Corporates. FY16 Outlook: Agricultural Commodities - Cotton. Global Surplus to Weigh Down Prices for another Year NEGATIVE.

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1 Global Surplus to Weigh Down Prices for another Year Outlook Report Agri Commodities Sector Outlook NEGATIVE (214: NEGATIVE TO STABLE) Muted domestic mill consumption Reduced demand for Indian cotton yarn by Chinese textiles Uncompetitive cotton exports Cotton prices near minimum support prices Amendment of Chinese reserve policy Rating Outlook NEGATIVE (214: STABLE) Sector Outlook Revised to Negative: India Ratings & Research (Ind-Ra) has revised the outlook for the cotton sector to negative for FY16 from negative to stable. This is because the unlikely recovery in cotton exports, contraction in domestic yarn production for exports, and a fall in domestic cotton prices below minimum support prices (MSP) have pushed domestic cotton stocks high. This is likely to keep domestic cotton prices under pressure in FY16. Rating Outlook Negative: The operating profitability of Indian cotton ginners and cotton exporters was under pressure in FY15 due to volatile cotton prices. Ind-Ra believes the credit profiles of cotton ginners and exporters will be stressed further in FY16. Therefore, the rating Outlook has been revised to Negative for FY16 from Stable. Amended Chinese Policy to Revive Internal Mill Consumption: The conversion of China s cotton reserve policy into direct subsidy from price support in April 214 will increase reserve cotton sales and reduce China s cotton imports from the global markets to half in FY16, thus affecting India s exports. The agency believes this will increase the yoy cotton mill consumption in China. We expect China s stock to use ratio to reduce gradually to 52.7% in marketing year (MY August-July) Downside Risk to Cotton Prices: We expect the global cotton prices to be low in the medium term due to the negative sentiments among market participants about the quantum of reduction in global cotton trade and the subsequent volume overhang. Indian cotton prices are expected to remain stressed in MY15-16 (October-September). Kapas prices (represented by Shanker-6 (S-6)) are likely to trade between INR4/kg and INR45/kg while lint prices will trade in the range of INR85-INR1/kg for MY Ind-Ra expect domestic stock to use ratio for MY15-16 to be near 12% (MY14-15: 12.2%). Low Domestic Cotton Consumption: The agency believes continued subdued export demand for Indian cotton yarn is likely to keep domestic mill consumption muted in MY Domestic cotton consumption and cotton yarn production have shown muted growth at 3.6% and 2.3%, respectively, for October-ember MY14-15 due to a drastic reduction in off-take from Chinese counterparts. Related Research FY16 Outlook Reports Analysts Ankit Sunil Bhembre ankit.bhembre@indiaratings.co.in Uncompetitive Cotton Exports: India s cotton exports to China declined 26.4% yoy over April-October 214 compared to a 4.3% yoy fall the year earlier. We believe lower global cotton prices and the relatively stable rupee will keep the attractiveness of Indian cotton under pressure in the export market in MY Thus, India s cotton exports to other destinations are unlikely to replace the quantum of lower trade with China. Operating Profitability to Remain Stressed: In MY15-16, the agency expects cotton prices to trade lower yoy unless cotton yarn demand recovers. Credit profile of domestic ginners and cotton exporters reflected by declining ginning spreads will continue to remain under pressure in FY16. Amey Joshi amey.joshi@indiaratings.co.in 24

2 Outlook Sensitivities Sector Outlook Stable Global Cotton Prices: Stability in global cotton prices, although at lower levels, commensurate with a sustained, directional decline in the stock to use ratio will lead to an outlook revision to stable. Rebound in Domestic Mill Consumption: A rebound in domestic mill consumption driven by higher demand for Indian textiles, adequate domestic availability at stable cotton prices above MSP will lead to the outlook being to stable. However, Ind-Ra expects the possibility of an outlook revision unlikely until MY16-17 given that the stock to use ratio will remain high in MY Rating Outlook Stable Operating Profile: A sustained improving trend in ginning spreads translating into improving/stable credit profile and liquidity will lead to a Stable Outlook for cotton ginners. However, Ind-Ra expects the possibility of an Outlook revision unlikely until FY17. The rating Outlook for cotton exporters will continue to be Negative. 2

