At 3x CY2008 EPS, Eastern Silk is one of the cheapest growth
stories we’ve ever seen, with very strong insider ownership (nearly 50% of the
company) and smart management.
Eastern Silk is a manufacturer and exporter of silk fabrics
of the largest, representing nearly 10% of all Indian silk exports in a very
fragmented market. The company, which is decades old, prepares and sells yarn created
from silk waste but also spins, dyes, weaves, prints, embroiders and finishes
handmade and machine-made silk fabrics. Over the past several years the company
has consistently pushed to generate higher revenue realizations per meter of
fabric. It is now commissioning a facility to dramatically increase made-up
capacity (curtains, bed covers, cushion covers, etc.) near Bangalore.
Despite significant growth and excellent execution, the
stock trades at 4x current fiscal year EPS (ends March 2008) and less than 3x
next year. The market cap of the company is $85 million, with net debt of $15
mm and an EV of $100 mm. The stock is fairly illiquid (trades maybe $200k per
day total on two Indian exchanges) but absurdly cheap. Our target price is at
least 600 rupees (+200%), which is 8x our FY 09 estimate.
We first purchased stock over a year ago as the company was
talking about investing $20mm in two expansions: 450k additional meters of
annual autoloom fabric capacity at its Bangalore unit (to a total of 1.85mm meters
per annum capacity companywide) and the new made-up plant in Bangalore to
produce 1,500 finished sets per day. Both of these projects were supposed to
come online in the first half of fiscal 2008.
At that time we spent a lot of time calling people in the
industry in India
trying to understand the company’s ability to sell out the added capacity and
get general impressions on the quality of management and the company’s product.
Every check came back positive. Our biggest concern back then was execution
regarding internal design capabilities as the company moved to higher-end
fabrics. In late 2006, the stock was trading around 260 rupees with projected
current year (FY 07) earnings per share of 36 rupees.
What has happened since then? The expansion of the autoloom
fabric capacity came on as planned in June 2007. The made-up plant has been
delayed several times and is now scheduled to start-up by the end of the March
2008 quarter (FQ4 ’08). Despite that hiccup, the company has dramatically
improved average per meter realizations, revenue, margins, EBITDA, and EPS.
With the expansion (which includes high-end double width jacquard and velvet
fabrics) and other internal design capability improvements, the company has
found new customers throughout Europe. Whereas
low margin yarn and plain fabric represented as much as 50 – 60% or more of
revenue combined in fiscal 2007, this will be down to 30% - 35% in fiscal 2008
and 20 – 25% in fiscal 2009. Made-ups will increase to 20 – 25% of revenue in
2009 from 16% - 17% in 2008. Average revenue realizations per meter of fabric
have climbed from <$10 to $12+ in 2007 and $15+ in 2008. We expect this to
further increase in 2009 to $17+, continuing the trend of margin expansion the
company has demonstrated over the past several years.
Year End March,
Profit to Common
The company has maintained a low tax rate based on its
building of manufacturing capacity in India’s
Special Economic Zones, which were launched in India in 2000 to promote investment
and exports. While we are not experts on this topic, our understanding is that the
company can maintain these tax rates for more than a decade assuming it makes
modest investment in additional capacity (not a problem given it is operating
at 90% of capacity today).
Eastern Silk has been planning a fairly large acquisition in
Europe of a distribution and design house. The
rationale is that the company can enhance its internal design capabilities,
lock-up an outlet for its product, dramatically improve earnings at the
acquired company by sourcing from itself (whereas many European distributors
source from Europe-manufactured silk), and improve its multiple by moving
downstream to a more design and brand-driven business with higher barriers to
entry. We obviously don’t like any type of equity dilution at these prices (the
company has talked about trying to minimize dilution by doing a convert), but
we do see this as a positive catalyst for the shares. We have spoken with the
company about initiating a buyback, which is difficult given the trading volume
but could presumably improve the price prior to any convert issue.
Eastern Silk’s forward expansion isn’t unprecedented. The best
comparable, Himatsingka Seide (HSS IN; $200mm market cap), has expanded into
made-ups and domestic and international retail (through its 13 Atmosphere home
furnishings stores in India
and several in other Asian countries). HSS also recently acquired two US distributors and a premium Italian linen
brand with a small retail presence throughout Europe.
It’s worth noting that Himatsingka (which has been missing expectations
recently), even after the recent mini correction, trades at 17x current fiscal
year EPS and 9x next year. Other textile comps in India trade at up to 15x forward
earnings. We would argue Eastern Silk has among the best growth potential of
the bunch, but perhaps deserves some discount due to the relative illiquidity
of the shares.
Eastern Silk is also pursuing domestic brand partnerships to
sell directly to consumers through Indian retail outlets.
The massive volatility in Indian markets (most indexes down
15% from peaks over the past month) caused investors to ignore a huge Q3 for
ESLK. The company showed that it can continue to improve margins while selling
out the added capacity (revenue up 35% y/y, EBITDA up 46%, EBITDA margins of
22.6%). There is certainly exposure to a US/European recession, but ESLK has
dramatically improved the quality of its offering, opening new markets (the
company only recently started selling in Poland,
Hungary, Ireland, and
other European countries). It is also among the worldwide low cost suppliers.
Many distributors are paying significantly higher prices for European
manufactured silk, and ESLK need only to continue to close the quality gap to
close the price gap.
DISCLOSURE: We and our affiliates are long Eastern
Silk, and may long additional shares or sell some or all of our shares, at any
time. We have no obligation to inform anyone of any changes in our views. This
is not a recommendation to buy or sell shares.
Continued earnings growth; potential stock buyback; distribution acquisition; branded partnership in Indian retail.