

The company began introducing specialty brands and formats such as Next, Nautica and Debenhams in FY12. This was followed by The Children’s Place in FY14 and GAP and Aeropostale in FY16.

Exhibit 26: Plans for Specialty retail

Brand No. of stores

(As at May, 2015) Stores to be added over next 2-4 years

Revenue projections over 5 years (` mn)

GAP 10 40 10,000

Aeropostale 7 40 5,000

The Children’s Place 7 8 5,000

Sephora 4 6 NA


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FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

Power brands Revenues (Rs bn) (LHS) EBITDA margin (%) (RHS)

Arvind Ltd


“Power” of Brands and troubles of Retail The “Power Brands” portfolio is centric to the company’s rise as a credible player in the branded apparel segment. But as much as the brands have been a torchbearer of growth and profitability, the retail business has been an enigma despite it undergoing many changes and corrections over last decade. While retail contributed 20% of Brand and Retail revenues in FY16, it contributed only 2% to EBITDA. Even the branded portfolio (ex “Power brands”) has contributed negatively to EBITDA, turning positive only in FY16.

Exhibit 27: Arvind Brands’ revenue and retail space


Exhibit 28: Megamart stores and total area


Exhibit 29: Comparison of business models of Indian peer group

Arvind Brands Raymond Madura Kewal Kiran Indian terrain

Positioning Casualwear Casual & Formalwear Formalwear Casualwear Formalwear

Operational since (year)

Since 1930; in retail since 1994

Since 1925; in retail since 1986

1989 1981 2000

Reach (stores)

EBO's & MBO's - 903 EBO's-235 EBO's-1,842

316 stores in 192 cities

EBO's - 111

Key Accounts - 1,023 Made to Measure - 52 MBO's-4,000 Counters in LFS - 169

Megamart - 95 The Raymond Shop – 764

Stores in stores-3,000 Present in MBO's

Value stores-162

Own brands Flying Machine

Park Avenue, Parx, Color Plus

Louis Philippe, Van Heusen, Allen Solly

Killer, Integriti, Lawman

Indian terrain

Distribution (franchisee or own stores)

COCO, COFO, FOFO and FOCO

COCO, COFO and FOFO

COCO, COFO and FOFO

COCO and FOCO COCO, COFO and FOFO

FY11-16 Revenue CAGR

22% 12% 17% 14% 22%

FY11-16 EBITDA CAGR

27% 4% 22% 9% 27%

FY16 RoCE 6% 13% 33% 42% 21%


COCO- Company owned Company operated FOFO- Franchisee owned Franchisee operated

COFO- Company owned Franchisee operated FOCO- Franchisee owned Company operated

Power brands form the core of the brands business Of the four Power Brands as mentioned earlier, Tommy Hilfiger (JV between Arvind Brands & Retail Limited (50%), PVH BH (41%) and Tommy Hilfiger Europe BV (9%)) accounts for 10% of Power Brand’s revenues (6% of brand and retail revenues) (Tommy’s share – 50% of the total company revenue). They continue to be the mainstay of the business and contribute all the profit.

Power brands continue to be profit drivers

The items of the brands business, barring the power brands, have not been profitable since FY11. The power brands portfolio has registered a CAGR of 20% from FY13-16 (prior to FY13 some brands were not yet classified as Power)

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Arvind Ltd


Exhibit 30: Power brands have grown at a CAGR of 20% from FY13-16

Power Brands Year of introduction Category Stores Cities

Flying Machine 1980 Premium 197 33

Arrow 1994 Premium 250 85

Tommy Hilfiger 2004 Bridge to luxury 171 39

U.S.P.A. 2009 Premium 126 50


Exhibit 31: Power brands’ revenues have more than doubled over the past 5 years


US Polo – The big pony

US Polo Assn. (USPA) is the largest power brand in the portfolio, with estimated revenues of `6bn in FY16 (37% of Power brand revenues). Since its launch in FY10, the brand has gone on to be a leader in the sports lifestyle segment, which possibly didn’t exist in a meaningful way in India. Over the years, USPA has become dominant in departmental stores and is also easily accepted due to the resemblance to Polo Ralph Lauren. Franchisees of the brand attribute the success of USPA (CAGR of 58% over FY11-16) to the said resemblance with affordable pricing.

Exhibit 32: Resemblance between Polo Ralph Lauren and USPA

Source: Jabong, Ralph Lauren

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“….the brand U.S. Polo Assn. has played a huge part in democratising the polo tee style which earlier was worn by a much smaller audience” – Alok Dubey, COO, Sports and Denim, Arvind Brands

The USPA T-shirt here is priced at $20 (converted from INR) as against the $98 of Polo Ralph Lauren

Arvind Ltd


Power brands gradually grew in power While US Polo and Tommy Hilfiger JV have scaled up rapidly with 58% and 28% revenue CAGR over FY11-16, Arrow and Flying Machine have had a far longer run to achieve scale. Moreover, most brands in India have to undergo the learning curve as documented in our thematic dated 28th Sept 2015

Flying Machine – born in 1980, but the real flight was in 2007

Flying Machine is a denim brand launched in 1980 by Arvind and was the market leader until 1995 when international brands like Levis entered India and consumer interest shifted. Thereon the brand could not breach the run-rate of `50mn to `60mn per annum until FY05. The company re-launched Flying Machine in 2007 by bringing Italian designer Chicco on board and rolling out exclusive brand stores. Also, London-based design firm JHP was brought on board to design exclusive Flying Machine stores and a Bollywood star was roped in as ambassador. Thereafter, the brand witnessed growth of 41% CAGR (FY11-16) with revenues of around `2bn in FY16. Arvind believes Flying Machine has the potential to be a `5bn brand by FY20.

Arrow - a miss until it began hitting the target in FY08

Arrow signed up with Arvind Limited in 1994 for licensed manufacturing of Arrow shirts in India. The brand targeted the affluent and was accordingly priced, which made it unaffordable for the mass market. Despite the advent of other formalwear brands like Louis Philippe and Van Heusen, Arrow managed to clock revenues of `550mn in FY2000. Thereafter, with the brand losing its sheen due to its restricted availability and its target market being the business class, Arrow revamped its strategy in FY08 to get back into competition and targeted the middle-aged and the youth as a part of the revamp, which resulted in the brand getting back on track with revenues of over `6,000mn in FY16.

Non-Power brands are yet to establish their position Non-Power brands are yet to establish profitability and stability in operations due to failure of some brands and incubation of some. The failures can be attributed to steep prices or faulty locations.

