#1© The Pakistan Credit Rating Agency Limited. PACRA SPINNING SECTOR An Overview September 2020#22 TABLE OF CONTENTS • • Textile | Value Chain Spinning | Introduction & Process Spinning A Brief Overview 3 • Rating Curve • World Cotton Dynamics • . • Pakistan Cotton Dynamics Installed Capacity & Production Business Risk · Cost Structure 4 7 8 9 12 14 18 20 • • • • Financial Risk Impact of COVID-19 Duty & Sales Tax Structure Regulatory Environment SWOT Analysis · Conclusion Bibliography 24 82222222 29 31 26 27 PACRA#3• 3 TEXTILE | VALUE CHAIN . Textile cluster has one of the largest value chains in the manufacturing universe. The following flow chart depicts the major processes along with the output of every process of the textile cluster's value chain: COTTON CROP GINNING SEED COTTON • RAW FIBER SYNTHETIC FIBER SPINNING WEAVING DYEING & FINISHING •YARN • RAW FABRIC • FINISHED FABRIC STITCHING •GARMENT/ HOME TEXTILE PACRA EXPORT/RETAIL#4• • • 4 SPINNING | INTRODUCTION & PROCESS . Spinning is the process of twisting together of drawn out strands of fibers to form yarn. Process: • Blow Room: To form a uniform lap from the cotton bale. Carding: Cleaning and intermixing of fibers to produce a continuous web. Combing: Separating long staple fibers from short staple fibers. Drawing: Strengthening fibers by passing them through rollers. Roving: Fibers are converted into low twist lea called roving. Ring Frame: Spinning and winding the fibers around a rotating spindle. Blow Room Carding Combing Drawing Roving Machine Ring Frame PACRA#5SPINNING | TECHNOLOGY & MACHINES • • . • Major manufacturers of spinning machines (i.e. spindles & rotor machines) and other textile machinery are based in Germany, Italy, Belgium, Switzerland, China, and Japan. Major manufacturing brands include Saurer Schlafhorst GmbH & Co., Toyota, Murata Machinery Limited, Savio Machine Tessilli, Rieter, RIFA Textile Machinery Co. Ltd. Lakshmi Machine Works Limited, among others. The efficiency of spinning machines is determined by the number of spindles installed on the machine and its RPM. More advanced machines have higher RPM, resulting in higher efficiency. The RPM of latest looms from major manufacturers can reach up to ~125,000 - 150,000RPM. Overall, spinning machines have low cost investments. The price ranges between USD ~300- 800/spindle depending on the RPM, level of automation of back processes and country. The spindles are mounted on frames. Almost all machinery used in the sector is imported from Europe and East Asian Countries (mainly China). Further, there is a need for continuous technological BMR to improve efficiency to remain competitive in the international landscape. 5 Source: Manufacturers Websites PACRA#6SPINNING | TYPES | YARN COUNT PACRA Types of yarn are differentiated by the material used and/or yarn count; Cotton Yarn • Synthetic Yarn (Polyester, Nylon, Acrylic, etc.) . Blended Yarn • Yarn count is a measurement which determines its fineness or coarseness. • • • • There are two methods of calculation of Yarn Count, Direct and Indirect, with Indirect method more widely practiced. The Direct Method uses weight per unit length to determine count with thicker/coarse yarn having higher count. There are various numbering systems as shown in the following table. The Indirect Method uses length per unit weight to determine count with finer yarn having higher count. There are various numbering systerms as shown in the table. Jute Count Numbering System English cotton count, Ne/S Numbering System Unit of Length Unit of Weight Tex System, Tt Denier, D or Td 1000 m No. of grams 9000 m No. of grams DeciTex, dtex 10,000 m No. of grams Millitex, mtex 1000 m No. of milligrams Kilotex, ktex 1000 m No. of kg 14,400 yards No. of lb. Unit of Length Unit of Weight 840 yards I lb. 1000m / 1km I kg 256 yds. I yd. I lb. I ounce (oz.) 560 yds. 300 yds. I lb. I lb Count Coarse Medium Fine S.Fine 1s - 20s 21s - 34s 36s - 47s 48s - 80s Metric count, Nm Woollen Count (YSW) Woollen Count (Dewsbury) Worsted Count Nek The English numbering system is practiced in Pakistan. The unit length of 840 yards is also Linen Count, NeL known as a hank. The number of hanks per lb. of yarn equals the yarn count. In Pakistan, yarn is divided between coarse, medium, fine and super fine categories based on count with major production concentrated in coarse and medium count yarns. . Different dying and chemical processes adds value to the product. • The higher count yarn attracts higher price. Yarn Type 6 Source: Yarn Counts & Calculations, Thomas