ABC Lanka is one of the leading weft knitted fabric manufacturers in the country providing innovative solutions to top global apparel brands. With approximately 35% market share, ABC operates one of the most technologically advanced manufacturing facilities in South Asia with a capacity of 2.8 Mn Meters of fabric per month. Currently ABC operates as a joint venture between Pacific BC and MN Lanka. We believe the substantial expansion in the top line as well as reduction in cost base driven mainly by the low cotton prices and energy cost saving through its recently commissioned multi fuel plant to bring superior growth in the bottom line. On a conservative estimate, we forecast three-year revenue CAGR of 10.3% for FY 2014/15E-FY2016/17E.
Equity Research Report
|Market cap (LKR Mn)||16,254.5|
|Market cap/Total market cap||0.55|
|Public Holding (%) – Dec’14||30.17|
|52-week High/Low (LKR)||24.90/15.20|
|Average Daily Volume (52 weeks)||704,295|
|52 week ASPI return (%)||21.1|
|52 week Stock return (%)||60.6|
|Share Price Movement|
|Summary Financials – Year end 31st March|
|Profit before Tax||1,193||1,304||1,635|
|Profit after Tax||1,153||1,258||1,577|
Healthy topline growth supported by strong order book
The long standing relationship with its main clients as well as company’s efforts to serve new clients guarantees a strong demand for ABC’s products. ABC’s increased focus on value-added products has helped expand ABC’s product & service offerings and is likely boost revenue of the company. The recovery in the US and Europe economies is expected to increase the demand for ABC’s products further. The capacity expansion that was carried out last year eliminates the risk of capacity constraints and allows the company to meet this increased demand.
Robust profit margins
ABC’s value added fabric portion currently accounts for nearly 23%of ABC’s product portfolio. Value added products allow company to charge premier prices over normal products and to maintain higher GP margin. The easing of production cost due to lowering yarn prices, energy cost saving from the multi- fuel boiler power plant and reduced dependence on outsourced orders should strengthen ABC’s margins.
ABC is currently trading at the P/E of 14.10. According to our estimates ABC will incur EPS of LKR 1.74, LKR 1.90 and LKR 2.39 in FY2014/15E, FY2015/16E and FY2016/17E respectively. Based on DCF valuation we suggest a share price of LKR 38.42 which is 56.2% higher than the current share price. We also projected average dividend payout of 75% in our forecasted period. We recommend BUY
Low cotton prices to improve profit margins
Fluctuations in global cotton prices are particularly relevant to ABC performance as cotton is the primary raw material through which knitted fabric is produced. The Yarn costs account for approx. 60 -65% of ABC’s turnover and accounts for largest cost component of the company. ABC sources cotton yarn predominantly from India and Bangladesh with a lead time of 10 weeks. Specialty yarn for value added products are sourced from Austria and a hub in India facilitates the storing of this fibre.
Cotton prices reached its all-time high of USD 2.15 per lb in March 2011 (Source: Bloomberg). This came out as a result of the devastating floods seen in Pakistan, which is one of the largest producers of cotton and due to the panic buying triggered with the scarcity. Heightened demand from China, world’s largest cotton consumer added further pressure to the price.
TJL is to benefit from low cotton prices
Cotton price movement
According to International Cotton Advisory Council (ICAC) cotton prices will prove their weakest in five years in year 2014-15 cautioning over the slide in Chinese imports prompted by excessive stockpiling. As the largest producer and importer of Cotton, Chinese Cotton supply and demand have a significant impact on global cotton prices. China produces approx. 28.0% (ie: 33,000 bales) of the World’s total Cotton supplies, but imports approx. 44.0% of global Cotton. By the end of the year, stocks held outside of China are forecast to rise by 20%, to nearly 9 million tons, the second largest volume after 2004/05 in the last 30 years. Much of this increase will be held by producing countries and will likely cause world exports to fall 15% to 7.5 million tons.
China Cotton Supply & Use
Source: National Cotton Council of America
However, world cotton output is estimated down 1% at 26.1 million tons from reductions in China and the Southern Hemisphere. The expected decline in the global cotton prices implies positive prospects for ABC’s short-medium term GP margins.