Next and Debenhams – undone by faulty pricing and location

The company took over the operations of Next, Debenhams and Nautica in FY13 from Planet Retail. At that time these brands were reportedly clocking `700mn revenues and the ambition was to grow the business 7x by FY17. However, steep price points, lack of flexibility to source locally, and faulty store locations led to shutdown of Debenhams in FY15 and failure of Next in attaining material retail footprint beyond a few stores.

Many brands failed and many are yet to scale up

The company has had 30 brands over last 3 decades, of which only 16 are currently active. Moreover, many brands such as Izod, Hanes, Wonderbra, ELLE, Ed Hardy, Nautica, etc. since FY09 but they are yet to be scaled up. These brands have not scaled up to the levels of Arrow or US Polo despite considerable years of presence in India. This is evident in the low revenue share and continuing losses (also a function of specialty retail) as seen in the exhibit below.

http://reports.ambitcapital.com/reports/Ambit_Retail_Thematic_Ownyourfortune_28Sept2015.pdf

Arvind Ltd


Exhibit 33: Arvind’s brand introductions have been adventurous

Own brands Year of introduction Licensed brands Year of introduction Joint Venture Brands Year of introduction

Flying Machine 1980 Arrow 1993 Wrangler* 1999

New Port University 1994 Lee* 1995 Tommy Hilfiger 2004

Ruff & Tuff 1995 GANT 2006 Jansport* 2005

Excalibur 1997 Cherokee 2007 Kipling* 2005

Ruggers Sansabelt* 2008 Calvin Klein 2014

Colt Izod 2008

Piere Cardin Paris* 2008

U.S. Polo 2009

ELLE 2011

Mossimo 2011

Geoffrey Beene 2011

NEXT 2012

Debenhams* 2012

Nautica 2012

Billabong* 2012

Wonderbra 2013

Ed Hardy 2013

Hanes 2013

The Children's Palace 2014

GAP 2014

Aeropostale 2015

Source: Company, Ambit Capital research. Note: *Indicates brands no longer in the portfolio

Retail has been a long experiment Megamart - A 21-year-old format that is yet to find its feet

Positioned as a discount outlet to liquidate old stocks in 1995, Megamart has not been profitable since inception (FY95) despite upping the store count until FY12 to generate volumes and revenues. The format has witnessed multiple changes with its position somewhere between discounted retailer and value retailer. While the management commentary has at most times suggested Megamart was positioned as a value retailer, in reality it remained a discounted retailer till most of FY16 and thereafter got rebranded and repositioned as Unlimited – an own brand, private label store.

Exhibit 34: Megamart’s margins have impacted the brands portfolio


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Arvind Ltd


Exhibit 35: Megamart has had a chequered history and enjoyed perseverance by management

Year Commentary Number of stores Area (mn sq ft) Revenue (` mn)

EBITDA (` mn)

FY09

Undertook restructuring of the brands portfolio by converting Excalibur & New Port into Private Brands of Megamart. This restructuring apart from strengthening the Private Brand portfolio of Megamart also streamlined the operations leading to a sharp reduction in salary and overhead expenses.

128 0.23 - -

FY10

The focus on improvement of operational efficiency resulted in the large format business becoming profitable. Mega-Mart will continue to aggressively expand in next year with the addition of both small format and large format stores.

124 0.45 - -

FY11 Mega-Mart made rapid progress in the current year to emerge as the leading Value Retail player in the country.

210 0.63 3,701 167

FY12 The operating margins were under severe pressure on account of higher cotton prices leading to increased COGS and also on account of levy of excise duty on branded garments.

216 0.69 5,140 54

FY13

There was severe pressure on operating margins on account of twin factors i.e. Incidence of excise duty on branded apparels and higher purchased cost of finished goods as a result of higher cotton prices. The Company had to take several corrective steps to restore the operating margins; the major being repositioning MegaMart from “Discount Store” to “Value Retail” with higher proportion of private labels, with the value proposition covering the entire range of men, women & kids segments. These initiatives have yielded the desired results and the profitability of MegaMart is restored back to yesteryears.

197 0.71 5,562 83

FY14

MegaMart brand of stores have undergone a major transformation in business model over the last year to be repositioned as a value format and the strategy has also started to deliver the expected results in terms of improved profitability.

166 0.75 5,997 145

FY15 With successful re-positioning of Megamart as Value Retail format, it will not only drive the growth but will lead to margin expansion too

140 0.83 6,200 87


Levy of excise duty hit discount outlets such as Megamart hard…

The introduction of excise duty on branded garments in FY12 impacted the profitability of discounted retailers as the levy was on MRP whereas the products were always sold below MRP. As a result, expansion plans were curated and the store count came down from 216 in in FY12 to about 130 in FY16.

…resulting in repositioning

With below par sales growth (revenue declined from FY14) and no improvement in profitability, Arvind shut down the smaller stores as they were not generating enough EBITDA (1.5%) and shifted focus to larger stores that operated at ~8% EBITDA margin rebranding them as Unlimited. These stores span more than 10,000 sq. ft. and sell premium brands such as US Polo and Arrow along with mass brands like Geoffrey Beene and Cherokee, thereby lending focus to the status of a value retailer.

Arvind Ltd


Specialty retail, ecommerce not so special! Arvind’s strategy of getting specialty brands with exclusive rights to retail in physical as well as ecommerce platforms seems a compelling proposition but come with their risks. Also, its strategy to build its own ecommerce marketplace is well placed but execution-related risks are likely to result in a period of losses given customer acquisition costs.

Specialty brands – competitive risks rising The brands come with their own risks given that the said brands are no longer the force they were and the very same competitors who dented their SSGs and forced store closures abroad are now setting up shop in India.

Specialty retail is still nascent and has been a mixed bag

The company also has a vertical of specialty brands to license and retail international brands such as Next, Debenhams, The Children’s Place, GAP and Aeropostale. Of these, Next and Debenhams as mentioned in the earlier section have flattered to deceive while TCP, GAP and Aeropostale are recent launches and are yet to contribute to profitability.

GAP and Aeropostale are no US Polo

Brands such as GAP and Aeropostale have been struggling in their domiciled markets as they face immense competition from fast fashion behemoths such as Zara, H&M and Uniqlo. The designs and pricing of GAP and Aeropostale no longer resonant with the millennials as is evident with the consistent decline in same store sales for GAP and bankruptcy of Aeropostale.

Exhibit 36: GAP Inc’s SSG has dipped drastically

Source: GAP Inc., Ambit Capital research

Exhibit 37: GAP Inc. has shut over 300 stores in the last 6 quarters

Quarter Stores closed

3QFY15 49

4QFY15 24

1QFY16 40

2QFY16 39

3QFY16 134

4QFY16 33

Source: GAP Inc., Ambit Capital research

US Polo’s success is attributed its product and pricing – where the product is aspirational and pricing affordable when compared to a Polo Ralph Lauren. GAP and Aeropostale are the exact antithesis of US Polo in that aspect and the product and its pricing may not be differentiated enough to replicate US Polo’s success. In India, too, there is competition not only from domestic brands but also from Zara and H&M that are priced significantly lower than GAP and Aeropostale.

