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.Hero Honda stock is expected to remain
volatile until clarity emerges on the Hero group’s product strategy after the split between
Hero and Honda. We believe valuations are rich, trading at 14.7X FY2012E EPS at a 7%
premium to historical averages given our expectations of moderate earnings growth
(10% CAGR over FY2011-13E). Hence, we maintain REDUCE rating on the stock.
Industry structure may not change dramatically till 2014
We believe the two-wheeler industry structure is not going to change dramatically till 2014 as
Honda will take time to expand its distribution network and Hero will have Honda’s technology till
2014. However, we expect the two-wheeler industry volume growth to moderate to 14% yoy in
2012 after a 20% yoy growth in FY2011E. We forecast Hero Honda to lose 100 bps market share
in 2012 as competitors become aggressive in launching new products. We estimate Hero Honda’s
domestic volumes to grow at 12% CAGR over FY2011-13E. We do not forsee a pricing war to
emerge in the industry as top-3 players are operating at capacity utilization levels of close to 90%
but believe pricing power will be limited and won’t be enough to compensate for the rising raw
material costs.
EBITDA margins to decline on rise in R&D, royalty expenses
We forecast higher R&D expenses (1.3% of net sales vs 0.2% earlier) and royalty expenses (3% of
net sales vs 2.6% earlier) to factor in higher royalty to Honda on new products post split with the
Hero group and higher R&D expenses as Hero group develops its own R&D. We expect EBITDA
margins to decline by 90 bps yoy in 2012E due to higher royalty, R&D expenses and limited pricing
power.
Valuations still rich and not in the value zone
We believe company’s valuations are rich considering slowing earnings growth and margin
pressures on account of increase in royalty and R&D expenses. However, we believe de-rating of
the company in the short term is difficult as we do not expect the two-wheeler industry structure
to change dramatically till 2014 in terms of both market share trends and competitive intensity.
However, premium valuations to historical average are also not justified, in our view, given
declining EBITDA margins and our expectations of slowing growth in the two-wheeler industry.
Hence, we value the company at historical average levels of 13.5X PE on our 2012E EPS. Our
target price is Rs1,494 implying 8% downside from current levels.
Maintain REDUCE rating on slowing earnings trajectory
We maintain REDUCE rating on the stock as we believe Hero Honda’s earnings growth is
likely to slow to 10% CAGR over FY2011-13E due to (1) a slowdown in two-wheeler
industry growth to 14% yoy in FY2012E from 20% yoy in FY2011E and Hero Honda loses
100 bps market share, (2) higher R&D and royalty expenses could lead to lower margins, and
(3) limited pricing power. We believe Hero Honda is in a precarious situation as they will
have to pay higher royalty and also build their own R&D capability by hiring skilled
manpower till 2014 to protect their market share beyond 2014. Stock trades at 14.7X which
is at a 7% premium to historical averages, which we believe is unjustified given headwinds to
margins and revenue growth in light of slower industry growth.
Higher royalty rates and R&D expenses to impact EBITDA margins
We forecast a 90 bps yoy decline in EBITDA margins in 2012E as we increase our (1) royalty
rate assumption to 3% of net sales (from 2.6% earlier) as we assume Hero Honda will pay
higher royalty to Honda post split on new product launches, and (2) the company will have
to incur higher R&D expenditure to build R&D capability beyond 2014 and we assume R&D
expenses at around 1.3% of net sales (Rs2,747 mn vs Bajaj’s annual R&D cost of Rs1,347
mn) due to higher market share than Bajaj Auto.
We have also shown a sensitivity to royalty rate increase as a % of net sales. Every 1%
increase in royalty rates as a % of net sales will impact our earnings estimates by 8%.
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