October 13, 2010 nbkcapital.com ORIENTAL WEAVERS The Carpet Behemoth KEY DATA Fair Value per share (EGP) 38 Closing Price (EGP) * 33 52-week High / Low (EGP) 37 / 25 YTD / 12-month return 25% / 28% P/E (TTM) 10.3 Shares Outstanding (Mn) 90 Market Cap (EGP Mn) 2,970 Free Float 22% Reuters / Bloomberg Code ORWE.CA / ORWE EY *As of October 12, 2010. Sources: Zawya and NBK Capital KEY METRICS Figures in EGP 2009A 2010F 2011F 2012F EPS 3.3 3.5 4.2 4.5 EPS Growth 1% 7% 19% 7% P/E 10.0 9.4 7.9 7.3 Dividend Yield 8% 4% 5% 5% EV/EBITDA 6.1 5.8 4.9 4.5 Revenue (Millions) 3,551 3,940 4,392 4,899 Revenue Growth 3% 11% 11% 12% EBITDA (Millions) 677 715 840 917 EBITDA Growth 1% 6% 17% 9% EBITDA Margin 19% 18% 19% 19% A = actual, F = forecast. Sources: Reuters and NBK Capital QUARTERLY FORECASTS EGP millions 3Q2009A 2Q2010A 3Q2010F 4Q2010F Revenue 901 973 991 1,061 EBITDA 152 156 186 203 Source: NBK Capital REBASED PERFORMANCE 20 25 30 35 40 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Oriental Weavers MSCI EGYPT Sources: MSCI, Reuters, and NBK Capital **Please refer to page 34 for recommendations and risk ratings. HIGHLIGHTS 12-Month Fair Value: EGP 38 Recommendation: Accumulate - Risk Level: 4** Reason for Report: Initiation of Coverage • Oriental Weavers (OW) is the largest producer of machine- woven carpets and rugs in the world, with an annual production capacity of 110 million square meters. The company is by far the market leader in Egypt, with close to 85% market share; it also has substantial market shares in the US and European rug markets at 25% and 20%, respectively. • OW’s resilient performance during the challenging years of 2008 and 2009—where it posted sales growth of 16% cumulatively compared to a decline of 20-35% for its competitors—provides evidence of the company’s competitiveness in the global market. The company strives to maintain its advantage by focusing on technology (in its production process) and innovation (in terms of introducing new designs and styles). A strong product line and a lower cost base has allowed OW to build strong alliances with international retailers which include big names such as Marks & Spencer, IKEA, Target, Carrefour, Sears, and JC Penny. • OW announced a major expansion plan to establish a new industrial complex with a total outlay of EGP 1.37 billion (USD 237 million), in light of the encouraging response from the DOMOTEX fair and current capacity constraints. The expansion will increase total woven capacity by approximately 40% (to 160 million square meters annually) by 2015. • The most important risk facing OW is the possible slowdown in its major export markets (North America and Europe). The elastic nature of OW’s product coupled with the fact that 60% of demand in the US and Europe comprises replacement purchases makes the company prone to economic slowdown in these regions. Additionally, the company is also vulnerable to global oil prices since 55% of the manufacturing cost is comprised of oil-based raw materials. • Our fair value for OW, based on discounted cash flow (DCF), is EGP 38 and we have an “Accumulate” recommendation with an upside potential of 15%. Analysts Suleman Soorani T. +971 4365 2818 E. [email protected]Samir Murad, CFA T. +965 2259 5145 E. [email protected]
Transcript
October 13, 2010
nbkcapi ta l .com
ORIENTAL WEAVERS
The Carpet Behemoth
kEy dATA
Fair Value per share (EGP) 38 Closing Price (EGP) * 33 52-week High / Low (EGP) 37 / 25YTD / 12-month return 25% / 28%P/E (TTM) 10.3 Shares Outstanding (Mn) 90 Market Cap (EGP Mn) 2,970 Free Float 22%Reuters / Bloomberg Code ORWE.CA / ORWE EY
*As of October 12, 2010. Sources: Zawya and NBK Capital
**Please refer to page 34 for recommendations and risk ratings.
HIgHLIgHTS
12-month fair Value: EgP 38
Recommendation: Accumulate - Risk Level: 4**
Reason for Report: Initiation of Coverage
• Oriental Weavers (OW) is the largest producer of machine-woven carpets and rugs in the world, with an annual production capacity of 110 million square meters. The company is by far the market leader in Egypt, with close to 85% market share; it also has substantial market shares in the US and European rug markets at 25% and 20%, respectively.
• OW’s resilient performance during the challenging years of 2008 and 2009—where it posted sales growth of 16% cumulatively compared to a decline of 20-35% for its competitors—provides evidence of the company’s competitiveness in the global market. The company strives to maintain its advantage by focusing on technology (in its production process) and innovation (in terms of introducing new designs and styles). A strong product line and a lower cost base has allowed OW to build strong alliances with international retailers which include big names such as Marks & Spencer, IKEA, Target, Carrefour, Sears, and JC Penny.
• OW announced a major expansion plan to establish a new industrial complex with a total outlay of EGP 1.37 billion (USD 237 million), in light of the encouraging response from the DOMOTEX fair and current capacity constraints. The expansion will increase total woven capacity by approximately 40% (to 160 million square meters annually) by 2015.
• The most important risk facing OW is the possible slowdown in its major export markets (North America and Europe). The elastic nature of OW’s product coupled with the fact that 60% of demand in the US and Europe comprises replacement purchases makes the company prone to economic slowdown in these regions. Additionally, the company is also vulnerable to global oil prices since 55% of the manufacturing cost is comprised of oil-based raw materials.
• OurfairvalueforOW,basedondiscountedcashflow(DCF),is EGP 38 and we have an “Accumulate” recommendation with an upside potential of 15%.
Oriental Weavers (OW) is the largest producer of machine-woven carpets and rugs in the world, with an annual production capacity of 110 million square meters. The company has an extensive retail presence in Egypt with a total of 226 showrooms spread across the country and a market share of close to 85%. OW has been export focused since its inception and currently derives close to 60% of its revenues from exports. OW has a market share of 25% and 20% in US and Europe rug sales respectively. The company operates an integrated production system, in that it has production facilities that span the entire value chain from manufacturing of polypropylene granulestodistributionoffinishedgoods.
The company’s relative performance during 2008 and 2009—which were challenging periods for the global economy—provides clear evidence of the strength and resilience of the company’s business model. While OW’s global competitors saw a sharp decline in their sales (20-35%) and operatingprofits(50-100%)fortheperiod2007-2009,OWwasabletoincreasesalesby16%duringthesameperiodandexperiencearelativelymodestdeclineof11%initsoperatingprofits.Key challenges facing the company are a declining gross margin (from 13.5% in 2007 to 11.8%), a declining return on equity (ROE) (from a high of 22% in 2005 to 15% in 2009), and a high working capital accounting for 42% of sales.
