>BLUE STAR LTD. (HDFC SECURITIES)

Background

Blue Star Ltd (BSL) is an end-to-end solutions provider in the field of airconditioning and commercial refrigeration as a manufacturer, contractor and after-sales service provider. The company primarily operates in three segments – Central & Packaged Airconditioning systems, Cooling Products and Professional Electronics & Applied Industrial systems. The company currently has five modern state of the art manufacturing facilities in Thane, Bharuch, Dadra and Kala Amb (Himachal Pradesh) and at Wada in Thane district of Maharashtra.

Investment Rationale

Fall in price overly discounts slowdown related fears – Fundamentals remain strong
BSL has fallen more than 65% from its high of Rs. 548 created on 4th January, 2008 and is currently trading at about Rs. 181. The fall in price discounts factors such as the economic slowdown, liquidity crunch and diminishing earnings visibility. However, we feel that at the current levels the price overly discounts these fears. BSL is a market leader in the central airconditioning business, has a strong order book and a lean balance sheet with a debt to equity ratio of about 0.1x. Superior growth, strong profitability, prudent financial management and a liberal dividend payout policy have resulted into high return ratios for BSL. RoE and RoCE has increased from 28.3% and 20.6% in FY06 to 56.4% and 58.7% in FY08. BSL could be one of the main beneficiaries of revival in economic activity expected a couple of quarters down the line.

Strong growth in the order book
As of 31st December, 2008, BSL has an outstanding order book of Rs. 1,626 cr, with an execution period of 9–12 months. This exudes confidence that BSL will sustain its momentum of high growth and profitability in the coming years. Moreover, BSL has limited its presence in the highly competitive, low-margin, consumer durables segment of the room airconditioner market. Instead, it has focused on the high-margin, institutional segment i.e. central airconditioning,

Growing market catered by three players with significant entry barriers
The market for airconditioning products and commercial refrigeration equipment grew 27% and 22% respectively during FY06-08. Based on plans announced by several players, the cumulative non-residential airconditioning opportunity over the next 5 years is estimated to be around Rs. 38,000 cr. Given the current market conditions one could expect a slowdown in segments like IT and Retail, however, sectors like infrastructure (Delhi Metro) and power continue to show decent growth potential. Currently, the non-residential HVAC (heating, ventilating and air conditioning) market is catered to by Blue Star, Voltas and ETA. Project engineering capabilities at various locations across the country and licensing / approval process is a barrier to new players eyeing this market. Internationally, players who are strong in the residential airconditioning market (consumer durables segment) like Samsung, LG, Hitachi etc are not focusing on the HVAC (non residential) project business, which is largely catered to by local players.

Acquisition of Naseer Electricals to increase the addressable market
BSL’s recent acquisition of Naseer Electricals will help BSL expand its business scope in the airconditioning business to MEP (mechanical, electrical and plumbing) projects, which will nearly double the company’s targeted market going forward. Moreover, today many customers seek Electrical Contracting services from the same contractor executing HVAC. Currently, Naseer has presence only in southern India, which BSL intends to scale up to other regions.

Recent fall in commodity prices could help improve margins in the medium term
During H1FY09, BSL’s operating margins were under pressure due to the increase in raw material prices like copper and steel. However, over the past few months, metal prices have corrected substantially. For example, from an average price of about $6,900 in the month of September, 2008, copper is currently trading at about $4,700 registering a drop in excess of 30%. This could help BSL reaching the margins it earned a couple of quarters
back.

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