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The Hero Honda split: Our view - Views on News from Equitymaster
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The Hero Honda split: Our view
Dec 17, 2010

It is official. Hero Honda, India's largest two wheeler company has made it public. The firm put out an announcement on the BSE website yesterday. The announcement talked about the new licensing agreement that will be in place between the two JV partners in the company, Hero Group and Honda Group.

As per the agreement, the Hero Group will buy out the 26% stake that Honda holds in the company. The financial details of the same have not been given though.

Let us have a look at the other key features of the agreement:

  • All existing products to continue

  • Fresh licensing agreement with Honda to provide new models

  • Freedom to go global - Export to new markets

  • Independence to set up own R&D and new product development capabilities and acquire technology

  • No change across ongoing operations

  • Process for smooth transition finalised

  • Company and brand name to be changed overtime.
A major concern had emerged as soon as the news of the split started doing the rounds. And it had to do with the excess royalty payment that Hero will have to shell out till the time there is complete transition.

The concern though has been put to rest. Going forward, royalty will be no more than what it has been and in fact, could actually come down a bit by 2011. Analysts worrying about the company's operating margins can breathe easy.

But royalty is not the only thing to be worried about. Throughout this long 25 year old partnership, it was pretty clear what partner was bringing which skill set on to the table. Hero Honda possesses unarguably the best distribution network of all the two wheeler companies present in India currently. It has passed the sternest of tests with flying colors. The most recent one being the slump in the industry that was witnessed in the year FY09. That the company's superior distribution network came to the company's rescue in that year could be an understatement. And most of the credit for this must of course go to the Hero Group. Through their focus on distribution and branding efforts, they have made the company a force to reckon with in the domestic markets.

However, Honda's contribution to the success that the company has enjoyed all these years cannot be belittled either. It is courtesy Honda's technology and its ruthless focus on quality that the company's products have come to be known as the gold standard in two wheelers. Thus, over the years, the unique strengths of the partners have fed on each other, making it the company that it is today.

Hence, going forward, the Hero Group's success will hinge on how quickly it is able to develop technology of its own that comes close to the Honda level and Honda on the other hand, will have to make rapid inroads into the country's hinterland if it wants to improve its market share.

The Hero Group though has time on its hands. The current technology agreement and the use of the Hero Honda brand name will continue till 2014, giving the Hero Group enough time to invest in R&D or may be, even buy it off the shelf from some other provider. Also important to add here that technology for two-wheelers is not as intensive as four-wheelers and hence, can be developed if there is enough time and money. Both these factors may not be a problem for the Hero Group.

That Hero Group will lose some market share to Honda going forward is perhaps a foregone conclusion now. But what is also heartening to know is the fact that the exports markets have opened up for Hero Group in a big way. One need not look beyond Bajaj Auto to find out how lucrative these markets can be. For the record, Bajaj Auto currently generates nearly half its volumes from export markets. Hence, loss of market share in domestic markets can be compensated from exports and may be even more.

Conclusion

Prima facie, the split does not look to be as detrimental to Hero Honda as was being believed. However, there is no denying the fact that the uncertainty with respect to the company's future has certainly gone up than what had been the case had the two promoters not parted ways. In other words, what can earlier be called as an investment has now become a speculation albeit with a lower risk we believe.

And betting too much on a speculation is certainly not our idea of investing. Hence, while those who already hold Hero Honda shares can keep holding, we would not advise a fresh position in the stock. In fact, even those who hold the shares should make it no more than 5% of their total portfolio. A speculation after all, no matter how safe, has to be made on a very small scale.

As far as ValuePro subscribers are concerned, we have already asked our clients to SELL the stock from their ValuePro portfolio and we stick with that view.

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