Exhibit 38: Aeropostale and GAP are priced at a premium to Zara and H&M

Men Women

Brand Tshirt Polo Shirt Trouser /Chino

Jeans Tshirt Shirt Trouser /Chino

Jeans

Zara 899 990 1,990 2,290 2,790 1,190 1,990 2,290 2,490

H&M 799 799 1,799 1,999 2,699 999 1,299 1,799 2,299

Aeropostale 1,399 1,799 2,299 2,499 2,999 1,199 2,799 - 2,499

GAP 1,260 1,499 2,499 - 3,000 1,260 2,499 - 3,000

Source: H&M, Zara, Arvind Internet

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“Brands such as GAP have no major design quotient; their designs are basic and customers are changing even in India. Even if the Indian customer does not articulate it in as many words their buying behavior exhibits preference towards great design at low prices.” – An executive with a leading women’s centric fashion chain

Arvind Ltd


What if these brands fail?

When a firm franchises a brand, it seldom shares the downside if the brand fails. The downside comes from capital investment in stores (often 2x higher than the normal cost), working capital and, of course, operational losses. The larger the store network of the brands the bigger the risk if the brand fails. While, theoretically, any brand can fail, this section is more relevant for brands such as GAP and Aeropostale given the issues they face elsewhere in the world. It is too early to judge the success or failure of these brands in India, but we believe it is a risk which has to be fairly appreciated while evaluating this business. We appreciate the company’s focus to localise production (most of the merchandise for Aeropostale) and 20-25% of merchandise for GAP over next few years

Ecommerce – Unchartered territory Maintaining brand exclusivity – no clear strategy yet

Arvind, unlike some of its peers, has seeded all ecommerce portals with its brands. For e.g., Aditya Birla Fashion Ltd refrained from selling its flagship Louis Philippe on any other portal other than its own or on its physical store partner’s websites (those of departmental stores).

The ecommerce experiment

The company launched Creyate, a customised garmenting portal in FY15 and is a part of its 100% subsidiary Arvind Internet Ltd (AIL). AIL posted losses of `150mn in FY15 and had operating cash outflows of `132mn for wages and launch of Creyate. Creyate clocked `12mn of revenues in FY15 and, as per Google trends, website traffic for Creyate has significantly plateaued after an initial spike at the launch. The company has exhibited tendencies to try new brands, and if such tendencies are replicated in the ecommerce space, its ecommerce vertical could undergo a phase of continued losses.

Exhibit 39: Arvind Internet’s profit & loss account

Profit & Loss (` mn) FY14 FY14

Sales - 13

Power & Fuel Cost 0 0

Employee Cost 9 68

Operating Expenses

20

General and Administration Expenses 5 36

Selling and Distribution Expenses 0 14

Miscellaneous Expenses 1 1

EBITDA (14) (134)

Depreciation 1 16

EBIT (15) (150)

Other Income

0

Interest 0 0

PBT (15) (150)

Provision for Tax (Deferred tax) 0 0

Profit After Tax (15) (150)


“Your company is looking to develop multiple ‘Differentiated Online Formats’ to play in E-Commerce space.”- Arvind’s FY16 Annual report

Arvind Ltd


Exhibit 40: Creyate’s customer interest levels are yet to pick up

Source: Google trends, Ambit Capital research. Note: LHS indicates search interest of the website relative to the peak

NNNOW and when?

The company launched its ecommerce marketplace nnnow.com in 1QFY16. The marketplace will be anchored by its own brands. It will also sell Arvind’s specialty brands exclusively online and will also offer an omni-channel platform. The company expects to spend $20mn in FY17 on marketing and popularising the channel.

Is omni-channel for everyone? At what cost?

This is a crucial question because successful case studies are from the West and also, in our view, represent survivorship bias. The costs of Omni channel are twofold – (a) investments in back-end and (b) customer acquisition costs. Offering a truly satisfying omni-channel experience means offering the inventory of all stores on a real time basis to the customer. This entails capital investment in the region of `500mn-1000mn. While there may not be rampant discounting like the pure play online retailers, discounts are part and parcel of this strategy. Moreover, there will be customer acquisition costs associated with this channel as discounts and couponing is what draws a customer to the website (like a store draws a customer with its ambience).

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Arvind Ltd


Valuations – yarn and brand can spin only this much value The textile business’ free cash flow (`4.4bn in FY16) continues to incubate a portfolio of brands at various stages; many of which are yet to be successful. Our DCF model assumes improvement in consolidated asset turns (central to operating leverage) from 1x in FY16 to 1.1x in FY19 led by ramp-up of specialty brands, which would boost branded margins from 6.5% in FY16 to 8.8% in FY19. However, this scenario assumes sustained margins for Power brands and Specialty brands, helping operating margins hit 10% in FY22 (currently negligible). Pursuing new brands such as GAP/Aeropostale which need capital and face competitive threats from H&M, Zara etc. can puncture these assumptions. Our DCF value of `311 implies FY18E EPS and 19x FY18E EV/EBITDA and is expensive given RoCE of 11% (after 360bps improvement over FY16) in FY19E. We initiate coverage with a SELL rating.

Brands will continue to depend on textiles for funding The textiles business housed in the parent company has been the cash cow which has supported the Brands & Retail business’ losses and expansion. The parent company has invested `1.9bn as equity and `1.7bn as loans in the Brands and Retail division. While the Brands and Retail business’ operating margins have improved from 5% in FY13 to 5.8% in FY16, the same is not sufficient to fund future growth at least till FY19. The expansion into specialty retail formats such as GAP, Aeropostale and TCP will not only involve additional working capital but also capex and opex for stores. Therefore, Brands and Retail will continue to depend on the parent despite improvement in operating margins (230bps over FY16-19E).

Any cyclicality in the textiles business will impact the expansion of brands business.

Exhibit 41: CFO/EBITDA has remained negative


Exhibit 42: Funds invested by Arvind in Brands & Retail


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Loans advanced by parent Equity invested by parent

Arvind Ltd


Exhibit 43: Brands & Retail business will continue to be funded by textiles


Exhibit 44: CFO of Brands & Retail excluding loans from parent vs reported CFO


Brands & Retail has been capex-intensive as well as brandex intensive

Brands & Retail business has witnessed capex of `8.5bn over FY10-16 as the company added stores for existing as well as new brands. Moreover, with addition of brands even where EBOs are not opened, ad spend for these brands would still have to be made. The asset turns for the brands business has remained around 2.3x since FY13, which is largely explained by increased capex intensity. We expect asset turns to increase to 3.7x by FY19E given investments in specialty retail. Therefore, margin improvement will be primarily led by gross margins (increasing share of specialty retail and increased local sourcing in GAP and Aeropostale).