Overall, we believe that OW is a healthy company that operates in a challenging industry with high competition in the export market and challenges from substitute products. Additionally, the bargaining power of OW’s customers—on the export side—is also high, which makes it harder for the company to fully pass cost increases to its international customers. Nonetheless, OW enjoys anenviablepositioninthelocalmarket,whichisreflectedinits85%marketshare.Moreover,OW’s focus on the higher-growth rugs sub-sector, its substantial size and the ensuing economies of scale, its embrace of technology and innovation, along with the alliances with global retailers have provided OW with a competitive edge in this mature industry.
Lookingforward,webelievethatOWcansustainasteadygrowthinsalesoverthenextfiveyearsin both domestic and global markets. The only factor currently hindering OW’s sales growth is its capacity, which is likely to be resolved with the completion of the expansion plan that will increase the current production capacity by 40%. We expect OW’s sales to grow at a cumulative averagegrowthrate(CAGR)of11%overthefive-yearperiod2010-2015andthenstabilizeataround6%.Intermsofprofitability,weseeagradualimprovementinOW’sgrossmarginontheback of optimization of the product mix by improving the sales volume of higher margin products, adjusting mid-end Grade B products to reduce its cost of production, achieving higher economies of scale with the 40% increase in capacity, and a more aggressive stance by management to increase prices. We forecast OW’s gross margins to steadily improve from 11.8% in 2009 to around 13.5% in 2015.
Our fair value for OW, based on DCF model, is EGP 38 and we have an “Accumulate” recommendation with an upside potential of 15%.
The purpose of this valuation exercise is to arrive, through the use of fundamental analysis, at a fair value estimate of OW’s share price in the next 12 months. This does not represent a guarantee that this value is achievable within that time frame, as a wide range of variables and market dynamics affect the market price of an asset.
Each investor must use his or her favorite mix of fundamental research, technical analysis, and market intelligence to arrive at an investment decision that matches his or her objectives and tolerance for risk.
We arrived at a 12-month fair value for OW of EGP 38 per share using only the DCF model. While it is our standard practice to use at least two valuation methods to reach our fair value estimate, the unavailability of forecasted data on OW’s peers (forward EPS and PE multiple), led us to rely solely on the DCF model. The 12-month fair value of EGP 38 represents a 15% upside potential from yesterday’s close, hence our “Accumulate” recommendation.
Figure 1 Fair Value per Share
Discounted cash flow 100% 38
Valuation Method Weight Value (EGP)
Source: NBK Capital
discounted Cash flow Valuation
OurDCFvaluation (Figure2) isbasedon forecastedfinancial results through2017.TheDCFvaluation is a function of the following major variables, which have been estimated by our models:
• Future net operating profit less adjusted taxes (NOPLAT), which is driven primarily byexpectations of sales and operating expenses
• Future changes in working capital
• Futurenetexpendituresonfixedassets
• The weighted average cost of capital (WACC), which is a weighted average of our estimated cost of equity and the after-tax cost of debt
• The long-term expected growth rate in NOPLAT and the expected rate of return on net new invested capital (RONIC)
From the forecastedfinancial results,we extracted the free cashflows thatwere used in ourvaluation.Wediscountedthosecashflowstoapointintimethatis12monthsintothefutureto obtain an estimate of the value of the company’s operations. After subtracting net debt and minority interest and adding the value of non-operating assets, we arrived at a total equity value of EGP 3.4 billion.
In order to estimate the value of OW’s operations, we incorporated a varying WACC into our model. Our selection of a cost of equity of 18% is based mainly on interest rate levels and the operating environment; the selection of 7% for the cost of debt is based on historical norms.
We performed a sensitivity analysis (Figure 3) on two important inputs for our DCF valuation model: the cost of equity and the perpetual growth rate used in computing the terminal value.
Figure 3 DCF Sensitivity
-0.50% -0.25% Base Case 0.25% 0.50%
-1.0% EGP 42 EGP 42 EGP 42 EGP 43 EGP 43
-0.5% EGP 40 EGP 40 EGP 40 EGP 40 EGP 40
Base Case EGP 37 EGP 38 EGP 38 EGP 38 EGP 38
+0.5% EGP 35 EGP 36 EGP 36 EGP 36 EGP 36
+1.0% EGP 34 EGP 34 EGP 34 EGP 34 EGP 34
Growth
Cos
t of
Equ
ity*
*Variations in the cost of equity result in variations in WACC. Source: NBK Capital
Peer group Comparison
With a market capitalization of EGP 3.0 billion, OW is the largest manufacturer of machine made carpets and rugs globally. Due to unavailability of exact peers for OW in the region, we opted to compare OW to home furnishing companies in the emerging markets as well as to global carpet manufacturers. Since the forward EPS and consequently the PE multiple for most of these peers is unavailable, we have not used this method for valuation purpose.
*Prices in local currency as of October 12, 2010. Sources: Bloomberg and NBK Capital
Risk factors
Foreign Exchange Risk
By virtue of being an export-oriented company, OW is exposed to movements in EGP versus the currencies of its export destinations (mainly USD, EUR and GBP). Looking at the historical trend over the past six years, these cross currency movements have largely offset each other (on a cumulative basis)—a trend that we believe will continue in the future. Nonetheless, the foreign exchange (FX) gains and losses are likely to remain volatile on a year-to-year basis, thus presenting a risk to the bottom line.
OWwillbenefitfromadepreciationofEGPagainstmajorforeigncurrencies,asthiswouldmakeits products more attractive for foreigners, while an appreciation in EGP will have the opposite effect. On the positive side, oil-based raw materials, which comprise 55% of the total cost of production and are priced in USD, act as a natural hedge for currency movements by offsetting some of the FX impact on sales.
Slowdown in US and Europe
Approximately 80% of OW’s exports in FY2009 were to North America and Europe, which highlights the company’s vulnerability to the economic cycles of these two regions. The possibility of a double dip recession—which some economists are already forecasting—or sub-par economic growth poses a threat for OW’s export business. On the positive side, the company’s exports and overall sales fared relativelywell during the financial and economic crisis in 2008 and early2009, which gives us some comfort regarding the strength of OW’s product portfolio and customer
base. In comparison, competition witnessed sales declines of 20-35% during the crisis, while OW’s sales increased by 16%.
