Hero Honda : Sell



Shareholders can use the recent rally to sell and lock into profits on the Hero Honda stock. Following uncertainty after the split with Honda, the shares touched a 52-week low of Rs 1,378 in end-February 2011. The stock has since moved up by 30 per cent, closing at Rs 1795 on Friday.

At this price, Hero Honda's valuations are at a premium to Bajaj Auto. While the latter trades at 15 times its trailing 12-month earnings and 13 times its estimated FY-12 earnings currently, Hero Honda discounts its trailing earnings by 18 times and its current year earnings by 15.5 times. However, investors who wish to have exposure to the stock can consider entering at lower levels later on.

Profit growth stunted

Despite being a year of high volume growth, the company's year-on-year profit growth has dipped in every quarter of 2010-11. For the quarter-ended March 2011, net profits dropped by 16 per cent, year-on-year, to Rs 502 crore, even as net sales grew by 31 per cent to Rs 5,351 crore for the same period. Pressures from spiralling input costs and an inability to effect as much price increases as competitors have been the major reasons for the same.

Raw material costs, as a percentage of sales, shot up to 73 per cent during the quarter from 68 per cent a year ago. . Adjusted operating margins (adjusted for change in accounting treatment of royalty for existing products which was earlier expensed off but is now treated as licence fee, an intangible asset and amortised) came in at around 12 per cent, down from 17 per cent a year ago.

Going forward, the Society of Indian Automobile Manufacturers (SIAM) expects industry growth (inclusive of cars, bikes and commercial vehicles) to settle at about 12-15 per cent this year. In this case, the company may find it more difficult to effect price increases, as it may become a gamble with demand. Besides, the company does not have the advantage of a product mix that is tiled towards executive and premium bikes such as that of Bajaj.

The latter's ability to hold on to profit margins at around 20 per cent stems from its strong brands in mid-to-premium motorcycles and its good hold on the three-wheelers market. It derives 11 per cent of its revenues from three-wheeler sales where margins are in excess of 30 per cent. Also, about 28 per cent of Bajaj's revenues come from exports, where margins are higher than 20 per cent. Majoring in lower-margin commuter bikes, with no three-wheeler offerings and export restrictions until it recently parted ways with Honda, Hero Honda scores poorly on this front. Exports, however, may gain traction over the medium-term.

Increased marketing expenses (in the form of offers/discounts) to keep the volumes ticking, expenses relating to rebranding and stepping up of R&D efforts and further royalty payable on any new products may still play spoilsport on margins.

Challenged by competition

Apart from this, macro-economic factors such as high inflation, interest rate increases and input cost escalations are expected to moderate the pace of growth in the industry. In such a scenario, Bajaj Auto may be better placed to handle a slowdown than Hero Honda. With a variety of products beginning from CD Dawn, CD Deluxe, Splendor and its variants, Hero Honda has remained the undisputed market leader in the up to 125 cc segment bikes category .

However, the company has faced stiff competition in the last two years and has grown at a slower pace than the sector ever since. In 2010-11, the company's volumes in this core entry segment grew only by 13 per cent, as against the industry growth of 19 per cent. As a result, Hero Honda's market share in this segment, which had moved to 80 per cent in 2008-09, slipped to 75 per cent the next year, and further to 71 per cent in the year ended March 2011.With interest rates moving steadily upwards, the entry segment bike buyers may postpone purchases, considering that they are rate-sensitive.

But what may support growth to a certain extent are the 125-250 cc segment products as buyers here have more disposable incomes and are less sensitive to rate hikes. The company, for example has introduced the Karizma ZMR (225cc) and Achiever (150cc) in this category in the last two years and has also managed to marginally improve its market share ( at 13 per cent currently).

Nevertheless, Bajaj, with over 50 per cent market share will put up a tough fight. Its strategy of positioning the ‘Discover' and ‘Pulsar' brands at various price points between the entry and executive segments as well as the executive and premium segments has paid off well for the company. Another player in this segment, Honda, may also be a threat, considering that the company may chart an aggressive growth plan for India, post the split with the Hero Group.

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