The Curious Case of Kitex Garments

The last 3 years have been exceptionally good for small cap investors in India. The BSE Small Cap index has more than doubled, driven by an increase in P/E multiples and also fairly good earnings growth. There are several companies in the small cap universe which have delivered astronomical returns of over 10-50x in a short period of time. Small cap investing is the latest get-rich-quick scheme. As history has shown, this kind of euphoria rarely ends well.

Kitex Garments Limited (“Kitex”) is one of the many multi-baggers in the small cap universe and has delivered over 8x returns in the last 3 years. This is despite the 50% fall in the stock over the last year (excluding which the returns are 16x!!!). However, what’s interesting about Kitex is the numerous questions it raises if you start studying its business and analysing its financials.  We discuss a few of the key concerns below.

1. The curious case of the unbelievably profitable “commodity” business

Kitex manufactures and exports infant garments and derives a majority of its revenues from export of garments to US and Europe. A part of Kitex’s revenues are from sale of fabric to a related party (Kitex Childrenswear) which also manufactures infant garments. Kitex has a concentrated customer base with its top 5 customers (likes of Gerber, Toys“R”Us, Mothercare, Jockey, Carter’s) accounting for over 80% of revenues.

Apparel manufacturing is an intensely competitive business as large customers (brand owners and retailers) have significant bargaining power and product differentiation is fairly low. Likes of WalMart, Gerber and Toys“R”Us have suppliers across the world and they set the prices. As such, the apparel manufacturing industry has struggled to generate a high ROE over the long term. This has been broadly true for the last 100 years.

Kitex, however, seems to be an exception. The company has an exceptionally high profit margin and ROE. Kitex is probably the world’s most profitable apparel manufacturing company (measured by ROCE – return on capital employed). In fact, Kitex which is a B2B company is more profitable than even B2C apparel companies which have strong brands (like Page Industries which owns the license for Jockey in India).

in Crs FY12 FY13 FY14 FY15 FY16
Kitex Revenue 321.0 317.1 454.4 524.7 565.3
EBITDA 65.7 65.8 110.2 184.1 208.5
EBITDA Margin 20.5% 20.8% 24.3% 35.1% 36.9%
Pre-Tax ROCE* 34.5% 32.8% 51.3% 75.4% 81.9%
Page Industries Revenue 705.7 908.1 1252.7 1622.8 1865.9
EBITDA 154.8 189.1 262.7 328.6 384.4
EBITDA Margin 21.9% 20.8% 21.0% 20.2% 20.6%
Pre-Tax ROCE* 54.8% 58.0% 57.9% 54.9% 55.3%

*Pre-Tax ROCE is EBIT / Capital Employed (Excl Cash)

Kitex’s high profitability is a source of mystery. One of the rules of capitalism is that any company earning supernormal profits will see the emergence of competition seeking to eat into its profits. The only way a company can then continue to enjoy supernormal profits is if it has a sustainable competitive advantage (say brand, network effects, economies of scale, switching costs). Companies that don’t have such an advantage (also referred to as moat) will see an eventual decline in their profits.

Kitex’s investors believe that its customers are willing to pay a premium because of its high standards of quality and compliance with labor and environment laws. Kitex is also believed to benefit from the high switching costs of its customers – buyers spend a lot of time in selecting, evaluating and approving vendors. The above points suggest that Kitex has a fair bit of leverage when it comes to its customers. However, the practical reality seems otherwise. While Kitex is largely dependent on 5 customers for a large majority of its revenues, Kitex accounts for less than 1% of supplies (rough estimate) to these companies and is one of 100s of empanelled suppliers. Why would customers with a high bargaining power knowing that Kitex is dependent on them (and they are not) still allow it to make supernormal profits? Even if Kitex has some pricing power, despite the one-sided dependence, is it likely to be so high as to allow them to have profit margins that are 2-3 times that of peers and even higher than B2C companies? That just seems too good to be true.

