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Not So WelSpun: Target Finds No Egyptian Cotton Used in Sheets Sold By Welspun, Terminates Relationship

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Welspun India is down 20% on its lower circuit today. That’s because Target, it’s second largest customer, terminated its relationship because:Welspun

  • Target was buying Egyptian cotton (500-count) sheets from Welspun, and sold them under the FieldCrest brand
  • They recently found after an investigation, that Welspun was using non-Egyptian cotton for the production between August 2014 and July 2016, of about 750,000 sheets and pillowcases.
  • Target then pulled out all the remaining product they had got from Welspun out of stores. And offered a refund to all customers who had bought in this time.
  • And Target has terminated its relationship because it’s furious about the violation of ethical standards.

(See full Target press release)
Welspun gets some 10% of revenue from Target, who has been its customer for more than a decade. The 10,000 cr. market cap company is the largest producer of Terry towels in Asia, and even supplies to Wimbledon. It also makes Sheets and Pillowcases. They traded at a P/E of about 14 on a very high Return on Equity of about 20%, where they have been growing EPS by about 20%.

What’s Happening?

Welspun has been accused of using Non-Egyptian cotton in sheets that were sold as Egyptian cotton based. Now to a regular bedsheet user, the difference may not be apparent. Egyptian cotton is very long staple, which tends to indicate higher quality. If you just “long” versus “extra long” staple, you might not really make out the difference in a sheet. And it’s quite likely that in terms of actual quality delivered, the product performs just well. But that’s not the point. You can get a shoe for Rs. 800 that gives you the exact same feel, grip and durability as a Reebok shoe that costs Rs. 6,000 – but this cannot be the excuse to sell it as a Reebok.
And therein lies the rub. Welspun had been selling Target its products for many years, but the sheets it sold to Target as “Egyptian cotton” sheets between 2014 and 2016 were apparently not from Egyptian cotton, but from some other kind of cotton. Ticked off by this, Target has taken out the entire relationship : not just sheets, but everything.
This hits Welspun with multiple pieces:

  • Target is 10% of the business, so that much will go.
  • They might have to lose current revenue as Target will withhold payments to help refund their customers.
  • Welspun will likely be investigated by other customers which can get complicated because, well, because.

In all of this, Welspun has only offered to get its supply processes audited by an external auditor.

Who’s impacted?

For one, the promoters. They own 73% of the company! Goldman Sachs owns 1.8%, and in total Foreign investors have 13.6% of the company.  Mutual funds own about 2%. (From Snap)Welspun Holding Pattern This means the folks that lost 2,000 cr. in market cap today were mostly the promoters, and then foreign investors.

What Happens Now?

The shares should fall until those folks selling 2.2 crore shares – on the sell side today – get their fills. The share now has fallen to Rs. 86, but at this point there is so much uncertainty about revenues that it’s best to avoid conjecture. Wait till their biggest customer – Bed, Bath and Beyond – has announced what they will do.
In general, customers don’t terminate relationships easily. It can take many years to build a good supplier relationship – process feedback, integrations, technology and quality control metrics aren’t set up overnight. So the fact that this relationship was terminated now probably indicates a point of no-return in discussions between the two parties, so much that they were willing to let all that investment go down the drain. And, given that they have now said this statement publicly, Target will not be able to justify re-hiring Welspun at least any time in the next decade. That’s one customer that stays lost.
Finally, shareholders can’t really cry fraud yet. The external auditor might find that a supplier to them substituted the cotton. Or that somehow this switch was done without the knowledge of management. Of a slew of other reasons, or excuses, to pass the blame on. But there’s only one loser here: the shareholder of Welspun India.

Our View

We have been shareholders of this company in a time gone by. In our momentum portfolio, where we exit when momentum is lost, we had made a reasonable return from Rs. 550 to Rs. 845 last year (this was before the 1:10 split). But this is the kind of thing we simply did not expect. Make no mistake – we left because of the lack of momentum, not because we detected anything shady. But at this time, because of what’s happened, we wouldn’t go near this stock at this price.
One thing that could have been an issue: the Egyptian crisis. After the Army took over in 2013, Egypt has been in more turmoil and perhaps sourcing was an issue. It’s quite likely that supply issues were escalated at the point, and at some point a bad decision was taken to replace Egyptian cotton with, well, non-Egyptian cotton. The responsibility may lie outside Welspun, or within it – we don’t know – but there’s one thing for sure: the impact will be felt by Welspun.
What’s likely to happen over the next few quarters is that more Indian companies will go through extreme scrutiny. We have other textile players too – in fact, India is one of the biggest textile exporters to the US. And many are listed – from the massive Arvind, to the tiny and upcoming Nandan Denim. Some export, some contract, and others have only parts that do yarn, fabrics or garments. Let’s hope this is an isolated story, otherwise this business will go down the Pharma/FDA way where all the surprises are only negative.
Disclosure: No positions.

  • Paddy says:

    Hmmm.. Guess only 600K (NSE+BSE) shares were traded today before we hit the circuit filter!.. Between FII’s and MF, we have 15 Cr shares :). I am sure a lot of them would want to press the exit button now!
    Interesting days ahead!

  • Manish Jain says:

    Welspun what a joke, I just don’t understand how they could get so lazy and throw quality control out the window. Or should I say, they threw in the the towel!

