Blue Star is in investment mode to gain market share in India’s Rs 4,200 crore water purifier industry. This should cap earnings upside, despite the strong air-conditioner (AC) business and engineering margin uptick. Our FY18E-20E EPS is 5-12 % below consensus estimates, reflecting this. Strong cash flows and ROEs should contain downside. We prefer Voltas (Buy) with scope for EPS improvement. Initiate on Blue Star at Hold, valuing it at 35x PE FY19E. Electro-mechanical projects (MEP) account for 51 % Blue Star’s FY17 revenue, primarily centralised cooling, and electrical and plumbing works in commercial establishments. The cooling products segment (consumer durables) accounts for 45% of its revenue, where it is in the investment mode currently. Management has indicated 100-150 bps margin pressure in this segment in FY18E for advertising & promotions for water purifiers.
During FY11-14, when management discussed re-entering the AC segment, its margins eroded 260 bps, impacting its share price performance. This segment’s margins dropped 342 bps y-o-y in 1HFY18; we assume a 150 bps margin drop in FY18E to 8.7%, followed by recovery to 9.2 % & 9.5% in FY19-20E. We are still below consensus despite these assumptions. Blue Star’s rise in AC market share has been steady, from 9 % in 2QFY15 to 11 % in 2QFY18. Its products are priced at a slight premium in the market, given its concentration in south India.
We believe it will remain a beneficiary of strong growth in the AC industry, driven by low penetration levels. Blue Star has been through a difficult phase of low margin orders in this segment. We believe the capex cycle should see a recovery post announcements in the next 12-18 months. Hence, while the MEP business is being discussed in a limited manner at this stage, we believe margin upside will continue in this segment during FY18E-20E.
Management has delivered on its promises of steadily increasing AC market share during FY14-17. High dividend payout ensures ROEs will remain upwards of 19%. Reducing working capital in MEP should also contribute to cash flows. We believe downside is limited and initiate coverage with ‘Hold’; price target of Rs 710, valuing at 35x PE FY19E (premium to 10-year average). Upside risk: 1) Stronger uptick in engineering segment margins Downside risk: 1) Sudden collapse in AC margins.