Exhibit 45: Capex intensity will have to be maintained to generate margins


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FCF-Textiles (Rs bn) (LHS) Capex in Brands and Retail (Rs bn) (LHS)Capex in Textiles (Rs bn) (LHS) FCF of Brands and Retail (Rs bn) (RHS)

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Capex in Brands & Retail (Rs bn) Brandex in Brands & Retail (Rs bn)

Arvind Ltd


Exhibit 46: Brands and retail business asset turns will be aided by EBIT margins


WC improvements require stellar performance from specialty brands

Arvind Brands & Retail working capital turns have fallen from FY15 due to increase in inventory days (140 days in FY15 vs 121 days in FY13) and increase in debtor days (93 days in FY15 from 78 days in FY13). The rise in debtor days could also be due to year-end sales push to distributors to attain targets. Specialty retail will be inventory heavy more so in the initial years due to store fill (`30mn/store). Therefore, even as working capital turns improve in brands, past highs of 4x are unlikely to be achieved before FY19E.

Exhibit 47: Working capital turns unlikely to scale earlier peaks due to specialty retail


A lot rides on getting specialty brands right

Incremental margin swings and profitability will be driven to a great extent by the ramp-up of GAP, Aeropostale, Sephora and TCP. With the company looking to take the store tally of GAP and Aeropostale to 50 and 40 stores each from 10 and 7 respectively now, the ramp-up and ability of these brands to withstand competition remains key to delivering incremental RoCE. While we assume that these brands will eventually scale up (35% revenue CAGR FY16-19E) and attain 2% EBITDA margins by FY19E, GAP and Aeropostale face threats from aggression of H&M and Zara in India. H&M and Zara have dented GAP’s business model in the US and there is a possibility that they could be replicate it in India.

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Arvind Ltd


Exhibit 48: A lot rides on other brands becoming materially EBITDA-accretive by FY19E


DCF Value Our DCF value of `311 captures margin improvement of over 230bps in branded business with steady margins in the textile business. Moreover, we assume 21% CAGR over FY16-19E in branded business led by specialty retail. We assume that the branded business will continue to be profitable and improve working capital turns, thus churning positive operating cash flow and becoming self-reliant by FY19E.

Exhibit 49: Revenues and EBIT margins of Arvind’s business


Exhibit 50: Capex intensity to sustain for the next few years


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Revenues - Megamart (Rs bn) (LHS) Revenues - other brands (Rs bn) (LHS)

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Arvind Ltd


Terminal growth assumptions

We build in 5% terminal growth rate, in line with the long-term sustainable GDP growth rate of India.

WACC assumptions

We build in a WACC of 13.5% despite FY17E debt:equity of 1.1x due to the relatively small size of the business, capex intensity, cyclicality of the textile business and competitive risks to brands such as GAP and Aeropostale.

Exhibit 51: SOTP valuation implies high multiple for brands business to justify CMP

SOTP Valuation Parameter Multiple FY18E Revenues

(` mn) FY18E EBITDA

(` mn) Value (`mn)

Textiles business EV/EBITDA 5 64,063 9,471 47,353

Brands business EV/EBITDA 19 40,603 3,257 61,877

Others EV/Sales 1 3,793 (250) 1,897

111,127

Net Debt

30,741

Equity Value

80,386

Value per share (`)

311


Exhibit 52: Key assumptions

FY16 FY17E FY18E FY19E Comments

Textiles 54,073 58,280 64,063 67,385

Denim 18,970 20,058 20,660 21,279 Led by better capacity utilisation and realisation

Woven 20,150 21,009 23,377 24,623 Led by better capacity utilisation and realisation

Garments 8,830 9,151 11,157 11,778 Led by capacity addition

Voiles 3,450 3,795 4,175 4,592 Led by capacity utilisation

Knits 3,020 3,322 3,654 4,020 Led by capacity addition

Brands & Retail 27,297 33,344 40,603 48,671

Power Brands 16,040 19,248 23,098 27,255 Assuming a 20% annual growth in Power brands led by distribution and brand extensions

Other Brands (incl. Specialty Retail) 5,713 7,998 10,798 14,037 Led by Stores of GAP, Aeropostale, TCP, Sephora

Megamart/Unlimited 5,543 6,098 6,708 7,378 Led by SSG of 6%

Others 3,135 3,448 3,793 4,173 Technical textiles capacity addition will drive top-line

Total 84,504 95,073 108,459 120,228

EBITDA margins (%):

Textiles 14.9% 14.3% 14.8% 14.3% Assumed stable cost structure

Brands & Retail 6.5% 7.2% 8.0% 8.8% Improvement in gross margins of Unlimited and Specialty retail breaks even in FY18E

Others 25% -14% -7% -4% Losses from ecommerce venture

Capex (` mn):

Textiles 3,547 2,500 814 827 Capacity for knits and garmenting in FY17 and thereafter maintenance capex

Brands & Retail 2,000 3,000 2,000 2,000 Capex for opening Specialty retail stores and EBOs

Other assumptions

Textiles:

Asset turnover (x) 0.5 0.5 0.5 0.5 No significant capacity addition that would dilute asset turns

WC turnover (x) 2.9 3.0 3.4 3.3 Assume no change in working capital cycle

Debt:Equity (x) 1.0 0.9 0.9 0.8 Debt equity falls as brand business becomes profitable; nevertheless it continues to rely on textiles till FY19

RoCE (%) 14% 13% 14% 13%

Brands & Retail:

Asset turnover (x) 2.7 3.0 3.3 3.7 Power brands grow through franchisees, Megamart/Unlimited has 8% SSG

WC turnover (x) 3.4 3.4 3.5 3.6 Assume GAP and Aeropostale are successful,

RoCE (%) 7% 7% 8% 11%

Ad spend as a % of Sales (%) 5.9% 5.9% 5.8% 5.7% Additions of brands will mean continued ad spend


Arvind Ltd


Cross-cycle valuations Arvind’s cross-cycle valuations over the last 4 years have been a tale of two halves – until Dec 2013 it was valued more as a textile company (single-digit P/E). After Dec 2013, the company’s valuation started moving towards that of branded apparel companies. However, while the valuation re-rating took place, it did not witness any significant improvement in asset turns, and we do not envisage any further improvement in asset turns given capex and working capital intensity of the brands business.

