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Management Speak: RAC channel checks - Long term demand to sustain

We met a few room air-conditioner (RAC) players recently. Below are some key takeaways:

RAC demand will continue to grow in double digits: RAC penetration in India has been low in the past causing demand growth to be restricted due to unavailability of electricity, especially in non-metros, unaffordability, high operational costs, etc. However, government thrust on improving electricity access, coupled with increase in affordability due to rising per capita income, lower operational costs due to energy-efficient products as well as changing lifestyles are driving increased penetration of RAC in Indian households. Consequently, we expect RAC demand to witness double digit growth going forward.

Growth to be driven by smaller cities, rural areas: RAC penetration in metros in India is high with top ~15 cities having ~70% share of domestic RAC market. While these metros will continue to drive demand, there is substantial room for increased penetration in smaller cities and rural areas. Moreover, government’s thrust on electrification and focus on strengthening rural economy is likely to benefit semi-urban and rural areas more, driving demand higher.

High energy-efficiency products to be dominated by inverters: The RAC market is gradually moving towards more energy-efficient products, supported by regular change in energy-efficiency ratings stringent consumption norms. For fixed speed RAC, there are practical limitations to further improve energy efficiency, as it entails increasing size of heat exchangers, which add to the cost and bulkiness of the product. Consequently, as market shifts towards energy-efficient products, share of inverter RAC is likely to rise, as most of these products will be in the inverter category.

Japanese/Korean brands looking to shed premium image, cater to mass market…: With growth in RAC demand expected to be driven by value-conscious customers in semi-urban and rural areas, many of the Japanese/Korean brands are looking to shed their premium image. Accordingly, these brands are filling gaps in product portfolios by adding and making efforts to expand distribution reach in these areas. We believe this will increase competition in these markets, as growth picks up.

…while focusing on increasing distribution reach: Having established presence in major metros, players are also looking at improving distribution reach, especially in smaller towns. Total distribution touch point universe stands at ~26000, in which Voltas and LG are leaders currently.

Prices likely to rise post rating change: We expect the cost of fixed-speed ACs to rise after changes in BEE ratings (higher energy efficiency). Further, rise in commodity prices have increased raw material costs for most companies. Thus we expect most brands to hike prices in the next few months, particularly once peak season sets in. 

Pre-buying seen ahead of table change: Retailers are allowed to sell products with stickers under the older rating system until stocks get exhausted. This has led to some pre-buying across channels in Q3FY18, as prices of products would be lower for the same star rating under the old rating system.

3-star to remain most popular category: Presently, 3-star RACs constitute 60-65% of split RAC sales while 5-star constitute ~20%. Consumers have a strong preference for 3-star and higher rated products and hence this category will continue to remain popular post change in rating table in Jan-18. Hence, products rated 3-star in the old rating system (downgraded to 1-star post rating change) are likely to witness a decline in share of sales.

Companies to have a balanced mix between in house and outsourced manufacturing: Outsourcing from EMS players provides flexibility in manufacturing, particularly in peak season, apart from being cost effective. A few larger players will continue to partly manufacture in-house, as a quality control measure on products, particularly the high-end premium products. Moreover, companies will continue to procure components (heat exchangers, condensers, motors, sheet metal parts, etc) from EMS players as it is more cost effective.

Prefer Voltas, Havells: We believe Voltas (26x FY20E earnings) is well positioned to capture the sustained growth momentum in the industry. Further, scale benefits, focus on distribution and sustained cost efficiencies are likely to aid the company's market leadership and superior margin profile. On the other hand, Havells (35x FY20E earnings) is likely to benefit from Lloyd acquisition, which would improve brand perception and help expand Havells' product portfolio. A culmination of these factors is likely to aid the growth momentum for Havells. Maintain Outperformer on Voltas and Havells.