The denim industry, representing below 10 per cent of the textile market, is likely to face deterioration in credit profile in the absence of improvements in realisations in FY18, says a recent report. Its operating margins could fall to 10-11 per cent in FY18 due to cost inflation amid surplus capacity in denim standard products with low cotton content. India Ratings and Research (Ind-Ra) has estimated prices to moderate in 2HFY18, highlighted in the report ‘Stable Input Prices, Fiscal Incentives to Support Textile and Cotton in FY18’. However, the denim surplus situation and inventory losses are likely to pressurise margins.

Moreover, the man-made industry demands a level playing field for the taxation of cotton, which is exempt from indirect taxation. If cotton is brought under the Goods and Services Tax (GST) then cotton fabrics including denim sector’s profitability may come under pressure in the transitory period.

The agencies denim peer set average EBITDA margins deteriorated in 9MFY17 to 12.6 per cent from FY16’s 13.2 per cent. The fall in margins is on account of players’ inability to completely pass on the increase in cotton prices, on the back of high competitive pressure, similar to the situation in FY14.

Raw cotton prices have increased by 32.8 per cent YoY in March 2017 and Ind-Ra expects it to remain elevated until 1HFY18. For Denim manufacturers’ cotton forms more than 35-40 per cent of the total raw material requirement. The agency notes that for many of the basic denim fabric manufacturers catering to domestic consumption average realisations remained steady, despite higher cotton prices in 9MFY17.

However, some of them have been able to increase realisations for 4QFY17 partly passing the cost inflation with a lag. Denim garments players are likely to perform better than fabric players, as the retail margins may sustain as fabric prices remain under pressure.

Ind-Ra expects the denim sector to post robust volume growth of over 10-15 per cent in line with the past trend along with rising disposable incomes, rapid growth of the retail sector, westernisation trend, young population demographics, and versatility of denim as a fabric. However, Ind-Ra views that the capacity addition is growing at a faster rate. Moreover, the existing capacities will face competition from new-age cost efficient plants.

The denim fabric industry is cyclical in nature and is characterised by periods of excess capacity followed by narrowing the demand-supply gap. The apparent short project pay-back has encouraged a number of denim fabric manufacturers to put up additional capacity, higher than the estimated demand growth. Further capacity additions are likely to keep the domestic competitive pressures heightened. As per CMIE data, a moderate level of new capacity rampup is underway in FY18. This includes capital expenditure for expansion and backward integration by a few companies namely, Nandan Denim Limited, Raymond Uco Denim Pvt Limited and RSWM Limited.Overall, the credit profile for most players has come under pressure also due to the stretched working capital cycle and debt-led capacity expansion in the backdrop of operating margin pressure.