ORIENTAL WEAVERS. The Carpet Behemoth

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1 ORIENTAL WEAVERS The Carpet Behemoth key data Highlights Fair Value per share (EGP) 38 Closing Price (EGP) * 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, Sources: Zawya and NBK Capital key metrics Figures in EGP 2009A 2010F 2011F 2012F EPS EPS Growth 1% 7% 19% 7% P/E Dividend Yield 8% 4% 5% 5% EV/EBITDA Revenue (Millions) 3,551 3,940 4,392 4,899 Revenue Growth 3% 11% 11% 12% EBITDA (Millions) 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 ,061 EBITDA Source: NBK Capital Rebased Performance Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Oriental Weavers MSCI EGYPT Sources: MSCI, Reuters, and NBK Capital 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 machinewoven 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 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 E. suleman.soorani@nbkcapital.com Samir Murad, CFA T E. samir.murad@nbkcapital.com **Please refer to page 34 for recommendations and risk ratings. nbkcapital. com

2 Contents Executive summary... 3 Valuation... 4 Discounted Cash Flow Valuation... 4 Sensitivity Analysis... 5 Peer Group Comparison... 5 Risk Factors... 6 Bull STORY... 8 Bear STORY... 9 Industry Analysis and OW s Positioning Company Overview Export Focus Focus on Innovation and Technology Consistent Introduction of New Designs Strong Alliances with its Customers An Integrated Production System Market Leader in the Domestic Market Major Products Oriental Weavers Brands Financial Analysis Outlook: Positive in the Long Term H2010 Result Update Financial Statements... 33

3 Executive summary 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 granules to distribution of finished goods. 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 operating profits (50-100%) for the period , OW was able to increase sales by 16% during the same period and experience a relatively modest decline of 11% in its operating profits. 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 an enviable position in the local market, which is reflected in its 85% market share. 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. Looking forward, we believe that OW can sustain a steady growth in sales over the next five years in 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 average growth rate (CAGR) of 11% over the five-year period and then stabilize at around 6%. In terms of profitability, we see a gradual improvement in OW s gross margin on the back 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 Our fair value for OW, based on DCF model, is EGP 38 and we have an Accumulate recommendation with an upside potential of 15%. nbkcapital. com 3

4 Valuation 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 Valuation Method Weight Value (EGP) Our 12-month fair value for OW is EGP 38 Discounted cash flow 100% 38 Source: NBK Capital Discounted Cash Flow Valuation Our DCF valuation (Figure 2) is based on forecasted financial results through The DCF valuation 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 by expectations of sales and operating expenses Future changes in working capital Future net expenditures on fixed assets 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 forecasted financial results, we extracted the free cash flows that were used in our valuation. We discounted those cash flows to a point in time that is 12 months into the future to 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. nbkcapital. com 4

5 Figure 2 DCF Valuation Figures in EGP Millions* Fiscal Year Ends December Forecast Net Operating Profit after Tax Add: Depreciation and Amortization Gross Cash Flow ,010 1,114 1,202 1,287 (Incr.)Decr. in Working Capital (192) (216) (243) (290) (250) (218) (205) (Incr.)Decr. in Operating Fixed Assets (359) (383) (408) (434) (331) (331) (331) Free Cash Flow from Operations Terminal Value 7,358 Value of Operations in 12 Months 4,982 Add: Excess Cash 549 Add: Value of Long-Term Investments 71 Add: Value of Other Long-Term Assets - Less: Total Debt (1,917) Less: Minority Interest (295) Value of Equity in 12 Months 3,389 Per-share Value in EGP 38 * Except per share values. Source: NBK Capital Sensitivity Analysis 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 Cost of Equity* Growth -0.50% -0.25% Base Case 0.25% 0.50% -1.0% EGP 42 EGP 42 EGP 42 EGP 43 EGP % EGP 40 EGP 40 EGP 40 EGP 40 EGP 40 Base Case EGP 37 EGP 38 EGP 38 EGP 38 EGP % EGP 35 EGP 36 EGP 36 EGP 36 EGP % EGP 34 EGP 34 EGP 34 EGP 34 EGP 34 *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. nbkcapital. com 5