Woodhouse (Oxford Technical Manuals), TCO#7. SPINNING | A BRIEF OVERVIEW The spinning sector is at mature stage and enjoys a long operating history in the country. PACRA • • • . . The spinning sector is divided into two segments, i). Organized segment and ii). Unorganized segment. Unorganized segment roughly accounts for ~40-50% of total spinning capacity. No conclusive figures are available on the share of each of these sub-segments in the total spinning sector. Our focus is on organized segment in this sector study. Overall, the structure of the sector is competitive, represented by many players of different sizes making homogeneous commoditized products. The price variation in local yarn prices come from quality and some differentiation (dyed yar, blended etc.) The major export destinations of the sector are other China, Asian & South Asian countries which utilize yarn as an input in the manufacturing process. There are ~80-100 players in the organized segment in operations. On average, players have installed capacity of ~40,000-50,000 spindles. Players having installed capacity of <30,000 spindles are considered small sized, between 30,000 to 60,000 are medium scale, and >60,000 are large scale manufacturers. Minimum installed capacity in organized segment is ~20,000 spindles. The large manufacturers enjoy economies of scale resulting in efficiency and higher margins than peers. Textile cluster represents ~20.9% weight in Large Scale Manufacturing (LSM) index with spinning sector having ~13% weight in LSM index. The spinning sector contributed an estimated 2.6% in the overall GDP of the country. 7 Source: PBS, SBP, TCO, PACRA Database#8SPINNING | RATING CURVE 8 • PACRA rates ~2,141,000 spindles or ~19% of the total operational spindles. Spinning | PACRA vs. VIS 10 8 6 4 2 I 2 4 9 7 5 4 2 2 3 0 0 0 0 0 0 AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ PACRA VIS 0 0 0 88 BB BB- B+ PACRA Source: PACRA Database#99 SPINNING | WORLD COTTON DYNAMICS PRODUCTION & YIELD PACRA World Cotton Production (000 MT) • World cotton production stood at 26.8mln MT in FY20, showing a CAGR of ~6.5% since 2016. Country FY16 FY17 FY18 FY19 FY20 India 5,639 5,879 6,314 5,617 6,641 China 4,790 4,953 5,987 6,042 5,933 • India & China remain two of the largest cotton producers in the world, representing ~47% of total output. United 2,806 3,738 4,555 3,999 4,336 States Brazil 1,289 1,528 2,007 2,830 2,874 Pakistan 1,524 1,676 1,785 1,655 1,350 • All major cotton producing countries have shown positive growth in the last 5 years. On the contrary, Pakistan experienced contraction in its cotton output by ~3%pa. Rest of 4,889 5,452 6,341 5,691 5,640 World Total 20,937 23,226 26,989 25,834 26,774 World Annual Cotton Yields (Kg/Ha) . Pakistan's cotton production represents ~5% of total world output. 2000 . Annual cotton yields remained relatively stable since FY 16 around the world. 1500 . Among the major cotton producers, China & Brazil have the highest cotton yield per hectare. 1000 500 • Pakistan's cotton yield clocked in at ~550kg./ha, one of the lowest in the world. 0 FY16 FY17 FY18 FY19 FY20 Brazil China USA India Pakistan Source: Trade Map, USDA#10SPINNING | WORLD COTTON DYNAMICS CONSUMPTION & ENDING STOCK PACRA World Cotton Consumption (000 MT) • Total world cotton consumption stood at ~22mln MT in FY20, showing a negative CAGR of ~2.5% since FY 16. Country FY16 FY17 FY18 FY19 FY20 China 7,838 8,382 8,927 8,600 7,185 India 5,389 5,302 5,258 5,225 4,355 • China & India are two of the largest cotton consumers in the world, representing ~52% of total world consumption. Pakistan 2,243 2,243 2,373 2,330 1,960 Bangladesh 1,372 1,481 1,633 1,611 1,350 Turkey 1,459 1,426 1,622 1,502 1,393 Vietnam 980 1,176 1,437 1,524 1,328 • Despite low contribution in world output, Pakistan stands as the third largest Rest of cotton consumer and consumes ~9% of total output. 