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Hero Honda Motors (HROH.BO)
Sell Equity Research
Assessing potential for margin reversal, and risks to valuation; Sell
What's changed
In this note we detail our stand on key questions we have received recently
from investors and quantify valuation risks.
Implications
1. What was fundamental driver of Hero Honda’s margin erosion
during 2010 (6ppt, among the highest relative to Indian auto coverage)?
We believe this was potentially driven by exposure to the economy
segment, component supply issues and lower operating leverage.
2. Do we think some or all of the lost margins can be recovered
through price increases or vendor / procurement management in FY12E? We
believe this could be challenging in an inflationary environment, with
downside risks to industry demand growth (refer “Increasing cyclical risks;
downgrading Hero Honda, M&M to Sell”, Jan 27, 2011). Hero Honda’s
material cost per unit is already low relative to 2-wheeler peers in our view.
3. What is the impact if company can reverse this margin erosion?
Assuming 15% FY12E EBITDA margin (vs 11.3% in Dec’11 quarter, and
12.8% FY12E Bloomberg cons) on 20% topline growth (vs 15% cons)
implies potential stock price variance of 15% on normalized multiples. We
also believe margin volatility in a largely stable demand environment so
far could reduce market confidence in earnings in the long run.
4. What do we think of renewed competition from Honda in FY12?
We view Honda’s India strategy poses incremental challenges to other
players in the industry. We also note that Honda has had limited impact on
Bajaj Auto’s dominance of the premium motorcycle segment since 2004.
Valuation
Hero Honda is currently trading at 12.6X FY12E P/E vs 12.7X 10-year
average, Indian peers at 12.3X and global peers at 10.0X. We reiterate our
Sell rating and FY12E P/E based 12m TP of Rs1,509.
Key risks
Lower than expected raw material costs or competition from Honda.
INVESTMENT LIST MEMBERSHIP
Asia Pacific Sell List
1. What was the fundamental driver of Hero Honda’s margin erosion during 2010 (6ppt,
among the highest relative to Indian auto industry, Exhibit 1)?
We believe this was potentially driven by exposure to the economy segment, component
supply issues and lower operating leverage.
2. Do we think the company can recover some or all of the lost margins through price
increases or more effective vendor / procurement management during FY2012E?
a) We believe this could be challenging in an inflationary environment, with downside
risks to industry demand growth (refer “Increasing cyclical risks; downgrading Hero
Honda, M&M to Sell”, Jan 27, 2011).
b) Further, margins could come under pressure from higher R&D and branding costs in
the near term, in our view.
c) We also believe that Hero Honda’s per unit raw material costs already seem low
relative to Bajaj Auto and TVS Motors (Exhibit 2), and margin upside from further
rationalizing of the vendor base could be limited in our view.
3. What is the likely impact on valuation if company can reverse this margin erosion?
a) Assuming 15% FY12E EBITDA margin (vs 11.3% in Dec’11 quarter, and 12.8% FY12E
Bloomberg cons) on 20% topline growth (vs 15% cons) implies potential stock price
variance of 15% on normalized multiples (Exhibit 3).
b) We believe that higher volatility in margins in a largely stable demand environment
could also reduce market confidence in earnings, with corresponding risk to valuation
multiples in our view.
4. What do we think of renewed competition from Honda, after their exit from the JV?
We view Honda’s India strategy as an incremental challenge to other players in the
industry. We also note that Honda has been competing in the premium motorcycle
segment since 2004 with limited impact so far on Bajaj Auto’s dominance of that segment.
(refer “Hero Honda: JV split – potentially transformational, tactical challenges; Neutral”
dated Dec 17, 2010, and “Hero Honda Motors (HROH.BO): Hero Honda announces
valuation for Honda stake purchase; Sell” dated March 08 2011).
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Hero Honda Motors (HROH.BO)
Sell Equity Research
Assessing potential for margin reversal, and risks to valuation; Sell
What's changed
In this note we detail our stand on key questions we have received recently
from investors and quantify valuation risks.
Implications
1. What was fundamental driver of Hero Honda’s margin erosion
during 2010 (6ppt, among the highest relative to Indian auto coverage)?
We believe this was potentially driven by exposure to the economy
segment, component supply issues and lower operating leverage.
2. Do we think some or all of the lost margins can be recovered
through price increases or vendor / procurement management in FY12E? We
believe this could be challenging in an inflationary environment, with
downside risks to industry demand growth (refer “Increasing cyclical risks;
downgrading Hero Honda, M&M to Sell”, Jan 27, 2011). Hero Honda’s
material cost per unit is already low relative to 2-wheeler peers in our view.
3. What is the impact if company can reverse this margin erosion?
Assuming 15% FY12E EBITDA margin (vs 11.3% in Dec’11 quarter, and
12.8% FY12E Bloomberg cons) on 20% topline growth (vs 15% cons)
implies potential stock price variance of 15% on normalized multiples. We
also believe margin volatility in a largely stable demand environment so
far could reduce market confidence in earnings in the long run.
4. What do we think of renewed competition from Honda in FY12?
We view Honda’s India strategy poses incremental challenges to other
players in the industry. We also note that Honda has had limited impact on
Bajaj Auto’s dominance of the premium motorcycle segment since 2004.
Valuation
Hero Honda is currently trading at 12.6X FY12E P/E vs 12.7X 10-year
average, Indian peers at 12.3X and global peers at 10.0X. We reiterate our
Sell rating and FY12E P/E based 12m TP of Rs1,509.
Key risks
Lower than expected raw material costs or competition from Honda.
INVESTMENT LIST MEMBERSHIP
Asia Pacific Sell List
1. What was the fundamental driver of Hero Honda’s margin erosion during 2010 (6ppt,
among the highest relative to Indian auto industry, Exhibit 1)?
We believe this was potentially driven by exposure to the economy segment, component
supply issues and lower operating leverage.
2. Do we think the company can recover some or all of the lost margins through price
increases or more effective vendor / procurement management during FY2012E?
a) We believe this could be challenging in an inflationary environment, with downside
risks to industry demand growth (refer “Increasing cyclical risks; downgrading Hero
Honda, M&M to Sell”, Jan 27, 2011).
b) Further, margins could come under pressure from higher R&D and branding costs in
the near term, in our view.
c) We also believe that Hero Honda’s per unit raw material costs already seem low
relative to Bajaj Auto and TVS Motors (Exhibit 2), and margin upside from further
rationalizing of the vendor base could be limited in our view.
3. What is the likely impact on valuation if company can reverse this margin erosion?
a) Assuming 15% FY12E EBITDA margin (vs 11.3% in Dec’11 quarter, and 12.8% FY12E
Bloomberg cons) on 20% topline growth (vs 15% cons) implies potential stock price
variance of 15% on normalized multiples (Exhibit 3).
b) We believe that higher volatility in margins in a largely stable demand environment
could also reduce market confidence in earnings, with corresponding risk to valuation
multiples in our view.
4. What do we think of renewed competition from Honda, after their exit from the JV?
We view Honda’s India strategy as an incremental challenge to other players in the
industry. We also note that Honda has been competing in the premium motorcycle
segment since 2004 with limited impact so far on Bajaj Auto’s dominance of that segment.
(refer “Hero Honda: JV split – potentially transformational, tactical challenges; Neutral”
dated Dec 17, 2010, and “Hero Honda Motors (HROH.BO): Hero Honda announces
valuation for Honda stake purchase; Sell” dated March 08 2011).
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