6 Figure 4 Trailing and Forward PE Comparison Company Marlet Data Market Cap Country (USD Millions) PE TTM PE 2011 The simple average trailing PE for the sample, excluding the outliers, stands at 12.8 Depa United Arab Emirates Interface Inc USA Seasons Furnishings India NA Mohawk Industries USA 3, Gratex Industries India NA Gloster Jute Mills India NA Al Abdullatif Industrial Saudi Arabia NA Orbit Exports India NA Malabar Trading India NA Sern Kou Resources Malaysia NA Tafi Industries Malaysia NA Alsorayai Group Saudi Arabia NA Rockworth Public Company Thailand NA Truong Thanh Furniture Vietnam NA Furniture Mart Botswana NA Narra Industries Malaysia NA Thailand Carpet Mfg co Thailand NA Vitafoam Nigeria Nigeria NA Oriental Weavers Egypt Simple average Simple average excluding outliers Median *Prices in local currency as of October 12, 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. OW will benefit from a depreciation of EGP against major foreign currencies, as this would make its 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 relatively well during the financial and economic crisis in 2008 and early 2009, which gives us some comfort regarding the strength of OW s product portfolio and customer nbkcapital. com 6

7 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 the major raw material used by OW and comprises around 25-30% 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 materials are not directly proportional to changes in oil prices, they are significantly influenced by it. The significant reliance on oil based raw materials makes OW vulnerable to volatility in global oil prices. Interest Rate Risk The bulk of OW s long term loans are on floating rates, at attractive spreads of 1-2% over USD London Inter Bank Offered Rate (LIBOR). The interest rates on these floating rate loans declined sharply during 2008 and OW s average finance cost declined from 9% in 2006 to 6% in 2009, helping the firm in reducing its finance expense. Looking ahead, a rise in US interest rates may result in an increase in the average finance cost for the company. nbkcapital. com 7

8 Bull STORY 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. Diversified customer networks in developed markets comprising major names in the global retail 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 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 have been very difficult years for the industry as a whole. While all of OW s major global competitors saw a sharp decline in their sales (20-35%) and operating profits (50-100%) over the period , OW was able to increase its sales by 16% during the same period and experienced a relatively modest decline of 11% in its operating profits. 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. OW enjoys significant economies of scale by virtue of being the largest machine-made carpet and 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. nbkcapital. com 8

9 Bear STORY Working capital heavy business model mainly due to very high inventory levels, which ties up significant cash flows and capital. 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 petrochemicalbased products such as polypropylene and plastics. The impact is magnified due to the relatively 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 restructuring of the export rebate scheme and announcement of a firm plan for the period mitigates the risk, in our view. nbkcapital. com 9

10 Industry Analysis and OW s Positioning OW operates in the broader floor covering industry, which, on a global level, is considered to be a mature industry with an average growth potential of around 3-4% annually. Within the floor covering industry, OW operates in the carpets and rugs 1 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). The demand for floor covering products is cyclical and is closely 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 economic indicators such as consumer income, consumer confidence, and corporate spending. The largest markets for floor covering products are the developed markets of North America and Europe followed by Asia Pacific. However, these large markets are quite mature and hence offer limited 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. The following is an analysis of OW s business model based on Porter s five forces. Threat of New Entrants Domestic: Low Export: Medium Overall: Low to Medium 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, another factor that would probably prevent a new entrant is the already low profit margins 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. 1 Although 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. nbkcapital. com 10

11 Bargaining Power of Suppliers Domestic: Medium Export: Medium Overall: Medium The major raw material used for the production of carpets is synthetic fiber, which is produced from 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 for their floor covering needs. They include 1) resilient products such as ceramics, wood, laminate 2) 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 product to other floor covering items. The fact that customers can still buy a rug for their wooden or 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 to be a mature industry with limited growth potential, the competition among existing firms is likely 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 to customers. Nonetheless, OW enjoys an enviable position in the local market, which is reflected in 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 nbkcapital. com 11

