Initiating Coverage Hero MotoCorp

R K Global Shares & Securities Ltd-Private Client Research | Equity Research For Private Client Circulation 1

Hero MotoCorp Limited | Automobile Initiating Coverage | 1st June, 2012

Hero MotoCorp after splitting JV with Honda Motorcycle and

Scooters India is now aiming to explore the global market.

Hero MotoCorp plans to make investments of `45000mn over

the next five years to become an independent and global 2-

wheeler company. The company also plans to set up two new

plants in India, adding to its existing three that have a total

annual capacity in excess of six million 2-wheelers.

New launches to help main market share:

Hero MotoCorp has unveiled three new models that are expected

to give a forceful push to its journey after its break-up with

Honda. The new models will hit the Indian market over the next

few months. The company has launched two new bikes -- 100 CC

bike Passion XPro and a 125 CC Bike Ignitor along with a 110 CC

scooter named Maestro. The two new motorcycle models will hit

the market later this year. Maestro will be targeted at male

customers in the age group of 18 to 24 while the Ignitor and XPro

will be looking for executives and college going students.

2W export to boost HMCL volume: We expect 2W exports to grow at a healthy 15% in FY13E. We

think the growth in exports will be led by income growth in the

key export markets, low penetration of motorcycles in Africa and

South Asian countries. In addition, the acceptance of Indian 2Ws

to Latin America has been steadily rising. We believe growth will

get a boost from Hero MotoCorp’s plan to enter new geographies,

where they previously were not exporting due to the agreement

with their erstwhile JV partner, Honda. In the last five years, 2W

exports have grown at a CAGR of 25%. The key export markets

for the Indian companies are lower-income developing countries

on a high per capita GDP growth trajectory from a low base.

Valuation:

At CMP of `1821, stock is trading at EV/EBIDTA of 9.6x and P/E

of 15.4x. We initiate our coverage on the company with ‘BUY’

rating and target price of `2178.

Descriptions FY'11 FY'12E FY'13E FY'14E

Revenue 193979 235790 264707 294415 EBITDA 25586 36187 39737 45327 PBT 168393 199603 224970 249088

PAT 20077 23672 26939 29091

EPS 101 119 135 146

BVPS 148 215 299 393

ROE 63% 66% 58% 51%

ROCE 59% 56% 60% 61% P/BV 14 9.6 6.9 5.3

EV/EBIDTA 16.7 11.8 10.8 9.4

P/E 21.4 17.5 15.3 14.2

Market Data Bloomberg Code HMCL IN Reuters Code HROM BO SENSEX 15965.2 NIFTY 4841.6 Dividend Yield (%) 2.4 52 Week High/ Low(`) 2278.5/1482.3 Equity Capital(`mn) 399.4 Face Value (`) 2.0 Market Cap (`mn) 367824.4 Avg. 10 day Vol. NSE 483877.1

Source: Ace Equity, R K Global Research, as on 20th Apr’12

Key Market Ratios TTM Latest EPS (`) 119.1 TTM Book Value (`) 214.8 TTM PE (x) 15.5 TTM P/BV (x) 8.6 TTM EV/EBIDTA (x) 9.6 EV/TTM Sales (x) 1.6 Mcap/TTM Sales (x) 1.6 Source: Ace Equity, R K Global Research, as on 20th Apr’12

Share-Holding Pattern (%)

Price vs Sensex

52.2%

33.5%

5.7%8.8%

Promoters FII's DII's Others

75.0

85.0

95.0

105.0

115.0

125.0

135.0

May-11 Aug-11 Nov-11 Feb-12 May-12

Sensex Hero MotoCorp

Research Analyst Aditya Vikram Jha [email protected]

CMP–` 1821 “BUY” TP-` 2178


Hero MotoCorp Limited | Automobile

Investment Rationale: HMCL a mixed bag of opportunity and uncertainty.