5,374 5,280 5,475 5,407 4,779 World Total 24,655 25,290 26,725 26,199 22,350 • The world held ~22mln. MT of cotton as at June 20. • China & India hold ~56% of the world's cotton inventory. Country FY17 World Cotton Ending Stocks (000 MT) FY16 FY18 FY19 FY20 China 12,345 9,998 8,272 7,766 8,109 • China has steadily reduced its cotton inventory since FY16. On the contrary, India 1,534 1,716 2,009 2,028 4,140 Brazil 1,243 1,509 1,885 2,668 3,022 India & Brazil have significantly increased their holdings. United 827 599 914 1,056 1,589 States • Pakistan's cotton stock remained relatively stable over the last few years. Pakistan 569 504 616 543 630 Rest of 3,118 3,149 3,922 3,460 4,404 World Total 19,636 17,475 17,618 17,521 21,894 10 Source: USDA, Trade Map#11SPINNING | WORLD COTTON DYNAMICS IMPORTS & EXPORTS • • Total world cotton trade remained relatively stable over the last few years and stood at USD 11.5bln in FY20. In volume terms, ~8.6mln MT cotton was traded in FY20. China, Vietnam and Bangladesh remained top 3 cotton importers in the world. Pakistan was the fifth largest importer of cotton in FY20. India has drastically reduced its cotton imports during last 5 years. China Vietnam Bangladesh PACRA World Cotton Imports (USD mln) Country FY16 FY17 FY18 FY19 FY20 1,315 1,803 2,820 3,302 2,720 1,384 1,924 2,429 2,063 1,699 869 1,474 1,732 1,690 1,392 Turkey Pakistan 1,043 1,383 1,243 1,456 1,199 750 805 1,078 767 880 Indonesia 916 1,093 1,285 1,035 852 • United States is the largest exporter of cotton and represents ~50% of total cotton exports. US has almost doubled its share in world exports since 2016. Rest of World 2,846 3,242 3,479 3,641 2,752 Total 9,122 11,723 14,065 13,955 11,494 World Cotton Exports (USD mln) • • Other than US, Brazil, Australia and India account for ~25% of world cotton exports. Pakistan's cotton imports grew by ~6.5% p.a. in quantity terms since 2016. The country's imports increased due to declining local production. Pakistan imported 536,000MT of raw cotton in FY20. During 2MFY20, Pakistan imported ~75,000MT (2MFY19: ~20,000MT) of cotton amounting to USD ~120mln (2MFY19: USD ~34mln), a ~317% rise. The extraordinary increase came on the back of cotton shortage in local market due to heavy rains. United States Country FY16 FY17 FY18 FY19 FY20 3,113 5,760 6,587 5,891 5,601 Brazil 1,429 956 1,505 2,093 2,032 Australia 922 1,320 1,612 1,823 660 India 1,874 1,657 1,958 1,554 544 Greece 306 380 399 522 490 Benin 232 266 406 487 111 Rest of 1,246 1,384 1,598 1,585 2,056 World Total 9,122 11,723 14,065 13,955 11,494 11 Source: Trade Map, USDA, PBS#12SPINNING | PAKISTAN COTTON DYNAMICS AREA UNDER CULTIVATION | COTTON ARRIVALS • . Cotton crop competes directly with rice, a major export crop, and sugarcane. The support price by government coupled with its high disease resistance makes sugarcane a strong competitor. Resultantly, Pakistan's area under cultivation for cotton crop has declined by ~375,000 (13%) hectare since FY16. Meanwhile, cotton yield remained stagnant over the last few years. In line with above-mentioned factors, Pakistan's cotton arrivals declined to 8.6mln bales in FY20 from high of 14.8mln bales in FY15. Pakistan achieved ~96% (i.e. ~2.2mln hectare) against proposed sowing target of ~2.3mln hectare in FY20. The cotton crop has been impacted by abnormal weather conditions so far. Hence, the quantity and quality of output is expected to deteriorate. Pakistan is expected to produce ~7-8mln bales in current harvesting season. Province Punjab Sindh KPK Region Punjab 12 PACRA Area Under Cultivation (000 Hec.) FY16 FY17 FY18 FY19 FY20 2,243 1,815 2,053 1,888 1,889 621 637 612 448 599 0 0 0 0 0 Baluchistan 38 37 35 37 39 Total 2,902 2,489 2,701 2,373 2,527 Pakistan Cotton Arrivals (Min. Bales) FY 16 FY17 FY18 FY19 FY20 6 6.9 7.3 6.6 5.1 Sindh Total of Pakistan 3.8 3.8 4.3 4.1 3.5 9.8 10.7 11.6 10.7 8.6 Cotton Unit Conversion Unit 1 Bale 1 MT Conversion 170kg 1,000kg Source: PCGA, PCCC#13SPINNING | PAKISTAN COTTON DYNAMICS COTTON ENDING STOCK • • In order to meet its consumption requirements, Pakistan has increased its reliance on imports as local production reduced. Pakistan's major import destination remains United States. Pakistan also imports cotton from Brazil, Turkey & Australia. The prices of Pakistan cotton are in parity with prices in international market. PACRA Pakistan Cotton Ending Stocks (000 MT) FY16 FY 17 FY18 FY19 FY20 Opening Stock Production 93 0 75 162 185 1,686 1,814 2,031 1,676 1,560 Imports 417 506 599 415 536 Consumption 2,147 2,220 2,508 2,055 1,960 Exports 49 25 35 13 13 • However, the country's ending stock has shown steady growth, clocking in at 308,000 MT in FY20. Ending Stock 0 75 162 185 308 13 Source: PCCC#14SPINNING | INSTALLED CAPACITY & UTILIZATION PACRA · There are ~13 million spindles and ~200,000 rotors installed in the country. LSM | Cotton Yarn Production (Tones) • Out of this capacity, ~1 million spindles (~85%) and ~127,000 rotors (~64%) were operational as at end of June 2020. 