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Hero Honda: In choppy waters! - Views on News from Equitymaster

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Hero Honda: In choppy waters!
Oct 26, 2006

Performance summary
Hero Honda, India’s largest two-wheeler manufacturer has put up a weak performance during 2QFY07. On a modest topline growth of 3%, the bottomline of the company has shrunk by 9% as compared to same quarter last year. This was largely a result of contraction in operating margins to the tune of 270 basis points. Had it not been for the increase in other income and lower tax outgo, damage would have been even higher. 1HFY07 performance has been slightly better with the company recording a 3% growth in profits on the back of an 11% growth in topline.

(Rs m) 2QFY06 2QFY07 Change 1HFY06 1HFY07 Change
Net sales 21,663 22,300 2.9% 41,433 45,943 10.9%
Expenditure 18,327 19,465 6.2% 35,175 39,919 13.5%
Operating profit (EBDITA) 3,336 2,835 -15.0% 6,258 6,025 -3.7%
EBDITA margin (%) 15.4% 12.7%   15.1% 13.1%  
Other income 431 595 38.0% 737 1,118 51.7%
Interest (net) 8 65 683.1% 11 98 768.1%
Depreciation 267 344 28.9% 517 667 29.0%
Profit before tax 3,508 3,151 -10.2% 6,489 6,573 1.3%
Extraordinary income/(expense) - -   - -  
Tax 1,129 991 -12.2% 2,065 2,036 -1.4%
Profit after tax/(loss) 2,379 2,160 -9.2% 4,424 4,537 2.6%
Net profit margin (%) 11.0% 9.7%   10.7% 9.9%  
No. of shares (m) 199.7 199.7   199.7 199.7  
Diluted earnings per share (Rs)* 47.7 43.3   44.3 45.4  
Price to earnings ratio (x)**         15.1  
(* 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 had a commanding 48% market share in the motorcycle segment in FY06

What has driven performance in 2QFY07?

Sales break-up (2QFY07)
Domestic 2QFY06 2QFY07 % change
Motorcycles 719,092 702,365 -2.3%
Scooter/scooterette - 21,311 N.A.
Total 719,092 723,676 0.6%
Exports      
Motorcycles 23,333 27,899 19.6%
Scooter/scooterette - 392 N.A.
Total 23,333 28,291 21.2%
Grand total 742,425 751,967 1.3%
Source: SIAM

Motorcycles - Rivals are closing in: Motorcycles sales of the company have witnessed a decline of 2% as against the industry growth rate of 15%. Just to put things in perspective, the gap between Hero Honda and its closest rival in terms of number of units sold has narrowed down to 30,000 units in September 2006 as against the gap of 1,00,000 units in the same quarter last year. This clearly indicates that the kind of pressure the company is being subjected to in order to retain its market share. Although exports grew at a decent pace of 20% YoY, it was still way below the industry growth rate of 59%. Apart from motorcycles, the company has also recently forayed into the fast growing segment of scooterettes where volumes stood in the region of 22,000 units and enabled the company to close the quarter with a positive growth in sales to the tune of 1.3%.

Cost break-up…
(Rs m) 2QFY06 2QFY07 Change
Raw materials 15,069 15,838 5.1%
% sales 69.6% 71.0%  
Staff cost 814 848 4.1%
% sales 3.8% 3.8%  
Other expenditure 2,443 2,778 13.7%
% sales 11.3% 12.5%  

Margins under pressure: In an effort to grow volumes, Hero Honda has resorted to providing quite a few incentives to the customers. Further, with competition fast heating up, the company was unable to pass on the hikes in raw material costs to the consumer thus translating into a double blow to the margins. Not surprisingly then, the company’s operating margins have contracted by 270 basis points as compared to same quarter last year. Hero Honda’s raw material costs as a percentage of sales jumped to 71%, an increase of 140 basis points over the level of the corresponding quarter in the previous year.

A 38% increase in other income and a 12% decline in tax outgo ensured that the damage to the bottomline was restricted to a decline of 9%.

Motorcycles market share

What to expect?
At the current price of Rs 744, the stock is trading at an attractive price-to-cash flow multiple of 9 times our estimated FY09 cash flow per share. Despite the fundamentals of the company taking a turn for the worse, we feel it is too early to start writing obituaries given the track record of the company. Hence we believe that over the long term the company would be able to take advantage of the industry growth story, although the market share might come under pressure. We maintain our positive view on the stock.

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