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UBS Investment Research
Hero Honda Ltd.
Negatives priced in, upgrade to Buy
Upgrade Hero Honda (HH) to Buy, maintain price target of Rs1,950
HH has corrected sharply (down c9%) in the past five days over concerns of
Honda’s exit and the higher royalty payments by Hero as speculated by media (not
confirmed by the company). We believe the negatives are priced in at the current
levels and a strong dividend yield of ~3% provides strong downside support to the
stock price at current levels. We upgrade HH from Neutral to Buy and maintain
our price target of Rs1,950.
Royalty a near-term overhang, margins to stabilise post FY14E
We believe higher royalty as speculated by media is a near-term issue. We expect
the EBITDA margins to stabilise at a cycle average of ~14.5% post the expiry of
the existing product agreement with Honda in June 2014. We believe positive
newsflow in terms of new capacity addition and export plans could drive the stock
price once the deal is closed.
Reducing FY12/13 estimates, raising royalty
We lower our FY12/13 margin assumptions by 140/50 bps to 13.1%/13.6% after
incorporating a 50% increase in royalty/bike to 3.6% (of sales) from FY12. This
leads to a 7.3%/1.1% decline in EPS estimates for FY12/13. In the worst case, a
2% higher royalty as percentage of sales versus our base case would lower EPS by
15% for FY12E. We maintain our positive view on two-wheeler industry growth in
India and expect HH volumes to grow 15%/11% YoY in FY12/13.
Valuation: upgrade to Buy, price target of Rs1,950 (unchanged)
We derive our price target from a DCF-based methodology and explicitly forecast
long-term valuation drivers using UBS’s VCAM tool, assuming a WACC of
11.3%.
Negatives priced in, upgrade to Buy
The stock has underperformed significantly particularly in the last couple of
days over concerns relating to Honda’s exit and higher royalty payments by
Hero as speculated by media (not disclosed by the company). We believe the
negatives are priced in at the current levels and a strong dividend yield of ~3%
provides strong downside support to the stock price at current levels.
Honda to sell its 26% stake in Hero Honda
According to media reports (The Economic Times, 16 December 2010), Honda
is selling its stake in Hero Honda to the Indian partner (Munjal family) at a
significant discount to the current market price. The Indian promoters are likely
to raise cash for buying the stake by putting this acquired shareholding in a SPV
and selling part stake in the SPV to private equity firms.
Honda is likely to maintain the technology agreement till 2014; however, the
royalty is expected to increase from current levels.
UBS Japanese auto analyst, Tatsuo Yoshida, believes that although the loss of
equity income is a negative, Honda will have more freedom and flexibility in its
motor cycle business in India. In addition to HH, Honda has its 100%
subsidiary (HMSI: Honda Motorcycle and Scooter India). With two operations
(HH and HMSI) existing, Honda had to consider a balance between these
operations. If HMSI becomes the only operation of Honda in India, Honda will
be able to give full support financially and technically without any hesitation. In
addition, decision-making speed (which is one of Honda's core competences)
will improve further.
Royalty increase—a near-term issue
We believe higher royalty as speculated by media is a near-term issue. We
believe the long-term margins are unlikely to be impacted by a near-term
increase in royalty. The company announced a 2% price hike from 1 October.
We expect the EBITDA margins to stabilise at a cycle average of ~14.5% post
the expiry of the existing product agreement with Honda in June 2014.
Mgmt. says no change in royalty
Honda to exit the co. in a phased manner, provide support and new models
Hero Honda today announced that Honda will sell its 26% stake to the Hero group
in a phased manner at an undisclosed price. Honda name will be dropped from the
co. name over a period of time likely by 2014. Co. also signed a new licensing
agreement with Honda on technology transfer for new models. Honda will also
continue to provide technical support to the co. However, no details were given
regarding the tenure of technical support agreement and royalty on new models.
Hero Honda to benefit from opportunity to grow internationally
Post new licensing agreement, Hero Honda will be free to sell its products globally
in any market. In addition, they will be able to seek/acquire new technological
partner internationally as well as set up their own R&D. Mgmt. is clearly focused
on growth and expects to announce location of the fourth plant soon.
Lack of royalty increase implies upside to estimates
According to mgt, royalty payments will be at the existing rate in near term and
will decline going forward as licensing agreements for the existing models expire.
Our current base case assumes royalty to increase by 1% to 3.6% of sales in FY12
from 2.6% in FY11. Given mgt. expectations of no change in royalty payments
going fwd, there exists 7-8% upside to our FY12/FY13 EPS estimates.
Valuation-maintain Buy and PT of Rs.1,950
We derive our price target from a DCF-based methodology and explicitly forecast.
long-term valuation driver using UBS’s VCAM tool, assuming a WACC of 11.3%
Reducing FY12/13 margin estimates
We lower our FY12/13 margin assumptions by 140/50 bps to 13.1%/13.6% after
incorporating a 50% increase in royalty/bike from FY12. This leads to a
7.3%/1.1% decline in EPS estimates to Rs114/135 in FY12/13. However, we
maintain our positive view on the two-wheeler industry growth in India. We
expect HH volumes to grow 15%/11% YoY in FY12/13.
Valuation
We upgrade Hero Honda from Neutral to Buy as we believe most of the
concerns relating to JV culmination as well as potential downside risk from a
near-term increase in royalty are now in the price. We expect the longer-term
EBITDA margins to revert to a cycle average (FY04-FY09) of ~14.5%.
We therefore believe DCF remains the best measure for valuing the company.
We derive our price target from a DCF-based methodology and explicitly
forecast long-term valuation drivers using UBS’s VCAM tool with a WACC of
11.3%.We maintain our price target of Rs1,950.
We believe Hero’s market position is unlikely to be impacted significantly in the
near term due to Honda’s exit.
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