 2. The curious case of the zero-interest earning cash and high cost debt

When the business has supernormal profitability, it generates tons of cash from operations. Kitex is no exception. Over the last 5 years, the company has generated over 340 crores in free cash flow (FCF). Typically, when a company generates so much FCF it either returns the excess cash to its shareholders through dividends or pays down its debt. Kitex has been an exception here. It has paid out very little cash as dividends over the last 5 years (less than 30 crs) and its debt has surprisingly increased in this period. This is quite odd because debt needs to be regularly serviced with interest payments of as high as 11.9% while cash deposited in even long-term FDs earns typically less than 8% per annum. It is not clear why a company would continue to pay high interest costs when it has cash available to repay the complete debt.

But this is not the most surprising part of Kitex’s cash situation. Kitex actually does not earn any interest on its cash balance as it has not converted its foreign exchange earnings into INR and instead kept it in a current account earning zero interest. This is because Kitex’s CEO (Mr. Sabu Jacob) believes he will generate higher returns by converting $s at a later date when the INR depreciates. It is amazing that Mr. Jacob believes that he can generate returns higher than 11.9% (the interest cost on debt) per annum by indulging in currency speculation. The fact that the CEO is focusing on these non-core activities reflects poorly on Kitex’s corporate governance standards. Over the last year, Mr. Jacob has at multiple times said that he will very soon pay down the entire debt. That hasn’t happened yet because Mr. Jacob isn’t quite happy with the current exchange rate!

in Crs FY12 FY13 FY14 FY15 FY16
Total Debt 101.5 101.2 134.2 161.2 110.1
Interest Cost 18.8 13.1 12.3 21.1 16.1
Avg. Cost of Debt 17.9% 12.9% 10.5% 14.3% 11.9%
Cash & Cash Equivalents 36.5 41.2 103.6 203.3 254.5
Interest Income 0.3 0.4 0.4 0.4 0.3
Avg. Interest on Cash 1.4% 1.0% 0.6% 0.3% 0.1%

But this is still not the most surprising part of Kitex’s cash situation. RBI mandates that all foreign exchange earnings need to be converted into INR within a month (Read here – https://goo.gl/DRcuOV). We discussed with banking experts if there was any way for companies to hold $s for more than a month and did not find any alternative option. So while the management says their entire cash has been lying in $s for the last several years, it is not clear how they are able to do so considering the RBI does not allow it!!

[Old market participants might find Kitex’s cash and debt situation similar to Geodesic Limited – http://goo.gl/vmmKDm]

 3. The curious case of the missing TUFS subsidy

One of the reasons given by the Kitex management for not reducing its debt burden is the subsidy it gets under the Technology Upgradation Fund Scheme (TUFS) of the government. As per Kitex, the TUFS subsidy effectively reduces the interest cost on their debt (bringing it down from 11.9% to 7%). While it does not make sense to incur even a 7% interest cost, the TUFS subsidy does reduce the negative impact of the debt burden.

However, as per the last 10 years’ annual report, Kitex does not seem to get a significant amount of subsidy from TUFS. Kitex has only recognized a TUFS subsidy income of INR 12 crs over the last 7 years. Most of this subsidy income actually came in the earlier period of 2010-2012. In fact, over the last 3 years when Kitex has seen the highest cash accretion it has received a TUFS subsidy of only INR 2 crs. This data conflicts with the management assertions of TUFS subsidy driving down net interest costs. If Kitex does receive sizable TUFS subsidy, why doesn’t it show up in its audited accounts?

in Crs FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 Total
Subsidy Income – TUFS 0.0 4.7 1.9 3.2 0.2 0.1 1.2 0.7 12.0

But wait, (as always) this is still not the most surprising part here. As of March 2016, Kitex had an outstanding TUFS subsidy receivable of INR 8.7 crs. This means that of the INR 12 crs of TUFS subsidy income, Kitex has so far only been able to collect INR 3.3 crs. In fact, over the last 2 years Kitex has not been able to collect even 1 rupee of TUFS subsidy!!! This is all a bit bizarre. Why is Kitex claiming TUFS subsidy as the reason for its continuation with high cost debt, when it does not really have a lot of income from it and is not even able to collect the meagre reported subsidy income? And why has the auditor not asked the company to write-off this receivable which is now several years old?

