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Hero Honda: Fighting spirit - Views on News from Equitymaster
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Hero Honda: Fighting spirit
Oct 20, 2005

Performance summary
Hero Honda, the market leader in the motorcycle segment, announced its 2QFY06 and 1HFY06 results today. While the topline growth in 2QFY06 at 23% was robust, lower operating margins and higher depreciation charges muted the bottomline growth. The decline in operating margins in the first half of the fiscal year is higher. Overall, the company is fighting back at the competition with a slew of new models, which is reflected in its 1HFY06 numbers.

(Rs m) 2QFY05 2QFY06 Change 1HFY05 1HFY06 Change
Units sold 654,619 742,425 13.4% 1,224,821 1,429,992 16.8%
Net sales 17,572 21,663 23.3% 34,794 41,433 19.1%
Expenditure 14,822 18,327 23.6% 29,191 35,166 20.5%
Operating profit (EBDITA) 2,750 3,336 21.3% 5,603 6,268 11.9%
EBDITA margin (%) 15.6% 15.4%   16.1% 15.1%  
Other income 411 431 4.8% 640 737 15.1%
Interest (net) (3) (8) 176.7% (4) (11) 182.5%
Depreciation 208 267 28.3% 413 517 25.2%
Profit before tax 2,956 3,508 18.7% 5,834 6,498 11.4%
Tax 1,011 1,129 11.6% 1,991 2,075 4.2%
Profit after tax/(loss) 1,945 2,379 22.3% 3,843 4,424 15.1%
Net profit margin (%) 11.1% 11.0%   11.0% 10.7%  
No. of shares (m) 199.7 199.7   199.7 199.7  
Diluted earnings per share (Rs)* 39.0 47.7   38.5 44.3  
Price to earnings ratio (x)         15.8  
(* annualised)            

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, now the company is planning its maiden entry in gearless scooterettee segment with the launch of ‘Pleasure’ in the next two months. 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 a series of new models and improved versions of existing ones. It has a commanding 49% market share in the motorcycle segment in the country.

What has driven performance in 2QFY06?
Volume sales picking up: During the first quarter, the company recorded a subdued performance on the volumes front. This was partly due to production constraints and also the lack of competitive new models. With the issues being sorted out (launch of new models i.e. 'Glamour' and 'Achiever'), the company was able to register more than 20% YoY growth in the month of August and September 2005. However, higher base effect restricted the overall volumes growth of the company. On the exports front, Hero Honda registered a commendable 60% YoY growth in the second quarter, thereby increasing the share of exports from 2% in 2QFY05 to 3% in 2QFY06. Going forward, on the domestic front, we expect the company to perform in line with the industry growth of 12% CAGR over the next three years. On the exports front, we do not expect the contribution to rise dramatically because unlike TVS and Bajaj Auto, Hero Honda is restricted to certain markets (has to be aligned with Honda's global presence).

The graphs above highlight the quarterly volume performance and unit sales in this fiscal year. While volumes sold in the domestic market in September 2005 were higher than April 2005, it is strictly not comparable owing to seasonality in demand for two-wheelers in general. Given the series of launches in the motorcycle segment, we expect volume growth to gain momentum going forward. Having said that, the company has had a volatile record with new models (post 'Passion', none of the other launches have contributed meaningfully to Hero Honda's volumes on a sustainable basis). This is one concern because the erstwhile strong brands like 'Splendor' and 'Passion' are aging. We have factored in a 16% growth in net sales for FY06 and the company's performance is in line with this estimate.

Cost break-up...
(Rs m) 2QFY05 2QFY06 % Change 1HFY05 1HFY06 % Change
Raw materials 12,072 15,069 24.8% 24,148 29,114 20.6%
% sales 68.7% 69.6%   69.4% 70.3%  
Staff cost 632 814 28.9% 1,271 1,524 19.9%
% sales 3.6% 3.8%   3.7% 3.7%  
Other expenses 2,118 2,443 15.4% 3,771 4,528 20.1%
% sales 12.1% 11.3%   10.8% 10.9%  

Material cost pressure exists: Looking at the cost heads, while raw material costs to sales continues to exhibit firmness, there has been a proportionately higher increase in other expenditure in the first half of the fiscal year. This could be attributed to higher marketing and distribution expenses for the new models. We had factored in a marginal increase in operating margins for FY06, in light of softening of raw material prices. We expect the company to benefit from lower prices in the second half and to that extent, we stand by our estimates.

Expansion reflects in depreciation: As compared to a 21% growth in operating profit in 2QFY06, net profit has grown at a faster clip of 22% owing to higher interest income and lower tax incidence. These have negated the sharp spurt in depreciation charges, which we believe is primarily due to expansion plans of the company (both on the motorcycle side as well as the venture related to ungeared-scooters market). We have factored in a 40% rise in depreciation charges in our estimates. Overall, the company's performance is commendable in an increasingly competitive scenario.

Over the last few quarters: As is evident from the graph, while the rate of growth in the topline has come down, it is no cause for concern. An 18% rise in volumes sold in 1HFY06 is good by any yardstick. Investors have to remember that the days of over 25% YoY growth are over, because the industry has gained in volumes in the last decade. As far as operating margins are concerned, there has been an improvement in the same as compared to the last few quarters, which we expect to continue going forward for the reasons mentioned earlier.

What to expect?
At the current price of Rs 698, the stock is trading at a price to earnings multiple of 15.8 times 1HFY06 annualised earnings (14.5 times our earnings estimate for FY06). Given the sharp rise in the stock price over the last one year, we believe that the current valuations adequately reflect growth prospects over the next two years. That said, we have not factored in the volume growth in ungeared scooters in our estimates. Once this gains scale and there is more visibility, we would re-look at our numbers. But for now, we believe that Bajaj Auto and TVS Motor are better plays in the two-wheeler sector.

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