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Smooth separation
The final contours of the Hero Honda (HH) – Honda split indicate an amicable
and smooth separation though we would have preferred better disclosure on
the details. Management commentary that royalty will be in-line with current
levels comes as a relief. We believe that nothing much changes for HH near
term given continuation of technical support and usage of the Honda brand
name till FY14. Post FY14, we see risk of a small slippage in HH’s India
franchise post end of the new licensing agreement but will be compensated by
zero royalty and higher exports. We expect stock to continue trading on near term earnings. Stock is likely to see a spike today but on a 12m view we see
lack of triggers for outperformance. U-PF stays.
Many questions unanswered but not much change for HH near-term
Details of valuation of Honda’s 26% stake and the new royalty structure are not
available but management commentary that the new royalty will be “in-line and
maybe even lower than current levels” is a positive. The new licensing agreement
will cover all existing models and will also require Honda to provide new models.
Usage of ‘Honda’ brand will continue till 2014. Hero will now have 3 comfortable
years to develop its own R&D and product development capabilities and we expect
R&D spend to rise. HH will also have the freedom to export to any market but we
don’t expect any early and large increase in export volumes since it takes time to
understand local nuances and build the supply chain in most export markets.
What does HMSI do now; implications for Bajaj
HMSI is now certain to turn more aggressive in capacity/network expansion and
product roll-out but we reckon that the big push will happen more in FY13 than
FY12. HH, however, will not want to see any drop in market share immediately
post split to support morale of its dealers, vendors and employees and might turn
a tad more aggressive in the domestic market, which at the margin is negative for
Bajaj. In addition, higher competition from HMSI in India and from HH in exports
markets makes us view this split as a long-term negative for Bajaj.
Expect the stock to trade on near-term earnings; maintain U-PF
Bottom-line – we believe that nothing much changes for HH near-term. Post FY14,
we expect one negative factor (slightly lower India market share) and two positive
factors (no royalty and higher exports) balancing each other. In either case, we
don’t want to hazard a guess on HH’s market share – margin equation in FY15
and beyond and expect the stock to trade on near-term earnings. Over FY12-13,
we see lack of product triggers in HH and see continued risk to market-share from
Bajaj. Overall, we prefer the 4Ws over 2Ws with M&M and Tata Motors being our
preferred picks. U-PF rating on HH stays.
Details of the split
ƒ Hero Honda (HH) has announced that the Hero Group will buy Honda’s
26% stake in HH. An MOU has been signed for a new licensing
arrangement between the two partners. The definitive agreement will be
signed in the next two weeks and the deal will be concluded sometime
next year.
ƒ No details of the value of the deal have been shared. We don’t know if the
US$1.0-1.2 bn purchase price for the 26% stake as speculated upon by
the media is accurate.
ƒ No specifics of the new royalty structure were shared. However, few
comments were made by HH’s management in the press conference – 1)
“Media comments that royalty will go up to 8% are incorrect”; 2) “Royalty
going forward will be in-line and maybe even lower than current levels”
and 3) “Royalty might start going down from as early as Jan 2011”.
ƒ These statements effectively mean that royalty is not likely to be higher
than current levels. It could also be that management is referring to
royalty as a % of sales here and that the Rs23-24 bn lump sum royalty
figure for the next three years (as mentioned by media) is correct but the
management has a very aggressive volume forecast resulting in royalty as
a % of sales staying the same.
ƒ HH will now have the freedom to export to any market. Under the earlier
agreement, HH was not allowed to export to any country where Honda
had a presence
ƒ The new licensing agreement will cover all existing HH models till Mar
2014 when the agreement expires. The agreement also requires Honda to
provide new models though details here were not shared.
ƒ Company name and brand name will be changed over time. This implies
that the Honda brand will continue to be used in the near term. We
reckon that the use of the Honda brand will cease in 2014.
ƒ HH will now have the freedom to set up its own R&D and product
development capabilities and acquire technology from other sources.
Not much near-term impact on HH
Given that the new licensing agreement covers all existing models, provides
for new model support, allows use of the ‘Honda’ brand till 2014 with no
meaningful change to royalty, we don’t see much change in HH’s operational
and financial situation over FY12-13
Will Honda play fair in the transfer of new models to HH?
We believe that there is a risk of Honda giving its better motorcycle models to
HMSI over the next three years instead of HH. However, this does not concern
us that much since over 70% of HH’s sales still come from the old ‘Splendor’
and ‘Passion’ bikes. All the new bikes that HH has launched over the last few
years cumulatively account for only 8% of its volumes.
TVS-Suzuki split precedent not really relevant
Post the TVS-Suzuki split in September 2001, there was a rise in TVS’ market
share in the two years post the split due to the success of the ‘TVS Victor’.
However market share started dropping in subsequent years as subsequent
model launches didn’t do as well. Royalty dropped to zero but advertising and
selling expenses rose sharply and overall EBITDA margins declined a bit
initially but subsequently improved in two years. R&D and product
development spend also rose from 1% of sales before the split to 2-3% of
sales post split.