Huge capex plans Hero MotoCorp plans to make investments of `45000mn over the next five years to become an independent and global 2-wheeler company. The company also plans to set up two new plants in India, adding to its existing three that have a total annual capacity in excess of six million 2-wheelers. The first new plant will be set up in one of the southern states with an initial capacity of 7.5 lakh units and will address the domestic market. The second plant will be set up in the west with unspecified capacity and would address both domestic and global markets. The company has identified 30 global markets, covering Southeast Asia, Latin & Central America, and Africa. To address these markets, the company is expected to start assembly plants outside India though the initial exports will be from its Indian plants.

Capacity addition among major 2-wheeler players in India

Company Installed Capacity FY'11 Capacity Expansion FY'12 Capacity Expansion FY'13

Bajaj Auto 4.50 0.30 0.00

Hero MotoCorp 6.20 0.40 0.75

TVS Motors 2.55 0.39 0.16

HMSI 1.60 1.20 1.20

Royal Enfield 0.07 0.03 0.06

Suzuki Motorcycle 0.25 0.15 0.00

M&M 0.60 0.00 0.00

Yamaha India 0.60 0.20 0.20

Source: Company, R K Global Research Estimates

New launches in the near future to boost sales Hero MotoCorp has unveiled three new models that are expected to give a forceful push to its journey after its break-up with Honda. The new models will hit the Indian market over the next few months. The company has launched two new bikes -- 100 CC bike Passion XPro and a 125 CC Bike Ignitor along with a 110 CC scooter named Maestro. The two new motorcycle models will hit the market later this year. Maestro will be targeted at male customers in the age group of 18 to 24 while the Ignitor and XPro will be looking for executives and college going students. Hero MotoCorp to grow domestic 2W volumes by 7.5% in FY13 We expect a slowdown in two-wheeler sales growth this year due to price hikes, high fuel cost, slower rural income growth and weak consumer sentiment. After growing at a CAGR of 26% over FY09-11, 2W sales growth has started to moderate over the last few months. Last year was mixed for 2W sales, as the first half was very strong with growth of 17% but in the second half, sales growth moderated to 11%. Further, the sales growth trend was mixed for 2W companies depending on their exposure to the executive motorcycle segment and scooters.

Q4FY11 Q2FY12 Q4FY12

1454

15301544

1589 1572

HMCL Volume growth ('000)


41.8%41.4%

39.4%

41.0%40.4%

HMCL market share in 2-wheeler



Racing for technology: Hero MotoCorp has formed a strategic partnership with Erik Buell Racing (EBR) of the US, encompassing multiple areas of collaboration. As part of the, partnership, HMCL will receive support in terms of cutting-edge technology and design to develop future models from EBR - the East Troy, Wisconsin-based firm, which specializes in designing and manufacturing powerful and high-speed motorcycles. Through this alliance, HMCL, for the first time, enters the exciting world of international motorcycle racing. The company will mark its foray into the racing arena by sponsoring two teams-Team Hero and AMSOIL Hero-a first by any Indian two-wheeler company at the AMA Pro Racing National Guard Superbikes Championship. Further, HMCL is also developing the concept hybrid scooter called 'Leap', showcased at the recently-concluded Auto Expo, in collaboration with EBR

2W export to boost HMCL volume We expect 2W exports to grow at a healthy 15% in FY13E. We think the growth in exports will be led by income growth in the key export markets, low penetration of motorcycles in Africa and South Asian countries. In addition, the acceptance of Indian 2Ws to Latin America has been steadily rising. We believe growth will get a boost from Hero MotoCorp’s plan to enter new geographies, where they previously were not exporting due to the agreement with their erstwhile JV partner, Honda. In the last five years, 2W exports have grown at a CAGR of 25%. The key export markets for the Indian companies are lower-income developing countries on a high per capita GDP growth trajectory from a low base. These markets are also characterized by a large working-age population, declining dependency ratios, growing urbanization and paucity of public transportation infrastructure.

