However, margins in the EMP segment are likely to be only modestly positive in FY17
Management argued that the cautious stance owing to a weak FY16 resulted in inventory shortfall in certain regions during April; this eased during May 2016. Our meetings and discussions with industry participants suggest secondary market sales as high as 20-25% during April while they have settled at c15-18% in May 2016.
Competitive intensity high
Most Unitary Cooling Products (UCP) players have set themselves aggressive targets with growing advertisement spend. Management expects this will restrict any price growth although it does not anticipate a price war owing to improving demand. Management expects UCP margins to settle at c10-11% (13% during FY16).
EMP segment much more gradual than earlier anticipated
While management anticipated margins to start recovering during FY17, the current R39 bn order book includes R10 bn of orders that are low margin with some potentially loss making. This, coupled with modest execution growth will keep FY17 margins only modestly positive and Q4FY16 margins of 3.4% cannot be extrapolated. However, the company also anticipates new EMP ordering for big Middle East events, like Dubai World Expo 2020 and FIFA Football World Cup 2022, to start during FY17/FY18.
Retain Hold with unchanged target price of Rs 318
Our fair value TP is derived using a PE based sum-of-the-parts methodology. The shares are currently trading at a Jun-17e PE of 25.7x, while our TP implies a Jun-17e PE of 25.6x. A better than expected UCP business growth and EMP margins are key upside risks, while sustained weak new orders inflows coupled with weak margins in the international EMP are key downside risks.
Strong demand visible: Management argued that the demand during April and May was healthy. While the industry witnessed inventory shortfall during April due to the cautious approach (Q1FY16 was weak) adopted by most peers, the inventory situation corrected during May. The company anticipates FY17 growth to remain healthy led by improving demand and a low base of FY16.
Distribution reach: Demand, which has historically come from the top 25 cities (80-85%) is likely to penetrate into smaller towns and cities owing to improved power availability. The company is also consistently expanding its dealership network to take advantage of this opportunity. However, it has consciously avoided using the e-commerce platform and any presence is through the dealers who largely use it to liquidate inventory.
Pricing will remain competitive: Many peers have set strong market share gain targets. LG, Bluestar (BLSTR IN, Rs 431, Not rated) and Lloyd (LEE IN, R234, Not rated) are emerging as the key competitors. However the strong competition will restrict the industry from taking any price hikes despite strong demand growth. It is still not competitive to manufacture domestically and the company will continue to use the outsourcing and assembling model it currently operates. Management expects UCP margins to settle at c10-11% (13% during FY16).
Stakeholders demanding entry into new consumer segment: Management admitted that the company’s success in the home air conditioner segment has led to growing stakeholder demand to capitalise on its strong brand equity in consumer products. However, the company argued that while it is actively looking at such options, any new product additions will be targeted towards the current unitary cooling products value chain. Air Coolers was the first such product and the company is studying the air purifier, microwave, washing machines and refrigerators market. It is also studying the portable drinking water segment.
Visible market opportunity, though scale-up will take 2-3 years: The company has a total order backlog of R39 bn (FY16) of which Rs 20 bn is contributed by the domestic market. Metro orders account for more than 30% of the business. While state governments are looking at introducing multiple new metro projects, new orders have started trickling in only for the main contractor. EMP ordering should pick up some time during FY18. A strong pick up in new orders will take 2-3 years. Customers are generally not in a hurry to execute projects, which have constrained accelerating execution pace. The company is looking to add rural electrification orders selectively to benefit from the government’s focus in this area. However, it expects to restrict itself to select geographies owing to a history of project delays.
Retain Hold rating and Rs 318 TP
We value Voltas using a PE-based SOTP approach. We value Voltas’ valuation driver, UCP segment, at 29.1x Jun-17e. We value Voltas UCP segment at 10% discount to Havells’ target PE valuation. We benchmark the UCP segment target PE with Havells as both companies operate in a similar category of fast moving consumer electrical goods (FMEG) but use a 10% discount due to higher volatility in margin and higher competitive intensity in the air conditioning segment for Voltas.
We have retained our EMP business target PE at 12.0x (a 50% discount to L&T (LT IN, Rs 1,480.25, Buy); the discount reflects the significantly higher exposure to the Middle East market and much less margin predictability. Our EP&S business target PE at 20.0x is also unchanged (a 15% discount to L&T). Our unchanged TP implies 0.6% downside; hence, we retain our Hold rating on Voltas.
Voltas is currently trading at a June-17e PE of 25.7x (broadly in line with our target price-implied valuation), which in our view fairly values its 15% earnings growth over FY16-19e. During the past business cycle (FY09-13), Voltas traded at a mean PE of c13.5x, although its EPS fell at c6% CAGR during the same period.