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Sector update: Capital Goods - RAC Channel checks; Strong growth in Q1FY20

We met few Room Air conditioner (RAC) players recently. Below are key takeaways:

Summer 2019 seeing robust growth: RAC volumes grew 15-20% yoy, led by hot summers and a low base (last year was a washout due to unseasonal rains across India). The industry saw robust growth in May and Jun 2019, while April saw moderate growth on the back of strong demand as also low base. Moreover, delayed onset of summer, have pushed higher sales in Apr-June 2019 vs Feb-Mar. At the regional level, demand is strong in North and South, with East being a dampener, as heavy rains have impacted demand.

No price hikes as yet: Most players did not take any price hikes at the start of the season in Feb 2019, in a bid to liquidate the high levels of inventory and the late onset of the season. On the other hand, discounts and promotional spends sustained with marginal tweaks due to high competitive intensity, as players competed for market share gains. Accordingly, we believe margin expansion would be driven by cost efficiencies and positive operating leverage.

Focus on localisation: Considering the sharp volatility in rupee and custom duty hike on imports seen in FY19, players are shifting towards localisation either via investing in manufacturing facilities or outsourcing from EMS players. The localisation is more focused on manufacturing of indoor and outdoor units. However, compressors will continue to be imported from China, due to lack of compressor capacities in India. Higher localisation will help control costs and give players the ability to dynamically respond to changes in demand trends.

Demand shift towards inverter ACs: With rising focus on energy efficiency, both industry and customers are moving towards inverter ACs, which now contribute 40-50% of total split AC sales. Moreover, the price gap between inverters and fixed speed ACs has reduced substantially (4-5% versus 15-20%+ earlier) over last few years, enabling faster shift to the former. The higher share of inverter ACs is driving scale benefits and reducing costs of inverter ACs.

E-Commerce – emerging as a key distribution channel: The e-commerce space now contributes 5-10% of sales for the industry versus 2-3% a few years ago. Demand from the urban middle class population, millennials, etc., is driving the shift. Although the channel initially faced challenges relating to installation and after sales services, companies now have a vendor network for the same. However, companies are developing completely different range of products at different price points for the e-commerce channel versus the physical distributor channel, considering a different customer profile.

We prefer Voltas and Amber: The RAC industry is likely to see sustained growth, low penetration, improved power availability, improving affordability as also availability of energy-efficient products. We believe Voltas is well placed to capture the sustained growth momentum in the industry considering its leadership position, driven by deep reach, strong brand and complete product portfolio. Voltas’ sustained focus on distribution and cost efficiencies are likely to aid the company's market leadership position and superior margin profile. On the other hand, Amber is likely to be a key beneficiary of indigenous sourcing by the industry with strong competitive edge of complete product range, backward integration and cost effective solutions. We reiterate our Outperformer rating on Voltas and Amber.