Motorcycle sales growth Scooter sales growth

Rising fuel price to impact growth In the initial phase, 2W sales are positively impacted by the high fuel prices given their superior fuel economy compared to entry level cars. However, if the fuel prices sustain at high levels, 2W sales growth will be negatively impacted. OMCs are currently losing `7.0/l on petrol and `11/l on diesel retailing. We believe petrol price increases are inevitable given the government’s fiscal situation, which is likely to hurt 2W demand.

13%

19% 17%13%

-12%

1%

26%23%

12% 10%13%

-15%-10%

-5%0%5%

10%15%20%25%30%

FY

04

FY

05

FY

06

FY

07

FY

08

FY

09

FY

10

FY

11

FY

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FY

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FY

14

6% 4%

-2%

4%

12%9%

27%

41%

25% 23%25%

-10%

0%

10%

20%

30%

40%

50%

FY

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FY

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FY

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FY

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FY

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FY

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FY

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FY

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FY

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3476

3693

3922 3878 3889

2-Wheelers Volume growth ('000)


2.1%

2.4% 2.7% 2.7%2.0%

HMCL's export % of total sales



The Game Play: Intensifying completion

After splitting the JV with Hero, Honda Motorcycle and Scooters India (HMSI) is now aiming to become the largest player in the Indian 2W market. The company has been aggressively expanding production capacity and dealer network over the last one and half years. The competitive intensity is expected to rise, as Honda is likely to aggressively price its new mass bike, Dream Yuga, which the company claims will offer the best fuel-efficiency and power in the segment. Honda plans to expand production capacity by 60% and add 100 new dealerships annually (500 dealers, 1,000 touch-points currently).

HMCL overall market share vs peer s HMCL core segment market share vs peers

Source: Company, R K Global Research

As Honda has already reached 2 level in executive segment (and~20% market share), their aim to become 1 by 2020 should not be taken lightly.

Over reliance on two brands HMCL depends majorly on two brands (Splendor & Passion) for volume growth. Currently Splendor and Passion together bring more than 65% of the volumes. HMCL’s models such as CBZ Xtreme & Hunk competes with Bajaj’s Pulsar & Discover and HMSI’s Unicorn in 150 cc segment but unfortunately many attempts to garner higher share in that segment have been futile. However Karizma has been successful competing with Avenger & Pulsar 220 cc. going forward, we expect HMCL will create new brands to compete with ever increasing competition in 2W industry in Indian market.

Competition in scooter segment intensifying Increasing working class of women along with higher acceptance for gearless scooters has resulted in CAGR of 18% for the scooter industry in last 5 years as compared to motorcycle industry growth of 9% in the same period. Honda enjoys 43% market share with Activa which is highly successful in the domestic market. Based on rising class of working women in metropolitan cities, Yamaha is also planning to launch scooter in India. HMCL enjoys 17% market share in scooter segment with its only product - Pleasure (Launched in Oct, 2005). Strong growth of HMCL in FY12 of 26% in scooter segment Vs industry growth of 17.7% has enabled 1.6% increase in market share on YoY basis. To fuel the growth, HMCL has unveiled a gearless scooter-Maestro 110 CC - to compete with Activa, Aviator, Scooty, and Access.

0%5%

10%15%20%25%30%35%40%45%

Q1FY11Q2FY11Q3FY11Q4FY11Q1FY12Q2FY12Q3FY12Q4FY12

BJAL HMCL HMSI Yamaha TVS

0%

10%

20%

30%

40%

50%

60%

Q1FY11Q2FY11Q3FY11Q4FY11Q1FY12Q2FY12Q3FY12Q4FY12

BJAL HMCL HMSI Yamaha TVS

Currently Splendor and Passion

together bring more than 65% of the

volume of HMCL.

Hero MotoCorp launched Maestro

110cc to compete with Honda’s Activa

and Aviator.