3 Key Issues Domestic Cotton Supply Decline in Acreage The Cotton Corporation of India Ltd. (CCI) expects India to witness another year of bumper crop in the cotton season (MY14-15) with domestic production at 4. million bales (MY13-14: 39.8 million bales). The cotton production has stabilised at higher levels despite a sharp 7.9% increase in acreage to a decade high of 12.6 million hectares. This was due to higher remuneration in relation with other competing crops such as rice, gaur and soybeans in the previous crop year. Higher acreage is primarily offset by lower yield at 537 yield kgs per hectare (MY13-14:577 yield kgs per hectare) due to untimely and erratic monsoon. Ind-Ra expects domestic cotton acreage to contract by 5%-1% to near 12. million hectares in FY16. This is in view of the recent sharp correction in domestic cotton prices to below MSP levels, MSP not increasing in tandem with the cost of production and the bleak demand outlook for cotton and cotton yarn exports. MY15-16 cotton production will be near MY14-15 levels with a 5% increase in yields on a normal monsoon spell. Figure 1 Domestic Cotton Balance Sheet a b Acreage Yield Production c Mill consumption c Small mill consumption c Non-mill consumption c Total consumption c Exports c Carry forward c Stock to use (%) a CCI estimates b Ind-Ra s estimates c Million bales Source: CCI, Ind-Ra s analysis Domestic Demand for Indian Cotton to Remain Muted MY13-14 ended with a stock to use ratio of 1.7% (down from 12.8% in MY12-13), driven by robust mill consumption at 15.7% (up from 5.7% in MY12-13) that supported a spurt in cotton yarn export to China. However, domestic cotton consumption and cotton yarn production has shown muted growth for MY Cotton yarn registrations have declined sharply over April- August 214 due to a drastic reduction in off-take from Chinese counterparts, leading to buildup of cotton yarn stock. Figure 2 Rising Cotton and Yarn Stock (m kgs) Ending cotton stock Ending yarn stock Source: Ind-Ra, Ministry of Textiles Cotton year: October-September Yarn year: April-March Figure 3 Moderation in Domestic Cotton Consumption and Yarn Production Oct- 14 (MY14-15) Cotton consumption up 3.6% yoy (MY13-14: 9.4%) Oct 14 Cotton yarn production up 2.3% yoy (Oct 13: 11.1%) Aug 14 Cotton yarn export registrations down 21% yoy (Oct 13: 49.3%) (m kgs) 6, 4, 2, Cotton consumption Cotton yarn production Cotton yarn export registrations 4, ,68.7 4, , , , ,46.4 2, , , , Source: Ind-Ra, Ministry of Textiles Cotton year: October-September Yarn year: April-March Oct Aug 12 Oct Aug 13 Oct Aug 14 3

4 Over August-ember 214, cotton imports from India into China declined 26.4% yoy from a 4.3% fall a year earlier due to declining demand. Low domestic mill consumption will push domestic cotton ending stocks high for MY We believe domestic mill consumption will remain muted while cotton exports will decline further 1%-15% as supply adjusts to lower consumption levels in MY Figure 4 Chinese Cotton Yarn Exports to Decline ( metric tonne) 1,5 1, Global cotton yarn exports (LHS) China (LHS) India imports growth rate (RHS) (%) MY9-1 MY1-11 MY11-12 MY12-13 MY13-14 Source: Bloomberg, Ind-Ra's analysis Cotton marketing year (MY): August-July MY14-15: Aug Figure 5 Sluggish Chinese Cotton Imports Unlikely to Recover ( metric tonne) 6, 4,5 3, 1,5 Global cotton imports (LHS) India imports growth rate (RHS) Indian imports (LHS) MY9-1 MY1-11 MY11-12 MY12-13 MY13-14 MY14-15 thus far Source: Bloomberg, Ind-Ra's analysis Cotton marketing year (MY): August-July MY14-15: Aug (%) Reduced Competitiveness For MY14-15, domestic raw cotton (ginned) prices were, on an average, 2% yoy lower (October-December 214) due to muted domestic mill consumption and a sharp reduction in export off-take due to lower global prices. Post the decline, domestic cotton prices have been trading at near-global prices measured by Cotlook A Index. Also, the Indian rupee was the least depreciated at 1.6% against the US dollar compared with the currencies of other exporting nations such as Australia (7.6%) and Brazil (11.3%) during the first three months of MY Figure 6 Monthly Cotlook A Index and India Raw Cotton Prices (US cents per lb) 125 MY Cotlook index value Wt. avg India raw cotton prices Oct 11 Feb 12 May 12 Aug Feb 13 May 13 Sep 13 Dec 13 Mar 14 Jun 14 Sep 14 Dec 14 Source: Bloomberg, CCI and Ind-Ra Indian cotton marketing year (MY): October-September 4