World Cotton Production
Source: National Cotton Council of America
The expected reduction in utility cost to improve the margins further
At present, ABC’s utility cost stands at 10% – 12% of turnover from which 67% is contributed by furnace oil and 33% by electricity. The utility cost is significantly higher than utility costs in FY10/11 (ie: 7% – 8% of sales) and this increase in cost has been due to energy price revisions in the domestic power & energy sector. However, in January 2015, the Ceylon Petroleum Corporation of Sri Lanka reduced the furnace oil prices by around 11% in line with the crude oil price reduction in global market. We expect this cost saving to reflect in ABC’s total cost from FY2015/16.
The reduction in furnace oil prices and electricity bill to ease the total energy cost
ABC identified the risk of totally relying on state provided furnace oil and its uncertain price volatility and began constructing the island’s first CCHP (Combined Cool Heat and Power) Multi- Fuel boiler and power plant during FY2013/14. As per the current plan, this will be commissioned in the second quarter of FY2014/15. Once operational, the plant will produce ABC’s total current steam requirement and will substantially reduce the dependence on furnace oil. The steam generated will also be used for air conditioning, and to generate 1 MW of power, which will reduce electricity consumption and dependency on the national grid.
The commissioning of the multi fuel boiler and power plant to reduce TJL’S dependence on national grid substantially
We expect this cost-saving initiative to reduce ABC’s medium-term energy costs and to reduce the current energy costs as a percentage of turnover to approx. 8.0% (from 10.0%) once the boiler plant is fully operational.
Capacity expansion and regional expansion strategy to add significant long term value
ABC increased its production capacity by around 10% via an investment of USD 4.0 mn to the existing capacity of the factory premises situated in Avissawella during 4QFY2014. This expansion modernize the existing machinery, increase efficiency and reduce costs by reducing dye, chemical and water consumption, as well as process time.
This added capacity is expected to fully materialize over the coming years and is expected to support top line growth of the company. ABC currently utilizes approx. 87% of its total productive capacity and is expected to increase capacity utilization to 88%-89% over the medium-term. ABC’s increased capacity implies that its reliance on outsourced orders will minimize and that new orders that are currently refused due to capacity constraints will ease. However, according to the company, ABC will continue to outsource around 10% of annual sales to arrive at optimum product mix which provides optimum returns while retaining all customer orders.
ABC expects to expand capacity via acquiring a running fabric mill as an initiative to become the leading solutions provider of weft knit fabric in the South Asian region. As a first step to this goal, ABC entered into a technical service agreement for two years commenced in October 2013 with Ocean India (Pvt) Limited, a knit fabric manufacturer located in India where ABC will receive a fee of USD 780,000 per annum for the services provided.
Going further ahead, ABC is now considering the acquisition of Ocean India Private Limited and Quenby Lanka Prints (Pvt) Ltd. Quenby Lanka Prints (Pvt) Ltd is currently a strategic vendor of ABC and located in the Seethawaka International Industrial Estate in Avissawella with close proximity to ABC’s production facility. If these two acquisitions will be made, it should help ABC’s expansion strategy while adding long term value.
Increased focus on Value-added fabrics to escalate revenue growth and to margin expansion
ABC’s topline growth is also likely to be supported by its increased focus on value-added fabrics. The continuous innovative process enables the ABC to deliver the finished products within the days of the purchase order and dramatically reduce the lead time to customers. ABC’s value added fabric portion currently accounts for nearly 23% in comparison to 8% in FY2011 whilst the management targets to achieve 40% in value added fabric over FY2015E-FY2017E. In FY2013/14 the value added products recorded 115% growth compared to previous year and company focuses on targeting products that were traditionally manufactured in Europe to be produced in Sri Lanka and this initiative has enabled the company to offer more value added fabric production via diversifying into multiple programs within key clients. Moreover, value added products allow ABC to charge premium prices over normal products and to increase its GP margin.
Robust pickup in demand supported by recovery in US and UE markets
ABC has a good mix of US and EU based customers and provides a healthy geographic diversification. During FY2014/14 these two markets showed a pick-up in demand compared to the previous year and we expect this momentum to continue with the improvement in the consumer spending particularly in U.S. We expect ABC’s strong order book with a diverse customer base including emerging brands to allow ABC to react proactively towards the market changes and to record impressive revenue growth.