2-Wheeler Industry: Racing on Indian roads

Two wheeler sectors is the most important segment of the Indian auto sector accounting for 75% of the total sales volume in the auto industry. The two wheeler industry is dominated by the motorcycle segment which contributed 80% to the sales volume in FY12. Hero MotoCorp, Bajaj Auto, TVS Motors and Honda Motorcycle are the major players in this sector. India’s 2-wheeler sector A) Motorcycle segment

I) Entry level (upto 100cc): BJAL dominate economy segment

with Platina and CT100 holding ~50% market shares. Hero MotoCorp holds ~30% with CD Dawn as its key model in the segment.

II) Executive level (100cc -150cc): This is the largest segment in the motorcycle space and HMCL is the leader in this segment with Splendor and Passion account ~ 70% market shares BJAL with its Discover provides competition to HMCL.

III) Premium level (above 150cc): BJAL dominates premium segment with Pulsar holding ~50% market share. Though, the gap is contracting with the increasing presence of Apache of TVS Motors and FZ 16 of Yamaha. This segment is important from the prospective of improving overall operating margin for any 2-wheeler company.

B) Scooter segment Scooter segment accounts for about 16% of the overall domestic two wheeler market. HMSI (Honda) is the market leader in the gearless scooter segment and accounts for more than 55% of the total market. Hero MotoCorp's only model in the scooter category is "Pleasure" which is targeted to the urban female segment. Activa model of the Honda is the largest selling model in this segment.

C) Mopeds Moped segment accounts for approximately 5.0% of the market share of Indian two wheeler markets with TVS motors dominating the segment with over 90% market share. This segment is small in terms of both volume and value and only has limited number of players. Mopeds have seen a downward trend in sales and we expect similar trend to continue in future.

Entry level segment generally offers

features like kick start, four gear and

spoke wheel

The motorcycle segment contributed ~80% to total sales volume within the two wheeler sector

Executive segment caters buyers who

have selection criteria like fuel

economy, style and purchase price of a

model



Business Overview: “Haar Gaon, Haar Aangan”

Target Market Out of 6.5 mn units sold in B2 segment (below 125 CC) in FY11, 4.6 mn units were produced by HMCL. The company is the market leader in B2 segment with strong brands such as Splendor, Passion & CD series. Over the years, competitors have failed to bring such a product in the market and the same to happen in the future is extremely difficult. Hero Honda's dependence on credit sales is lower as compared to its peers. The company has a strong rural network and cash sales in rural areas are higher as compared to urban areas. Share of B3 & scooters in the overall sales volume has consistently increased from 6% in FY07 to 13% in FY11 (CAGR-37%). Higher expenditure on marketing & advertising for brand conscious B3 segment has well paid to HMCL. Volume play Preference towards higher volumes as compared to realization per bike has resulted into HMC focusing on B2 segment by launching low cost & fuel efficient bikes. Maximum number of customer touch points in rural areas help to garner 45% of the revenue. Establishing new brand will require higher expenditure Over the last 5 years HMCL’s advertising expenses are in the range of 2 to 2.4% of net sales. However management expects to spend additional `1000 mn for brand building purpose. Through advertising campaign of “HUM MEIN HAI HERO”, company has initiated brand building process. Company has targeted youth through the modes of sports, music & entertainment. Company has been sponsoring MTV Roadies, SA RE GA MA PA & Mumbai Indians in IPL etc. specially to target youth which is their main target audience. Apart from sponsoring events, advertisement with slogan like “YAARI KI GAADI”, “DESH KI DHADKAN HUM DUNIYA HILA DENGE”, “HERO HONDA DHAK DHAK GO” etc. deepens the level of emotional connect between the company and its customers. We expect Advertising expense as % of net sales to increase by 0.4% to 3.2% in FY13.

Hero MotoCorp timeline…..

Source: Company, R K Global Research

HMCL hold strong presence in

executive (below 125 CC) B2 segment.

B3 & Scooter segment supporting

growth.

Rural market contributes about 45%

of Hero MotoCorp’s total domestic

sales.