5 We believe global cotton prices being lower than India s and a relatively stable rupee (albeit at near INR: USD at 6 or lower) will keep the attractiveness of domestic cotton in the export market under pressure in MY A spurt in cotton shipments to export destinations such as Bangladesh, Korea, Vietnam and Indonesia is unlikely to offset the magnitude of lower trade with China. Indian Government Policy: Price Support unlikely to Correct Fundamentals Domestic kapas prices traded at average premium of 31.4% over the MSP for MY13-14 for S- 6. The premium was down to 4.5% on an average for the first three months of MY14-15 (October-December) from 3.% average the year earlier. Figure 7 Monthly Shanker-6 and MSP Prices (INR/kg) 65 MY Shanker-6 kapas MSP for long staple kapas Jan 13 Mar 13 May 13 Jul 13 Sep Jan 14 Mar 14 May 14 Jul 14 Sep Jan 15 Source: Bloomberg, CCI and Ind-Ra Indian cotton marketing year (MY): October-September Given that domestic cotton prices are near MSP prices for S-6 (INR4.5/kg for MY14-15), Ind- Ra expects large-scale MSP operations initiated by CCI in various parts of the country to continue, should market prices fall any lower. CCI will be unable to offload the procured stocks into the weak domestic markets until 2HMY15-16 due to further muted domestic mill consumption and sluggish export off-take due to lower global prices. This will lead to a build-up of domestic cotton stocks. Global Cotton Demand Supply Dynamics U. S. Department of Agriculture (USDA) estimates the global cotton acreage to rise by 5% in MY14-15 (MY13-14: 4.7%), driven by higher acreage in the US (rebound) and India. However, global production is likely to decline marginally to million bales in MY14-15 (MY13-14: 12.3 million bales) due to lower yields caused by unfavourable weather conditions in the southern hemisphere. Global stock to use ratio ended at a decade high of 93.3% for MY Unsurprisingly, 61.7% of the ending stock continues to be held by China. However with the amendment of the cotton reserve policy to income/target support policy (or direct subsidy policy) from a price support policy, Chinese cotton imports are likely to be reduced to half. Lower import demand from China means that production will outstrip demand, leading to a fifth consecutive year of higher global ending stocks for MY Ind-Ra believes lower prices (an outcome of revised policies) will no longer provide an incentive for growers to sow cotton for another crop year. Therefore, cotton acreage in China and outside is likely to contract MY15-16 onwards. Also, global consumption will improve marginally by 3%-5% in MY15-16 as economic growth recovers in major export markets. The narrowing gap between production and consumption will lead to the global stock to use contracting to 91% in MY15-16 (MY14-15: 96%). 5

