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.

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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 – 4^th April, FY15 – 6^th April, FY14 – 3^rd April, FY13 – 4^th 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 1^st 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.

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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.