Exhibit 53: Arvind’s multiples have re-rated…


Exhibit 54: ..as visibility on the branded business has improved


Exhibit 55: Consolidated asset turns unlikely to improve


Mitra Adiperkasa (MAPI) – A distant cousin with similar model with important lessons Working capital heavy model has a price to pay

Indonesia’s MAPI, is a licensee of well renowned brands, a model somewhat similar to Arvind'. MAPI saw EBITDA margins fall by 1000bps in 2014 (YoY) despite increasing revenues by a healthy 21% YoY. The increase in revenues was attributable to heavy discounting undertaken to clear unsold inventory but came at the cost of gross margins falling by 350bps from 49.8% in 2013 to 46.3% in 2014. In addition to the dip in gross margins, inflation in power and fuel costs, water costs and salaries due to change in regulations by the Indonesian government (raised minimum wages) resulted in operating expenses increasing by 21% YoY.

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Arvind Ltd


MAPI’s de-rating, as with the de-rating of any retail business, can be attributed to inventory/working capital. For MAPI, most of its inventory was imported and had to deal with a depreciating rupiah (30% over FY13-16). Though Arvind’s brand business doesn’t have much currency risk, a working-capital-heavy model coupled with increasing exposure to specialty brands such as GAP, which faces headwinds from fast fashion brands (present in India as well), are risks that cannot be ignored.

Exhibit 56: MAPI is trading at an 8% premium to its 1-year forward P/E


Exhibit 57: MAPI is trading at a 15% discount to its 1-year forward EV/EBITDA


Exhibit 58: MAPI’s EBIT margins have dipped to 4%


Exhibit 59: MAPI’s inventory problems have resulted in receding working capital turns


Peer comparison

Arvind trades at a discount to its branded peers due to a) cyclicality of the textile business and b) high dependence on textiles for funding unlike most of its peers. This discount is unlikely to narrow as long as the dependency on textiles continues.

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Arvind Ltd


Exhibit 60: Peer comparison

Companies Mcap EV/EBITDA (x) P/E (x) CAGR (FY16-19E) (%) RoE (%) RoCE (%)

US$ mn FY16 FY17 FY18 FY16 FY17 FY18 Revenue EBITDA EPS FY16 FY17 FY18 FY15 FY16

Arvind 1,247 14 10 8 24 21 15 12 14 23 13 14 15 11 9

Indian Retailers Aditya Birla Fashion & Retail

1,650 33 23 19 - 79 49 29 46 - (16) 12 17 113 N.A.

Indian Terrain Fashions 85 13 10 14 0 0 0 27 34 21 8 12 15 17 23

Raymond 420 10 8 7 31 18 13 8 15 25 6 9 11 11 5

Kewal Kiran Clothing 327 20 17 14 33 24 22 14 15 14 22 27 25 24 22

Global Retailers

PVH CORP 7,674 9 10 9 14 15 13 5 9 11 13 11 9 6 9

VF CORP 26,944 15 13 12 22 19 17 11 15 16 22 26 28 15 15

MAPI 508 9 8 7 176 33 18 19 27 61 1 7 10 21 20

Textiles

RSWM 153 5 4 4 10 8 7 4 14 21 22 23 23 - 13

Vardhman 902 7 6 6 9 10 9 2 11 22 19 16 15 6 10

Source: Bloomberg, Ambit Capital research. Note: Revenue, EBITDA and EPS CAGR for Raymond, RSWM and Vardhaman are from FY15-18

Madura vs Arvind – a brands business case study Among the Indian peers, Raymond and ABFRL (retail and brands business) resemble Arvind in terms of business profile. While ABFRL’s retail business differs from that Arvind, its branded part Madura is similar. Madura operates the largest portfolio of brands in India. While Arvind’s brand business resembles that of Madura, there are differences in the following aspects: (1) reliance on licensed brands; (2) capex intensity; and (3) focus on women’s wear. Brand extensions, though a longer and tougher journey, can deliver superior RoCE (Madura clocked 33% FY16) led by asset turns.

Brand extensions vs adding new brands

Brand extensions not only accentuate margins but also capital efficiency through higher asset turns as the brand begins to offer wider wardrobe choices. Madura Garments has grown 9x over FY04-15 and established itself as the largest men’s wear brand portfolio. One of the key drivers of growth was non-formal wear, which grew at 36% CAGR over FY10-15. Successful product extension resulted in capturing a higher share of the customer’s wardrobe as also wallet share. New initiatives such as shoes (already `800mn in revenues), luggage, inner wear, kids wear etc. added to growth, margins and, more importantly, RoCEs. Arvind’s business model has been focused on adding Brands & Retail formats. While it has made product extensions in Arrow (Arrow Sport) and US Polo (US Polo Denim), Madura has made extensions across each of its 4 core brands as evident from the below exhibits.

Exhibit 61: Madura’s mix has changed significantly…


Exhibit 62: …over 5 years through brand extensions


Mainline, 72%

Sports, 4%

Women, 3%

Jeans, 7%

Luxure/Elite/Others, 14%

Mix of top 4 brands in FY10

Mainline, 55%

Sports, 16%

Women, 5%

Jeans, 7%

Luxure/Elite/Others,

17%

Mix of Top 4 brands in FY15

Arvind Ltd


Capital efficiency and working capital management

Madura’s capital employed turnover improved from 3x in FY11 to 6x (excluding goodwill on merger with Pantaloons) in FY16 largely due to fixed asset turns of 12x (FY15) and working capital turns of 8x (FY15). Meanwhile, Arvind’s asset turns remained around 2.3x since FY13 as capex intensity increased. The superior asset turns compared to Arvind can be attributed to a leaner portfolio, brand extensions, and lower capex intensity.

Exhibit 63: Madura’s capital employed turnover ratio has increased briskly…


Exhibit 64: …while Arvind’s capex intensity will deter it from achieving those levels


De-merged value is a function of de-merged capital and costs – there can be surprises there

Lastly, some of the learnings for investors while evaluating potential spin-off businesses like Arvind (as was Madura in FY16) are the prospects of (a) surprises on inter-company transactions – profits on stock transfers; (b) change in capital employed as hitherto unallocable capital may get allocated on de-merger; (c) costs of all subsidiaries which were possibly ignored by the street. Considering these, we would be cautious of forecasting sustainable margins or mitigate this risk by ascribing this business a higher cost of capital. The unallocable segment accounts for 20% of Arvind’s capital employed, bringing down the total RoCE of the company despite textile clocking an RoCE north of 20%. The size of the unallocable segment is material and noteworthy while considering any future de-merger of the Brands & Retail business as some portion may get allocated to it, thus possibly diluting the RoCE.

Exhibit 65: Unallocables, a substantial portion of Arvind’s capital employed, significantly reduces overall RoCE

Source: Company, Ambit Capital research. Note: RoCE is Segment RoCE.

