Margins hit a 20-quarter low in Q2, but lower cotton prices and demand restoration can ease pressure

The second quarter of fiscal 2018 was the least profitable in five years for spinners, or cotton yarn mills. Margins touched 10.3%, compared with a peak of 18.8% in the corresponding quarter of fiscal 2014.

That’s because the spread between prices of cotton (with a one-quarter lag) and cotton yarn was at a low of Rs 89/kg (compared with Rs 130/kg at peak in the fourth quarter of fiscal 2013). The spread is a good indicator of the profitability of mills, considering cotton accounts for over 65% of the total operating cost. A one-quarter lag in cotton prices is presumed as most spinners maintain an inventory of 60-90 days.

Among other issues, disruptions stemming from rollout of the Goods & Services Tax (GST) took a toll. As such, excess spinning capacity in the past two years (~2.5 million spindles added over fiscals 2016 and 2017) in anticipation of expiring textiles policies in Maharashtra and Gujarat had affected the pricing flexibility of mills. Further, a decline in yarn exports, induced by reduced sourcing from China (accounting for 36% of India’s exports), also impacted the margins.

However, a sharp increase in cotton production (expected ~375 lakh bales) in cotton season (CS) 2017-18 will be a shot in the arm for spinners in the last two quarters of this fiscal, and thwart further drop in margins. Also, demand normalisation after demonetisation and GST-led disruptions would improve utilisation.

Falling cotton prices will also improve prospects for cotton yarn exporters in the second half of this fiscal. India is the largest producer of cotton, which improves competitive advantage of local mills for fibre procurement. Further, rising synthetic fibre prices amid inflationary pressure on crude oil will drive substitution demand towards cotton yarn manufacturers. Overall, we still expect ~200 bps fall in the margins for cotton spinners on year basis in fiscal 2018 inspite of the improvement expected in the second half.