  • Satheesh says:

    I have around 10 year experience in home textile, so let me clarify/elaborate few technical points for you.
    But before that, let me remind you, these are purely technical details and doesn’t suggest how stock will move. These are only my understanding of common practices and as with any opinion/understanding, these may not be necessarily 100% true.
    First about Egyptian cotton- As the name suggest, these are cultivated in Egypt and it is one of the premium cotton in the world (other one being American Pima cotton). Staple length of Egyptian cotton is usually longer than regular Indian cotton. So this is used to make finest cotton yarns.
    Now about the problems,
    1. There are Indian cotton varieties available with longer staple length which can imitate Egyptian cotton.
    2. Textile products usually undergo three kind of quality control.
    Physical inspection where QC check product size, label, fabric feel etc etc
    Lab testing where QC check fabric strength, yarn count, threads per inch, shrinkage etc etc.
    Third kind (optional, rare and on special case)- documentation check. Buyer will ask supplier to mention that these are 100% Egyptian cotton on documents. They will also ask supplier to get import packing list of Egyptian cotton.
    First two tests can not find out origin of the cotton. So no point in blaming Welspun QC or Target QC. About documentation test- these systems can easily forged.
    3. There are no foolproof methods to find out origin of cotton except for DNA test. Welspun could have tried to find staple length of cotton yarn when they bought from their spinner (not sure Welspun made this from their own spinning mill). But if spinner made this yarn by mixing Egyptian cotton and extra long staple Indian cotton, staple length testing wont show a significant difference.
    4. DNA testing- this is quite expensive one and it doesn’t make sense to do DNA test on textile products which should be sold with competitive prices. Moreover, there are several stages on textile production where fiber becomes yarn to greige fabric to finished fabric and then to finished product. These stages involve lot of chemical and physical processes. Cotton lose DNA during these production stages. However DNA testing companies claim they can get DNA traces even from finished product. I guess Target did a DNA test, but this is quite quite expensive one. All buyers/suppliers wont be able to do it on a continuous basis.
    read this
    http://www.cottoninc.com/fiber/quality/PELab/PE-Lab-Frequently-Asked-Questions/
    and this
    http://www.forbes.com/sites/stevensavage/2016/02/12/using-dna-to-fight-fabric-fraud/#2f4fc9162006
    Now about the malpractice,
    If this is so difficult to detect, don’t you guys think people will be doing that? I was actually surprised to see that Target found problem with just one product range from Welspun. I would have expected Target to find problems with all Egyptian cotton ranges if they actually did DNA testing. Either Target didnt do DNA test, or Welspun is much much better than I thought.
    Plus read this,
    http://www.homeandtextilestoday.com/article/528520-welspun-certified-egyptian-cotton-gold-seal
    Now here comes the twist,
    There is a simply way to know authenticity of Egyptian cotton sheet- look at the price.
    Let’s take an example of Reebok shoe Deepak mentioned. If you are buying a Reebok shoe for 800 rs, do you want to do DNA test to know authenticity? Come on, neither sales team of Welspun nor buying team of Target are stupids. Those guys should be knowing what they are buying and what they are selling. What I dont understand is Target position. They opened a Pandora box but why?
    Anyway, I was just trying to give you all some textile technical aspects.
    Disclosure:-
    No business transactions with Welspun/Target in personal or professional capacity.
    No position in Welspun

  • Kaushik says:

    Satheesh,why do you think Welspun wanted to sell it for 800 rs ? I see the story implies they sold the counterfeit stuff at 6000 rs to Target.
    The 4th argument you pointed is shaky. Either the business with Target matters to you(even at competitive prices) or it is not. If you bothered, then you certainly would have done DNA test with right sampling. If not, then I would expect Welspun to have enough evidence against Target to call the bluff.

    • Satheesh says:

      sorry for the late reply. Just saw this comment
      let me explain about the price point- say an Indian cotton sheet set buying price is around 15 dollars. This is usually sold in USA at around 60 dollars. Egyptian cotton of same quality may cost around 20 to buy and selling rate will be around 80 (these are not accurate as it differs from quality to quality).
      Now let’s say Target was buying Egyptian cotton sheet set around 17 dollars and they were selling this at 70 dollars. In this case, I dont think Target guys need to do DNA test. They would be knowing that they are buying blended Egyptian/Indian cotton sheet sets.
      I should not have used Reebok shoe example, but I thought it would be easy for people to relate.
      Regarding 4th argument, I’m pretty sure Target business mattered to Welspun. They must have did all the test on the product except DNA. The fact is that DNA test is just not in the picture. Nobody does this as this doesn’t make sense. At one hand, this is quite expensive. And secondly, how you can make sure that this foolproof? What if supplier did DNA test on one lot and used blended cotton on all other lots. We are talking about millions of meters. There is no way anyone can do DNA test even with AQL standard.

  • Uttam says:

    I completely disagree with target. Welspun sheet is good and they have given livelihood to lacs of people at earth quake devastated kutch reason. Assuming it is not Egyptian cotton but the quality what they produce is better than Egyptian cotton. The share market is not the measure of their value. I strongly support welspun. Welspun change the home textile industry in india and put india,s name in world market. We as indian all should strongly support to welspun. Today with welspun then tomorrow could be with another one for same allegation. One cotton change will not make any health issue but when nestle maggi made our children life issue at that time all other country supported. This time all textile industry from india should strongly support welspun. No cotton is free and there is another 50 processes after the raw cotton. Welspun had latest technology to do better value addition products and we should rate that rather than a silly indian and Egyptian cotton. uttam qa manager mmg india