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Hero Honda (HH)
Automobiles
Sharp run-up ignores potential risks. A sharp run in Hero Honda’s stock price
appears to factor in an improvement in EBITDA margins. We believe margins could face
risks from (1) the sharp increase in costs related to R&D and promotion, (2) limited
pricing power and (3) limited visibility on management’s efforts to localize imported
components. The stock trades at a 16.6X PE multiple on our FY2012E estimates at a
23% premium to historical average which we believe is expensive for 12% yoy earnings
growth. Maintain Reduce rating.
Volume growth and pricing stability key to improving EBITDA margins
EBITDA margins for Hero Honda declined by 176 bps over FY2006-2009 driven by a muted 7%
CAGR in volumes, pricing pressure as Bajaj Auto became aggressive in a bid to maintain market
share despite efforts by Hero Honda to increase localization of components and increase sourcing
from group auto component companies. We believe it will be very difficult for Hero Honda to
retain benefits of improvement in localization, which could potentially improve EBITDA margins by
0.7-1.1% given increasing competition in the two wheeler industry and moderating volume
growth outlook.
We forecast a 100 bps decline in Hero Honda’s market share
We also forecast a 100 bps decline in market share for Hero Honda in domestic motorcycles in
FY2012E driven by (1) superior product momentum of Bajaj Auto, (2) increase in competition from
Honda and (3) capacity constraints at Hero Honda (we expect capacity utilization to reach 97% by
FY2012E). Hence, we forecast a 10% yoy volume growth for Hero Honda in FY2012E.
We forecast a 40 bps yoy decline in EBITDA margins in FY2012E
We forecast a 40 bps yoy decline in EBITDA margins in FY2012E driven by increasing input cost
pressures, increase in rebranding and R&D costs offset by increase in production at Haridwar plant,
stable pricing power and salary cost savings due to resignation of Japanese directors from Hero
Honda’s board.
We maintain our REDUCE rating but increase our target price slightly to Rs 1,510 (from Rs 1,485)
We maintain our REDUCE rating on the stock but increase our target price slightly due to 1-1.7%
upward revision in earnings over FY2011-2013E. Earnings revision primarily reflects increase in our
volume estimates. Our target price of Rs 1,510 is based on 13.5X PE multiple on our FY2012E EPS.
EBITDA margin expansion looks too optimistic
We analyze the reasons underlying the market’s enthusiasm regarding Hero Honda’s EBITDA
margin expansion and our view on risks to those assumptions.
We believe increase in sourcing from group companies and increase in localization efforts
are not the key drivers for margin expansion. Since 2005, raw material sourced from Hero
Honda’s group companies as a percentage of total raw material cost has increased from
27% to 33% in FY2010 while the imported components as a proportion of total raw
material cost has remained static despite an improvement in product mix.
Hero Honda’s auto component group companies operate at low EBITDA margins as
indicated from financial history of Munjal Showa and Sunbeam Auto Limited. The company
has also made significant efforts to reduce imported components proportion in overall raw
material cost. However, EBITDA margins for Hero Honda declined by 176 bps over FY2006-
FY2009 which was for the following reasons:
1) In FY2007, Bajaj Auto followed an aggressive pricing strategy in a bid to gain
market share and Hero Honda followed. Despite an aggressive pricing strategy,
Bajaj Auto gained only 1.7% market share in motorcycles in FY2007 but EBITDA
margins of Bajaj Auto and Hero Honda declined by 2.7-3.7%, respectively, during
this period.
2) In FY2008, domestic motorcycle industry declined by 13% yoy and Bajaj Auto
domestic volumes declined by 23% yoy while Hero Honda volumes were flat.
Industry volumes declined because of a sharp rise in interest costs on account of
which banks curtailed lending to the sector. In FY2008, about 60% of domestic
motorcycles were financed. EBITDA margins for Bajaj Auto declined by 80 bps while
for Hero Honda, EBITDA margins increased by 120 bps yoy.
3) FY2009 was also a tough year for domestic motorcycle industry with volumes being
flat yoy. Hero Honda EBITDA margins improved by 80 bps yoy largely due to 5.3%
increase in market share while Bajaj Auto’s margins declined by 60 bps yoy as it lost
6.9% market share.
4) FY2010 saw a sharp rebound in volumes due to government stimulus package
(sixth pay commission and cut in excise duties). Domestic motorcycle volumes
increased by 26% yoy in FY2010 and EBITDA margins for both companies reached
historic highs because of the sharp decline in raw material costs which was not
passed through by companies to consumers because of strong demand.