HMCL has emerged as strong player in

scooter segment through special

outlets for women - “just 4 her”.



Key Concerns: The bumpy road ahead

High interest rates Sustained inflation forced RBI to tighten monetary policy. While Hero MotoCorp has not been significantly affected by higher interest because of its strong balance sheet and healthy cash flows, some of the smaller vendors of the company could face expansion constraints if the cost of finance continues to remain high. The company is now pursuing an aggressive policy of multiple sourcing to counter this challenge. Weak world economy Global uncertainty didn't significantly affect past performance as the company's operations were mostly concentrated in domestic markets. With widening transcontinental footprint, the susceptibility to geo political events can escalate significantly. However, considering the company's product profile and planned focus on emerging and nascent markets similar to India, the management believes the challenge of uncertainty can be overcome. Dependence on fiscal incentives means higher risk to profitability The Government of India offers various incentives to encourage and make exports viable from India. A Special Focus Market scheme (wherein 3.5% benefit is made available on exports destined for certain distant markets) has been expanded to include most of the target countries for Indian 2W manufacturers. Important existing and emerging markets such as Angola and several other African countries, Colombia, Mexico and Peru are covered under the scheme. Secondly, exports are dependent on the import duties and local factors in the target countries. Sri Lanka has recently raised import duties on 2Ws from 61% to 100%. Sri Lanka accounts for ~10% of 2W exports from India and we believe such a large price hike will hit demand in the medium term. We believe similar risks exist for other key markets in Africa and LATAM. Challenges post split with Honda After splitting the JV with Hero, Honda Motorcycle and Scooters India (HMSI) is now aiming to become the largest player in the Indian 2W market. The company has been aggressively expanding production capacity and dealer network over the last one and half years. In the past, HMSI had refrained from launching any product in direct competition to Hero MotoCorp. However, this will change now, as HMSI is likely to launch multiple bikes in the executive segment (100-110cc) over the next two years. Market shares unlikely to change in near term, but risks ahead. HMSI’s Dream Yuga is to be positioned against Hero’s Splendor and Passion (75% of HMCL’s volume). Honda, which was constrained for capacity, is likely to dedicate ~600-800k (of 1.8mn new capacity by March 2013) of additional capacities to motorcycles and primarily Dream Yuga. We believe HMSI’s aggressive intent to ramp up volume and distribution will first impact Discover due to its weak brand compared to HMCL’s Splendor. However, market share loss risks for HMCL still exist if HMSI’s new brands succeed in the market.

Last year, the government launched a

new scheme, following the withdrawal

of the Duty Entitlement Passbook

(DEPB) Scheme, under which around

9% of free-on-board (FoB) value of

exported two-Wheelers.

DEPB scheme was replaced by a Duty

Drawback Scheme, offering 5.5%

incentive on FoB value with an

additional 1% special incentive for

exports until March 2012.



Outlook and Valuation HMCL expects the industry to grow at ~10% for the year FY13 and has guided to outperform the industry. However, we believe company might face certain problems achieving its target given the expansion by the unlisted players of international repute. Going by robust sales volume in FY12 (6235475 units), Current capacity of HMCL is around 6.6 mn and would go upto 7 mn in next two quarters. The capacity of Haridwar plant is 9500 units/day from 8000 units/day and contribution from Haridwar plant would be 40%. We expect FY13E EBITDA margin to 16%. We do not anticipate major threat from Honda Motors in Sub-125 cc segment despite increase in capacity for Honda Motors.

HMCL P/E trend HMCL EV/EBITDA trend

We estimate more executive launches from Honda Motors by the end of FY13 and believe competition to intensify and escalate by end of FY14 rather than in FY13. By the time competition intensifies, Hero MotoCorp will be ready with its export strategy. At the CMP of `1821, the stock is trading at P/E of 15.4x FY13E, EPS of `119.2 and EV/EBITDA of 9.6x. We recommend a BUY on the stock with target price `2178.

