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; the adverse variance of the actual cash flow to the initial projected cash flow; and the delay in the commencement of the China’s plant operations, and the group’s modest liquidity position. Mitigating factors are 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. The ratings are also underpinned by a balanced exposure to the export and retail markets which insulates the group from business concentration risk.

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 has increased substantially and is currently comparable to contribution from Nike. 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 for its export segment (Original Export Manufacturer). 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% for FY2006 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% for FY2006 compared to 7.2% in the previous year. Moreover the actual operating margin is below the projected operating margin of 7.9%. The drop in margin has been a cause of concern as it has been declining for the last 4 years in review. 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 the amortisation of negative goodwill.

Whilst the Group’s audited accounts for the year ended 30 March 2006 reported a surplus in cash flow from operating activities, this surplus is under stress from an increase in stockholding and slower collection from debtors. The Cash Flow from Operations also lacks the robustness to support the interest and debt coverage as well as the significant 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 December 2006. The pressure on the cash flow was alleviated by infusion of funds from short term bank borrowings and proceeds from the bonds issuance which were 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 further strain 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 the construction of the plant. The plant has since been completed and is expected to commence operation in December 2006 and will be fully operational next year. Barring any unforeseen circumstances, the group expects the China operation to contribute positively to its earnings in the second half of 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 but 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 December 2006.