4. The curious case of other related entities doing the same business

Kitex’s cash management practices might seem bizarre but the way it has structured its operations is quite interesting as well. Kitex’s promoters have related entities which are engaged in the same activities as Kitex Garments Limited. Kitex Childrenswear Limited (“KCL”) which is 100% owned by Kitex’s promoters uses the same infrastructure, has same management, makes similar products and pretty much sells to the same customers as Kitex. In fact, ICRA in its credit rating of Kitex’s debt takes a consolidated view of Kitex and KCL’s financials due to the strong operational linkages between the two entities. Such a structure is rarely seen in companies with good corporate governance practices due to the inherent conflict of interest.

Kitex’s promoters attribute the structure to legacy reasons wherein they were compelled to start another venture as the banks were unwilling to lend to the listed entity. Even if this were true, what does not make sense is why the promoters have done little to resolve the conflicts created by a structure of the past. In 2015, Kitex’s foray into brand retail in US was done as a JV with KCL – which further increased the operational linkages and the conflict of interest. Considering the similarity in the business of Kitex and KCL, it might be expected that their fortunes move in tandem. But that does not seem to be the case. KCL’s revenues and margins have see-sawed compared to the one-way improvement in Kitex’s financial performance. KCL though does share Kitex’s penchant of hoarding cash despite a high debt outstanding on its books.

Kitex Childrenswear Limited – Financial Summary

in Crs FY11 FY12 FY13 FY14 FY15
Revenue 111.9 206.7 143.5 250.2 204.2
EBITDA 18.0 29.8 23.5 57.4 39.7
EBITDA Margin 16.1% 14.4% 16.4% 22.9% 19.4%
Total Debt 59.8 90.9 69.9 83.2 79.4
Cash & Cash Equivalents 3.6 41.1 22.3 80.1 103.8

Over the last two years, Kitex’s promoters have formed three more companies (separate from the listed entity) – Kitex Infantswear Limited, Kitex Apparels Limited and Kitex Herbals Limited. At least 2 of these companies have names that suggest they may be in a similar business as Kitex. It is unclear why promoters are even now forming companies outside the Kitex listed entity. Are they still facing challenges similar to what led to the formation of KCL?

5. The curious case of speedy reporting of financial results

Over the last four years, Kitex has been the first listed company in India to report its audited financial results (Reporting dates: FY16 – 4th April, FY15 – 6th April, FY14 – 3rd April, FY13 – 4th April). Normally, this would be viewed positively as it is reflective of strong financial controls inside the company.

In order to ratify the accounts, the auditor needs to gather substantive audit evidence which includes – physical inspection of assets (machinery, inventory), obtaining confirmations from third parties (banks, suppliers, customers), examining transaction records, checking assumptions and calculations. Completing all these activities within 3-4 days of the end of the financial year while theoretically possible has several practical challenges (for eg. In FY16, April 1st was a bank holiday followed by a weekend which limits ability to get third party confirmations). Even large audit firms with extensive resources are unable to complete the annual audit in such a short period of time.

Kitex’s auditor is the Cochin-based Kolath & Co which does not audit any listed entity other than Kitex. Given Kolath’s limited experience in auditing large businesses, its ultra-quick completion of Kitex’s audit raises concerns about the comprehensiveness of the audit. While Kitex’s audited results demonstrate a high level of efficiency, its secretarial compliance reports show delays in its filings (P&L, Balance Sheet, Modification of Charge, Changes in Directors) with the Registrar of Companies. Kitex’s selective efficiency in financial reporting is quite puzzling.

Kitex has clearly been a significant value-creator for shareholders over the last 5 years. However, many of the business practices of the company raise serious concerns. It would be good to understand what magic wand the company uses to park its surplus cash in $s when RBI policy clearly does not allow it. The claims of the benefits of TUFS does not seem consistent with the reported financials. The promoter’s actions of forming JVs and more new companies outside the listed company is clearly poor corporate governance practice. Even if all the issues above are ignored, it is still difficult to comprehend what competitive advantage Kitex enjoys that allows it to have best-in-the-world ROCE.

