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Hero Honda FY06 results: Our view - Views on News from Equitymaster

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Hero Honda FY06 results: Our view
May 30, 2006

Performance summary
Hero Honda, the largest two-wheeler manufacturer in the country, announced strong results for the fourth quarter and fiscal ended March 2006. Led by 15% YoY growth in volume sales and 3% YoY improvement in realisations, the company reported a 15% YoY growth in revenues during FY06. While operating margins have been flat during the fiscal, lower effective tax rate has helped the company grow its bottomline at a faster clip than the growth in topline. For 4QFY06, revenues and net profits have grown by 13% YoY and 29% YoY respectively, with the latter being helped by expansion in operating margins and higher other income.

(Rs m) 4QFY05 4QFY06 Change FY05 FY06 Change
Units sold 685,429 772,455 12.7% 2,621,400 3,000,448 14.5%
Net sales 19,403 22,559 16.3% 74,217 87,140 17.4%
Expenditure 16,471 18,927 14.9% 62,571 73,460 17.4%
Operating profit (EBDITA) 2,932 3,632 23.9% 11,645 13,680 17.5%
EBDITA margin (%) 15.1% 16.1%   15.7% 15.7%  
Other income 358 430 20.3% 1,410 1,527 8.3%
Interest (net) (4) (39) 793.2% (11) (61) 462.4%
Depreciation 264 305 15.6% 894 1,146 28.2%
Profit before tax 3,031 3,797 25.3% 12,173 14,122 16.0%
Tax 960 1,125 17.2% 4,068 4,409 8.4%
Profit after tax/(loss) 2,071 2,672 29.0% 8,105 9,713 19.8%
Net profit margin (%) 10.7% 11.8%   10.9% 11.1%  
No. of shares (m) 199.7 199.7   199.7 199.7  
Diluted earnings per share (Rs)   13.4     48.6
Price to earnings ratio (x)         16.0  

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, it is planning its maiden entry into the gearless scooterettee market. 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 FY06?
Volumes drive topline: Hero Honda recorded a 15% YoY growth in volume sales during FY06, which contributed to a large part of the growth in topline. The company sold a net of 3 m units, against 2.6 m units sold in FY05. However, on the back of higher base, the company’s volume growth figure is gradually slowing down (see adjacent chart). But, it is still commendable on the company’s part to maintain the strong growth in topline, despite diminishing pricing power due to intensifying competition from other domestic players like Bajaj Auto and TVS Motor. In fact, during FY06, Hero Honda recorded a 2.6% YoY improvement in average realisations. Higher volumes and improvement in realisations during FY06 is part due to the company’s new product launches during the fiscal, especially the launch of its scooter – Pleasure. The management has also indicated that, in the motorcycle segment, new launches contribute to 36% of the company’s FY06 sales, especially on the back of its ‘Super Splendor’ and ‘CD Deluxe’ models.

During FY06, Hero Honda expanded its capacity to 3.9 m units. Further, the expansion of 450,000 units at the Gurgaon plant is already completed at an investment of Rs 470 m. Also, an expansion of additional 4,50,000 units is in progress at the company’s Dharuhera plant and the estimated investment towards the same will be Rs 960 m. The Dharuhera expansion is expected to commence production by August 2006.

In anticipation of higher demand in the future, the company has announced plans for its third plant to be located at Jaipur (production capacity of 5,00,000 units expandable to a capacity of 1 m). Towards this, the management has announced an investment of Rs 3.2 bn, to be spent in the next 12 months. The company has also announced 8 new launches in FY07, in order to strengthen its product portfolio across segments.

Lower input costs save margin decline: Hero Honda’s operating margins during FY06 stayed at similar levels as FY05. This was despite higher staff and other costs (as % of sales) and was due to lower raw material costs. Softening of the steel prices has helped the company to keep a check on its raw material expenses during the fiscal. In fact, during 4QFY06, it was the decline in raw material costs that helped the 1% expansion ion operating margins.

Cost break-up...
(Rs m) 4QFY05 4QFY06 %Change FY05 FY06 %Change
Raw materials 13,693 15,307 11.8% 52,146 60,673 16.4%
% sales 70.6% 67.9%   70.3% 69.6%  
Staff cost 729 821 12.6% 2,680 3,206 19.6%
% sales 3.8% 3.6%   3.6% 3.7%  
Other expenses 2,107 2,711 28.7% 7,896 9,731 23.2%
% sales 10.9% 12.0%   10.6% 11.2%  

Lower effective tax rate help bottomline: Apart from flat operating margins, a decline in the effective tax rate, from 33% to 31%, helped Hero Honda grow its net profits at a faster rate than growth in topline during the fiscal. The bottomline growth would have been higher but for higher depreciation expenses on the back of the company’s ongoing expansion, as indicated above. The actual net profits are 1% lower than our estimates.

What to expect?
At the current price of Rs 780, the stock is trading at 10.4 times our estimated FY06 cash flows. The board has recommended a dividend of Rs 20 per share (dividend yield of 2.6%). In our view, given the competitive environment, we believe that Hero Honda’s market share will remain under threat from Bajaj Auto and TVS Motor going forward. In this context, we have a cautious view on the company. Our preferred plays in the sector remain Bajaj Auto and TVS Motor from a long-term perspective (as they have growth plans outside India as well).

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