HERO HONDA: 2QFY11 margins may disappoint; Volumes & realizations to improve in 2HFY11; Honda exit may impact brand, but not existing technology; Under Review
We spoke to the management of Hero Honda to get an update on business and the implications of a break-up with Honda. Key takeaways:
2QFY11 margins may disappoint
- We model 70bp QoQ improvement to 14.1% (after factoring in lower-than-estimated Sep-10 volumes). The company is guiding for margin improvement to be muted due to lower volumes in Sep-10 driven by flooding and consequent build up of inventory of ~52,000 units at the more profitable Haridwar plant.
- Further, cost push has been severe due to higher tyre prices, use of imported batteries (shortage of domestic batteries) and higher logistics cost which have not been recouped through price increases.
- While several auto companies have taken price hikes recently, there may be some negative surprises in margins reported for 2QFY11 led by cost push.
Expect Oct-10 volumes to improve to 480-500k
- Oct-10 volumes are expected to improve to 480-500K (v/s our estimate of 450k; 433k in Sep-10; 354k in Oct-09) as production would be closer to 450-460k and inventory accumulated in September will be de-stocked.
- We model volume growth of 15% for FY11 to 5.3m units (implying a residual monthly run rate of 461,724 units v/s 419,967 units in FY11YTD).
EBITDA margins to improve in 2HFY11 driven by volume normalizations and price increases
- HH plans to raise prices from Oct-Nov-10, although quantum is not clear. This price increase is on back of price increase by its peers in Oct-10.
- This, coupled with normalization of volumes, will drive improvement in margins in 2HFY11. We model 170bp improvement in 2HFY11 over 1HFY11 margins.
Capacity de-bottlenecking by Jan-11; No decision on new plant could impact FY12 growth
- HH’s recent volumes have been disappointing, impacted by production constraints as well as factors beyond its control. As a result, it is losing out on strong demand at retail level and might see impact on its festive sales.
- HH’s production constraints are expected to ease by Jan-11 as it adds 300k capacity at Haridwar and another 100k at its other two plants. As a result, HH will exit 4QFY11 with a capacity of 5.8m v/s 5.4m units now.
- However, the management has not yet decided on its fourth plant, which would be necessary if industry growth remains strong. Based on 4QFY11 exit capacity, it would have headroom to grow only 10% in FY12. Upon finalization of site, it would take about 10-12 months for the new plant to be operational.
- We factor in FY12 volume growth of 12.5% to 5.95m units.
Break-up with Honda may impact usage of ‘Hero Honda’ brand, but not existing product line-up
- Brand usage is not covered under license agreement, but by a shareholders’ agreement between Hero Group and Honda Group. Hence, if Honda sells its stake in HH, it might not allow HH usage of Honda brand, although details will be known only if the event takes place. However, HH can continue using sub-brands like Splendor, Passion, Glamour etc
- As per the technology license agreement, HH can continue using technology used in existing product by paying 50% of royalty for 3 years.
- Contrary to general perception that Hero Honda is losing out to HMSI in terms of new product supply from the parent, the management indicated that new product launches upto 2014 are already well defined for both the companies. Hero Honda plans to launch 3 new product platforms next year, after a gap of almost two years.
Valuation & view
- Hero Honda has been lagging industry growth due to production constraints, resulting in market share loss.
- This coupled with news flow relating to probable exit of Honda from the company, has resulted in 16% underperformance of the stock to BSE Sensex over last 6 months.
- The stock trades at 16x FY11 EPS of Rs113.6 and 13.7x FY12 EPS of Rs133.9. Under Review.
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