However, we don’t believe that this is an apples-to-apples comparison. HH is
on a significantly stronger wicket than TVS was in 2001 and is much better
positioned to develop its own R&D and product development capabilities. We,
however, see a rise in HH’s advertising and selling expenses post FY14 like
TVS did post its split with Suzuki.
Making motorcycles is not rocket science and we believe that the three year
window that HH has is ample time to develop its own R&D and product
development capabilities. There will however be a rise in HH’s R&D spend.
Bajaj spends 1-1.5% of sales on R&D while TVS spends about 2%. The 4W
companies (M&M, Tata Motors and Ashok Leyland) spend a higher 2-3% of
sales on R&D.
At the same time, we don’t expect the road to be completely smooth for HH.
Despite substantial cash resources, Bajaj suffered several product failures
(Wind, Caliber, Discover 125CC, XCD 125CC etc) during its journey to build its
own motorcycles. Getting a motorcycle right requires a combination of the
right technology and specs, good styling and appropriate positioning and a lot
of trial and error. Getting the right team of R&D engineers is also not as easy
as it seems and Bajaj is again an example of the same. We won’t be surprised
if HH too suffer some product failures as well post FY14.
The freedom to export to any export market is definitely a big positive for HH
since it was not allowed to export to any country where Honda had a
presence in the earlier agreement. However, we note that ramp-up in export
markets will not be an easy and quick affair for HH. Bajaj has built its export
presence in African and South and Central American markets after years of
hard work at the ground level understanding local dynamics and nuances and
creating appropriate supply chain infrastructure. We are sceptical of any early
sharp rise in export volumes for HH. However, this is definitely a long-term
positive for HH.
Staff costs could see a drop
We note that the two executive directors from Honda on HH’s board were paid
a combined salary of Rs600 mn in FY10. It is quite possible that other
members of the Munjal family might replace the Honda directors with large
salaries as well. If that does not happen, the staff cost savings post exit of
the two Honda directors could result in a 2% upgrade to our FY12 EPS.
What happens to HH post FY14?
We anticipate some weakening in HH’s India franchise post FY14 when the
new licensing agreement comes to an end. The drop in market share would
be small but we believe that there will be some drop as there could be some
setbacks to HH’s self-made bike launches. We don’t see any meaningful
impact from the ‘Honda’ brand name going away. We believe that models like
‘Splendor’ and ‘Passion’ are big brands by themselves, even with ‘Honda’.
However, this will be compensated by the fact that royalty will go down to
zero post FY14 and HH will hopefully have improved its exports presence
substantially by then.
Our DCF for HH throws up a value of Rs1907
Given that there will be a structural change in HH’s operational and financial
situation post FY14, we believe that there is merit in looking at a DCF
valuation of the company.
We assume 2W industry growth at 13% over FY11-15 and 8% over FY16-20
and assume HH’s market share at 51% over FY11-15 and at 48% over FY16-
20. We assume exports rising to 9% of sales (1.3 mn units) by FY20 from 2%
in FY10. Over FY15-20, we factor in zero royalty, higher advertising and
marketing spend and assume R&D spend at ~1.5% of sales with 100%
expensing. EBITDA margins are at ~13% over FY15-20 (14.5% excluding the
100% expensed R&D spend).
Using a WACC of 13% and a terminal growth of 4%, we get a DCF value of
Rs1907 for HH, which implies 15.4x FY12 P/E.
However, we are reluctant to make sweeping assumptions on HH’s market
share – margin equation post FY14 and believe that the stock will continue to
trade on near-term earnings. Our target price of HH is Rs1830 – average of
FY12 and FY13 target prices at 14x P/E – equal to its historical average.
HMSI will be more aggressive, but not immediately
HMSI is now certain to turn more aggressive post this split in terms of
capacity / network expansion and product roll-out. However, we believe that
this will take some time and expect HMSI’s big push to happen in FY13 and
not in FY12. HMSI is also reportedly planning to set up 0.6 mn unit capacity
plant in Rajasthan in FY12 at a capex of US$110mn. Contrary to perception,
HMSI already has a fairly large network but we do see some risk of HMSI
trying to poach dealers from HH/Bajaj.
However, HMSI has not really set the charts on fire in the motorcycle segment
thus far. All its bike launches till 2010 have been in the 125CC+ segment and
have never competed directly with HH. In early 2010, HMSI launched its first
100CC bike – ‘Twister’, which has seen a lukewarm response in the market.
HMSI, too, will have an uphill climb in the Indian motorcycle market.
HH-Honda split is a long-term negative for Bajaj
It is quite possible that HH will not want to see any drop in market share
immediately post split to boost morale of its dealers, vendors and employees
and might turn a tad more aggressive in the domestic market, which at the
margin is negative for Bajaj. However, this will mean higher competition for
Bajaj in the executive motorcycle segment, which accounts for only 17% of
Bajaj’s EBITDA. HH does not compete much with Bajaj in the premium
motorcycle segment.
In the longer-term, higher competition from HMSI in India and from HH in
exports markets makes us view this split as a long-term negative for Bajaj.
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