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Hero Honda: Seasonal uptick… - Views on News from Equitymaster
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Hero Honda: Seasonal uptick…
Jan 30, 2006

Performance Summary
Hero Honda, the largest two-wheeler player in the country, announced its 3QFY06 results a short while ago. For the third quarter, while the topline grew by 16% YoY, an expansion in operating margins resulted in operating profits outpacing the topline growth. However, a substantial increase in depreciation charges coupled with a decline in other income restricted the profit before tax (PBT) growth to 16% YoY. Despite this, the bottomline grew by a healthy 20% YoY on account of a decline in the effective tax rate.

(Rs m) 3QFY05 3QFY06 Change 9QFY05 9QFY06 Change
Units sold 712,062 798,001 12.1% 1,935,981 2,227,993 15.1%
Net sales 20,019 23,148 15.6% 54,813 64,581 17.8%
Expenditure 16,910 19,367 14.5% 46,100 54,533 18.3%
Operating profit (EBDITA) 3,109 3,781 21.6% 8,713 10,048 15.3%
EBDITA margin (%) 15.5% 16.3%   15.9% 15.6%  
Other income 413 360 -12.7% 1,053 1,097 4.2%
Interest (net) (2) (11) 345.8% (7) (22) 233.8%
Depreciation 217 324 49.2% 630 842 33.5%
Profit before tax 3,307 3,827 15.7% 9,142 10,325 12.9%
Tax 1,118 1,209 8.2% 3,108 3,284 5.7%
Profit after tax/(loss) 2,189 2,618 19.6% 6,034 7,041 16.7%
Net profit margin (%) 10.9% 11.3%   11.0% 10.9%  
No. of shares (m) 199.7 199.7   199.7 199.7  
Diluted earnings per share (Rs)*         45.6  
Price to earnings ratio (x)*         19.0  
(*trailing twelve months)            

What is the company’s business?
Hero Honda Motors, the largest manufacturer of motorcycles in the world, is a joint venture promoted by Hero Cycles (P) Limited and Honda Motor Company of Japan. Each partner holds 26% stake in the company. The company is solely engaged in manufacturing and sale of motorcycles. However, now company is planning its maiden entry in gearless scooterettee segment with the launch of ‘Pleasure’ in next two months. While sale of motorcycles accounted for 96% of revenues in FY05, spare parts contributed the rest. Hero Honda's initial technology agreement with Honda expired in 2004. But the company has extended its technology agreement with Honda for a further period of ten years and has plans to introduce a series of new models/improved versions of existing ones. It has a commanding 49% market share in the motorcycle segment.

What has driven performance in 3QFY06?
Volume sales picking up: The company continued to report healthy volume sales during the quarter. However, the volume growth numbers in terms of percentage have been on the decline due to the high base effect. It must be noted that major sales for the company during 3QFY06 came about in the month of October 2005 (pre-Diwali demand), post which, the sales slackened a bit. However, the topline has grown at a faster pace as compared to volume sales, which is heartening, especially when one considers the lack of pricing power due to intensifying competition from other domestic players (read Bajaj Auto and TVS Motor). The faster topline growth was seemingly aided by the company’s recent launches (Glamour and Achiever), as generally new launches command some premium in terms of pricing, if the product is well accepted by the consumers.

Operating costs – a mixed bag: While a declining trend of the steel prices (a key raw material), has helped the company to keep a check on the raw material expenses (as a percentage of sales), there has been an increase in other expenditure. This could be attributed to higher marketing and distribution expenses for the new models (in motorcycle as well as ungeared scooters). Though for the nine-month period there has been a marginal decline in the operating margins, we expect the same to even out in the next quarter. We have factored in a marginal increase in operating margins for FY06, in light of softening of raw material prices. We expect the company to benefit from lower steel prices in the second half (already reflected in the 3QFY06 results) and to that extent, we stand by our estimates.

Cost break-up...
(Rs m) 3QFY05 3QFY06 %Change 9QFY05 9QFY06 %Change
Raw materials 14,057 16,015 13.9% 38,452 45,129 17.4%
% sales 70.2% 69.2%   70.2% 69.9%  
Staff cost 679 860 26.7% 1,950 2,384 22.3%
% sales 3.4% 3.7%   3.6% 3.7%  
Other expenses 2,018 2,492 23.5% 5,789 7,020 21.3%
% sales 10.1% 10.8%   10.6% 10.9%  

Higher depreciation restricts bottomline growth: There has been a significant increase in depreciation charges. This, we believe is primarily due to expansion plans of the company, both on the motorcycle side (company is not only increasing its present capacity but is also in process of setting up a new plant) as well as the venture related to ungeared-scooters. It should be noted that company launched its first ungeared scooter called ‘Pleasure’ in 3QFY06. We have factored in a 40% rise in depreciation charges in our estimates. Higher capex appears to have affected the surplus funds of the company, thereby resulting in a reduction in other income. However, a 220 basis points reduction in effective tax rate enabled the company to negate the impact of above stated factors and report an increase in net margins.

What to expect?
At the current price of Rs 698, the stock is trading at a price to cash flow multiple of 11.3 times our FY08 estimates. The nine-month performance of the company is more or less in line with our full year estimates. We had recommended a sell on the stock in December 2005. We maintain our view and prefer TVS Motor in this segment.

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