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

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 – 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

[Old market participants might find Kitex’s cash and debt situation similar
to Geodesic Limited –]

* 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


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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