350,000 300,000 250,000 200,000 FY16 FY17 FY18 FY19 FY20 Spindles Installed Spindles Worked 150,000 Punjab Rotors Installed 9,546,468 8,108,030 85,480 9,546,468 9,546,468 9,546,468 9,546,468 8,108,030 8,164,270 8,164,270 8,164,270 100,000 Rotors Worked 59,038 85,480 59,038 Spindles Installed 2,661,701 2,661,701 85,480 59,038 2,661,701 85,480 59,038 2,661,701 85,480 50,000 59,038 0 2,661,701 July Spindles Worked 2,150,328 2,150,328 2,169,328 2,169,328 2,169,328 Sindh Rotors Installed 85,400 85,400 96,942 96,942 96,942 October April January July October January April July October January April July October January April July October January April Rotors Worked 45,782 45,782 57,324 57,324 57,324 FY16 FY17 FY18 FY19 FY20 Spindles Installed 838,376 838,376 838,376 838,376 838,376 Spindles Worked 698,309 698,309 698,309 698,309 698,309 • KPK Rotors Installed 2,690 2,690 2,690 2,690 2,690 Rotors Worked 2,452 2,452 2,452 2,452 2,452 Spindles Installed 269,208 269,208 269,208 269,208 269,208 Spindles Worked 225,260 225,260 225,260 225,260 225,260 Baluchistan Rotors Installed 13,689 13,689 13,689 13,689 Rotors Worked 7,769 7,769 7,769 7,769 Spindles Installed 13,409,420 13,409,420 Spindles Worked 11,263,025 11,263,025 13,409,420 11,338,256 13,409,420 13,689 7,769 13,409,420 11,338,256 11,338,256 Pakistan Rotors Installed 187,259 187,259 198,801 198,801 198,801 Rotors Worked 115,041 115,041 126,583 126,583 126,583 14 • The country's yarn production remained stable at ~285,000 Tones per month since FY16 as focus was on BMR rather than expansion. However, there was a significant decline from March to May 20 on the back of countrywide lockdown to contain the spread of COVID-19. Source: PBS, SBP, TCO#15• SPINNING | YARN PRODUCTION Pakistan produced ~3,059mln kg yarn of different varieties during FY20. Majority of the yarn produced is of coarse or medium count (-23% and -24%, respectively), for which local cotton is more suitable. ~39% of yarn produced is synthetic or blended yarn. Production of Yarn (000 Kgs) FY 16 FY17 FY18 FY19 FY20* Coarse (Is - 20s) 781,388 835,510 787,376 790,223 704,575 Medium (21s 34s) Fine (36s 47s) - S. Fine (48s-80s) Synthetic/Blended Total 815,361 702,144 826,399 823,784 734,499 390,694 424,822 393,126 395,655 352,772 84.933 114,876 88,406 85,699 76,411 1,324,963 1,344,974 1,334,743 1,335,929 1,191,135 3,397,339 3,422,326 3,430,050 3,431,290 3,059,392 *FY20 figures have been prorated using FY19 data 15 Source: TCO, Pakistan Bureau of Statistics (PBS) PACRA#16Quantity (MT) 60,000 50,000 40,000 30,000 20,000 10,000 • • SPINNING | YARN EXPORTS Pakistan's yarn exports have experienced decline in both quantitative and value terms in the last two financial years, mainly because of lower local cotton production and better local prices. Exports were of USD 985mln in FY20 (FY19: 1,125mln) 3,500 3,000 There has been a decline in the per unit price of yarn exported by ~5.5% p.a. since FY16. Quantity / Value 2,500 2,000 1,500 1,000 500 The cyclical nature of the demand can be observed with lower exports during winter months and peak exports taking place between March and August. 16 FY17 * Spinning | Monthly Yarn Exports FY18 Feb Mar Apr May June FY19 Jan Feb FY20 June 200 150 100 50 FY 16 Spinning | Yarn Exports FY17 Quantity (000 MT) Price (USD per MT) FY18 FY19 FY20 Value (Mln USD) Avg. Exchange Rate International Yarn Price Trend FY16 FY17 FY18 FY19 FY20 International Price (USD per 10lb) Avg. Exchange Rate Source: Pakistan Bureau of Statistics (PBS), SBP PACRA 180 160 140 120 100 8 3 ៖ ន ៖ ៖ ៖ ៖ ន 40 20 Price/Exchange Rate#17SPINNING | TOP EXPORT DESTINATIONS Exports to China constitute ~67% of total cotton yarn exports during FY20, reflecting a high level of export concentration. Other export destinations include European and East Asian countries. FY 18 000 USD % FY19 000 USD % *FY20 000 USD % China Bangladesh Turkey 869,780 63% 83,602 6% 72,540 China Bangladesh 707,923 63% 83,508 7% 5% Turkey 44,442 4% China Bangladesh Turkey 662,586 67% 58,494 6% 51,974 5% Portugal 56,472 4% Portugal 42,808 4% Portugal 38,828 4% Hong Kong 35,399 3% Japan Rep. of Korea 34,004 2% Rep. of Korea Japan 33,191 2% Italy Italy 30,091 2% U.S.A U.S.A Germany 13,532 1% Hong Kong 12,346 1% Germany Other Total 130,962 1,371,919 10% Other 21,693 11,502 1% 109,076 10% 26,602 24,554 2% 22,457 2% 2% 30,854 3% 2% Japan 23,330 2% Rep. of Korea 22,004 2% U.S.A 20,263 2% Italy 16,793 2% Hong Kong 10,799 1% Germany 10,347 1% Total 1,125,419 Other Total 69,485 7% 984,903 *FY20 figures have been prorated using IHFY20 data 17 Source: PBS, Trade Development Authority of Pakistan (TDAP) PACRA#18SPINNING | BUSINESS RISK • The business risks of the sector have been