Description

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 from India—one 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.

 

Fiscal Year End March,
(in Million Rupees)	2006	2007	2008E	2009E
Revenue	3905	4512	5751	7073
Revenue Growth	15.6%	15.5%	27.5%	23.0%
EBITDA	678	855	1248	1768
EBITDA Margin	17.4%	18.9%	21.7%	25.0%
Depreciation	(118)	(104)	(129)	(180)
Interest	(176)	(202)	(210)	(270)
Other Income	56	147	100	100
Taxes	(52)	(120)	(160)	(230)
	-11.8%	-17.2%	-15.9%	-16.2%
Net Profit to Common	377	565	838	1,177
Shares	13.49	15.79	15.90	15.90
EPS	28.0	35.8	52.7	74.0

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.

Catalyst

Continued earnings growth; potential stock buyback; distribution acquisition; branded partnership in Indian retail.