Hero Honda: Margins continue to shrink:: Macquarie

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Hero Honda
Margins continue to shrink
Event
 Hero Honda reported 2Q FY3/11 results that were significantly below our and
street estimates. We maintain our Underperform rating, as we expect
increasing competition to limit earnings growth.
Impact
 Poor 2Q results: Hero Honda reported net sales of Rs45.1bn (up 12% YoY),
exactly in line with estimates. PAT at Rs5.06bn (down 15% YoY) was 13%
and 10% below our and the street estimates, respectively. This was largely on
account of lower-than-expected operating income.
 High raw material costs deflate margins: Operating margins for the quarter
stood at 12.6%, down ~80bp on QoQ basis. The key reasons for the decline
in margins were greater-than-expected raw material costs due to negative
product mix and inability to pass on entire cost hikes. With higher volumes
and control on costs, we expect margins to improve in the coming quarters.
 Partners going their separate ways?: Media reports suggest that Hero
group’s founders, the Munjal group, are in talks with HMSI to purchase its
26% stake in Hero Honda along with PE players. We believe the split can be
largely negative for Hero Honda and the two-wheeler industry, as competition
can intensify further. HMSI could ask for a higher royalty payment from Hero
Honda in exchange for access to foreign markets. Further, the company may
have to increase spending on R&D, which currently stands at only ~0.2–0.4%
of sales. All these factors could push margins downward in the coming
quarters.
 Heightened competition to keep margin under pressure: Competition is
growing in the executive motorcycle segment, with key new model launches
by other players in the last few quarters (See Fig 5). Hero Honda has already
lost over 11ppt market share from its peak in the 75–125cc segment (See Fig
6), and we expect the company to lose market share further in the coming
quarters, as recently launched new products from competition gain traction.
Earnings and target price revision
 We decrease earnings by 4% for FY11E, mainly on account of lower margin
assumptions.
Price catalyst
 12-month price target: Rs1,630.00 based on a DCF methodology.
 Catalyst: Increasing raw material prices and loss in market share.
Action and recommendation
 Maintain Underperform: We believe that increasing competition and high
base will limit Hero Honda’s earnings growth to ~9% over the next three
years. Thus, at over 15x FY12E PER, the stock remains expensive.