categorized as sales risk and operating risk (i.e. Cost structure). • The spinning sector's sales comprise both export & local sales. PACRA . . . • . Pakistan exported yarn amounting to PKR ~155bln in FY20 (FY19: PKR 153bln). The sector's exports are facing pressure for a few years due to low value addition and competition. This is reflected in relatively lower prices. Export prices declined by ~5.6% in last 5 years. This has resulted in declining exports in dollar terms, although exports remained relatively stable in volume over these years. The demand was further impacted during the COVID- 19 pandemic and subsequent lockdowns. The demand for local sales also remained relatively stable over the years except for FY20 due to COVID-19. The prices of local yarn increased on average by ~70-80% since FY16 on the back of robust local demand as rupee depreciated, improving margins on local sales. The gross and operating margins of the sector remain low (~5-6 % gross margin), reflecting commoditized nature of the products and low economies of scale. Large manufacturers enjoy better gross margins ranging between 8-12%. The sector is protected by favorable duty structure with yarn imports subject to up to 16% duty. With commoditized output and protection by duty structure, the duty withdrawal will impact the sector significantly although its probability remains low. Overall, the business risk of the spinning sector remains moderate on the back of declining export prices but stable export quantity, stable local demand and improving local yarn prices, resulting in better margins lately. However, the impact of COVID outbreak can impact demand and margins. 18 Source: PBS, PACRA Database#19SPINNING | SALES RISK • Over the years, production level and local demand have remained stable except in FY20, where there was significant decline due to COVID-19 lockdown. Spinning | Local Demand 4,000 3,500 . The prices of local yarn increased on average by ~70-80% since FY16. However, this was partially 3,000 countered by higher cotton prices, which increased by ~12% since FY 16. 2,500 2,000 . The gross and operating margins have shown an increasing trend in last few years on the back of improving yarn prices due to robust local demand and significant rupee depreciation. However, the margins remain relatively low. 1,500 1,000 500 . . The sales risk of exports is high on the back of low value addition, declining unit prices and increasing international competition. Further, the sales risk of local demand is moderate due to stable demand, partially countered by improving output prices. 19 FY 16 FY17 FY18 FY19 PACRA FY20 Cotton Yarn Prices (PKR per 10 lb.) ■Production of Yarn (000 MT) Local Demand (000 MT) Historic Margins 2,500 10% 8% 2,000 6% 1,500 4% 2% 1,000 0% 500 FY16 FY17 FY18 FY19 FY20 -2% -4% FY16 FY17 ⚫Coarse FY18 FY19 FY20 -6% Medium Fine S. Fine Gross Margin Operating Margin Net Margin Source: Pakistan Bureau of Statistics (PBS), PACRA Database#20. SPINNING | COST STRUCTURE The cost structure of spinning sector is mostly variable with ~90% variable cost. Resultantly, the sector has low operating leverage. Spinning | Cost Breakdown 6% 9% . • • On average, the sector spends ~78% of its total production costs on raw material, i.e. cotton. The prices of local cotton remain in parity with international prices. The prices of yarn in international market have declined by ~30% since FY18. However, the yarn prices have increased in local market by ~70-80% due to significant rupee devaluation. 200 7% ■Raw Material ■Salaries & Wages 78% ■Fuel/Utilities ■ Other Spinning | Cotton Price Trend PACRA 150 . Other major costs include Salaries and Wages as well as Fuel and Utilities which both consist of ~16% of the total production cost. 100 50 • Remaining ~6% is attributable to other costs such as depreciation, repairs, maintenance, insurance, packing and chemicals. 