In times of euphoria, corporate governance is rarely focused on. However, over the long term, it is the most important source of value creation. Long term investors would do well to keep that in mind.

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27 Comments
  1. Ankit Jai

    Well written!!!

  2. Rahul

    Dude… good details… pls write more…

  3. Ashwini Damani

    Questions for Amit
    Well at the outset, I must congratulate you for the well-structured write-up. I am not that good a writer and really this was a lesson to me on how to structure the thoughts beautifully.
    Well since it’s a blog, I expect you would want a counter view also. Well, cutting down the chase, here are my alternate viewpoints on the Kitex Saga.

    TUF Subsidy
    • TUF Subsidy is received in two parts – for Capex (deducted from cost of assets) and for Interest Subsidy (shown as other income). Refer document attached
    http://texmin.nic.in/sites/default/files/Anx-A%20Modified%20TUFS%20Scheme%202012-2017.pdf
    • The receivable of both is shown under Current Assest. Unfortunately you have forgotten to conisder the Capex TUF Subisdy, so your analysis is incorrect here (Refer Annual Report page 100 and Page 110)
    • You will observe similar numbers in Balance Sheet of SP Apparels – a competitor – Refer documentattached (http://www.sebi.gov.in/cms/sebi_data/attachdocs/1451449620283.pdf)

    Margins
    • Check Margins of other players (including Jay Jay Mills and SP Apparells (http://www.sebi.gov.in/cms/sebi_data/attachdocs/1451449620283.pdf). – Refer document attached
    • Kitex earns higher due to avg cost being lower due to volume effect. So customer will look for a product at a specific rate say 100 Rs. Everyone is free to supply at 100 and for the customer it doesn’t matter whether you produce at 60 or 70 or 110. The margins are for yours to keep.
    • Still there have been players who were not in the childwear segment and have managed to observe the margins of Kitex and come into the segment and have been able to scale up the sales phenomenally. So Capitalism is alive and kicking. Refer document attached (http://www.careratings.com/upload/CompanyFiles/RR/Jay%20Jay%20Mills%20_India_%20Private%20Limited-02-10-2014.pdf)
    • Also do watch out for comments on Kitex in the prospectus. SP and Jay Jay (not a full time player) earn 20%+ margins in the kids segment.
    • As regards Page is concerned, they have stated that they can earn much superior margins but want to keep competition out, so they ensure that margins are maintained near 22% and additional income is deployed in Sales and Promotion to ward competition off. A lesson Kitex must learn. Page adopted the strategy to keep entry prices at Rs. 10-20 higher than Lux/Rupa so that they can entice customers

    c. Debt
    • Well as far as currency speculation is concerned Mr Sabu is wrong.
    • But he seems to have earned 163 mINR in Forex Gain, which is higher than his Interest cost for the year
    • Average cost of debt calculation – you need to guide me how you got that. I seem to be not arriving at the same numbers as you have. I guess you have just done = Interest Cost/ (Opening Debt +Closing Debt)/2. You need to answer if this is scientific.
    • Many companies have debt as well as cash on books (Case in Point Symphony). This because Debt is cheap. As per Kitex AR, they get debt at less than 12%.

    1. Amit Mantri

      Thanks Ashwini for writing in. Appreciate all counter-views. My thoughts on the points you mention –

      1. TUFS
      As far as I understand, Capex TUFS subsidy does not result in a decrease in interest cost. It is a subsidy on the capex not on the loans from the banks. So even if Kitex did not take any debt for this capex they would still get the capex subsidy. Either way, given the low capex by Kitex it is not a significant amount. More importantly, this still does not address why they have not been able to collect any significant TUFS interest subsidy over the last several years. These receivables are now outstanding for 3-4 years at the least.

