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Hero Honda: Getting difficult out there - Views on News from Equitymaster

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Hero Honda: Getting difficult out there
Feb 1, 2007

Performance summary
Hero Honda, India’s largest two-wheeler manufacturer announced its 3QFY07 results yesterday. The company has yet again put up a weak performance. Facing pressure on the market share as well as profitability fronts, the company’s bottomline has fallen by a sizeable 20% YoY during 3QFY07. While the topline growth at 15% YoY has been fairly reasonable, it is the 500 basis points contraction of operating margins that has badly impacted the company’s overall showing. Things have been slightly better for the nine month period with the fall in bottomline being restricted to 6% YoY on the back of a 12% YoY jump in topline. Here again, operating margins have been the chief wreckers as they have witnessed a 310 basis points reduction.

(Rs m) 3QFY06 3QFY07 Change 9mFY06 9mFY07 Change
Units sold 798,302 896,113 12.3% 2,228,294 2,480,772 11.3%
Net sales 23,148 26,661 15.2% 64,581 72,604 12.4%
Expenditure 19,367 23,641 22.1% 54,533 63,560 16.6%
Operating profit (EBDITA) 3,781 3,019 -20.1% 10,048 9,044 -10.0%
EBDITA margin (%) 16.3% 11.3%   15.6% 12.5%  
Other income 360 336 -6.8% 1,097 1,453 32.5%
Interest (net) (11) (55) 415.0% (22) (153) 595.5%
Depreciation 324 376 15.8% 842 1,043 23.9%
Profit before tax 3,827 3,034 -20.7% 10,326 9,608 -7.0%
Extraordinary income/(expense) - -   - -  
Tax 1,209 943 -22.1% 3,284 2,979 -9.3%
Profit after tax/(loss) 2,618 2,092 -20.1% 7,042 6,629 -5.9%
Net profit margin (%) 11.3% 7.8%   10.9% 9.1%  
No. of shares (m) 199.7 199.7   199.7 199.7  
Diluted earnings per share (Rs)* 52.4 41.9   47.0 44.3  
Price to earnings ratio (x)**         14.1  
(* annualised, ** on trailing twelve months earnings)

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. 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 six new models/improved versions of existing ones. It has a commanding 47% market share in the motorcycle segment.

What has driven performance in 2QFY07?

Sales break-up (3QFY07)
Domestic 3QFY06 3QFY07 % change 9mFY06 9mFY07 % change
Motorcycles 778,361 845,316 8.6% 2,155,479 2,329,158 8.1%
Scooter/scooterette - 29,279 n.a. - 72,106 n.a.
Total 778,361 874,595 12.4% 2,155,479 2,401,264 11.4%
Exports
Motorcycles 19,941 21,518 7.9% 72,815 78,532 7.9%
Scooter/scooterette - - n.a. - 976 n.a.
Total 19,941 21,518 7.9% 72,815 79,508 9.2%
Grand total 798,302 896,113 12.3% 2,228,294 2,480,772 11.3%
Source: SIAM

Motorcycles – New launches not working: Hero Honda’s total volume sales were higher by 12% YoY during 3QFY07. Motorcycles continued to grow at rates below the industry growth rate. Here, the domestic sales jumped 9% YoY as against the industry growth rate of 11% YoY. The fact that the company still has to rely on ‘Splendor’ for driving most of its sales speaks volumes about its inability to come out with successful models in recent times. None of

(Rs m) 3QFY06 3QFY07 Change 9mFY06 9mFY07 Change
Raw materials 16,015 19,629 22.6% 45,129 52,497 16.3%
% sales 69.2% 73.6%   69.9% 72.3%  
Staff cost 860 917 6.6% 2,385 2,634 10.4%
% sales 3.7% 3.4%   3.7% 3.6%  
Other expenditure 2,492 3,095 24.2% 7,020 8,430 20.1%
% sales 10.8% 11.6%   10.9% 11.6%  
the recent launches have been able to make any significant inroads into the market share of rivals. Performance for the nine-month period has been even worse with motorcycles growing at half the industry growth rate of 16% YoY. Not surprisingly, the company’s share in the domestic market has fallen to 47% as against 50% at the end of December 2005. While new launches will continue, it remains to be seen whether they will give the volumes a big boost.

Cost break-up…
(Rs m) 3QFY06 3QFY07 Change 9mFY06 9mFY07 Change
Raw materials 16,015 19,629 22.6% 45,129 52,497 16.3%
% sales 69.2% 73.6%   69.9% 72.3%  
Staff cost 860 917 6.6% 2,385 2,634 10.4%
% sales 3.7% 3.4%   3.7% 3.6%  
Other expenditure 2,492 3,095 24.2% 7,020 8,430 20.1%
% sales 10.8% 11.6%   10.9% 11.6%  

Input costs – Absorption taking toll: Increased raw material expenses have been taking a big toll on the operating performance of all two-wheeler companies and Hero Honda has been no exception. While the company has been able to pass on some part of it to customers, the impact has been so huge so as to reduce the company’s operating margins by 500 basis points during 3QFY07. Rise in other expenses (as percentage of sales) have also contributed towards margin contraction.

Unlike the previous quarter, a 7% YoY decrease in other income has not helped matters and, as a consequence, decline in bottomline at 21% YoY has been marginally higher than the decline in operating profits during the quarter. For the nine-month period, despite the 32% YoY jump in other income and a near seven-fold rise in interest income, the bottomline has declined by 6% YoY.

What to expect?
At the current price of Rs 717, the stock is trading at an attractive multiple of 14.1 times its trailing 12-month earnings. Although the performance of the company has continued to go downhill, we would like to wait for a few more quarters before changing our view on the stock. Given the industry growth potential and the track record of the company, we believe it has the potential to adequately reward shareholders over the long-term.

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