0 Jun-16 Local Price (PKR/lb.) Jun-17 Jun-18 Jun-19 Jun-20 International Price (cents/lb.) Avg. Exchange Rate 20 Source: Trading Economics, Business Recorder, PACRA Database#21SPINNING | REGIONAL COST COMPARISON • • 21 Pakistan has the second highest interest rate in the region behind Turkey. The high cost of borrowing acts as a barrier to investment in the country. In contrast, China has the lowest borrowing rate. However, the SBP provides subsidized financing at internationally competitive rates to the textile cluster. The Pakistani businesses face competitive disadvantage due to the high electricity tariffs it incurs which exceed all regional players. However, the government provides subsidized electricity and gas at internationally competitive prices to the textile cluster. In contrast, Sri Lanka and Indonesia have the lowest electricity tariffs in the region. Pakistan's minimum wage translates to 0.6 USD per hour which is higher than countries such as Sri Lanka, Bangladesh and India. However, we maintain competitive advantage of low labor cost over regional players China, Vietnam, Indonesia and Turkey. USD/kwh 2% 0% Electricity Tariffs 2.50 0.16 2.00 0.14 0.12 0.10 0.08 0.06 0.04 0.02 0.00 China Bangladesh Sri Lanka Vietnam Pakistan Overall Pakistan Textile Indonsia Turkey World Average 1.50 1.00 India Interest Rates 10% 8% 6% 4% India China Bangladesh Turkey Sri Lanka Vietnam Pakistan Overall Pakistan Textile Indonsia Minimum Wage Rates ..... 0.50 0.00 India China Bangladesh Sri Lanka Vietnam Pakistan Indonsia Source: Trading Economics, Statista.com, globalpetrolprices.com Turkey PACRA#22SPINNING | FINANCIAL RISK PACRA • • . Overall, the spinning sector is moderately leveraged with average sector's borrowings standing at ~50% of total capital. Total borrowings of the spinning sector stood at PKR ~439bln as at 30th July 2020. Around 12% of the total borrowings are on SBP's subsidized rates. PKR ~53bln of LTFF financing at end-July 20; Most of the borrowings (~65%) constitute short-term borrowings utilized to finance the working capital requirements. Spinning sector does not qualify for EFS or other short-term subsidized borrowing schemes. Total banking advances to the textile cluster is PKR ~1.2tln as at end-June 20 with infection ratio of 14.7% (~10% for overall corporate advances). Spinning sector has greater proportion of short-term borrowings in overall financing mix with these funds borrowed at normal rates sa it does not qualify for subsidized rates due to lower value addition. Hence, the financial risk of the sector is relatively high. SBP's rate cut of 625bps since March 20 is expected to reduce finance cost by PKR ~24bln for the sector. 22 Source: SBP, PACRA Database#23SPINNING | WORKING CAPITAL MANAGEMENT • The largest component of working capital of the spinning sector is inventory with the sector's average inventory days standing at ~80. Spinning | Working Capital Cycle 100 . Inventory consists mostly of raw material (i.e. ginned cotton) and finished goods while work-in- process makes only a small contribution. 80 60 40 • The margins of the sector are largely dependent on cotton procurement terms. Timely and efficient cotton procurement at better prices results in better margins. 20 • . Many players within the organized segment are forward integrated resulting in more efficient working capital management and ease of procurement of raw material. The inventory days reach their peak in December on the back of procurement season. The sector then offloads inventory in third & fourth quarter of financial year. The sector's average trade receivable days are ~40 while the average trade payable days stand at ~12. The cycle for payables peaks during the second quarter of each fiscal year on the back of local cotton procurement season. The sector meets its working capital financing requirements through short term borrowings. 23 PACRA Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Inventory Days Trade Receivable Days Sep-19 Dec-19 Mar-20 Trade Payable Days Source: PACRA Database#24SPINNING | COVID-19 | IMPACT PACRA . • . Textile exports are dependent on demand from European & North American markets. Since the spread of COVID-19 and subsequent impositions of lockdowns, major brands in USA and Europe had shut down retail operations resulting in orders on hold or cancellation. Local demand was also impacted negatively during 4QFY20 on the back of countrywide lockdowns. The businesses also missed peak demand seasons of Eids for textile products, which represent ~35-40% of total local demand. The sector imports a significant portion of cotton from other countries, especially during fourth quarter. The countrywide lockdown during 4QFY20 impacted the supply chain. The sector is dependent on imports for supply of chemicals and dyes. The lockdowns disrupted global supply chains. However, businesses carried sufficient inventories of ~2-3 months which provided time to re-establish supply chains. Despite being exempted from restrictions, the capacity utilization of spinning sector remained sub-optimal on the back of labor shortages and supply chain issues. . Lower demand and higher inventory levels resulted in liquidity and cash flow issues. 