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Company Financials:

Income Statement (`Mn)

Balance Sheet (` Mn)



Revenue 193979 235790 264707 294415

Sources Of Funds

Expenditure 168394 199603 224970 249088

Share Capital 399 399 399 399

EBITDA (ExOI) 25586 36187 39737 45327

Total Reserves 29161 42504 59113 77874

Other Income 3442 3646 4011 4412

Shareholder's Funds 29560 42903 59512 78273

Interest 158 213 200 200

Total Debt 14912 10113 5613 1123

PBDT 25428 35974 39537 45127

Total Liabilities 44472 53016 65125 79396

Depreciation 4024 11082 11478 12002

Application Of Funds

PBT 24846 28538 32070 37537

Gross Block 55385 62655 69695 77655

Tax 4769 4866 5131 8446

Less: Acc. Dep. 14582 25664 37141 49143

PAT 20077 23672 26939 29091

Net Block 40803 36991 32513 28512

CWIP 1251 1251 1251 100

Financial Ratios

Cash At Bank 19072 715 768 15404

Description FY'11 FY'12E FY'13E FY'14E

Investments 51288 39643 45000 55000

Per Share (Rs)

Net CA -46402 -22792 -11562 -3028

Adj.EPS 101 119 135 146

Diff. Tax Asset -2468 -2083 -2083 -2083

CEPS 121 174 193 206

Total Asset 44472 53011 65120 79401

DPS 105 45 45 45

Book value 148 215 299 393

Cash Flow Statement (` Mn)

Margin Ratios (%)

PAT 20077 23672 26939 29091

EBIDTM 13% 15% 16% 15%

Depreciation 4024 11082 11478 12002

Pre-Tax Margin 13% 11% 14% 17%

Change in WIP 7616 -23172 3407 9941

PATM 10% 10% 11% 11%

Others 800 0 0 0

CPM 17% 21% 19% 21%

Cash from Operation 31720 11582 41823 51034

Performance Ratios (%)

Cash Flow From Investments

ROE 63% 66% 58% 51%

CAPEX -28845 -7270 -7000 -7749

ROCE 59% 56% 60% 61%

Change in Investments -12030 11645 -5357 -10000

Sales/FA 350% 376% 380% 379%

Cash from Investing -40875 4375 -12357 -17749

Efficiency Ratios (%)

Cash Flow From Financing

Revenue Growth 22% 22% 12% 11%

Inc/ Dec in Debt 0 -4799 -4500 -4490

EBIDTA Growth -8% 41% 10% 14%

Dividends Paid -9401 -10330 -10330 -10330

PAT Growth -10% 18% 14% 8%

Cash from Financing -9401 -15129 -14830 -14820

EPS Growth

19% 13% 8%

Net Change in Cash -18356 70.8 14636 18475

Valuation ratios(x)

Cash at the Binging 19072 715 768 15404

EV/EBIDTA 16.7 11.8 10.8 9.4

Cash At The End 716 786 15404 33879

EV/Sales 2.2 1.8 1.6 1.5

P/BV 14 9.6 6.9 5.3

DuPont Analysis

P/E 21.4 17.5 15.3 14.2

Description FY'11 FY'12E FY'13E FY'14E

PAT/PBT 0.8 0.8 0.8 0.8

PBT/EBIT 1.0 1.0 1.0 1.0

EBIT/Sales 0.1 0.1 0.1 0.1

Sales/TA 4.4 4.4 4.1 3.7

TA/NW 1.5 1.2 1.1 1.0



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Rating Criteria BUY Stock to generate return above 15% from CMP over the next 12 months period HOLD Stock to generate return between 0-15% from CMP over the next 12 months period SELL Stock to generate less than 0% from CMP over the next 12 months period

Coverage Terminology IC = Initiating Coverage RU = Result Update EU = Event Update NC = Not Covered

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Documents

Initiating Coverage Hero MotoCorp