The U.S. economy started the 2015 year with momentum and it is expected to record highest economic growth rate after 2003. A primary driver for the stronger estimates of overall economic growth in the year is stronger consumer spending. The acceleration in improvement of the labor market is a likely reason for increased consumer confidence and the improvement in wages. Another factor that may support consumer spending on clothing is the recent decrease in gasoline prices. Since gasoline can be considered as an obligatory expense for many households, the decrease in gasoline prices can be expected to lift disposable income. In November 2014 the U.S. month over- month increase in consumer spending on apparel was the strongest in nearly three years.
Customer Centricity to strengthen the order book
The four leading brands under ABC’s key client portfolio, Intimissimi, Victoria’s Secrets, Marks & Spencer, and DBA currently account for nearly 80% of its revenue. Company has built a strong relationship with its main clients over the years and its product & service offerings evolve with the Client’s unique needs. The continuous innovations to add value to products, excellence in quality and customer service have enabled ABC’s clients to gain a competitive edge over many of the producers.
ABC has been consciously reduced the risk exposure to its key client portfolio via the initiation of catering to emerging brands such as Calvin Klein, Express, Original Marines and Polo Ralph Lauren. These emerging brands account for 20% of ABC’s revenue and in during FY2013/14 revenue from this segment increased around 50%.
Financial Analysis and Forecast
We expect the revenue of the ABC to post a YoY growth of 7% during FY2014/15E. Our revenue forecasts are maintained at 11% YoY to LRK 15,113 Mn in FY2015/16E and 13% YoY to LKR 17,078 Mn in FY2016/17E on the back of improved value added product mix and volume growth. Moreover, we believe demand for ABC’s product volume will be supported its well-established client relationships, the recovery in US and UE markets and capacity expansion of the company. We expect Addition of new capacity to eliminate the risk of capacity constraints and minimize the rejection of orders that are currently refused due to capacity constraints while minimizing low-margin third party subcontracting.
According to our projection sales volumes are expected to grow by 5% YoY in FY2014/15E, 7% in FY2015/16E and 9% in FY2016/17E.
Revenue and Revenue Growth
Source: TJL & SMB estimates
We projected the GP margin of the company to increase to 13% in FY2015/16E from current GP margin of 11.45%. The declining trend in the yarn prices with the cotton price reduction and the utility cost saving from the multi- fuel boiler and power plant likely to reduce production cost while providing margin expansion. According to our projection the Operating profit margin of the company will also expand with the expansion in the GP margin. We expect administration expenses to escalate 12.8% YoY in FY2014/15E and 10.9% YoY in FY2015/16E.
Source: TJL & SMB estimates
We projected full year earnings of ABC to post 9.16% growth to LKR 1,258 Mn in FY2014/15E, with 9 months earnings growth of 2% to LKR 822 Mn, driven by healthy revenue growth (7% YoY) coupled with strong margin expansion at both the gross and operating levels. We expect net profit growth to accelerate to 25.4% in FY2015/16E.
Our valuation is based on the free cash flow method and the stock has the potential value of LKR 38.42. In order to carry out the valuation, we took 7% as the nominal risk free rate. We assumed a risk premium of 5.5% with the beta value of 1.2 (based on ASPI and stock price movement). The terminal growth rate is expected to be 8%, which is in line with our forecasted GDP growth rate of over 8%.
The stock has a forward PE multiple of 12.92x on FY2014/15E EPS of LKR 1.90 and the current price of LKR 24.60. Based on the FY2015/16E and FY2016/17E the stock has a forward PE multiple of 10.30x and 9.02x on forward EPS of LKR 2.39 and LKR 2.73. The Manufacturing sector PE stands at 22.62x as at 16th February 2015.
We further expect ABC to maintain average dividend payout of 70% in our forecasted period. Accordingly ABC will incur DPS of LKR 1.33, LKR 1.67 and LKR 1.91 for FY2014/15E, FY2015/16E and FY2016/17E respectively.
Considering the company’s positive future prospects and the current trading price, as well as high dividend payout, we estimate the share to have significant upside potential. BUY