Rising demand for silk: Globally, the growth of silk fabric industry is largely influenced by the health of the US and European economies, its principal consumers (65% of consumption). Apart from these two economic heavyweights the hotel industry, which is amongst the largest corporate consumers of silk, has also driven the demand for silk due in light of the capacity expansions. To put things in perspective, the share of branded hotel rooms in Europe increased from 15% in FY00 to 25% in FY05. In the domestic market, strong economic growth and higher disposable incomes have leveraged incremental home buying and furnishing, which in turn has increased the consumption of high-end home furnishing fabrics. The fact that the demand pattern for high-end silk-based fabrics and yarns does not exhibit much seasonal fluctuation makes its case stronger vis-à-vis its lower-end peers such as cotton and wool.

Further, manufacturing capacities for silk fabrics are being shifted from Europe to destinations such as India and China primarily on cost and environment considerations. India is the second largest producer of silk and international acceptance of its textile designers is improving its positioning in the global silk industry. Indian textile industry also stands to gain considerably from the removal of export quota restrictions, US restrictions on Chinese textile imports, value-added quality products and timely delivery schedules. Also, India's home textile exports (which use considerable silk inputs) are being projected to grow from US$ 1.5 bn in FY05 to US$ 5 bn by FY10. Parallely, silk fabric exports are expected to grow from US$ 750 m in FY05 to US$ 1.5 bn by FY10 (Source: Ministry of Textiles). Large organised players such as Eastern Silk have the capability to capitalise on this growth opportunity.

Merger synergies: Eastern silk, which was earlier a pure handloom silk player with an established global marketing network, merged Sstella Silks (with mechanized manufacturing infrastructure but no global exposure) and Eastern Jingying (standalone yarn manufacturing facility) with itself in FY05. The said merger lent Eastern Silk a presence across the silk value chain - right from in-house yarn manufacturing capacity to mechanized high-realisation fabric manufacturing capacity. This also reduced the company's turnover time and gave it a better bargaining power vis-a-vis its customers. Streamlining of administrative activities dismissed the duplication of costs and thereby, enhanced the company's EBIDTA margins from 10% in FY04 to 18% in FY06. Also, due to Sstella Silk's location in a SEZ, Eastern Silk is liable to get MAT (minimum alternate tax) benefit until FY09, which will reduce its effective tax rate by approximately 400 to 500 basis points.

Realisations scale up: Eastern Silk has consistently made an effort to enhance the proportion of value added products in its product mix since FY00. Apart from increasing its reliance on in-house powerloom fabrics, the company has also forayed into higher margin embroidered fabrics and madeups. The proportion of value added products in its product portfolio has increased from 12% in FY05 to 15% in FY06. This has helped the company increase its average realisations by approximately US$ 4 to US$ 5 per metre. Since the cost of conversion of fabric into a value-added product is less than 50% of the incremental realisation, it makes a significant contribution to the company's bottomline.

Broad based customer segment: Of the company's 220 clients, more than 60% enjoy a relation of over a decade while the rest have been retained for over three generations. Also, since Eastern Silk does not have any exclusive tie-ups, it can participate in trade fairs and enjoys the pricing power. As against this, a player like Himatsingka Seide (the largest silk exporter in the country) that has exclusive tie-ups and concentrated customer base (around 20) is barred from participating in the trade fairs and accessing new customer segments (so as to enhance margins), which limits its pricing power.

Initiatives benign on margins: Eastern Silk Industries is taking several initiatives that we believe will stand the company in good stead in the longer term. The initiatives, besides improving the company's operating margins will also de-risk its revenue stream and sustain its incremental growth rate at a higher level as compared to its peers.

Improved product mix: Shift from small volume fashion fabrics to high volume furnishing fabric (70% of revenue in FY05 against 40% in FY04) had a benign effect on the company's operating margins.

Mechanisation of production techniques: The proportion of handloom-made to machine-made fabrics has improved from 70:30 in FY04 to 50:50 in FY06 and the company sees this going up to 30:70 by FY08. This will enhance the company's net realisations by approximately US$ 3 per metre.

Shift from outsourcing to inhouse production: The mix of the company's in-house to outsourced production, which was largely skewed towards the former earlier, has considerably reduced due to the capacities acquired during the merger and the commissioning of fabric capacity at Anekal (Unit II) in 1QFY07. Also, the made-ups segment (currently reliant on outsourced job work) will reduce benefit once the Bangalore capacity of 1,500 pieces a day is commissioned in 4QFY07. With this, the proportion of in-house fabrics that is currently being consumed for production of made-ups will increase from 25% to 40%.

Wider reach: Although the export markets of US and Europe alone account for 65% of Eastern Silk's revenue, the company is represented globally by over 30 agents in the EU, US and East Asian markets. Also, what gives it an edge in logistics is the fact that the company transports 70% of its products by air from Bangalore.

China dependence: Eastern Silk imports 70% of its yarn requirements from China, which exposes it to considerable raw material supply and cost risk. While China consumes nearly 50% of its raw silk output, it is compelled to export the rest to countries like India due to its incompetence in the global silk export market. Globally, the quality of silk and silk-blended fabrics, superior design and the ability to deliver reliable products within given time frame are the most important criterions for selection of a supplier. As the European buyers are hesitant to enter into contracts with Chinese suppliers, the products are sourced from India, which makes the case stronger for players like Eastern Silk. Besides, Eastern Silk's relations with its Chinese suppliers spans over 3 decades. To that extent, the supply risk remains limited.

