David Finnigan: Cotton Industry Provides Intriguing Investment Opportunities for Private Equity

When global yarn spinning equipment manufacturers say that the US is the lowest cost producer of open-end cotton yarns in the world, listeners scratch their heads in disbelief. People normally think of textile manufacturing as the domain of low labor cost countries. But, due to low labor requirements of highly automated yarn manufacturing plants, the low costs of US electrical power, and the proximity to the most efficient and effective cotton growers in the world, American yarn manufacturers are the low-cost model for the world.

Roughly 75 percent of US-produced cotton and blended yarns are exported to Central America, Mexico, South America, Korea and China. In many cases, these yarns are made into socks, T-shirts, underwear, and jeans, and returned to the American consumer.

As the world’s third-largest cotton producer, the US holds considerable sway over an industry that is highly automated and among the most quality-oriented in the world. The US Department of Agriculture projects that the nation’s cotton crop will be more than 16.5 million bales in 2011, trailing only China – the world’s top producer – and India.

Because of its global status, the US cotton industry is of interest to strategic investors but also presents attractive opportunities for private equity firms experienced in developing underperforming and growing businesses. The sector’s long-term stability has been a major selling point, especially within the US, which has consistently been among the world’s biggest cotton producers and exporters. Foreign competition is limited — according to the National Cotton Council of America, just 10,000 bales of cotton were expected to be imported to the US in 2011 — due in large part to prohibitive costs associated with shipping bales overseas.

Foreign entrants to the US market face other barriers. Positioning a business for success in the cotton industry requires considerable capital expenditures to acquire, maintain and reinvest in state-of-the-art equipment in order to meet demand. The cost is often too high for many to consider competing in the space. Even for businesses that can afford the steep expenses, the industry is characterized by a high concentration of a few sizable clothing manufacturers that drive demand, and a larger number of smaller customers also supplying US retail outlets.

For private equity firms eying opportunities in the cotton industry, these are all factors to consider. Cotton-spinning companies with key customer relationships are attractive, as are those that use federal Farm Bill incentives to invest in expanded capacity and improvements to manufacturing facilities and distribution capabilities.

These desirable traits were in place in 2008 when an affiliate of Sun Capital Partners acquired Frontier Spinning Mills. Founded in 1996 with a single facility, the Sanford, NC-based company was an established industry player by the time that Sun Capital took ownership, but the acquisition was made with future growth and operational enhancements in mind. This has been done in part by embracing leading-edge technologies such as vortex spinning, which is used to spin fine yarns with less “hairiness,” and one which allows spinners to run multiple SKUs on a single machine. Also, federal Farm Bill Incentives of more than $15 million annually have been used to keep Frontier’s manufacturing and distribution operations up-to-date.

Other measures implemented to improve Frontier’s global market position included bringing in a new chief executive officer, John Bakane, and a seasoned cotton commodities risk manager and introducing a metrics-based approach to measuring and tracking performance across the business, and generating significant cost savings. The creation of the commodities risk manager position has allowed Frontier to lock in favorable prices and provided the company with additional stability in what has recently been a volatile market.

As a result of key operational improvements and its ability to maneuver volatile commodity markets, Frontier has become the second-largest cotton spinner in the US Between 2009 and 2010, sales and EBITDA grew an unprecedented 34 percent and 84.1 percent respectively. As a supplier of yarns to some of the clothing industry’s biggest manufacturers, Frontier has grown with them in the various channels they serve. More importantly, by abandoning a typical textile approach for one that embraces a cotton merchant’s view of the industry, Frontier set a new benchmark in the spinning industry for cotton commodity management. It enables the company to stay abreast of cotton production levels and global supply and demand. Frontier’s decision to lock in cotton prices gained importance in the past year, as normally predictable cotton prices began to rise. Adjusted for inflation, cotton prices have been at levels not seen in a decade, thanks in part to increased demand from growing countries such as China. Despite being the world’s largest cotton producer, China is also the No. 1 importer. Prices in China have outpaced those in the US, and even with transportation and import costs factored in, it is still cheaper for Chinese customers to buy US cotton.

The more unpredictable nature of the market environment in the past couple years and its impact on demand reinforces the need for a strategic approach to doing business in the cotton industry. This may include product and geographic diversification. Asia, for example, represents a viable expansion opportunity for Frontier and other cotton spinners. Those countries are already importing cotton because they find it cheaper to import bales from the US, where manufacturing and electricity costs are much lower. In addition to China’s steady demand for cotton, the other top importers on the NCC’s 2011 rankings are – in order — Bangladesh, Turkey, Indonesia, Thailand, Vietnam, and Pakistan. While the region is known for growing cotton, the demand of those countries easily outweighs other regions of the world, and provides US cotton spinners with additional markets to pursue.

The challenges of running a commodity-driven business have certainly increased during the ongoing economic downturn, and while there is hope that the price swings of the past year will become less frequent and less significant, they remain a significant issue. However, using the industry’s historical stability as a guide, cotton spinning in the US remains attractive to those investors who can identify worthwhile opportunities and who are willing to make the capital expenditures needed to take advantage of new technologies.

David F. Finnigan is managing director of operations with Sun European Partners. From 2003 to 2007, he also served as president and CEO of Elan Nutrition, a Sun Capital Partners portfolio company.