Management Speak: Voltas (Outperformer) - All eyes on next summer season

We met Voltas’ management. Below are the key takeaways:

• Unitary Cooling - demand remains weak: Demand was impacted in 1HFY19 (Industry volumes fell 9% yoy; Voltas marginally negative) due to unfavourable season, which led to build-up of inventory for ~3 months. Weak festive season sales led to limited liquidation in inventory (~2 months), causing management to guide flat industry volumes for FY19. We note, Voltas has grown ahead of the industry on market share gains in 1HFY19 (25.6% in 2QFY19 versus 22% in FY18).
• Unitary Cooling - 11-12% margin guidance: 1HFY19 margins have been under pressure due to higher input costs, rupee depreciation and negative operating leverage. Recent import duty hike will only impact compressors and complete units, and not IDUs, as these are components. However, Voltas is looking to increase its indigenous sourcing for IDUs, either through in-house manufacturing or via OEMs. The higher marketing and promotional schemes to liquidate inventory is being offset by lower ad spend. As a result, management has maintained its margin guidance at 11-12% for FY19E.
• Electro Mechanical Projects – strong execution traction across international and domestic markets: Order inflows are largely driven by rural electrification and other government capex like hospitals, water, etc., while metro order is yet to pick up. Although international markets are seeing inflows and are favourable on rupee depreciation, management is treading cautiously and completing the projects at a fast pace to avoid completion risks from geo-political issue. Voltas is focused on sustaining margins at 7-7.5% over the next 2 years by largely executing domestic orders.
• Voltas-Beko JV - positive response: The Volt-Beko JV has seen a positive response from the market, considering its wide range of SKUs, product quality and price (comparable to leading players). The JV is expanding its distribution reach in a phased manner (Tier 1 metros by Dec 2018), which will gradually cover ~80-85% of Voltas’ 15,000 touch points, apart from franchise stores that showcase the group’s exclusive products. Currently, products are being imported from Thailand, China and Turkey, which will shift to local manufacturing, once the plant is operational (3QFY20). Semi-automatic washing machines are likely to be outsourced to OEMs, while refrigerators and fully automatic WM will be manufactured in-house. Voltas-Beko have invested Rs6.5bn in the JV, which could increase to Rs10bn, if required.

Valuations and view

While, the UCPL segment is seeing near term pain on the back of weak demand (unseasonal rain), scale benefits, deeper reach, higher focus on inverters and cost efficiencies are factors that have helped the segment sustain market leadership, as seen in 1HFY19 (~25% market share). We believe once demand revives and inventory is liquidated, margins will reverse, led by Voltas’ scale and cost efficiencies. On the other hand, focus on process improvements, better commercial terms and profitable orders have helped reap benefits, as EMP margins have improved to 7%+. While near-term concerns exist on UCPL’s growth and margins, given the weak demand and cost pressures, we believe, long-term structural growth remains intact. We believe valuations at 26x FY20E earnings are attractive, considering the long-term structural story on RAC penetration, free cash generation and strong balance sheet. Maintain Outperformer with a target price of Rs600.