5) FY2011 was also a repeat of FY2010 with a 23% yoy growth in domestic
motorcycle volumes but Bajaj Auto gained 2.5% market share while Hero Honda
lost 3.9% market share during this period. Bajaj Auto EBITDA margins declined by
1.7% yoy due to sharp rise in input costs while Hero Honda EBITDA margins
declined sharply by 5% in FY2011. Hero Honda got adversely impacted by changes
in emission norms due to which company had to incur higher input costs while
Bajaj Auto’s bikes were compliant for BS-3 norms.
Hence, it is clear that volume growth and pricing stability is critical to improve margins for
two wheeler companies. Localization of components could potentially lead to improvement
in margins, however, if industry volumes does not grow as per expectations of companies,
they could be willing to sacrifice margins for market share. Bajaj Auto is enjoying EBITDA
margins of 20% which were last seen by the company in FY2003. Given that Honda is
increasing capacities and becoming more aggressive, we do not see a possibility of Hero
Honda retaining benefits derived from localization which may also take some time to fructify.
We also forecast a 100 bps decline in market share for Hero Honda in domestic motorcycles
in FY2012E driven by (1) superior product momentum of Bajaj Auto. Bajaj Auto has just
launched Discover 125cc to complete the gap in its product portfolio while Hero Honda will
be launching upgrades of existing models and launch two new motorcycles which will be
given by Honda as part of their new agreement. In our view, the products offered by Honda
would be in the premium segment which is unlikely to help Hero Honda in maintain its
market share, (2) Honda has also announced that it may launch a 100cc bike in a bid to
increase its market share. Honda will also increase its capacity from 1.6 million units to 2.2
mn units by July 2011. Hero Honda is also facing capacity constraints and has an installed
capacity of 6.2 mn units (we expect capacity utilization to reach 97% by FY2012E). The
company is looking for a fourth plant to increase capacities which may take 18-24 months
to come on stream in our view and (3) Bajaj Auto has a market share of 27%, which is still
5% below its peak market share.
EBITDA margins walkdown
We have presented EBITDA walkdown in the table below:
1) Positive impact on EBITDA margins could come through from increase in production
from Haridwar plant, a slight improvement in product mix, stable pricing power in
FY2012E (giving benefit of doubt because capacity utilization is high) and salary
savings due to resignation of Honda directors.
2) Negative impact on EBITDA margins could come through from an increase in raw
material cost pressures, increase in rebranding costs and increase in costs related to
setting up of R&D network. We have not assumed an increase in costs related to
setting up an export distribution network.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Hero Honda (HH)
Automobiles
Sharp run-up ignores potential risks. A sharp run in Hero Honda’s stock price
appears to factor in an improvement in EBITDA margins. We believe margins could face
risks from (1) the sharp increase in costs related to R&D and promotion, (2) limited
pricing power and (3) limited visibility on management’s efforts to localize imported
components. The stock trades at a 16.6X PE multiple on our FY2012E estimates at a
23% premium to historical average which we believe is expensive for 12% yoy earnings
growth. Maintain Reduce rating.
Volume growth and pricing stability key to improving EBITDA margins
EBITDA margins for Hero Honda declined by 176 bps over FY2006-2009 driven by a muted 7%
CAGR in volumes, pricing pressure as Bajaj Auto became aggressive in a bid to maintain market
share despite efforts by Hero Honda to increase localization of components and increase sourcing
from group auto component companies. We believe it will be very difficult for Hero Honda to
retain benefits of improvement in localization, which could potentially improve EBITDA margins by
0.7-1.1% given increasing competition in the two wheeler industry and moderating volume
growth outlook.
We forecast a 100 bps decline in Hero Honda’s market share
We also forecast a 100 bps decline in market share for Hero Honda in domestic motorcycles in
FY2012E driven by (1) superior product momentum of Bajaj Auto, (2) increase in competition from
Honda and (3) capacity constraints at Hero Honda (we expect capacity utilization to reach 97% by
FY2012E). Hence, we forecast a 10% yoy volume growth for Hero Honda in FY2012E.
We forecast a 40 bps yoy decline in EBITDA margins in FY2012E
We forecast a 40 bps yoy decline in EBITDA margins in FY2012E driven by increasing input cost
pressures, increase in rebranding and R&D costs offset by increase in production at Haridwar plant,
stable pricing power and salary cost savings due to resignation of Japanese directors from Hero
Honda’s board.
We maintain our REDUCE rating but increase our target price slightly to Rs 1,510 (from Rs 1,485)
We maintain our REDUCE rating on the stock but increase our target price slightly due to 1-1.7%
upward revision in earnings over FY2011-2013E. Earnings revision primarily reflects increase in our
volume estimates. Our target price of Rs 1,510 is based on 13.5X PE multiple on our FY2012E EPS.
