Bank of America Merrill Lynch: Hero Honda :Upgrade to Buy

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Hero Honda 
   
Royalty, technology issues 
addressed; Upgrade to Buy 
„Royalty rates largely unchanged; PO raised to Rs 2,088
Honda’s exit from JV has allayed investor concerns over a possible hike in royalty
rates. Following the 16% stock underperformance this fiscal year, we upgrade our
rating to Buy and raise PO to Rs 2,088 (from Rs 1,965) driven by, (1) slight increase
to EPS forecasts over FY12-13E, and (2) expected re-rating of core multiple to 15x
FY12E P/E (earlier 14x), as worries over financial impact is unfounded.

Royalty rates largely unaltered
Contrary to concerns that royalty rates will increase either as a lumpsum payment
or on a recurring basis, management indicated that rates will remain in line. We
believe this could happen over time due to introduction of indigenous brands. Our
forecasts however, factor a royalty increase of Rs 100/unit in FY12E and further
Rs 65/unit in FY13E, mainly due to newer models using Honda’s support.

Technology issues likely to be overcome
Hero Honda's technology agreement will continue until 2014, which ensures
support to its existing portfolio. We believe this transition period is adequate to
develop R&D capability given the relative simplicity of two wheeler technology and
the group’s lengthy involvement in this business. In the interim, the company
could enter into a fresh licensing agreement with Honda for new products.

New opportunities could provide upside surprise
Given the brand franchise, we expect models such as Splendor, Passion Pro, CDDawn and Pleasure (75% of sales) to drive 13% sales CAGR over FY12-13E,
similar to industry. Our assumptions do not include (1) a likely foray into new export
markets, and (2) product initiatives in the relatively faster growing aspirational
segment (27% of market, 26% MS), through indigenously developed models.


Price objective basis & risk
Hero Honda (HRHDF)
Our PO of Rs 2088 is based on sum of parts of (1) core two wheeler business
valued at 15x FY12E P/E or Rs 1706/share, up from earlier 14x on reduced
overhang and increased visibility, and (2) cash & equivalents of Rs 382/share. At
our PO, stock would trade at 16.3x FY12E P/E. Risks: New models from
competition, as well execution risk due to indigenous technology. Higher input
costs would also impact profitability.