24 • The demand and production is recovering since July subsequent to the easing of restrictions both in Pakistan and major demand destinations (USA & Europe).#2525 SPINNING | COVID-19 | RELIEF MEASURES PACRA • • In order to relieve liquidity pressure on the sector, the SBP allowed to defer principal repayments for one year to the corporate sector. Further, the SBP also allowed to restructure loans up to 30th June 2020. The SBP, over the course of 4 months, reduced benchmark rate by 625bps to 7%. This is expected to improve the bottom-line of the sector, since majority of the borrowings are utilized at commercial rates. In addition, the Securities & Exchange Commission of Pakistan (SECP) provided several regulatory reliefs to the companies on a proactive basis during lockdown. Source: SBP, SECP#26SPINNING | DUTY & SALES TAX STRUCTURE PACRA Additional Custom Duty Custom Duty Regulatory Duty Total PCT Code Description 2019- 2018- 2019- 2018-2019- 2018- 2019-2020 2018-2019 2020 2019 2020 2019 2020 2019 Raw Cotton 52.01 Cotton, not carded or combed 52.03 Cotton, carded or combed 0% 0% 0% 3% 0% 0% 0% 3% 0% 0% 0% 3% 0% 0% 0% 3% 52.04 Cotton sewing thread, whether or not put up for retail sale Cotton yarn (other than sewing thread), containing 85% or Yarn 2% 0% 16% 16% 0% 0% 18% 16% more by weight of cotton, not 52.05 put up for retail sale 2% 0% 11% 11% 10% 10% 23% 21% Cotton yarn (other than sewing thread), containing less than 85% by weight of cotton, not 52.06 put up for retail sale 2% 0% 11% 11% 10% 10% 23% 21% Cotton Yarn (other than sewing thread) put up for retail Description Imported Local Imported Local In addition to Sales Tax, there is Advance Tax of 1% applicable on the import of these products. However, the amount of Advance Tax is adjustable against final income tax liability. Polyester filament yarn is subject to anti-dumping duty in the range of 3.25-11.35% on imports from China and Malaysia. This duty has been in effect since August 2017 providing protection to local players. Sales Tax 5% 10% 17% 17% 52.07 sale 2% 0% 11% 11% 10% 10% 23% 21% Synthetic Filament Yarn (other than sewing thread), not put up for retail sale (includes 54.02 polyester and nylon) 2% 0% 11% 11% 2.5% 5% 16% 16% Artificial Filament Yarn (other than sewing thread), not put up for retail sale (includes 54.03 viscose rayon) 2% 0% 11% 11% 0% 0% 13% 11% Source: Federal Board of Revenue (FBR), National Tariff Commission 26#27SPINNING | REGULATORY ENVIRONMENT PACRA • • • • With respect to Income Tax, the spinning sector is under the Normal Tax Regime (NTR). Further, the sector is also subject to Minimum Tax @ 1.5% of turnover, if tax liability under NTR is lower than minimum tax. However, the additional tax paid under minimum tax is adjustable against future tax liabilities for the next 5 years. The sector receives subsidized financing from SBP under the following schemes; • Long Term Financing Facility (LTFF) up to PKR 5bln for installation of new plant & machinery @ -3-4%. Govt. provides subsidized electricity at USD 7.5 cents/kwh and gas at USD 6.5 /mmbtu in order to increase export competitiveness in export markets (Total impact of PKR ~40bln/annum to the textile cluster). Duty structure of the sector provides protection to the local spinning players. Govt. also provides Drawback of Local Taxes and Levies (DLTL) at the rate of 2% on eligible product line of processed fabric (2% additional drawback is also allowable for exports to non-traditional markets). All Pakistan Textile Mill Association (APTMA) acts as the national trade association of textile cluster in the country. 27 Source: Federal Board of Revenue (FBR), SBP, Ministry of Commerce, APTMA#28SPINNING | SWOT ANALYSTS • Local cotton better suited for coarser counts • . Large installed capacity Integrated into textile value chain as key raw material • Government protection from tariff & duty structure • Strong sector association resulting in high lobbying power PKR depreciation leading to improved • Recent international competitiveness Geographical export concentration • Strong bargaining power of buyers Withdrawal of tax credits for expansion and replacement has hindered new investments Possible withdrawal of subsidies on electricity and gas Strengths Weaknesses PACRA Presence of large unorganized segment resulting in quality variations. • Low BMR resulting in technological obsolescence • Low value addition/commodity product • Periodic imposition of import duties on import of cotton . • Lower focus on synthetic fibers