Volatility in Global Oil Prices
OW utilizes a number of oil-based raw materials in its production and packaging processes that account for approximately 55% of the total cost of production. Polypropylene—used in the production of synthetic fibers—is themajor rawmaterial used by OW and comprises around25-30% of the cost of production. Plastics and other packaging materials—manufactured from oil derivatives—form another 25% of the cost base. Although changes in prices of oil-based raw materialsarenotdirectlyproportionaltochangesinoilprices,theyaresignificantlyinfluencedbyit.ThesignificantrelianceonoilbasedrawmaterialsmakesOWvulnerabletovolatilityinglobaloil prices.
• Formidable position in the Egyptian carpets and rugs market with a market share of 85% and an extensive network of 226 stores spread across Egypt.
• Strong position in the global carpets and rugs industry, especially in the developed markets of North America and Europe. The company has market shares of 25% in the US and 20% in Europe in machine-made tufted and area rugs. Additionally, the company exports to 149 countries across the seven continents.
• Diversifiedcustomernetworks indevelopedmarketscomprisingmajornames in theglobalretail and hospitality segment. Major customers in the retail sector include Marks & Spencer, Kmart, B&Q, IKEA, Target, Carrefour, Tesco, Bed Bath & Beyond, Sears, JC Penny, and others. The company enjoys very strong relationships with most of these retailers that ensure the company’s leadership position in the developed markets.
• Ability to execute urgent orders swiftly—for major clients—through production facilities in US and China.
• The focus on research and development has established OW as an innovator in the global carpets and rugs industry. The company uses hi-tech machinery in its production processes with very little human involvement. On average, a new product is introduced every two weeks. The company has a total of 4 million copyrighted designs created and archived since 1980. Additionally, the company has six patents covering technology throughout the value chain.
• OW has been able to grow sales and gain market share over the past two years—which havebeenverydifficult years for the industryasawhole. WhileallofOW’smajorglobalcompetitorssawasharpdeclineintheirsales(20-35%)andoperatingprofits(50-100%)overthe period 2007-2009, OW was able to increase its sales by 16% during the same period and experiencedarelativelymodestdeclineof11%initsoperatingprofits.
• Partnership arrangement with Van De Wiele—the largest global supplier of machinery used for carpet and rug manufacturing—which allows OW to be involved in the design of new machinery. Subsequently, OW gets exclusive rights to use the customized machinery for an average of two years before Van De Wiele can market it to its other customers.
• Strong product development and a marketing team that is able to identify the latest global trends and apply it to OW’s product line.
• Integrated production system that guarantees a smooth production process and consistent quality.
• A 67% increase in orders in the DOMOTEX Hannover Floor Covering fair on 72 new collections bodes well for the sales of the company in the short to medium term.
• A 40% import duty on carpets and rugs protects the company from foreign competition in the local market.
• Increasing penetration into high value-added and high margin products such as Axminster, which has the potential to improve overall gross margins.
• OWenjoyssignificanteconomiesofscalebyvirtueofbeingthelargestmachine-madecarpetand rug manufacturer in the world. This results in a relatively lower cost of production, providing the company with a competitive edge over small and medium-sized players.
• Working capital heavy business model mainly due to very high inventory levels, which ties up significantcashflowsandcapital.
• The elastic nature of OW’s product, which is considered more of a luxury than a necessity. Additionally, in the case of exports to US and Europe, approximately 60% of demand comprises replacement purchase and not new purchase. In times of distress, consumers are likely to cut back on their spending on discretionary products—such as carpets and rugs—making the company prone to follow the economic cycle.
• Challenging economic situation in US and Europe—the two largest markets for OW’s product—due to higher unemployment, high consumer debt and slow economic growth.
• Vulnerability to global oil prices as close to 55% of raw materials are comprised of petrochemical-based products such as polypropylene and plastics. The impact is magnified due to therelatively weak pricing power of the company owing to challenging industry dynamics.
• A substantial contribution by export rebates to the operating income poses a risk for the company’s bottom line in the advent of an unexpected withdrawal. However, the recent restructuringof theexport rebateschemeandannouncementofafirmplanfor theperiod2010-2013 mitigates the risk, in our view.
OWoperatesinthebroaderfloorcoveringindustry,which,onagloballevel,isconsideredtobeamature industrywithanaveragegrowthpotentialofaround3-4%annually.Within thefloorcovering industry, OW operates in the carpets and rugs1 sub-sector—with the other two sub-sectors being resilient products (such as vinyl, linoleum and rubber products) and non-resilient products (such as ceramic,wood, laminate). Thedemand for floor coveringproducts is cyclical and isclosely tied to housing activities such as construction and refurbishment, as well as growth in the commercial real estate sector (such as hotels). The industry is sensitive to changes in broader economicindicatorssuchasconsumerincome,consumerconfidence,andcorporatespending.
ThelargestmarketsforfloorcoveringproductsarethedevelopedmarketsofNorthAmericaandEuropefollowedbyAsiaPacific.However,theselargemarketsarequitematureandhenceofferlimited growth potential. To provide a little perspective, approximately 60% of the demand for carpets and rugs represents replacement orders in North America and Europe. Emerging markets represent better growth prospects due to their high GDP growth rates and rising purchasing power.
Overall, we believe that the threat of a new entrant in OW’s case is low. While it is rather easy for a potential new player to establish a production facility (by purchasing a couple of looms), established manufacturers, such as OW, will have formidable advantages over the new entrant due to:
• The expertise—in terms of developing new design and technology—that OW has developed over the past 20 years of its operations
• Experience in running large and complex plants and machinery
• Economies of scale due to substantial volumes
• Relationship and alliances with large customers comprising global retail chains and hotels
Additionally,anotherfactorthatwouldprobablypreventanewentrantisthealreadylowprofitmargins in the industry (10-12% on the gross level) and low growth potential at 4-6% annually.
Bargaining Power of Customers
Domestic: Low
Export: High
Overall: Medium
The bargaining power of customers in OW’s case is high in the export market, while it is low in the domestic market. In the domestic market, OW has virtual domination with a market share of 85% and hence raising prices is relatively easy. Additionally, an import duty of 40% on carpets also protects OW from competition in the local market. However, in the export market, OW’s pricing power is limited due the nature of OW’s major customers in the US and Europe, which includes large retail chains such as Wal-Mart, IKEA, Kmart, Carrefour, and others. These retailers tend to enjoy high bargaining power due to the large size of their orders and the extensive market access they provide.
1Although the terms carpet and rug are used interchangeably, there is a difference between the two products. Carpets are generally sold in big pieces and are meant for the entire floor area, i.e., wall–to-wall, while rugs are sold in pieces with varying sizes.