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Arvind Ltd


Risks and catalysts Key risks Faster-than-estimated expansion of specialty brands: Specialty brands such as GAP and Aeropostale would ramp us faster if customers in India find the offering and designs compelling despite competition from the likes of Zara and H&M. This scenario leads to achieving 5% EBITDA margin by FY18E and adds 15% to the FY18 EBITDA of branded business.

A significant turnaround in Unlimited: If the repositioned stores of Megamart become relevant in value fashion through higher gross margin own-branded offerings market (500bps higher) and deliver 8% margins in FY18E, they could pose risks to our estimates. The scenario would add 15% to EBITDA of branded business.

Lower capex intensity: The historically high capex intensity could reduce if the company offers more brands through franchisees and MBOs, thus improving overall assets turns over the historical average of 1x. This could drive a 50% reduction in our capex estimates from FY18E and add 7% to our fair value of `311.

Catalysts Adventurism in brand additions to limit margin expansion: Over three-fourth of Arvind’s branded portfolio is yet to be proven or has been persevered with for over 5 years. We believe the insatiable hunger for new brands will result in increased capital employed (`12bn over FY16-19) while brandex will remain at 5.8% of sales in FY19E despite 21% revenue over FY16-19E. This would cap margins of Brands and Retail at 8% in FY18E.

Burn on ecommerce: Foray into ecommerce with the ambition of multiple offerings will translate into a cash burn of around `2.1bn over FY17E and FY18E even as portals such as Creyate.com is yet to take off

Weaker-than-guidance performance of specialty retail: Management expects specialty retail formats GAP and Aeropostale to become a `15bn brand by FY20 with a capital employed of `5bn (3x CE turnover). Given that Zara (Inditex Trent), the most successful foreign brand retailer in India, has capital employed turns of 3x, Arvind brands have to invest more than the indicated `5bn given relatively weaker offerings and inability to match prices and designs. Alternatively, if Arvind invests `5n or less, it is unlikely to meet guided size. Regardless of route chosen, we believe margins will remain low.

Exhibit 66: Explanation of flags

Segment Score Comments

Accounting AMBER Arvind has a low cash conversion ratio at 62% as against 69% for peers, Arvind also has a lower provisioning for debtors > 6 months at 6% vs 25% for peers.

Predictability AMBER Whilst the company has met the guidance at the top line most of the times, we remain worried wrt multiple/ unrelated brand launches and continuing delay in turning around Megamart.

Earnings momentum RED Consensus EPS estimates have been revised downwards post 4QFY16 earnings on the back of increasing debtors- indicating a sales push.


Arvind Ltd


Balance Sheet


Shareholder's equity 2,582 2,582 2,582 2,582 2,582

Reserves & Surplus 24,656 26,535 29,841 34,778 40,786

Total Networth 27,239 29,117 32,424 37,361 43,369

Long Term Borrowings 13,941 14,917 14,453 14,647 13,653

Long Term Provisions 208 236 196 196 196

Total Non Current Liabilities 14,947 16,279 15,681 15,948 15,035

Trade Payables 13,494 15,748 15,174 17,309 19,457

Short Term Borrowings (incl. current portion of long term debt)

20,026 20,485 21,241 20,805 20,512

Short Term Provisions 1,082 925 885 885 885

Total Current Liabilities 37,223 39,794 39,881 41,955 44,141

Total Equity and liabilities 79,757 85,718 88,515 95,793 103,074

Net Block 32,082 34,595 37,146 36,609 35,778

Long Term loans and advances 6,104 5,789 6,555 6,981 7,368

Total Non-Current Assets 39,843 42,635 44,447 44,336 43,892

Inventories 18,450 18,319 18,601 21,030 23,087

Trade Receivables 11,658 14,173 13,012 14,721 16,873

Cash and cash equivalents 833 651 1,828 4,020 6,605

Short Term loans and advances 6,344 6,689 7,526 8,586 9,517

Other Current assets 2,614 3,216 3,100 3,100 3,100

Total Current Assets 39,914 43,083 44,068 51,457 59,183

Total Assets 79,757 85,718 88,515 95,793 103,074


Income Statement


Sales 78,514 84,504 95,073 108,459 120,228

YoY growth 14% 8% 13% 14% 11%

Gross Profit 43,575 47,730 54,531 62,411 68,699

YoY growth 17% 10% 14% 14% 10%

Power and Fuel cost 4,882 4,949 4,952 5,444 5,726

EBITDA 10,129 10,651 11,890 14,271 15,815

YoY growth 11% 5% 12% 20% 11%

Depreciatiom 2,124 2,559 2,949 3,352 3,658

EBIT 8,005 8,092 8,941 10,919 12,157

YoY growth 17% 1% 10% 22% 11%

Other income 932 964 1,168 1,438 1,725

Interest expenses 3,946 3,811 4,266 4,269 4,177

PBT 4,448 5,165 5,844 8,089 9,705

Tax 1,072 1,517 1,753 2,427 2,912

PAT 3,376 3,648 4,091 5,662 6,794

YoY growth -4% 8% 12% 38% 20%

Share of minority interest (35) 21 - - -

Consolidated PAT 3,411 3,627 4,091 5,662 6,794


Arvind Ltd


Cash Flow statement


PBT 4,448 5,165 5,844 8,089 9,705

Depreciation 2,124 2,559 2,949 3,352 3,658

Changes in Working Capital (3,142) (768) (1,375) (3,041) (2,967)

Tax (1,308) (1,225) (1,753) (2,427) (2,912)

Cash Flow from Operations 5,584 8,992 8,762 8,804 9,937

Purchase of Fixed Assets (5,967) (6,206) (5,500) (2,814) (2,827)

Interest received 292 412 1,168 1,438 1,725

Cash Flow from Investing Activities (5,874) (4,977) (2,827) (1,376) (1,102)

Increase/(Decrease) in Long Term Borrowings 1,532 1,326 (464) 194 (993)

Increase/(Decrease) in Short Term Borrowings 2,518 168 756 (436) (293)

Interest paid (3,976) (3,801) (4,266) (4,269) (4,177)

Cash Flow from Financing Activities (485) (4,093) (4,758) (5,235) (6,249)