6 Figure 8 World Cotton Balance Sheet a b World beginning stock c 43,995 5,68 73,697 9,2 1,1,638 1,8,76 World cotton production c 1,17,64 1,27,28 1,23,561 1,2,293 1,18,978 1,17,783 World cotton consumption c 1,15,778 1,4,23 1,7,74 1,8,966 1,12,62 1,18,523 World cotton imports c 36,765 45,319 46,31 4,584 34,248 33,473 World cotton exports c 35,393 45,857 46,681 4,768 34,288 34,312 World ending stocks c 5,68 73,697 9,2 1,1,638 1,8,76 1,7,95 China ending stocks c 1,63 31,81 5,361 62,77 62,657 56,797 World stock to use (%) China stock to use (%) a USDA estimates b Ind-Ra estimates c 1, 48-lb. bales Source: USDA, Ind-Ra s analysis Damaging Dynamics of Chinese Cotton Reserve Policy The Chinese reserve policy served to support high domestic prices by purchasing domestic cotton from Chinese growers at a guaranteed price since MY11/12. The rising cost of textiles (due to higher domestic cotton prices and limited import cotton quota) had driven out a large number of orders to Southeast Asia; some Chinese mills chose to import foreign yarn directly at a low price. This transpired into a steady decline in China s historically buoyant cotton imports while imports of cotton yarn surged during the same period. Figure 9 Higher Reserve Sales MY11/12 Onwards MY Cotton harvest (million bales) Purchase (million bales) Sales (million bales) Net change in reserve (million bales) Ending reserve stocks (million bales) Guaranteed price (cents/lb) 28/ / / / / / Source: USDA, Ind-Ra s analysis Subsequent to the revision of the Chinese policy in April 214, reserve cotton sales (accumulated over MY11-14) are likely to rise due to the proposal of a lower auction price for Chinese reserve cotton. Cotton prices in China (measured by monthly average prices according to China Cotton (CC) Index 229, CC Index 328 and CC Index 527) have declined 22% while the Cotlook A (a measure for international cotton prices) declined 26% to all-time lows in December 214. Despite the decline, cotton prices in China continued to be at a premium of 55.7% (average CC Index 229, CC Index 328 and CC Index 527) in December 214 from 76.7% in December 213). Figure 1 Monthly Average Cotlook A Index and China Cotton Index (US cents per lb) Cotlook A index value (LHS) CC index (328) (RHS) CC index (527) (RHS) CC index (229) (RHS) (US cents per lb) Aug 12 Oct 12 Dec 12 Feb 13 Apr 13 Jun 13 Aug 13 Oct 13 Dec 13 Feb 14 Apr 14 Jun 14 Aug 14 Oct 14 Dec 14 Source: Bloomberg, China Cotton Association and Ind-Ra 6

7 Feb 1 May 1 Aug 1 1 Feb 11 May 11 Aug Feb 12 May 12 Aug Feb 13 May 13 Aug Feb 14 May 14 Aug Corporates Figure 11 International Cotton Prices in Relation to Cotton Prices in China MY MY12/ 13 MY13/ 14 MY14/ 15 Cotlook A Premias over Cotlook A (cents/lb) CC Index (527) CC Index (328) CC Index (229) MY: August-July Source: Bloomberg, Ind-Ra s analysis Ind-Ra believes the change in the reserve policy will create a market for domestic cotton in China as domestic sourcing for Chinese cotton mills now becomes a viable option. Also, according to China s National Development and Reform Commission, the government is likely to reduce the options for cotton import to only World Trade Organisation related tariff-rate quota of 894, tons (4.1 million bales) from MY Thus, China s cotton import is likely to drastically reduce. Figure 12 Cotton and Yarn Imports into China (1, tons) MY cotton imports (LHS) Monthly cotton imports (RHS) MY yarn imports (LHS) Monthly yarn imports (RHS) April 214: Change in Chinese reserve policy (1, tons) Chinese cotton marketing year (MY): August-July Source: Bloomberg, China Cotton Association and Ind-Ra's analysis Cotton Prices Ind-Ra expects a calibrated release of the reserve cotton by Chinese authorities August 215 onwards. However, the lack of transparency from these authorities over the import volume (quota) and negative sentiments among market participants about the volume overhang will keep global cotton prices low. Long-term stability in global cotton prices will depend upon the rate of China s consumption of its reserve cotton which will be adjusted over the next two-tothree crop years starting MY Nevertheless, we believe Chinese stocks will reduce (as opposed to stocks outside China which are expected to rise) gradually with a stock to use ratio of 52.7% in MY15-16 from 58.% for MY14-15 (USDA estimates). Ind-Ra expects Indian cotton prices will remain stressed in MY Kapas prices (S-6) will trade between INR4/kg and INR45/kg (October-January 214: INR41/kg) or ideally near 5% of MSP levels while lint prices will trade in the range of INR85-INR1/kg for MY15-16 (INR92/kg). Ind-Ra expects domestic stock to use ratio for MY15-16 to be near 12% (MY14-15: 12.2%) with no immediate improvement in the global inventory glut until MY A domestic stock to use ratio of 1% is a situation where a directional uptick in cotton prices will be exhibited. Operating Profitability under Stress During 1HFY15, a decline in kapas prices below MSP levels led to higher sales to CCI and consequently, lower availability of cotton kapas for ginners. Furthermore, some growers were holding inventory for better prices. Many domestic ginners were operating at sub-optimal capacity with relatively high cost cotton inventory from the previous season leading to weak operating margins. While cotton availability improved in 2HFY15 due to a rise in prices above MSP levels, lower off-take by domestic spinning mills as well as exporters led to muted top-line but positive operating margins. Cotton exporters have been worst hit due to low volumes and thin margins. 7