Themajorrawmaterialusedfortheproductionofcarpetsissyntheticfiber,whichisproducedfrom polypropylene—an oil derivative. Polypropylene is a globally traded commodity and its price is largely determined by global supply and demand dynamics. Additionally, the company also uses other petrochemical-based raw materials in its production and packaging process. These petrochemical-based raw materials represent approximately 50-55% of the total cost of production. The bargaining power of a supplier can be considered medium, since neither OW nor suppliers of polypropylene have any influence over the price of the commodity.
Threat of Substitutes
Domestic: Medium
Export: Medium
Overall: Medium
There are a number of substitute products available to carpets and rugs that customers can use fortheirfloorcoveringneeds.Theyinclude1)resilientproductssuchasceramics,wood,laminate2) non-resilient products such as vinyl, linoleum and rubber products and 3) hand-made rugs. The selection of any one product depends upon the preference of the buyer and relative prices for each segment. On the positive side, rugs can be considered a complimentary rather than a substitute producttootherfloorcoveringitems.Thefactthatcustomerscanstillbuyarugfortheirwoodenor ceramic flooring—as a decoration piece—reduces the threat of substitute.Considering the complementary nature of rugs and the fact that 95% of OW’s current capacity comprises rugs, the threat of a substitute can be considered medium.
Rivalry Among Existing firms
Domestic: Low
Export: High
Overall: Medium
Globally, there are a few large players dominating the machine-made carpets and rugs industry. OW’s strength in the export market is focused on rug sales, in which it commands a market share of 25% in the US and 20% in Europe. Since the carpets and rugs industry is considered tobeamatureindustrywithlimitedgrowthpotential,thecompetitionamongexistingfirmsislikely to be relatively high. OW employs several differentiation strategies—foremost being its focus on innovative design and technology—to distinguish its products from its competition. On the domestic front, the company is the market leader with a whopping 85% market share—an indication of very low domestic competition.
Conclusion: A Strong Position in a Challenging Industry
Overall, we believe that OW operates in a challenging industry with high rivalry in the export market and competition from substitute products. Additionally, the bargaining power of customers—on the export front—is also high, which makes it harder for the company to fully pass cost increases tocustomers.Nonetheless,OWenjoysanenviablepositioninthelocalmarket,whichisreflectedin its 85% market share. Moreover, OW’s focus on the higher-growth rugs subsector, its substantial size and the ensuing economies of scale, its embrace of technology and innovation, along with the
existing alliances with global retailers provides a competitive edge in this mature industry.
Expected growth in the Industry
According to statistics provided by Freedonia Group Inc.—an international business research firm—theoverallmarketforthefloorcoveringindustryislikelytogrowatanaverageof3.8%for the next 6-8 years. Interestingly, it forecasts the carpets and rugs segment to grow at a much slower pace at around 2.2%, while the highest growth is being forecasted for the non-resilient segment at 4.4%. However, the slower growth is predominantly on account of lower growth expected in carpets (wall-to-wall)—especially in the corporate and commercial segment. The rugs subsector, on the other hand, is expected to continue to grow at a brisk pace of 4-6% annually. According to Floor Focus magazine, the market share for rugs increased for the third consecutive year to 14.2% in 2009 from 13.7% in 2008.
Figure 5 Global Floor Covering Market in USD Millions
4,0454,295 4,755 5,365
1,450
1,6701,945 2,185
4,5856,555 8,500 10,550
2002A 2007A 2012E 2017E
Carpets and rugs Resilient Flooring Nonreslilient Flooring
Founded in 1980 with just a single loom, OW has emerged as the largest producer of machine-woven carpets and rugs in the world, with global leadership in tufted and jet-printed carpets and rugs. OW’s production capacity has increased steadily over the past several years, reaching 110 million square meters annually in 2009 with a utilization rate of 95%. The company has an extensive retail presence in Egypt, with a total of 226 showrooms spread across the country. The company has traded on the Egyptian exchange since 1997.
Export focus
Since its inception, OW has had a global focus as it has considered exports a major revenue source. As of FY2009, 57% of total sales value (56% in terms of sales volume) comprised exports, translating into revenues of approximately USD 360 million, making OW one of the largest exporters in Egypt. The company’s export destinations include 149 countries across the seven continents in 2010—after adding 30 new destinations in the recent DOMOTEX Hannover Floor Coverings Fair in 2010. OW has a global presence, with production and distribution facilities in the United States and China and distribution and warehousing centers in the United States, United Kingdom, Germany, Canada, Italy and Dubai.
Figure 6 Export Breakdown
39%
2%
44%
9%
3% 3%
Europe Africa America and Canada Arab countries Russia and China Asia
Sources: OW presentation and NBK Capital
focus on Innovation and Technology
A hallmark of OW’s strategy and overall organizational culture is its focus on innovation and technology. Unlike traditional carpet manufacturers that employ labor-intensive production processes and rely on the craftsmanship of their laborers for carpet quality, OW operates modern and state-of-the-art manufacturing facilities that utilize hi-tech machinery and equipment. Labor costs comprise just 6% of the total production cost for OW, as the bulk of the production is done through automated machinery. A modern and hi-tech manufacturing system is one of the reasons for OW’s substantial growth over the past 10 years and the size and scale that it has achieved.
OW has formed a strategic alliance with Van De Wiele—one of the largest manufacturers of carpet weaving machines—whereby OW’s research and development (R&D) team work closely with Van De Wiele to create customized machinery. Once designed, OW is provided the exclusive rights to use the machinery for a period of at least two years before Van De Wiele can sell it to other rug manufacturers.
With regards to innovation, OW has achieved several major breakthroughs over the past years in terms of technology and product design. OW’s technological progress can be gauged from the enhancements that it has achieved in loom technology—increasing loom color combinations from 8 to 92. As of December 09, the company has a total of 4 million copyrighted designs—created since the 1980’s—and has six patents covering technology throughout the value chain.
Consistent Introduction of New designs
OW strives to maintain its leading position in the global carpets and rugs market by constantly introducing new products and designs to serve the tastes of the diverse global market. According to OW’s management, a new product or design is developed every two weeks. The company invests substantially in keeping itself abreast of all the latest trends and lifestyles, by having its marketing and design team travel to all the major cultural and design hubs in the world. In order to facilitate the process and to gain a better insight into each of its markets, the company has established partnerships with leading lifestyle and media companies including National Geographic, Andy Warhol, and Disney.
Strong Alliances with Customers
OW’s business model entails marketing and selling its products through both its own domestic outlets and large retailing chains in US and Europe. In terms of large retail chains, OW counts many of the major global players as its customers including Marks & Spencer, Kmart, B&Q, IKEA, Target, Carrefour, Tesco, Bed Bath & Beyond, Sears, JC Penny, and others. The company enjoys very strong relationships with most of these retailers, which ensures the company’s leadership position in developed markets.