Restrictions on sales to unorganized segment creating hurdles Opportunities • Threats • Forward and horizontal integration to produce value added and differentiated products Opportunity to increase efficiency through technological upgrade • Special Economic Zones provide incentives to sector#29SPINNING | CONCLUSION PACRA • . • . The absence of value addition, minimal investment in new technologies and relatively lower economies of scale have impacted the position of the sector in international markets in the preceding decade. The installed capacity and production of the sector remained almost stagnant over the last several years. Despite relatively stable export quantity, exports of the sector declined in dollar terms by ~6% since FY16. The sector has not fully capitalized on strong local supply chain, government policy support, depreciating rupee, and financial support in the form of subsidized financing from SBP and subsidized energy prices. Although margins and profitability of the sector have improved in recent years, it largely remains a factor of gains on rupee depreciation and prudent cotton buying. The sector has not been able to gain much in terms of volumes. The margins remained under pressure during 4QFY20 owing to sub-optimal capacity utilization amid lockdowns. Further, the net margins of the sector remained negligible and profitability of the sector will be impacted due to low sales and margins in 4QFY20. The sector has moderately leveraged capital structure on the back of lower ability to generate operating cash flows amid low margins. The sector avails majority of borrowings at commercial rates. The infection ratio of the sector is significantly higher than overall corporate sector infection ratio, reflecting financial risk. 29#30SPINNING | GOING FORWARD EXPECTATIONS PACRA • . • . Without any significant investments on new technology, it is expected that spinning sector will continue to operate as a low value addition and relatively low margin sector. The recent BMR activities spurred by SBP LTTF schemes is a good sign and should contribute towards higher production quality. The large players will enjoy better margins. This may result in consolidation as smaller players may struggle to survive. The sector remains reliant on the government support as it is a price taker on both ends. It is expected that the duty structure will continue to provide relief to the sector, going forward. The sector is expected to face increasing competition from other regional players in the international markets. This may result in increasing pressure on export margins. Timely and efficient procurement of cotton remains critical for the profitability of the sector. Although the output volumes declined significantly in 4QFY20, the capacity utilization has improved and volumes have started to recover to historic levels (July 20:286, 115 Tonnes). However, the pressure on margins will remain as demand is expected to remain volatile in current environemnt. The sector will face cash flow and liquidity issues in case second wave of COVID-19 spreads, which will result in another round of hold on or cancellation of orders. Although the financial risk is high for the sector, the recent cut in interest rates and deferment of loan repayments will provide short-term relief. 30#31SPINNING | BIBLIOGRAPHY PACRA • Pakistan Bureau of Statistics (PBS) • Textile Commissioner Organization (TCO) Research Team Ateeb Riaz • Trade Development Authority of Pakistan (TDAP) • Ministry of Commerce (MoC) • Federal Board of Revenue (FBR) • Securities & Exchange Commission of Pakistan (SECP) Team Lead [email protected] Insia Raza Associate Analyst [email protected] Contact Number: +92 323 8457222 • Pakistan Central Cotton Committee (PCCC) • Business Recorder (BR) • Trading Economics • State Bank of Pakistan (SBP) • • • Yarn Counts & Calculations, Thomas Woodhouse, Oxford Technical Manuals Statista.com Globalpetrolprices.com • Trade Map . United States Department of Agriculture (USDA) • PACRA Database • • • National Tariff Commission (NTC) All Pakistan Textile Mills Association (APTMA) Pakistan Cotton Ginners Association (PCGA) DISCLAIMER PACRA has used due care in preparation of this document. Our information has been obtained from sources we consider to be reliable but its accuracy or completeness is not guaranteed. The information in this document may be copied or otherwise reproduced, in whole or in part, provided the source is duly acknowledged. The presentation should not be relied upon as professional advice. 31