8 Kapas prices have fallen 13.% since April 214 while cotton lint prices have declined 2.7%. On MY basis, ginning spreads (on gross basis) in MY14-15 reduced to an average INR52/kg (October-December 214) from an average of INR65.6/kg in MY13-14 (October-September 214). Ind-Ra believes cotton ginners top-line and operating profitability will remain under pressure in FY16. Ginning units with an integrated oil mill could support their viability. Figure 13 Spinning Margins Stable, Ginning Margins Decline 25 S-6 kapas S-6 lint Wt. avg. cotton yarn (Hoisery cones) Sep 12 Dec 12 Mar 13 Jun 13 Sep 13 Dec 13 Mar 14 Jun 14 Sep 14 Dec 14 Source: Bloomberg,Ind-Ra's analysis Cotton marketing year (MY): August-July MY14-15: Aug-14 Since Ind-Ra expects MY14-15 to end with higher domestic cotton stocks, MY15-16 cotton prices will trade lower than those in MY14-15 unless cotton yarn demand recovers. Cotton yarn prices have declined 11.7% since April 214. However, cotton yarn spreads have remained stable at an average of INR114.3/Kg (October-December 214) for MY14-15 (MY13-14: INR114/kg). The credit profile of domestic ginners and cotton exporters will continue to be stressed in FY16. Ginners will procure inventory on a daily or weekly basis as opposed to traditional stocking of two-to-three months. Receivable management will also take priority and contracts will only be entered into for confirmed orders. We believe exchange rate will play a limited role in Indian cotton s export competitiveness but quality will. 214 Review In 214, Ind-Ra rated cotton ginners experienced a fall in revenue due to a drastic reduction in cotton lint sourcing by domestic spinners on higher cotton lint prices. FY14 was the worst year for cotton exporters which faced a drastic reduction in demand from Chinese mills. Operating profitability and interest coverage remained weak in 2HFY14. 8

9 Appendix Figure 14 Issuer Ratings Issuer Rating/Outlook (current) Rating/Outlook (end-214) Sunny Trexim Private Limited IND A4+ IND A4+ Bhadresh Trading Corporation Limited IND BBB-/Stable IND BBB-/Stable Om Namah Shivay Trading Company IND B /Stable IND B /Stable Source: Ind-Ra 9

10 Annexure Figure 15 Changing Mix of Top 5 Indian Cotton Yarn Export Destinations Over MY11-14 (%) China Bangladesh Vietnam Egypt Source: CMIE, Ind-Ra's analysis International cotton year: August-July Innermost ring: MY11; Outermost ring: MY14 Korea Republic (South) Figure 16 Trend of Chinese Imports of Ginned Cotton Over MY11-14 (%) 35.7 Source: CMIE, Ind-Ra's analysis International cotton year: August-July Innermost ring: MY11; Outermost ring: MY Australia US India Others 1

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