In the commercial segment, OW customers include major global hotel chains including Four Seasons, Meridien, Fairmont, Intercontinental, Hilton, Marriot, Holiday Inn, Movenpick, MGM Grand, The Ritz Carlton, and others.
An Integrated Production System
A unique feature of OW’s business model is the integration that it has achieved in terms of its production and distribution process. The company’s production process starts right from the manufacturing of polypropylene granules—the raw material used for the production of synthetic fibers—to spinning and dyeing yarn, to weaving and finishing and ultimately packaging anddistribution. In Egypt, OW sells directly through its showrooms as well as through franchise agreements with other retailers. Internationally, the company uses its own distribution network to distribute its products to major retail and hotel chains and other customers.
It is worth mentioning that the production of polypropylene is done indirectly through its 10% owned associate, Oriental Petrochemical Company (OPC)—which has a production capacity of 160,000 tons. OW’s total polypropylene requirement is around 4,000 to 5,000 tons (less than 5% of OPC’s total capacity). Additionally, OW’s management assert that all the transactions with OPC are done at arm’s length and that OW is free to source the product from any other company ifitgetsbetterpricesordeals.ThebenefitthatOWderivesbysourcingpolypropylenefromOPCis a lower inventory requirement due to the proximity of the plant, which is 90 km from OW’s production facilities. However, considering the small stake in OPC at 10%, coupled with the fact
that OW’s polypropylene requirement represents less than 5% of OPC’s capacity, OW is likely to havelimitedinfluenceonOPC’soperations.
Figure 7 Production Flow at OW
Production of polypropylene
Spinning and dyeing yarn
Weaving, finishing and packing
Delivery and distribution
Sources: OW presentation and NBK Capital
market Leader in the domestic market
OW is by far the market leader in the Egyptian carpet and rugs industry with a market share of 85%. The company has a total of 226 showrooms spread across Egypt, which includes the largest rugshowroomintheworld.EgyptrepresentsanimportantmarketforthefirmintermsofitshighendGradeAproduct(themostprofitablecategoryforOW).Itssubstantialmarketshareprovidesevidence that the company enjoys strong brand equity in Egypt and has no major competitors. The major demand drivers include strong demographics and growth in the real estate market.
major Products
OW has a diverse product range, catering to all market segments. Broadly speaking, the company manufactures three major product categories, namely woven, tufted and non-woven. Within woven, the company has three grades of products (A, B, and C) with Grade A being the premium product (with80-100%natural fibers) andGradeC the low-endproduct (with0-25%natural fibers).GradeBcomessomewhereinthemiddlewitharound50%naturalfibers.GradeAcommandsthehighestprofitmarginsataround35%naturalfibersandcomprisesaround8%ofsalesbyvaluefollowedbyGradeBwith10-15%profitmarginsandsalescontributionof23%byvalue.GradeChasthelowestprofitmarginsatapproximately5%andhasthehighestsalesvolume.Accordingto the company’s management, the reason for having such a low-margin product is to achieve a higher utilization of the manufacturing facilities.
OW owns and operates several brands across Europe and the US, which provides it direct market access in these large markets. The company owns three brands, which are described below:
Cambridge Weavers (CW)
This division caters mainly to the hospitality and entertainment industry and produces woven AxminsterCarpets,whichisregardedasit’smostdurableandflexibleproduct.Axminsterbasicallyrepresents an English way of making carpets (named after a town in Southwest England which continues to produce carpets today) produced for high comfort and luxury. As with OW’s other divisions, CW maintains state of the art machinery (imported mainly from Belgium) to maintain the quality of its products and also uses design experts from England to ensure consistent quality.
The head office for CW is based in England, and includes design, sales and administrativestaff, while the manufacturing facility is based in Egypt. The bulk of CW’s work is customized accordingtothespecificneedsandrequirementsofitsclients.SinceCW’scustomersincludelarge corporations in the hospitality industry, the company mostly gets it orders through a bidding processorthroughagents.CWisbyfarthemostprofitabledivisionatOWwithgrossprofitmarginsranging between 20-50%.
Looking ahead, OW has plans to substantially expand its CW operations by increasing its penetration in the US—the largest market for Axminster products. CW has already established a new company in the US (CW Hospitality Weavers) and is working to get almost 30% of its sales from the US. The company is planning to get a major chunk of the refurbishment market in the US and Europe where major hospitality chains tend to overhaul their carpets every four to six yearsdependingontraffic.Additionally,CWplanstoexpandintothehighgrowthAsiaandMENAregion. Expansion in Egypt would be particularly easy as import duties of 40% are imposed on carpets, which makes imports virtually infeasible.
CW current production capacity is around 1.0-1.3 million square meters annually, which is currently fully utilized. Going forward, the company plans to add three looms by the end of this year, which will add approximately 300,000 square meters of new capacity.
According to CW’s management, the company aims to become the largest player in Axminster carpets globally over the next three years from its current 4th position. To achieve that, the company plans to capitalize on OW’s low-cost production base in Egypt and by designing innovative products. CW is currently the preferred vendor for the Four Seasons chain of hotels, and is in the advanced stages of becoming the preferred vendor for the Grand Hyatt and Fairmont.
La Boutique Oriental Weavers
La Boutique is a newly established division of Oriental Weavers catering to the higher-end niche market by allowing clients to customize their own carpets and rugs. It is developed around the concept of customer involvement by providing clients with the ability to select their own fabric, design and pattern to develop carpets and rugs that suit their own preferences.
OW Life Style Rugs and Carpets
OW Life Style designs are based on modern lifestyles, are produced from premium materials and involve complex construction methods. The brand is mostly targeted towards wealthy individuals to meet their home furnishing needs.
Aftershowinghealthygrowthduringtheperiod2004-2007,OW’sfinancialperformancecameundersomepressureduring2008and2009againstthebackdropoftheglobalfinancialcrisis.Nonetheless,OWwasabletomaintainoverallprofitabilitywithnetprofitsofclosetoEGP300million during 2008 and 2009. The following is a brief analysis of the important financialbenchmarks for OW.
Sales mix—Tilted Towards Low margin grade C and Tufted Products
With regards to OW’s 2009 sales mix, the woven category (comprising Grade A, B and C) represents the highest portion of total sales volume at 43%, followed by the tufted segment at 38%. Within the woven category, the low-margin Grade C products dominate, with 67% of sales volume followed by Grade B at 27%.
Figure 9 Sales Volumes by Category
2%12%
29%
6%
38%
13%
Grade A Grade B Grade C Wall-Wall Tufted Pieces Non-woven felt
Source: OW
Grade A has the lowest share of volume in the woven category at just 4% as it caters to the very high-endmarketsegment.Nonetheless,GradeA’sshareinsalesvalueishighat16%,reflectingthe high price tag of the product.
