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Hero Honda: Lagging behind - Views on News from Equitymaster
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Hero Honda: Lagging behind
Jul 18, 2005

Performance summary
Hero Honda Limited, the largest two-wheeler manufacturer in the country, announced its 1QFY06 a short while ago. Though the topline grew by 15% YoY, rising input costs and a faster increase in promotional expenses affected operating margins (down 160 basis points YoY). Had it not been for a 33% rise in other income, the growth in bottomline would have been on the lower side.

(Rs m) 1QFY05 1QFY06 Change
No. of units sold 609,123 687,567 12.9%
Net sales 17,223 19,771 14.8%
Expenditure 14,369 16,848 17.3%
Operating profit (EBDITA) 2,854 2,923 2.4%
Operating profit margin (%) 16.6% 14.8%  
Other income 229 306 33.3%
Interest 2 (3) -250.0%
Depreciation 205 250 22.3%
Profit before tax 2,877 2,981 3.6%
Tax 980 937 -4.4%
Profit after tax/(loss) 1,898 2,045 7.7%
Net profit margin (%) 11.0% 10.3%  
No. of shares (m) 199.7 199.7  
Diluted earnings per share (Rs)* 38.0 41.0  
P/E ratio (x)   15.9  
*annulised      

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. 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 six new models/improved versions of existing ones. It has a commanding 49% market share in the motorcycle segment.

What has driven the performance in 1QFY06?
High base effect restricts volume growth:  As can be seen from the chart, the YoY volume growth is slowing down. This is on account of two factors. Firstly, competition has started taking toll on the performance of the company. It should be noted that in FY05, the company failed to introduce any major new models, except for improved versions of its existing models. At the same time, its competitors like Bajaj and TVS launched new motorcycles. Apart from this, higher base effect also affected the YoY growth. To put things in perspective, during the first quarter of FY06, though Bajaj Auto recorded a 53% YoY growth in volumes, Hero Honda managed to sell 63% more motorcycles than its nearest competitor. Going forward, we expect Hero Honda to grow more or less in line with the industry growth of 12% to 15%.

Raw materials - It’s the same old story:  The unabated rise in the raw material costs has affected all the players in the automobile industry. In last two years, cost of steel has increased by almost 57%. Apart from this, inability to pass on the burden of rising input costs due to competitive pressures directly affected the bottomline of the company, as is evident from a 160 basis point fall in operating margins. With steel prices showing signs of softening, margins of the company can improve, as steel typically accounts for almost 50% of operating costs. Having said that, we do not expect significant benefits accruing to the company in the first half of the fiscal year.

(Rs m) 1QFY05 1QFY06 Change
Raw materials 12,021 14,081 17.1%
% sales 69.8% 71.2%  
Staff cost 639 710 11.1%
% sales 3.7% 3.6%  
Other expenses 1,653 2,094 26.6%
% sales 9.6% 10.6%  

Apart from raw materials, the rise in other expenses has also created a dent in margins, primarily on account of higher publicity and promotion expenses in order to market its new motorcycle ‘Glamour’ (launched in May 2005).

Other income saves the day:  Despite just a 2% growth in operating profit, the profit before tax of the company increased at a higher rate on account of higher other income. The lowering of corporate tax rate in the budget is clearly reflected in the reduced effective tax rate in 1QFY06. But for these benefits, the net profit would have declined in 1QFY06.

Over the last few quarters:  As is evident from the graph, operating margins have been under pressure, owing to higher commodity prices. But what is also important to note is that operating margins in 1QFY06 are below Bajaj Auto (15.8% in 1QFY06). Since the rise in input cost is common to all players, the fact that Hero Honda’s margins are lower indicate weakness in pricing.

What to expect?
At the current price of Rs 653 the stock is trading at a price to earnings multiple of 15.9 times. In our view at this price to earnings multiple, the stock is trading at upper end of valuations for an auto company. Based on our FY07 estimates, the stock is trading at a price to earnings multiple of 13.3 times. On the balance, taking into account the growth prospects of the motorcycle sector (at 11.3% CAGR in the next three years) and increasing competition, we believe that the risk-return trade off is skewed towards risks at the current juncture. To that extent, investors should exercise caution.

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