Net change in cash (775) (78) 1,177 2,192 2,585

Opening Cash Balance 459 651 1,828 4,020 6,605

Closing Cash Balance Cash Balance (316) 573 3,005 6,212 9,190

FCFF 198 3,442 3,262 5,989 7,109


Ration analysis/Valuation parameters


Gross Margin 55% 56% 57% 58% 57%

EBITDA margin 13% 13% 13% 13% 13%

EBIT margin 10% 10% 9% 10% 10%

PAT margin 4% 4% 4% 5% 6%

Net Debt:Equity 1.2 1.2 1.0 0.8 0.6

RoCE 11% 9% 9% 11% 11%

RoE 14% 13% 14% 15% 16%

EPS 13.2 14.0 15.8 21.9 26.3

P/E 25.1 23.6 21.0 15.1 12.6

P/B 3.1 2.9 2.6 2.3 2.0

EV/EBITDA 14.5 14.1 10.1 8.2 7.2

EV/Sales 1.9 1.8 1.3 1.1 0.9

P/CFO 15.4 9.5 9.8 9.7 8.6


Arvind Ltd


Appendix Distinct five phases in evolution In the backdrop of the Great Depression of 1930, Arvind Ltd. (‘Arvind’) was incorporated in the pre-independence era in order to satiate the demands of superfine fabric whose supply had abruptly been halted due to the boycott of cloth imported from UK. Since commencing with weaving and spinning operations, Arvind has come a long way in evolving from a company deriving revenue from textiles to getting international brands on board and diversifying into retailing.

Exhibit 67: Evolution of Arvind (consolidated) over FY1997-2016

Source: Company, Ambit Capital research. Note: RoCE=EBIT(1-t)/ (average capital employed)

Exhibit 68: Post FY09 turmoil leverage levels have been under control


Phase I (FY97-FY02): Massive expansion, debt restructuring and learnings

In 1997, Arvind initiated massive expansion to become the third largest denim manufacturer in the world, with a 120mn meter annual production capacity. This expansion plan, to build a `10bn complex in Gujarat, was funded by loans from both Indian and foreign lenders.

0%

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(` bn) Textiles revenues (LHS) Brands & retail revenues (LHS) RoCE (RHS)

Leveraged Expansion and the downturn

Hit by denim cycle laws

Uncertainity StabilityShift in focus to brands

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FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15

(x)(%)

Capex to operating cash flow Net debt to equity

Revenues CAGR 11% Median RoCE 4% Cash generation over the period 154% Leverage 1.9x over FY03-06

Arvind Ltd


However, the expansion plans went awry due to: (a) delays in commissioning of the plant, (b) down cycle in the demand for denim; other cotton products (such as chinos, gabardine and corduroy) were replacing demand for denim, (c) global overcapacity in denim production leading to a price crash, and (d) translation loss on dollar debt due to depreciation of INR. Consequently, the company suffered losses in FY00 of `2,714 mn and `5,000mn in FY01 and debt-equity ballooned to 5.7x making interest payments difficult (debt service coverage ratio was at 38% in FY01).

In early 2001, Arvind announced the plan to restructure its total debt of over `27bn owed to more than 80 lenders, including several foreign lenders (36% of total debt). The plan provided for a permanent reduction in the interest burden of the company.

The company then followed a de-risking strategy by (a) de-commoditising the denim business through a more differentiated/value added portfolio (b) reducing dependence on denim (due to its cyclical nature) (c) focusing on higher value added garments, and (d) divesture of 54% stake in Arvind Brands Limited to ICICI Ventures in FY04 (this stake was later bought back by Arvind in FY06).

Phase 2 (FY03-FY06): Diversification and garmenting expansion

This phase witnessed diversification from denims to wovens (increased shirt and knits and addition in garmenting capacity in the run up to dismantling of quota regime (which capped the exports of countries such as India).

During the period, Arvind undertook vertical integration; established shirt manufacturing facility of 4.8mn pieces per annum, jeans manufacturing facility of 4mn pieces per annum, and commissioned spinning facility. Further, denim capacity was increased by 10mn meters, to 120mn meters by end of FY05. Despite the capex and enhanced capacity, the capital employed turnover remained fairly stable at 6.1x during the phase.

Phase III (FY07-FY09): De-centralisation across verticals and focus on value addition

This phase witnessed de-centralisation in textiles – with geographic marketing teams and new business head in Brands & Retail – Mr J Suresh. During this phase, Arvind formulated the strategy of forgoing volumes in lieu of profitability and pursuant to this had reduced its denim manufacturing capacity to 84mn meters from around 120mn meters. Focus on the premium market has been a key reason for turnaround of the denim business; with realisations increasing to `116 per meter in FY09 from `94 per meter in FY07.

Over FY07-09, the garments and brands & retail business started contributing significantly (20%) to the top line; these two businesses deliver lower operating margins (less than half of textiles) compared to the traditional fabric manufacturing business. Megamart was repositioned from surplus outlet to selling private labels (such as and brands such as GANT, US Polo Association, Izod and Pierre Cardin Paris were launched. This phase also witnessed the sale of Arvind’s stake in JV with VF brands which held the licensing rights for Lee and Wrangler. The company made a one-time gain of `1bn in FY07 on sale of its stake.

The brands business moved towards focus on buying finished/packaged goods instead of buying/manufacturing fabrics and getting job work done. This had a further dampening effect on the operating margin but it improved the cash conversion to 100% while RoCE remained meagre at 5% as company incurred two thirds of `9bn CFO as capex.

“Everything on paper looked right. The plan was aggressive, but strategically well-placed. But the company failed to anticipate the execution complexities and lacked management bandwidth. The projects took longer to come on stream and the capex cycles had started. They had to go through a significant amount of pain as they were overleveraged.” Arvind Singhal, Founder of Technopak in Mint newspaper 28 Aug 2015

Revenues CAGR 6% Median RoCE 8% Cash generation over the period of 29% Leverage of 1.5x

Revenues CAGR 12% Median RoCE 4% Cash generation for the phase of 101% Leverage of 1.7x over FY07-09

Arvind Ltd


Exhibit 69: Decline in denim volumes


Exhibit 70: Decline in revenue contribution from fabrics


Phase IV (FY10-FY12): Shift towards brands

Over FY10-12 revenues grew at a 23% CAGR, with the Brands & Retail business exhibiting a stellar growth of 45% CAGR; power brands such as Arrow, US Polo (growing at more than 100% YoY) and Flying Machine were major contributors to growth. Moreover, share of the Brands & Retail business grew from 18% to 27% over the three years resulting higher working capital and hence deteriorating in cash generation (average 62%). However, textiles business drove the margin expansion where EBIT margins improved to 9% in FY12 (from 7% in FY10). The company also embarked on generating cashflows from sale of surplus real estate to reduce debt.

Exhibit 71: Change in revenue mix over FY10-12


Phase V (FY13-FY16): Building on portfolio of brands

During this phase the company forayed into technical textiles, Brands & Retail started firing as a portfolio. During this period capex intensity (`18bn) continued to increase the capacity of wovens (from 96 to 132 mn metres) and garmenting (from 10 to 23 mn pieces) and roll out of stores in Brands & Retail. Also, the real estate development businesses (Arvind Infrastructure) were demerged.