Grade B is the most popular product in the international market with 60% of sales volume coming from exports. In contrast, Grade A and Grade C are more popular in the local market with the respective sales volumes of 62% and 67% based in the domestic market.
Looking ahead, the move towards the higher end Grade A products represents an attractive opportunityforOWtoimproveitsmarginsandprofitability.WiththegradualriseinpercapitaGDP in Egypt and increasing wealth levels, there is the likelihood of increasing the proportion of Grade A products. The company’s strategy of expanding its Axminster line also represents a step towards this direction.
Figure 11 Sales Mix by Product Categories (Volume)
Themajorrawmaterialusedintheproductionofcarpetsissyntheticfiber,whichisproducedfrompolypropylene and accounts for approximately 30% of the total cost of production. Polypropylene is an oil derivative, and hence its price is somewhat linked to global oil prices. However, its actual price is determined in the international markets based on supply and demand dynamics. Figure 12revealsthatpolypropylenepriceshaveremainedquitevolatileoverthepastfiveyears.
Figure 12 Global Polypropylene Prices
0
500
1,000
1,500
2,000
2,500
USD
/ to
n
Source: Bloomberg
Finishing materials (mainly plastics) and backing (material used on the back of the carpets) are the other two major cost items, each comprising 10-15% of cost of production. The prices of these two components are also broadly linked to international oil prices as they both use some form of oil derivatives. Hence in aggregate, petrochemical-based raw materials total around 50-55% of OW’s total cost of production, which makes the company vulnerable to international oil prices.
Figure 13 Cost of Production Breakdown
4%
30%
20%6%
4%
21%
15%
Wool Polypropylene Backing & Finishing Wages Depreciation Selling Other including OW China
Given that OW has an advanced machine-driven production process, labor cost accounts for just 6% of the cost of production. Selling and other expenses, which mainly represent the cost of operating the distribution channels outside Egypt, comprise 34% of the cost of production.
EBITdA Analysis
OW’sEBITDAgrewsharplyduringtheperiod2003-2006,benefitingfromanincreaseinexportsand consequently rising export rebates2. Overall, EBITDA grew at a CAGR of 15% during the period 2003-2006 (from EGP 278 million to EGP 522 million), while EBITDA margins stood in the range of 25-27%. However, EBITDA growth slowed down sharply during the past three years (2007-2009) and has averaged 3.3% on the back of slowdowns in sales growth momentum and decline in the EBITDA margin to 19% in 2009 from 27% in 2006. The lower EBITDA margin was a result of pressure on OW’s gross margin amidst rising raw materials costs that the company was unable to fully pass on to customers.
Figure 14 EBITDA and Margins
278
348368
483
517542
52225% 26%27%
21% 21%19% 19%
0%
5%
10%
15%
20%
25%
30%
-
100
200
300
400
500
600
2003 2004 2005 2006 2007 2008 2009
EGP
Mn
EBITDA EBITDA margin
Sources: OW financials and NBK Capital
Working Capital Heavy Business model
OW’soverallworkingcapitalhasremainedatanelevatedleveloverthepastfiveyears,resultinginhighercashflowandcapital requirements.Onaverage,OW’sworkingcapitalstoodat47%of sales over the past seven years with a high of 61% in 2005 and a low of 33% in 2003. On the positive side, the company was able to reduce its working capital in 2009 to 42% of sales (EGP 1.5 billion), down from 54% of sales in 2008 (EGP 1.8 billion).
2We have included export rebates while calculating EBITDA as it is part of the overall export considerations received by the company
A detailed analysis of the working capital reveals that the primary reason for the high working capital is elevated inventory levels, as payables and receivables largely offset each other. The average inventory level of the company has steadily increased during the past six years, rising from 137 days in 2003 to 183 days in 2009. On the positive side, the company has been successful in reducing the receivables cycle from 138 days in 2005 to 85 days in 2009.
The following table shows the working capital analysis of some of OW’s regional and global peers. The overall cash conversion cycle ranges between 108 to 290 days with OW at 183 days. Hence, we believe that there is some room for improvement in the case of OW to bring down its working capital—predominantlyinventory—tofreeupcapitalandimprovecashflows.
Raw Materials and Finished Products are the Major Inventory Items
AsofFY2009,finishedgoodscomprised52%oftotalinventory(EGP725million)followedbyraw materials at 37% (EGP 525 million). The remaining inventory comprised work in progress and sparepartsforplantandequipment.Asubstantialamountoffinishedgoodsinventoryrelatestothe products on display at OW’s retail outlets in Egypt. Export orders are generally ‘made to order’ and are shipped upon completion.
Figure 18 Inventory Breakdown
525.337%
73.255%
81.36%
750.452%
Raw materials Spare parts & materials Work in progress Finished products
Source: OW financials
Steady decline in ROE and ROC
OW’sROEandreturnoncapital(ROC)hasdeclinedsteadilyduringthepastfiveyearsonthebackofpersistentdeclineingrossprofitmarginandhigherworkingcapitalrequirements.OverallROE (excluding goodwill) declined from 22% in 2005 to 15% in 2009 while ROC declined from 16% to 11% during the same time. It is worth mentioning that the sharp declines during 2008
and 2009 took place during extraordinary times where the global economy was facing historic challenges in terms of a sharp spike in oil prices in 2008, followed by a severe economic crisis in 2009.
Figure 19 ROE and ROC (Excluding Goodwill)
19%20%
22%
20% 20%
16%15%
18%
16% 16%
15% 14%
11% 11%
2003 2004 2005 2006 2007 2008 2009
ROE ROC
Source: OW financials
Lower Net margins and Lower Asset Turnover Resulting in a Lower ROE
A DuPont analysis of OW’s ROE reveals that the decline in net margins and a lower asset turnover havebeentheprimaryreasonsforlowerROE.OW’snetprofitmargindeclinedfrom14.7%in2003 to 8.4% in 2009, whereas asset turnover declined from 0.76x in 2003 to 0.67x in 2009. Lower net margins were on account of a rise in raw material prices and an increase in the share of lower margin tufted products—after the acquisition and subsequent consolidation of Mac carpets. Lower asset turnover is mainly on account of a rise in working capital.
OW’sleveragehasincreasedconsiderablyoverthepastfiveyearsasthecompanyuseddebttofinancetheacquisitionofMacCarpetsin2006.Overallnetdebttoequityincreasedfrom13%in2003 to 43% in 2009, while net debt to total capital ratio increased from 11% to 28% over the same period. In terms of interest coverage, OW is at a comfortable level of 5.2x in 2009, down from 7.2x in 2006.