12 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 the overall market for the floor covering industry is likely to grow at an average of 3.8% 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 Figure 5 Global Floor Covering Market in USD Millions 4,585 6,555 8,500 10,550 Consistent increase in the market share for rugs 1,450 1,670 1,945 2,185 4,045 4,295 4,755 5,365 Source: OW presentation 2002A 2007A 2012E 2017E Carpets and rugs Resilient Flooring Nonreslilient Flooring nbkcapital. com 12

13 Company Overview 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 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 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 9% 3% 3% 39% North America and Europe comprise 83% of total exports 44% 2% 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. nbkcapital. com 13

14 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 and distribution. 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 if it gets better prices or deals. The benefit that OW derives by sourcing polypropylene from OPC is 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 nbkcapital. com 14

15 that OW s polypropylene requirement represents less than 5% of OPC s capacity, OW is likely to have limited influence on OPC s operations. Figure 7 Production Flow at OW Production of polypropylene Spinning and dyeing yarn Fully integrated production process 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 rug showroom in the world. Egypt represents an important market for the firm in terms of its high end Grade A product (the most profitable category for OW). Its substantial market share provides evidence 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 (with % natural fibers) and Grade C the low-end product (with 0-25% natural fibers). Grade B comes somewhere in the middle with around 50% natural fibers. Grade A commands the highest profit margins at around 35% natural fibers and comprises around 8% of sales by value followed by Grade B with 10-15% profit margins and sales contribution of 23% by value. Grade C has the lowest profit margins at approximately 5% and has the highest sales volume. According to the company s management, the reason for having such a low-margin product is to achieve a higher utilization of the manufacturing facilities. nbkcapital. com 15

16 Figure 8 Major Products for OW Oriental Weavers Woven Tufted Non-woven A diversified product range Grade A Pieces Master batch Grade B Wall to Wall Non-woven fiber Grade C Fiber Sources: OW reports and NBK Capital Oriental Weavers Brands 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 Axminster Carpets, which is regarded as it s most durable and flexible product. Axminster basically represents 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 administrative staff, while the manufacturing facility is based in Egypt. The bulk of CW s work is customized according to the specific needs and requirements of its clients. Since CW s customers include large corporations in the hospitality industry, the company mostly gets it orders through a bidding process or through agents. CW is by far the most profitable division at OW with gross profit margins ranging 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 years depending on traffic. Additionally, CW plans to expand into the high growth Asia and MENA region. 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 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. nbkcapital. com 16

17 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 4 th 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. nbkcapital. com 17

18 Financial Analysis After showing healthy growth during the period , OW s financial performance came under some pressure during 2008 and 2009 against the backdrop of the global financial crisis. Nonetheless, OW was able to maintain overall profitability with net profits of close to EGP 300 million during 2008 and The following is a brief analysis of the important financial benchmarks 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 13% 2% 12% Dominated by low margin Grade C and tufted products 29% 38% 6% 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-end market segment. Nonetheless, Grade A s share in sales value is high at 16%, reflecting the 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. nbkcapital. com 18

19 Figure 10 Woven Segment Sales Product Mix in % 90% 80% 41% Dominated by Grade B and C 70% 60% 50% 67% 40% 44% 30% 20% 10% 0% 29% 4% Volume 16% Value Grade A Grade B Grade C Sources: OW presentation and NBK Capital Looking ahead, the move towards the higher end Grade A products represents an attractive opportunity for OW to improve its margins and profitability. With the gradual rise in per capita GDP 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) 38% 33% 60% Grade B most popular export product 62% 67% 40% Grade A Grade B Grade C Local Export Source: OW presentation and data nbkcapital. com 19

20 Cost Analysis The major raw material used in the production of carpets is synthetic fiber, which is produced from polypropylene 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 12 reveals that polypropylene prices have remained quite volatile over the past five years. Figure 12 Global Polypropylene Prices 2,500 2,000 Higher volatility impacting OW s gross margin USD / ton 1,500 1, 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 15% 4% 30% 50% comprises petrochemicalbased raw material 21% 4% 6% 20% Wool Polypropylene Backing & Finishing Wages Depreciation Selling Other including OW China Source: OW data nbkcapital. com 20

