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Hero Honda: A facile victory! - Views on News from Equitymaster
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Hero Honda: A facile victory!
May 11, 2007

Performance summary
Hero Honda, India’s largest manufacturer of two-wheelers has announced its fourth quarter and full year FY07 results and it does not make for a good sight. Facing pressure from all corners, the company’s bottomline has dropped 27% YoY during the quarter, led largely by a huge 590 basis points drop in operating margins. Performance for the full year has also been disappointing, as despite the 14% YoY jump in topline, the bottomline has fallen by 12% YoY. Here too, it is the 390 basis points fall in operating margins that has acted as the wrecker-in-chief.

(Rs m) 4QFY06 4QFY07 Change FY06 FY07 Change
Units sold 772,457 866,247 12.1% 3,000,751 3,347,019 11.5%
Net sales 22,559 26,396 17.0% 87,140 99,000 13.6%
Expenditure 18,927 23,709 25.3% 73,460 87,269 18.8%
Operating profit (EBDITA) 3,632 2,687 -26.0% 13,680 11,730 -14.3%
EBDITA margin (%) 16.1% 10.2%   15.7% 11.8%  
Other income 430 445 3.4% 1,527 1,899 24.3%
Interest (net) (39) (77) 95.7% (61) (230) 275.0%
Depreciation 305 355 16.5% 1,146 1,398 22.0%
Profit before tax 3,797 2,854 -24.8% 14,122 12,461 -11.8%
Tax 1,125 904 -19.7% 4,409 3,882 -12.0%
Profit after tax/(loss) 2,672 1,950 -27.0% 9,713 8,579 -11.7%
Net profit margin (%) 11.8% 7.4%   11.1% 8.7%  
No. of shares (m) 199.7 199.7   199.7 199.7  
Diluted earnings per share (Rs)* 53.5 39.1   48.6 43.0  
Price to earnings ratio (x)**         16.3  
(* 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 4QFY07?
Volumes – Back in the reckoning: The topline of the company grew by 17% YoY during the quarter, slightly higher than the 12% growth in volumes sold, indicating improvement in realizations. Volume growth for the full year also remained in the region of 12% YoY, a task that looked difficult mid way through the fiscal. Infact, company’s volume growth during 2QFY07 had fallen to as low as 1% YoY. However, it recovered well to once again grow its volumes in double digits for the full year.

This was made possible due to a flurry of new launches, 8 to be precise, which the company launched throughout the year. The fact that its closest rival faced some production constraints during the fag end of the year also helped Hero Honda. Further, with its scooter offerings growing more than 6 fold in FY07, it helped take the pressure off motorcycles, where growth stood in the higher single digit of 9% YoY. With the competition also coming out with contemporary bikes, the company’s growth in this segment has come under pressure. Exports of the company also remained sedate during the year, notching a modest growth rate of 5% YoY.

Sales break-up
Domestic 4QFY06 4QFY07 % change FY06 FY07 % change
Motorcycles 737,591 828,271 12.3% 2,893,070 3,157,429 9.1%
Scooter/scooterette 15,014 19,839 32.1% 15,014 91,945 512.4%
Total 752,605 848,110 12.7% 2,908,084 3,249,374 11.7%
Motorcycles 19,851 18,081 -8.9% 92,666 96,613 4.3%
Scooter/scooterette 1 56 5500.0% 1 1,032 103100.0%
Total 19,852 18,137 -8.6% 92,667 97,645 5.4%
Grand total 772,457 866,247 12.1% 3,000,751 3,347,019 11.5%

Volumes over profitability: With the company going all out to increase its volumes in the face of intense competition, profitability has taken a back seat during FY07, as operating margins eroded by 390 basis points on a YoY basis. As this coincided with a period significant inflationary pressures, Hero Honda suffered a double whammy. Raw material costs a percentage of sales increased by a substantial 300 basis points during the fiscal and this further put pressure on margins. Infact, all auto companies across the board are facing similar margin pressure from rising raw material costs. While the company chose to pass on some of these, the fact that its margins have fallen substantially indicates that it had to absorb a major chunk of the same. With raw material prices showing no signs of cooling off, there seems to be no respite in the near term.

Cost break-up…
(Rs m) 4QFY06 4QFY07 Change FY06 FY07 Change
Raw materials 15,394 19,290 25.3% 60,523 71,787 18.6%
% sales 68.2% 73.1%   69.5% 72.5%  
Staff cost 821 905 10.1% 3,206 3,538 10.4%
% sales 3.6% 3.4%   3.7% 3.6%  
Other expenditure 2,711 3,514 29.6% 9,731 11,944 22.7%
% sales 12.0% 13.3%   11.2% 12.1%  

The fall in bottomline for the full year has come in at 12% YoY, slightly lower than the 14% fall in operating profits, mainly due to the 24% jump in other income and a near four fold increase in interest earnings. Since the company has very little debt on its books, it has earned interest income rather than an expense.

Over the last few quarters
As seen from the table below, while the growth in topline, barring 2QFY07, is indeed heartening, a consistent decline in operating margins does raise some concerns over the company’s future growth potential. With pressure from all sides, it is highly unlikely that the company would be able to address this problem anytime soon.

Over the last few quarters…
  3QFY06 4QFY06 1QFY07 2QFY07 3QFY07 4QFY07
Revenue growth (%YoY) 15.6% 16.3% 19.6% 2.9% 15.2% 17.0%
OPM (%) 16.3% 16.1% 13.5% 12.7% 11.3% 10.2%
NPM (%) 11.3% 11.8% 10.1% 9.7% 7.8% 7.4%

What to expect?
At the current price of Rs 705, the stock is trading at a P/E multiple of 16 times its FY07 earnings. We believe the volume growth will continue to rule at double-digit levels in the medium term. However, it is the quality of earnings or the drop in profitability that is worrying us. We will come out with an updated research report on the company soon.

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