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Hero Honda: Business as usual - Views on News from Equitymaster
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Hero Honda: Business as usual
Jul 12, 2006

Performance Summary
Hero Honda, India’s largest two-wheeler manufacturer, announced its 1QFY07 results. While volume growth has been robust, competition as well as input pressures have taken some sheen off the company’s margins. EBITDA margin has fallen by 70 basis points as compared to the same quarter last year and net profit margin has also seen a drop of 20 basis points during the same period.

Financial performance: Standalone snapshot
(Rs m) 1QFY06 1QFY07 Change
No of units sold 687,567 834,691 21.4%
Net sales 19,771 23,644 19.6%
Expenditure 16,848 20,454 21.4%
Operating profit (EBDITA) 2,923 3,190 9.1%
EBDITA margin (%) 14.8% 13.5%  
Other income 306 523 71.0%
Interest (net) 3 33 1003.3%
Depreciation 250 323 29.2%
Profit before tax 2,981 3,423 14.8%
Extraordinary income/(expense) - -  
Tax 937 1,045 11.6%
Profit after tax/(loss) 2,045 2,377 16.3%
Net profit margin (%) 10.3% 10.1%  
No. of shares (m) 199.7 199.7  
Diluted earnings per share (Rs)* 41.0 47.6  
Price to earnings ratio (x)**   14.3  
(* 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 48% market share in the motorcycle segment.

What has driven performance in 1QFY07?
Favorable demographics continue to drive volume growth: India is home to one of the youngest population in the world and is also the one with one of the lowest two-wheeler penetration levels. This has really given a boost to the domestic two-wheeler industry in the past few years where double-digit growth rates in motorcycles have become the norm rather than the exception.

Hero Honda, by virtue of being the largest motorcycle manufacturer in the country, has benefited from this trend and has reported yet another 21% YoY growth in volumes in the first quarter. It has to be remembered that the volume numbers also include the sale of scooters (which was not a part of the portfolio in the same quarter last year). Since scooter volumes are not clearly available, growth numbers have been viewed in this context (just to put things in perspective, in April 2006, the company sold around 6,400 scooters).

Cost break-up…
(Rs m) 1QFY06 1QFY07 Change
Raw materials 14,044 17,029 21.3%
% sales 71.0% 72.0%  
Staff cost 710 868 22.3%
% sales 3.6% 3.7%  
Other expenses 2,094 2,557 22.1%
% sales 10.6% 10.8%  

Competitive and cost pressures have affected margins: The industry currently is facing pressure on both the cost as well as realisations front. Increasing competition has led to the players offering a host of discounts to the end consumers, thus putting pressure on realisations. Rising prices of input as well as shortening product life cycles has resulted in cost escalation. The story with Hero Honda has been no different (as indicated in the chart). While operating margins may not reach the previous highs of over 16%, we expect them to improve to a certain extent.

Bottomline benefits: A substantial 71% rise in the other income has not allowed the damage at operating level to trickle down completely and as a consequence, the net profits of the company have grown at a decent 16% YoY.

What to expect?
At the current price of Rs 720, the stock is trading at a price to earnings multiple of 11.4 times our estimated FY08 earnings. In our view, over the next two years, we expect the company’s market share in the domestic motorcycle segment to decline below the 40% mark. Unlike Bajaj Auto and TVS, Hero Honda has a concentrated portfolio as well as concentrated market focus (i.e. India). With Bajaj Auto and TVS investing heavily in product development as well as overseas expansion, growth in earnings is likely to be faster for these two companies as compared to Hero Honda. On a relative basis therefore, we continue to maintain a cautious view on Hero Honda whilst maintaining our stand that Bajaj Auto and TVS are our preferred plays with a medium-term perspective.

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