MARC has downgraded the long term ratings of Hytex Integrated Berhad’s (“HIB”) Murabahah Underwritten Notes Issuance Facility/Islamic Medium Term Notes (“MUNIF/IMTN”) of up to RM100.0 million from AID to A-ID and affirmed the short term rating at Marc-2 with stable outlook. The revision of the long term rating to A-ID reflects the declining financial profile arising from the continued compression in the operating profit margin; lower than expected actual cash flow compared with initial projection; and the delay in the commencement of the China’s plant operations. The moderating factors include the group’s modest liquidity position, the group’s profile as an integrated garment manufacturer; long established relationship with Nike; and superior product quality which sets it apart from other mass/low cost producers. Also underpinning the rating is the balanced exposure to the export and retail markets which insulates the group from business concentration.

HIB provides contract manufacturing and retailing services and is the leading contract manufacturer of printed round neck t-shirts for Nike in Malaysia. Its long established relationship with Nike is a testament of the group’s competitive pricing, superior product quality and timely delivery of goods; factors vital to remain competitive in the textile industry. For FY2006, the group experienced a significant growth in sales from Puma. In the past, Puma’s contribution to the group’s earnings has been in the single digit level. Conversely for the year under review, Puma contribution was significant to the group’s revenue. Guidance provided by the management of HIB indicated that Puma is expected to continue to be an important contributor to the earnings. This would be of immense benefit to Hytex as it would reduce its concentration risk from 1 major customer to 2 major customers. However, contributions in terms of value from the Original Design Manufacturing and Original Brand Manufacturing remain constant.

The group’s financial result for FY2006 was below projection. Although, the revenue showed a growth of 9.2% against the previous year due to higher export sales of Nike and Puma apparels, operating margin, on the other hand, deteriorated further to 3.7% compared to 7.2% in the previous year. The continued compression in margin has been a major concern as it has been declining for the last 4 years in review. At the same time, the operating margin for the year did not meet the forecasted number which was significantly higher at 7.9%. The main cause for the deviation was due to the rise in oil prices which affected the transportation cost, subcontracting of excess orders to a third party manufacturer as well as increase in raw material prices during the year. In addition the operating margins in previous years were boosted by amortisation of negative goodwill.

The group also reported a deficit in cash flow from operating activities which has widen from RM521,000 to RM 8.8 million for FY2006. The increase in stockholding and slower collection from debtors has resulted in the deficit in the cash flow from operating activities. In respect of this, Cash Flow from Operations interest and debt coverage has also moved into negative territory. The deficit recorded by the group was not able to support the significant cash outflow in capital expenditure amounting to RM54 million. This capital expenditure was incurred largely for the expansion in the China plant which is expected to be operational in November 2006. The deficit was principally financed by short term bank borrowings and from the bonds issuance which was used not only to finance the capital expenditure but also the working capital of the group. For the coming financial year, HIB is expected to incur additional amount of substantial capital expenditure which may strained the cash flow.

The delay in commencement of the China operation was caused by the hold up in the approval from the Chinese government as well as minor problems with construction of the plant. The plant has since been completed and is expected to commence operation in November 2006 and will be fully operational next year. Baring any unforeseen circumstances, the group expects the China operation to contribute positively to its earnings in the second half of year 2007. In the short term, any possible hiccups in the start-up of the China Plant could result in a possible deterioration of the group’s financial performance.

Due to the issuance of the bonds, the group’s debt leverage increased to 1.32x against 0.6x in the previous year. Despite the increase, the debt leverage position stood below the covenanted level of 1.5x under the issue structure.

Moving forward, revenue will largely be driven by its OEM business underpinned by strong demand from its OEM customers and also from the new China plant, to be operational by November 2006.