      2. Margins
      Volumes can result in a little higher profitability than others but not the kind that Kitex is reporting. Apparel manufacturing just does not have those kind of economies of scale. I don’t know any other large player (globally) who makes even 10% PAT margins let alone the levels that Kitex makes. The kind of ROCEs being generated is rare in any industry let alone when one has a concentrated customer base with low differentiation. Nevertheless, since I cannot factually disprove their profitability I have tried to provide other areas where there is clearly something funny going on. I am surprised that no one has still been able to explain the EEFC $ cash issue. How is that possible when RBI does not allow it and banks cannot do it. Why are ppl believing managements claims when this can be easily verified independently (as we have done)? And if management is lying about this, what does that mean about their reported financials? Request you to call your bank RM and ask them an explanation how the company can do this EEFC magic. If you get a proper response, share it here and I will pretty much remove this entire post.

      3. Yes, I have calculated the debt cost by using average of debt levels. This is normal practice to get rough estimates (not looking for exact %). In fact, the annual report provides the interest cost for different loans and they are broadly similar. 11-12% cost of debt is not cheap especially when cash is earning 0% and can be easily used to repay the debt. I am not sure if forex gain was due to the cash on books or due to some forward contracts that Sabu talks about. And the fact they have made gain of 16 cr on 250 crs cash to compensate for much lower debt amount just seems bad cash management. Next year, that gain could turn into a loss. Irrespective of the actual forex gains or losses this is not a sensible thing to do.

      1. Janarthanan Natarajan

        Amit,

        Well written article. However, your conclusion that one cannot maintain money in foreign currency in EEFC is not correct.
        I am reproducing the below 2 Q&A from the RBI website ( https://rbi.org.in/Scripts/FAQView.aspx?Id=21 )

        Q 4. How much of one’s foreign exchange earnings can be credited into an EEFC account?
        Ans. 100% foreign exchange earnings can be credited to the EEFC account subject to the condition that the sum total of the accruals in the account during a calendar month should be converted into Rupees on or before the last day of the succeeding calendar month after adjusting for utilization of the balances for approved purposes or forward commitments.

        Q. 12. Whether the EEFC balances can be covered against exchange risk?
        Ans. Yes, the EEFC account balances can be hedged. The balances in the account sold forward by the account holders has to remain earmarked for delivery. However, the contracts can be rolled over.

        You can see from the above that bank converts USD to INR by end of next calendar month only for the amount which does not have a forward contract. One can continue to hold the money in USD as long as there is a forward contract. These forward contracts can be rolled over too. This way one can continue to hold foreign money in EEFC account.

        Coming to cost of debt – Kitex long term debt is at ~11.7%. But most of their debt is short term which is packing credit (in INR). With interest equalisation the interest rate for packing credit is is 6.75%. You can check this in FY16 Kitex annual report too.
        Also when you book forward contracts there is a forward premium. For example, you can check USDINR for 1 year forward contracts. Current spot rate is ~Rs 67 for 1 USD. 1 Year forward is ~Rs 71 for 1 USD. So essentially you lock in money with some premium(in this case Rs 4 premium to the current spot rate which is roughly 6%).
        So essentially the company is borrowing packing credit at 6.75% and getting a forward premium of 6% on their money in EEFC account. I personally do not think it is a bad strategy.

        1. Amit Mantri

          We have checked with multiple bankers that your interpretation is not possible. You can check the same.

          1. Janarthanan Natarajan

            Go through the below link
            https://buyerscredit.wordpress.com/2015/03/19/using-eefc-buyers-credit-payment/

            You will find an instance where you can retain money in foreign currency in EEFC for future. In the above link you will find that the reason is for repayment of buyers credit. You can also check the clarification from RBI for this specific case. There are many other cases where one can do the same as long as the exporter can show the money in EEFC is required for future commitments. Some of the other reasons could be – payment for import of machinery, materials, investment in foreign subsidiary etc. Also, if the balance in EEFC has forward contracts, these contracts could be rolled over on maturity(these forward contracts cannot be cancelled however since 2012 RBI circular). When rollover happens on maturity date you have future contract again. This way foreign currency in EEFC stays for longer duration. This is the point I was trying to make in my previous post. I have confirmed all this with a retired banker(who spent his entire career in treasury/forex) and who is now consulting with an export unit on forex related matters.

            I want to emphasize that the statement “RBI mandates that all foreign exchange earnings need to be converted into INR within a month. We discussed with banking experts if there was any way for companies to hold $s for more than a month and did not find any alternative option” is not correct. There are ways to keep foreign currency in EEFC account for longer duration.