21 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 s EBITDA grew sharply during the period , benefiting from an increase in exports and consequently rising export rebates 2. Overall, EBITDA grew at a CAGR of 15% during the period (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 ( ) 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 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 % 26% 27% % 25% % 21% 19% 19% 20% On a downward path EGP Mn % % 100 5% % EBITDA EBITDA margin Sources: OW financials and NBK Capital Working Capital Heavy Business Model OW s overall working capital has remained at an elevated level over the past five years, resulting in higher cash flow and capital requirements. On average, OW s working capital stood at 47% of sales over the past seven years with a high of 61% in 2005 and a low of 33% in 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). 2 We have included export rebates while calculating EBITDA as it is part of the overall export considerations received by the company nbkcapital. com 21

22 Figure 15 Working capital % % 61% 43% 42% 54% 42% 60% 50% Rising working capital a drain on cash flows EGP Bn % % 30% % % 0% Working Capital WC as % of sales Sources: OW financials and NBK Capital Substantial Inventory Levels 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 On the positive side, the company has been successful in reducing the receivables cycle from 138 days in 2005 to 85 days in Figure 16 OW s Working Capital Working capital Higher inventory levels lead to a long cash conversion cycle Inventory Turnover (x) Average No. Days Inventory in stock Receivable Turnover (x) Average No. Days sales in receivables Payables Turnover (x) Avg No. Days Payables Outstanding Cash Conversion Cycle-Days Sources: OW financials and NBK Capital 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 predominantly inventory to free up capital and improve cash flows. nbkcapital. com 22

23 Figure 17 Relative Working Capital Analysis for Peers Cash conversion cycle Alsorayai Group Al Abdullatif Industrial Invest Co Dixie group Interface Mohawk Industries Inc Oriental Weavers Sales - USD Mn , Room for improvement in the working capital cycle Inventory Turnover (x) Inventory Turnover - Days Accounts Receivable Turnover (x) Accounts Receivable Turnover - Days Accounts Payable Turnover (x) Accounts Payable Turnover - Days Cash Conversion Cycle - Days Sources: Bloomberg and OW Presentation Raw Materials and Finished Products are the Major Inventory Items As of FY2009, finished goods comprised 52% of total inventory (EGP 725 million) followed by raw materials at 37% (EGP 525 million). The remaining inventory comprised work in progress and spare parts for plant and equipment. A substantial amount of finished goods inventory relates to the 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 % High finished goods and raw materials inventory % % % Raw materials Spare parts & materials Work in progress Finished products Source: OW financials Steady Decline in ROE and ROC OW s ROE and return on capital (ROC) has declined steadily during the past five years on the back of persistent decline in gross profit margin and higher working capital requirements. Overall ROE (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 nbkcapital. com 23

24 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 Figure 19 ROE and ROC (Excluding Goodwill) 22% 19% 20% 20% 20% Steady decline since % 16% 16% 16% 15% 15% 14% 11% 11% 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 have been the primary reasons for lower ROE. OW s net profit margin declined from 14.7% in 2003 to 8.4% in 2009, whereas asset turnover declined from 0.76x in 2003 to 0.67x in 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. Figure 20 ROE Breakdown for OW Dupont Analysis Lower asset turnover and net margin Net profit margin (Net income/sales) 14.7% 13.3% 14.9% 9.3% 10.7% 8.6% 8.4% Asset turnover (Sales/Total assets) Equity multipler (Assets/Equity) Return on Equity (ROE) 19.0% 19.7% 21.6% 19.8% 19.9% 16.2% 15.5% Sources: OW financials and NBK Capital Rising Debt to Equity Ratio OW s leverage has increased considerably over the past five years as the company used debt to finance the acquisition of Mac Carpets in Overall net debt to equity increased from 13% in 2003 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 nbkcapital. com 24