Kewal Kiran- It is not always about growth

For the last three years, I am invested in this apparel company that has hardly grown its core profits and yet share price has doubled during this period. Quite often, my friends question my investment rationale on a company that has not been offensive in its approach to expand (despite having relevant opportunities) and available at high valuations (30x trailing P/E). I say high valuations, because most investors compare P/E with growth (popularly known as PEG ratio) and for a company that is not growing its earnings this mean PEG ratio of 30 (a very high number)

I thought to review the investment case after its full-year FY17 numbers were released last week. Before I get going with financials, let me explain the business profile for the beginners. Kewal Kiran Clothing Ltd. (KKCL) designs, manufactures and markets branded jeans, formals, semi-formal and casual wear for both men and women under 4 brands- Killer, Integriti, Lawman and Easies. It is largely a branded jeans player (65% of revs.) and deriving majority of its revenues from its flagship brand Killer (51% of revs.)  The branded apparel sector growth should be driven by usual investment case (i.e. rising per capita income, growing fashion consciousness, aspiration value, etc.) and within the branded apparel sector, denim wear provides a stable long-term growth opportunity driven by the timeless appeal of denim amongst the youth. The largest section of the market is still catered by the unorganized sector and the transition to the organized (so easy to plug-in GST word here) and branded segment has lured many domestic (Flying Machine/Wrangler from Arvind Ltd, Spykar owned by PE fund.) and MNC players (Levis, Pepe).

However, it is not the biz profile that drives my attention, but accompanying financial strength that keeps me invested. Let me explain some numbers here- For FY17, company reported Rs 5 bn in revenues and with an impressive ~20% EBITDA margin (Rs 1 bn in EBITDA), minimal depreciation charge, virtually zero debt and tax rate of ~30%, it reported adj. net profit (excl. other income) of Rs 0.65 bn.    This net profit is generated on net worth of Rs 3.6 bn and capital employed of Rs 3.75 bn, translating into RoE of 18% and RoCE of 17%. But what fascinates me is how this capital (Rs 3.75 bn) is employed into biz – it has Fixed Aseets of 0.75 bn, non-current assets (excl. Investments in MFs) of only Rs 50 mn and working capital (excl. cash & ST inv.) of Rs 0.4 bn. In other words, the actual money employed into biz is only Rs 1.2 bn and rest is cash equivalents (Rs 2.5bn). Therefore, the point I am making here is KKCL’s return ratios are much higher than what appears at first sight. My calculations suggest that it has RoCE of whopping 55% (NOPAT of Rs 0.67 bn / CE of Rs 1.2 bn). Company claims for RoCE in operation are even higher at 65% for FY17. To confirm if P&L numbers are not inflated, I look at cash flow statement where I see that reconciliation between reported earnings and cash flows is excellent as EBITDA to Op. cash flow is at ~100%.

Thus, its financial strength is impeccable with sector-leading margin of 20%, net cash of ~Rs 2.5 bn, RoCE of 55%, strong cash flows and payout ratio of ~50%. Such financial strength is unheard among its peers (except Page Industries which owns Jockey brand) and is a result of KKCL’s successful brand, pan-India distribution, asset-light franchise biz. model, and most importantly it is a reflection of conscious strategy to not run with the crowd and chase market share, but indulge in steady race. Further, I find solace in the fact that promoters have ~75% of total ownership and no pledges or dilutions in the past.

The next question is at what price such financially strong biz is available- I would put that in context of theoretical RoE and P/BV relation which states that P/BV = RoE- g/ Ke–g. Assuming cost of equity as 12%, growth at 5% and RoE as calculated above at ~55%, theoretical P/BV should be 7x. Whereas stock at CMP of Rs 1700 and Mkt-cap of Rs 21bn, trades at 5.9x. In a market where most other companies are trading at frothy valuation and some making new highs everyday even disregarding basic P&L risks, I think this discount in valuation for KKCL should be pounced upon.

Key risks:

Some investors doubt how KKCL generates such margins and return ratios and have failed to understand the moat in the business that drives the strength: My argument will be that financial irregularities and P&L fancies generally do not last wrong, but KKCL has delivered consistently for last 5-6 years now with reasonably good dividend track record. Also, I have mentioned moat above- franchise based biz model, pan-India distribution network and efficient manufacturing setup.

Can denims continue to grow in the longer run: Maybe not as strong as other fashion-wear category, but certainly denims have timeless appeal among youth. 

Conclusion:

The branded retail segment has seen few success stories and quite often wealth-erosion (Koutons, Canatabil, Zodiac) companies due to over-bloated B/S and super aggressive strategies that lead to encompassing excess risks. KKCL's biz. strategy on the other hand is a classic example of slow and steady to win the race.