Forex risks: Eastern Silk is affected by cross currency fluctuations due to two reasons. Firstly, outsourced yarn requirement is entirely imported and secondly, nearly 70% of the company's turnover is derived from exports. However, it should be noted that this works as a natural hedge, as export revenues cover the import liability. Also, to protect itself from currency fluctuations, the company has a dollar denominated bank account, which helps it meet the foreign currency liabilities with minimum forex risk. Further, the fact that Eastern Silk is a 100% export oriented unit exempts it from payment of customs duty.

Eastern Silk Industries, established in 1946, is one of the leading exporters of silk fabrics from India. It is present across the entire value chain from yarn to basic and designed fabrics to embroidered fabrics to made-ups. It caters to the specialised requirements of fashion labels (for garments and accessories) and furnishing companies. The company garners 70% of its revenues from exports, of which consumption in the US and Europe account for about two-third of its export despatches. The company has realigned its portfolio mix in favour of larger volume furnishing fabrics (75% of revenues in FY06) as compared to small volume fashion apparel fabrics. It has also embarked on various initiatives such as capacity expansion, forward integration, inorganic growth and greater market reach so as to align its margins with that of the market leader.

The high-end silk-based fabric and yarn industry is highly fragmented, with a large number of small to medium-sized manufacturers and suppliers having local presence with focus on specific geographical areas. Only a few large manufacturers and suppliers have a global presence, with a great disparity in terms of relative size, capacities and financial resources. Globally, the supplier's ability to provide superior design followed by timely service and technical support are the key parameters for the buyers' selection. Thus, despite India being the second largest producer of silk, it enjoys an upper hand over China with respect to silk exports to the US and European markets. India consumes approximately 60% of Chinese raw silk exports and India exports 30% of its total silk output (the domestic consumption being reasonably high). The total global silk export market (in value terms) was US$ 6.5 bn in FY06 of which India has 9% market share (US$ 750 m and is expected to grow at a CAGR of 19% over the next 4 years).

Sector: The growth in the global silk industry is closely linked to the GDP growth of the European nations and the US. While the growth in the said geographies has started picking up, what is enthusing is the fact with growing disposable incomes, the domestic market also offers significant potential. The supply of silk being limited (5,500 silkworms are required to manufacture 1 kg of silk) and well in short of the expected demand, the prices for the fibre are expected to remain firm. However, the over dependence on China for supplies cannot be ignored. Also, the rising inflation and interest rates may limit economic growth in the overseas markets. Based on these factors, we have assigned a medium risk rating of 4 to the stock.

Sales: Eastern Silk has witnessed a CAGR of 16% in its topline over the last 5 years, which is double the industry average of 8%. Foray into high-end value add products and vertical integration are expected to fuel its sales growth further. This shall be backed by a firm trend in silk prices and rise in volumes on account of capacity expansion. However, since the company has not yet breached our parameter of sales above US$ 100 m, we assign a medium risk rating of 6 to the stock.

Long term EPS growth: We expect the company's net profit to grow at a CAGR of 29% between FY06 to FY08 (CAGR of 57% during FY04-FY08). In a normal scenario, we consider a compounded growth of over 20% in net profits over a period of 3 to 5 years as healthy for a company. As such, the rating assigned to the stock on this factor is 8.

Dividend payout: A stable dividend history inspires confidence in the management's intentions of rewarding shareholders. Eastern Silk has had a consistent dividend history of 25 years. However, since we expect Eastern Silk's payout ratio to remain at a low 8% (which has been the historical trend), the rating assigned is 3.

Current ratio: Eastern Silk's average current ratio during the period FY06 to FY08 is estimated to be around 5 times, indicating the company's ability to pay up short-term obligations. A ratio under 1 suggests that the company is unable, at that point, to pay off its obligations if they came due. We assign a low-risk rating of 9 to the stock.

Debt to equity ratio: A highly leveraged business is the first to get hit during times of economic downturn, as companies have to consistently pay interest costs, despite lower profitability. We believe that a debt to equity ratio of greater than 1 is a high-risk proposition. With the additional capital raising in 1QFY07, Eastern Silk's debt to equity ratio has come down to 0.3. We have thus, assigned it a low risk rating of 8.

Promoter holding: A larger share of promoter holding indicates the confidence of the people who run it. We believe that a greater than 40% promoter holding indicates safety for retail investors. At the end of March 2006, the promoter holding in Eastern Silk stood at 54%, which is healthy. We have assigned a low risk rating of 8 to the stock.

FII holding: We believe that FII holding of greater than 25% can lead to high volatility in the stock price. FII holding in the company stood at 0% at the end of March 2006, which is a very comforting factor. Therefore, the rating assigned is 9.

Liquidity: The past one-year average daily volume of the stock is in the range of 53,475 shares, which is very low. The rating assigned is 2.

Margin of safety: This is to determine the value of the stock relative to its price and the returns over a risk free rate. Margin of safety of a stock lies in its earning power, which is calculated as - EPS divided by Market price (reciprocal of P/E). Considering Eastern Silk's P/E of 7.0 times our estimated FY08 earnings, the earning power is 14%. This is much higher than the risk free rate of 7.5%, which is a positive. Thus, the rating assigned is 10.

Considering the above parameters, the total ranking assigned to the company is 67. This makes the stock a low-risk investment from a long-term perspective.