          2. Amit Mantri

            I apologize for the lack of clarity in my statements. My statement is indeed incorrect because it lacks the correct context. As the RBI clarification circular (link in post) clearly states – “sum total of the accruals in the account during a calendar month should be converted into Rupees on or before the last day of the succeeding calendar month after adjusting for utilization of the balances for approved purposes or forward commitments”, EEFC balance for approved use and forward commitments can indeed be kept for longer duration. My statement that it is not possible was in the context of Kitex as it does not have comparable forward commitments (its imports are less than 50 crs) and management has stated that the only reason to keep it in $ is for exchange rate timing. My discussions with bankers was regarding EEFC balances without any significant forward commitments (as in the case of Kitex). This has been confirmed to not be doable under RBI regulations. There is no issue with EEFC balances with approved uses though bankers say it is rare for companies to have approved uses beyond a few months thus forcing them to convert most of the EEFC balance in a month. I should have provided this context in the blog post as well as my earlier comment.

        2. Ak

          @Amit: In regards to the comment by JN, Kitex can still keep the cash for forward contracts. Maybe they made money on the forward contracts and hence, the 6.75%+6% (typical) premium made sense for them. While I agree this is not a sustainable deployment of cash, what are your thoughts on that?

  4. Kumar

    is it another satyam?

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  6. Prash

    Well written article.
    Just a comment on the Debt part. I think, it makes all the sense to leverage sometimes as you do get to pay lower taxes because of interest cost. So net effective interest after accounting for subsidy and lower taxes will be much lower than 11.9% reported.
    Many company’s which have a Capex, do keep the Debt and never close it even if cash is present because of this reason.

    1. Rishit

      It would be fairly ridiculous to save 30% tax and let go 70% as interest cost when you could have spent 0% as interest cost. Keeping a reasonably sufficient cash balance to avoid any cash or liquidity crunch is a different story, but keeping as much cash as is sufficient to repay unnecessary debt is something inexplicable!

      1. Ak

        @Rishit: How did you calculate the 70% on interest cost?

  7. raj

    nice one

  8. Sreekanth

    Just brilliant analysis. I always suspected this company but didn’t have ability to pin-point as much as the author did.

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  10. dilip sethi

    This type of study creates confidence in the investors. Well written and good study.

  11. Puru Ji

    Very good information.

  12. Snehal

    Well written Amit !

  13. Varun

    Have anyone checked their inventory levels? A company with Rs 600 cr of sale with inventory of just Rs 51 lacs or less than 1 day of finished goods inventory and just 10-12 days worth of raw material (cost basis) ?

    Is it something I am missing here?

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    1. Amith

      This is a spam website with sole intension to defame Kitex. The above mentioned website http://thebetterinvestor.com was registered on 29-October-2016, just two days before the post is made. Also the above mentioned post is made exactly on November-1 which shows that either both http://2point2capital.com and http://thebetterinvestor.com belongs to the same owner or that you know each other. Because on the same day it is not possible to get the source through a Google search. Please stop this non sense criticism. We are serious investors and this kind of defamative actions are against the interest of broader public.

      1. Amit Mantri

        The post was made in July 2016 and not November as you say and I do not know the owner of the thebetterinvestor.com. The post is based on publicly available information. None of this is even remotely defamatory. I do not think the criticism is nonsense but you have the right to believe so.

  15. Upen

    I’m a trying to gather data about this company inorder to assess the existing investment. Unfortunately, I didn’t find much information on their company website.Could you please provide some pointers on how to research? or where to find it? Appreciate your help on this

  16. Vimal

    https://janav.wordpress.com/2015/04/07/kitex-garments
    This is a nice piece of review about Kitex. Even though there was a correction after this post, there is a huge upside in waiting for the stock.

  17. atul

    I read book Shoe Dog and memoir on Nike fouder Phil Knight. I observed that though show making is a much complicated task than sewing cloths Nike changed vendors seamlessly. So I am quite sure that there is no MOAT in terms of relationship with big brands buying from Kitex.

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