OW’sdividendpayouthistoryhasbeeninconsistentoverthelastfiveyears.Thecompanydoesnothaveadefineddividendpolicy—suchasadefinedpayoutratioordefinedDPS.Toprovideanexample, the company substantially increased its dividend during 2008 and 2009, while at the sametimeincreasingitsborrowingsignificantly.Whilehigherdividendsaregenerallywelcomebyinvestors, a stable dividend policy would reduce the uncertainty regarding future dividend stream andmayhelpattractinvestorswhopreferstabledividendcashflows.
Overall, we have a positive outlook for OW for the long term due to its formidable position in the domestic and global carpets and rugs industry. The company’s performance during 2008 and 2009—which inarguably were the most challenging periods in the global economy’s history—provides clear evidence of the strength and resilience of the company’s business model. Figure 23 reveals that while all OW’s global competitors saw a sharp decline in their sales (20-35%) and operatingprofits(50-100%)overtheperiod2007-2009,OWwasabletoincreaseitssalesby16% during the same period and experience a relatively modest decline of 11% in its operating profits.During1H2010,OWwasabletofurtherconsolidateitspositionintheglobalmarketwitha 23% increase in its exports compared to 9-11% increase for the industry.
Figure 23 Financial Performance of Peers
OW Peers Performance Country 2007 2008 2009Decline
over 2007Sales revenue - USD MnMohawk US 7,586 6,826 5,344 -30%Interface US 1,081 1,082 860 -20%Dixie Group US 321 283 203 -37%Shaw industries US 5,373 5,052 4,011 -25%Oriental weavers Egypt 548 615 634 16%
Operating profit - USD MnMohawk US 750 419 44 -94%Interface US 131 114 65 -51%Dixie Group US 17 (1) (12) -174%Shaw industries US 436 205 144 -67%Oriental weavers Egypt 63 61 56 -11%
Positive Response from the dOmOTEx fair to Benefit in the Long Term
The annual DOMOTEX Hannover Floor Covering fair—which is considered to be a good indicator of the outlook on the global carpet and rugs industry—proved to be highly successful for OW, as it achieved a 67% increase in orders. The substantial rise in orders from the fair has already had a positiveimpactonOW’ssalesduring2Q2010,withsomeimpacttobereflectedin3Q2010sales.In addition to the spike in short term sales, the new customers that OW gained from the fair will most likely have a long term impact through repeat orders.
Expansion Plans
In the light of the encouraging response from the DOMOTEX fair and current capacity constraints, OW announced a major expansion plan to establish a new industrial complex with a total outlay of EGP 1.37 billion (USD 237 million). According to management, the current site does not have enough space to accommodate new capacities, which necessitates the establishment of a new complex.
Thefirstphaseoftheexpansionisexpectedtobecompletedbymid-2011andwouldincludetheestablishmentofanewfiberplantwithanannualcapacityof400,000tons.Additionally,wovencapacities are expected to increase by approximately 40% (40-50 million square meters annually) by 2015. The expansion in woven capacities is likely to be in a staggered manner whereby the company will add around 5-7% new capacity every year. We expect overall woven capacity to increase from 110 million square meters in 2009 to 166 million square meters by 2015, a CAGR of 8.8%.
During 1H2010, OW acquired new production lines from three Belgian plants and is currently in negotiationtoacquireadditionallines,afterevaluatingtheirproductioncapacityandefficiency.According to management, this acquisition is being done on an opportunistic basis and is not part of the EGP 1.37 billion expansion plan. In total, OW has acquired three new looms at a cost of USD 1.5 million (EGP 8.4 million) and is planning to acquire three more looms in 2H2010. Management states that these looms represent state-of-the-art machinery in very good condition and are likely to increase woven capacities by around 3.0 million square meters annually. Additionally, OW also enhanced the capacity in the finishing unit atMAC Carpetsthroughdebottlenecking—leadingtoanincreaseinfinishingcapacityby8-9%.Theincreaseincapacity is likely to lead to higher sales during 2H2010 as the demand side on both the local and export front is expected to remain buoyant.
Acquisition of Rosetex a Step Towards the Expansion Plan
AnothersignificantinvestmentthatOWmadeduring1H2010wasinanaffiliatedcompanynamedRosetex—a non-operating textile company—for EGP 40 million. According to management, the acquisition has been made in view of the strategic location of the facility, which is very close to the company’s current production site and the substantial land bank (totaling 65,000 square meters) available within the facility. The company plans to utilize the available land to build a state of the art warehousing facility, while at the same time expanding and moving some of its finishingcapacitytothenewsite.Weseethisacquisitionasapositivesteptowardstheultimateexpansionplanas itwill leadtoenhancedproductionflowandprovidethespacerequiredforfuture expansion.
Sales growth of 11% over the Period 2010-2015
Lookingahead,webelievethatOWcansustainasteadygrowthinsalesoverthenextfiveyears,driven by both domestic and global markets. The only factor currently hindering OW’s sales growth is its capacity, which is likely to be resolved with the completion of the expansion plan. We expect OW’s sales to grow at a CAGR of 11% for the six-year period 2010-2015 and then stabilize at around the 6% level. We expect the growth in sales during 2010-2015 to be driven by an average 7-8% growth in volumes and an average 3-4% increase in prices.
In the domestic market, the company will capitalize on rising demand from Egypt’s young and growing population coupled with a rising per capita GDP. As per various estimates, Egypt is likely to witness annual marriages to the tune of 500,000 to 600,000. This is likely to translate into a proportionate demand for new houses and consequently home products such as carpets and rugs. The bulk of the demand is expected to come from newly married couples moving into their new houses as Egypt is predominantly a ‘one-time purchase market’ and not a replacement market. On the global front, growth is likely to come from increased market share in the US and Europe and from high GDP growth in emerging markets.
gross margins to Improve with the global Economic Recovery
OW’sgrossprofitmarginhasbeenshrinkingforthepast2-3years,decliningfrom13.9%in2006to 11.8% in 2009. During 2007 and 2008, gross margin came under pressure on the back of an unprecedented increase in global polypropylene prices, which increased from around USD 1,100/ton at the beginning of 2007 to over USD 2,000/ton by July 2008. Subsequently, the global financialcrisisledtoasharpdeclineindemandforcarpetsandrugsglobally,thuspressuringthecompany to reduce prices in order to maintain sales volumes.
Looking ahead, we don’t see a marked improvement in gross margins over the next 12-18 months, given the fragile economic situation in the US and Europe. Although the US and European economies have seen some improvement over the past 12 months, they still face mounting challenges, foremostbeingsubstantialunemployment—leading toweakconsumerconfidence.In our view, these challenges—which do not seem to have any short term solution—will continue to hinder global economic recovery. This, in turn, will affect the demand for cyclical products, including home furnishing goods such as carpets and rugs.
