Stock Review: Hero Honda

 

Hero Honda is grappling with aggressive rivals and a fall in market share. Its performance over the past two years has been mediocre compared to its nearest rival. Investors are likely to find limited upside in the company

   Hero Honda is the largest player in the domestic twowheeler market, and like other players in the sector, it has been grappling with high input costs for the past several quarters. In addition, its Japanese partner Honda recently exited the local joint venture.

A new licensing agreement has been signed with Honda, but it appears inevitable that Hero Honda would need to boost its R&D budget to develop new motorcycle models. This in turn could continue to put pressure on its operating margins. The company's financial performance vis-à-vis its nearest rival Bajaj Auto was quite mediocre during the two years ended March 2011. And even though Hero Honda has posted strong sales in the current fiscal, rising auto finance rates could dampen growth prospects for the industry.

BUSINESS

Hero Honda has a strong focus on the 75-125 cc motorcycle segment via its models Passion and Splendor. For the premium 125 cc plus segment, it competes with the Ambition and CBZ models.
The company also has a presence in the scooter segment with the Pleasure model. Scooters accounted for about 6-7% of its total twowheeler sales during FY 11. It sold 5.4 million two-wheelers in FY 11 at a two-year compounded growth rate (CAGR) of 20.5%.
Rival Bajaj Auto grew its twowheeler sales at a CAGR of 32% during this period to 3.82 million units. As a result, Hero Honda's market share fell to nearly 56 % at end of FY11, compared to 62% at end of the June 2009 quarter. To retain its market share, the company will have to consider ways to introduce new models either through indigenous R&D or design outsourcing.

GROWTH DRIVERS

Hero Honda grew its capacity by 0.75 million units to 6.15 million units during the year ended March 2011. It has also expanded its dealer network in rural markets, helped by a strong revival in the agri-sector. The company is also expected to shortly announce the location of its fourth plant. It is expanding at a time when competition has become intense.

FINANCIALS

Hero Honda's financial performance has lagged that of Bajaj Auto. For example, during the years from March 2009 to March 2011, Hero Honda's net sales grew at a CAGR of 25.2 % to 19, 401 crore while operating profit improved 20.4 %. In contrast, Bajaj Auto's net sales improved at a CAGR of 37.3 % during this period, while operating profit grew 84.5 %.

CONCERNS

Recently, the Japan-based Honda group exited the local joint venture. Hero Honda has entered into a new licence agreement with Honda Motor. Under this deal, it would pay nearly 2,479.3 crore till June 2014. This license fee would be amortised during this period by Hero Honda. Post split, Hero Honda will have to enlarge its R&D budget over the next few years, in a bid to develop its own models. In addition, the company is expected to ramp up its marketing and advertising budgets over the next few quarters. The above measures could continue to hurt the company's operating margins. Also, while commodity input prices have shown signs of fatigue in the last few weeks, they still remain at elevated levels.

VALUATIONS

At 1,866.2, the stock of Hero Honda trades at a P/E of 19.3 on a trailing four-quarter basis. The valuation looks expensive given that Bajaj Auto trades at a P/E of 12 times, while TVS Motor is at 12.9 times. Given its higher valuation and declining market share due to intense competition, the upside in Hero Honda looks limited in the medium term. Instead, investors could consider Bajaj Auto.