EBITDA margin expansion looks too optimistic
We analyze the reasons underlying the market’s enthusiasm regarding Hero Honda’s EBITDA
margin expansion and our view on risks to those assumptions.
We believe increase in sourcing from group companies and increase in localization efforts
are not the key drivers for margin expansion. Since 2005, raw material sourced from Hero
Honda’s group companies as a percentage of total raw material cost has increased from
27% to 33% in FY2010 while the imported components as a proportion of total raw
material cost has remained static despite an improvement in product mix.
Hero Honda’s auto component group companies operate at low EBITDA margins as
indicated from financial history of Munjal Showa and Sunbeam Auto Limited. The company
has also made significant efforts to reduce imported components proportion in overall raw
material cost. However, EBITDA margins for Hero Honda declined by 176 bps over FY2006-
FY2009 which was for the following reasons:
1) In FY2007, Bajaj Auto followed an aggressive pricing strategy in a bid to gain
market share and Hero Honda followed. Despite an aggressive pricing strategy,
Bajaj Auto gained only 1.7% market share in motorcycles in FY2007 but EBITDA
margins of Bajaj Auto and Hero Honda declined by 2.7-3.7%, respectively, during
this period.
2) In FY2008, domestic motorcycle industry declined by 13% yoy and Bajaj Auto
domestic volumes declined by 23% yoy while Hero Honda volumes were flat.
Industry volumes declined because of a sharp rise in interest costs on account of
which banks curtailed lending to the sector. In FY2008, about 60% of domestic
motorcycles were financed. EBITDA margins for Bajaj Auto declined by 80 bps while
for Hero Honda, EBITDA margins increased by 120 bps yoy.
3) FY2009 was also a tough year for domestic motorcycle industry with volumes being
flat yoy. Hero Honda EBITDA margins improved by 80 bps yoy largely due to 5.3%
increase in market share while Bajaj Auto’s margins declined by 60 bps yoy as it lost
6.9% market share.
4) FY2010 saw a sharp rebound in volumes due to government stimulus package
(sixth pay commission and cut in excise duties). Domestic motorcycle volumes
increased by 26% yoy in FY2010 and EBITDA margins for both companies reached
historic highs because of the sharp decline in raw material costs which was not
passed through by companies to consumers because of strong demand.
5) FY2011 was also a repeat of FY2010 with a 23% yoy growth in domestic
motorcycle volumes but Bajaj Auto gained 2.5% market share while Hero Honda
lost 3.9% market share during this period. Bajaj Auto EBITDA margins declined by
1.7% yoy due to sharp rise in input costs while Hero Honda EBITDA margins
declined sharply by 5% in FY2011. Hero Honda got adversely impacted by changes
in emission norms due to which company had to incur higher input costs while
Bajaj Auto’s bikes were compliant for BS-3 norms.
Hence, it is clear that volume growth and pricing stability is critical to improve margins for
two wheeler companies. Localization of components could potentially lead to improvement
in margins, however, if industry volumes does not grow as per expectations of companies,
they could be willing to sacrifice margins for market share. Bajaj Auto is enjoying EBITDA
margins of 20% which were last seen by the company in FY2003. Given that Honda is
increasing capacities and becoming more aggressive, we do not see a possibility of Hero
Honda retaining benefits derived from localization which may also take some time to fructify.
We also forecast a 100 bps decline in market share for Hero Honda in domestic motorcycles
in FY2012E driven by (1) superior product momentum of Bajaj Auto. Bajaj Auto has just
launched Discover 125cc to complete the gap in its product portfolio while Hero Honda will
be launching upgrades of existing models and launch two new motorcycles which will be
given by Honda as part of their new agreement. In our view, the products offered by Honda
would be in the premium segment which is unlikely to help Hero Honda in maintain its
market share, (2) Honda has also announced that it may launch a 100cc bike in a bid to
increase its market share. Honda will also increase its capacity from 1.6 million units to 2.2
mn units by July 2011. Hero Honda is also facing capacity constraints and has an installed
capacity of 6.2 mn units (we expect capacity utilization to reach 97% by FY2012E). The
company is looking for a fourth plant to increase capacities which may take 18-24 months
to come on stream in our view and (3) Bajaj Auto has a market share of 27%, which is still
5% below its peak market share.
EBITDA margins walkdown
We have presented EBITDA walkdown in the table below:
1) Positive impact on EBITDA margins could come through from increase in production
from Haridwar plant, a slight improvement in product mix, stable pricing power in
FY2012E (giving benefit of doubt because capacity utilization is high) and salary
savings due to resignation of Honda directors.
2) Negative impact on EBITDA margins could come through from an increase in raw
material cost pressures, increase in rebranding costs and increase in costs related to
setting up of R&D network. We have not assumed an increase in costs related to
setting up an export distribution network.
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