Nonetheless, we see gradual improvement in OW’s gross margins in the medium term, given its formidable position in the global market and virtual dominance in the domestic market. We believe that future margin improvement will come from the following areas:
• Optimization of the product mix by improving the sales volume of higher margin Grade A products such as Axminster, Tapestry and Goblin.
• Adjusting mid-end Grade B products to reduce the cost of production by using fewer raw materials or changing the composition of raw materials.
• Economies of scale with the 40% expansion—especially with regard to the fixed sellingexpenses.
• A more aggressive stance by management to increase prices, along with a change in focus fromgainingmarketsharetomaximizingprofitability.
We forecast OW’s gross margins to steadily improve from 11.8% in 2009 to 13.5% in 2015. However, the margins are likely to remain in the range of 11.5-12.0% during 2H2010 and in 2011.
Figure 25 OW Gross Margins
11.8%12.0%
12.2%12.5%
13.3%13.5%
2010 2011 2012 2013 2014 2015
Source: NBK Capital
Export Rebate a major Contributor in Profitability
Like other exporters in Egypt, OW has been receiving export rebates from the Egyptian government for the past several years, as part of the government’s policy to boost exports. Overall, rebates have rangedbetween6-7%ofexportrevenueoverthepastfiveyearsandhaveallowedOWtopriceitsproducts attractively in international markets. The contribution of these export rebates to OW’s overalloperatingincomehasincreasedsubstantiallyoverthepastfiveyears—from8%in2003to almost 34% in 20093. These export rebates have allowed OW to gain competitiveness in the internationalmarkets,whileatthesametimemaintainingadecentlevelofprofitability.
New Export Rebate Scheme to Boost Earnings
As part of the government’s plan to further encourage exports and bring it more in line with Egypt’s overall economic development, the government announced significant changes in theexisting export rebate structure. As part of the new structure, which will be implemented from July 2010, the export rebates are linked with the product’s value addition and its localization. In general, rebates are increased for companies that are using higher percentage of local parts and for those that are involved in the export of high value-added products. Additionally, the discrepancy betweenexportrebatesinthefree-zoneandnonfree-zonewasreducedsignificantly.Finally,thegovernment has provided clarity on the rate of decline in rebates for the period 2010-2013.
• Being involved in the export of high value-added carpets and rugs
• Averyhighlocalizationlevelofmorethan90%,asthebulkofthesyntheticfibersisobtainedlocally from its subsidiary
• Around 30% production based in free-zones which have witnessed 300-400 bps increase in export rebates.
3The sharp rise in the export rebate in 2009 is on account of the Egyptian government’s decision to offer a one-time ad-ditional stimulus to exporters a tackle the effects of the global financial crisis.
According to OW’s management, the new scheme will increase the average export rebate from 4.5% in 1H2010 to around 8% in 2H2010–leading to an average rebate of 6.5% for 2010. Subsequently, the rebate is expected to remain at the 8% level in 2011 before declining to 7% in 2012 and 6% in 2013. Beyond that, there is no clarity available and we have assumed the rebate will stabilize at around 5% level from 2014 onwards.
Adjusted EBITdA margin to Jump in 2011 on Higher Export Rebate
We forecast OW’s adjusted EBITDA margin to jump sharply in 2H2010 and in 2011 on the back of the higher export rebates. Overall, EBITDA margin is expected to jump to 19.0% in 2H2010 (from 17.3% in 1H2010), taking the overall EBITDA margin in 2010 to 18.2%. Subsequently, the EBITDA is expected to decline steadily, starting form 2012, on the back of expected decline in export rebates.
OW posted healthy sales growth of 23% during 2Q2010 (13% during 1H2010) on the back of recovery in exports and execution of orders from the DOMOTEX exhibition. Total sales volume during 1H2010 increased by around 13%, mainly led by higher sales from the woven segment (+30% YoY), while the tufted segment witnessed a decline of 6% in volumes during the period.
Figure 27 P&L 1H2010
EGP Million 2Q09 2Q10 YoY 1H09 1H10 YoY
Sales 789 973 23% 1,676 1,888 13%
Cost of goods sold (708) (880) 24% (1,469) (1,666) 13%Gross profit 81 93 15% 207 222 7%
Net profit declined due to Lower gross Profit margins and Lower Export Rebates
Notwithstandingthehealthysalesgrowth,OW’sprofitabilityremainedsubduedduring2Q2010and 1H2010. Overall net income declined by 8% YoY during 2Q2010 (6% YoY during 1H2010) on the back of 1) lower gross margins 2) lower export rebates and 3) higher foreign exchange losses. Overall gross margins declined to 9.6% in 2Q2010 (11.8% in 1H2010) from 10.2% in 2Q2009 (12.4% in 1H2009) as the company continued its focus on gaining market share and maintaining relationships with its large customers, rather thanmaximizing profitability. OW’smanagement believes that the global demand for floor coverings has still not fully recoveredand hence the priority is still to consolidate its global leadership position and maximize sales. Additionally, the rise in petrochemical-based raw materials prices also had a negative impact on margins.
Export rebates (other revenues) declined from EGP 54 million in 2Q2009 (EGP 86 million in 1H2009) to EGP 37 million in 2Q2010 (EGP 54 million in 1H2010) due to the absence of the one-off rebates that were part of the government’s economic stimulus package in 2009.
With capacity constraints and booming orders, OW prioritized meeting export orders during 1H2010whilesacrificingthelocalcarpetdemand.Consequently,theshareofexportsintotalsales increased to 63% in 1H2010 from 57% in 1H2009, as exports increased by 23% during 1H2010 compared to a 3% decline in local sales during the same time. Europe witnessed a strong increase in demand—with exports to Europe increasing by 32% YoY in 1H2010. Looking ahead, we believe that local sales are likely to catch up with the addition of new woven capacities.
Figure 28 Sales Breakdown in 1H2010
43%37%
57%63%
1H09 1H10
Local sales Export sales
Source: OW data
Cost Pressure Leading to Lower margins
OW’scostofproductionincreasedsignificantlyduring1H2010onthebackofariseinpolypropyleneprices—with the recovery in oil prices—and a sharp increase in wool prices. Total wool cost increased by 81% YoY during 1H2010, while polypropylene increased by 18%—compared to revenue growth of 13% in 1H2010. Additionally, backing (the raw material used on the back of the carpet) also increased by 18% YoY. OW’s management—as part of its strategy—did not pass on the cost increase to its customers to consolidate its position in the international markets.
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