Hold Hero Honda, Target 1800: Kotak Sec,

Hero and Honda: Divorce or limited engagement? Our scenario analysis coughs up
valuations ranging from Rs1,650 to Rs2,050. We have altered the long-term revenue
CAGR and combined the R&D + royalty spend for each scenario. We believe both
parties would continue the technology agreement in some form and have assigned a
higher probability for the same. If terminated, the key issues are the speed and cost at
which Hero Honda can ramp up its R&D capabilities and manage the brand perception
of its products.


Hero Honda scenario analysis comes up with valuations ranging from Rs1,650 to Rs2,050
We believe a scenario analysis would best capture the current uncertainty or noise over Hero
Honda’s relationship with Honda. Our analysis concentrates on the financial implications of each
scenario and does not dwell on the technical issues related to the reduction in Honda’s stake. The
stake sales speculation has brought to the fore two fundamental issues – (1) brand perception of
Hero Honda’s products and the company’s technology capabilities in the event of termination of
the agreement with Honda and (2) royalty rate in the event of a continuation of the technology
agreement compared to the current 2.5%. The continuation of the technology agreement may
depend on resolving the contentious issues between the two parties. For instance, Honda may not
be amenable to Hero Honda exporting vehicles with the Honda badge.
Our analysis includes scenarios ranging from status quo to Honda increasing its royalty rate to
termination of the technology agreement and resulting decline in Hero Honda’s revenue CAGR.
We have given equal probabilities for each scenario. However, we have assigned a higher
probability of 60% for a continuation in the technology agreement in some form.
Hero Honda spends 0.2% of sales in R&D versus 1.2% by Bajaj Auto
Without the technological expertise of Honda, we believe Hero Honda would have to ratchet up
its R&D spend significantly. This catch up to competitors, we believe, would result in Hero Honda
having to spend at least 2% of sales in R&D in the initial years. In addition, the company might
need to incur capital expenditure in an R&D facility.
Scenario analysis coughs up a probability weighted valuation of Rs1,800
Our scenario analysis comes out with a probability-weighted target price of Rs1,800. We are
maintaining our EPS estimates at Rs115 and Rs130 for FY2011E and FY2012E and are maintaining
our Rs1,800 target. We are, however, raising our rating on the stock to REDUCE from SELL as our
target implies limited downside from the current market price. We remain cautious on the stock
given the recent market share loss driven by renewed focus by the competition on Hero Honda’s
bread and butter commuter segment. We see downside risks to our EPS estimates as the
company’s volumes would need to grow at a 19% yoy pace to reach our volume estimates.