EBITDA margins remained stable at 13% throughout the phase, thus the rise in RoCE can be attributed to (a) the increase in asset sweating/utilisation (to 1.4x in FY15 from 1.2x in FY13), and (b) fall in depreciation charge (due to extension in useful asset life).

82 71 67

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140

- 10 20 30 40 50 60 70 80 90

FY07 FY08 FY09

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(in

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Volumes Realisations

57%47% 50%

15%17% 20%

18%19%

21%

10% 17% 9%

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FY07 FY08 FY09

Fabric Garments Brand & retail Others

75% 72% 68%

19% 22% 27%

6% 6% 5%

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100%

FY10 FY11 FY12Textiles Brands and Retail Others

Revenues CAGR 23% Median RoCE 10%

Cash generation of 75% over FY10-12 Leverage of 1.3x over the period

Revenues grew at 17% CAGR Median RoCE 11%

Cash generation of 71% during this phase Leverage of 1.1x over the period

Arvind Ltd


Exhibit 72: Brand and retail contribution to revenue mix has risen gradually


Capital allocation Over FY06-15, the company heavily invested in the Brands & Retail business; funding all capex, losses and working capital requirements of the segment. Most funding has been made through loans and advances to and equity investments in Brands & Retail subsidiaries. Therefore, the standalone cashflows have been utilised for capex as well investments and over the period resulted in increase in debt. Over the period, interest rates averaged at 11% (peaking at 15% in FY12). The company has over the years invested in other businesses such as technical textiles and real estate (now de-merged).

Exhibit 73: Sources of funds over FY06-15(Standalone)

Source: Company, Ambit Capital research, Note: the capital allocation is based on the standalone business

Exhibit 74: Application of funds over FY06-15

Source: Company, Ambit Capital research, Investments represent funding other businesses including brands

70% 68% 63% 61%

26% 28% 30% 32%

4% 4% 7% 7%

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20%

40%

60%

80%

100%

FY13 FY14 FY15 FY16

Textiles Brands and Retail Others

CFO, 68%

Net borrowing,

14%

Sale of business/share in JV,

8%

Share capital, 4%

Other income, 6%

Interest paid, 42%

Investments, 28%

Capex, 26%

Dividend paid, 4%

Arvind Ltd


Institutional Equities Team Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research Analysts

Name Industry Sectors Desk-Phone E-mail

Nitin Bhasin - Head of Research E&C / Infra / Cement / Industrials (022) 30433241 [email protected]

Aadesh Mehta, CFA Banking / Financial Services (022) 30433239 [email protected]

Aakash Adukia Oil & Gas / Chemicals / Agri Inputs (022) 30433273 [email protected]

Abhishek Ranganathan, CFA Retail (022) 30433085 [email protected]

Achint Bhagat, CFA Cement / Home Building (022) 30433178 [email protected]

Anuj Bansal Mid-caps (022) 30433122 [email protected] Ashvin Shetty, CFA Automobile (022) 30433285 [email protected]

Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 [email protected]

Deepesh Agarwal, CFA Power Utilities / Capital Goods (022) 30433275 [email protected] Dhiraj Mistry, CFA Consumer (022) 30433264 [email protected]

Gaurav Khandelwal, CFA Automobile (022) 30433132 [email protected] Girisha Saraf Mid-caps / Small-caps (022) 30433211 [email protected]

Karan Khanna, CFA Strategy (022) 30433251 [email protected]

Kushank Poddar Technology (022) 30433203 [email protected] Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected]

Paresh Dave, CFA Healthcare (022) 30433212 [email protected]

Parita Ashar, CFA Metals & Mining / Aviation (022) 30433223 [email protected]

Prashant Mittal, CFA Strategy / Derivatives (022) 30433218 [email protected]

Rahil Shah Banking / Financial Services (022) 30433217 [email protected]

Rakshit Ranjan, CFA Consumer (022) 30433201 [email protected]

Ravi Singh Banking / Financial Services (022) 30433181 [email protected]

Ritesh Gupta, CFA Oil & Gas / Chemicals / Agri Inputs (022) 30433242 [email protected]

Ritesh Vaidya, CFA Consumer (022) 30433246 [email protected] Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Automobile (022) 30433292 [email protected]

Sagar Rastogi Technology (022) 30433291 [email protected]

Sumit Shekhar Economy / Strategy (022) 30433229 [email protected]

Utsav Mehta, CFA E&C / Industrials (022) 30433209 [email protected]

Vivekanand Subbaraman, CFA Media (022) 30433261 [email protected]

Sales

Name Regions Desk-Phone E-mail

Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7614 8374 [email protected]

Dharmen Shah India / Asia (022) 30433289 [email protected]

Dipti Mehta India / USA (022) 30433053 [email protected]

Hitakshi Mehra India (022) 30433204 [email protected]

Krishnan V India / Asia (022) 30433295 [email protected]

Nityam Shah, CFA USA / Europe (022) 30433259 [email protected]

Parees Purohit, CFA UK / USA (022) 30433169 [email protected]

Praveena Pattabiraman India / Asia (022) 30433268 [email protected]

Shaleen Silori India (022) 30433256 [email protected]

Singapore

Pramod Gubbi, CFA – Director Singapore +65 8606 6476 [email protected]

Shashank Abhisheik Singapore +65 6536 1935 [email protected]

USA / Canada

Ravilochan Pola - CEO Americas +1(646) 361 3107 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Sharoz G Hussain Production (022) 30433183 [email protected]

Jestin George Editor (022) 30433272 [email protected]

Nikhil Pillai Database (022) 30433265 [email protected]

mailto:[email protected]

Arvind Ltd


Arvind Ltd (ARVND IN, SELL)

Source: Bloomberg, Ambit Capital research

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Arvind Ltd

Arvind Ltd


Explanation of Investment Rating

Investment Rating Expected return (over 12-month)

BUY >10%

SELL <10%

NO STANCE We have forward looking estimates for the stock but we refrain from assigning valuation and recommendation

UNDER REVIEW We will revisit our recommendation, valuation and estimates on the stock following recent events

NOT RATED We do not have any forward looking estimates, valuation or recommendation for the stock POSITIVE We have a positive view on the sector and most of stocks under our coverage in the sector are BUYs

NEGATIVE We have a negative view on the sector and most of stocks under our coverage in the sector are SELLs

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Documents

INITIATING COVERAGE ARVND IN EQUITY July 11, 2016 …reports.ambitcapital.com/reports/Ambit_Arvind_Initiation_Theyarn... · Arvind’s cyclical textile business generated steady cash