Institutional Equities - Nirmal Bang Coverage-21 April 2014.pdf · Institutional Equities g erage ... the scooter business is economic value ... HML has already embarked on big-ticket

Please refer to the disclaimer towards the end of the document.

Institutional Equities

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Reuters: HROM.BO; Bloomberg: HMCL IN

Hero MotoCorp

Hero No. 1 We believe the accelerated pace at which Honda Motors and Scooters India (HMSI) gobbled up market share of its rivals over FY12-FY14 could soon be a thing of the past. Hero MotoCorp (HML) shed 380bps of domestic two-wheeler market share over FY12-FY14, while HMSI gained 910bps of market share in the same period. Over the next two years, a new equilibrium in market share (HML versus HMSI) is likely, wherein an optimistic scenario could be flattish or improving market share for HML, and a worst-case scenario of a mere 50bps-75bps further erosion in market share for this company. Further, we believe HML will register a secular margin improvement (395bps between now and FY16E), driven by aggressive cost reduction initiatives and declining royalty payment. HML appears to have successfully managed the transition from its earlier avatar of a Hero-Honda joint venture to a standalone entity currently. The stock currently trades at 14.9x FY15E EPS and 12.5x FY16E EPS. We have assigned Buy rating to it with a one-year target price of Rs2,968 (16.7x FY16E EPS).

New equilibrium likely in market share: We believe the earlier sharpness and intensity witnessed in HML’s market share erosion over FY12-FY14 (380bps loss) driven by HMSI’s new found aggression is now losing its edge and is ebbing. Our call is that over FY15-FY16 there could be a new equilibrium in market shares of HML and HMSI, which should be favourable for HML. Our channel checks indicate that ‘Dream Neo’ and ‘Dream Yuga’ 110cc motorcycles- the two new models from the HMSI stable that fired its sales charts over FY12-FY14 - are now witnessing customer fatigue.

Aggressive cost reduction initiatives and declining royalty payment to drive margins: The quarterly amortisation (Rs1.77bn per quarter) on the Rs24.79bn one-time licencing fee paid to Honda just prior to the parting of ways by HML ends in 1QFY15, and this should boost reported PAT from 2QFY15 onwards. Declining royalties may be more than offset by rising research and development (R&D) expenditure. Yet, HML’s massive cost reduction and value engineering exercises coupled with a likely rise in sales volume are likely to ensure a ~395bps EBITDA margin uptick over the next two years.

No rude shocks from the management: Unlike in the case of Maruti Suzuki India (MSIL), wherein parent Suzuki sprang a nasty surprise by turning MSIL’s upcoming Gujarat plant into a 100% subsidiary (the rationale for which still remains unexplained by Suzuki), minority investors can draw more comfort in HML’s management. The Munjal family-led Hero Group is totally committed to HML as its sole investment vehicle in two-wheelers.

A play on likely two-wheeler demand recovery: After a significant lull in demand for HML vehicles and the two-wheeler industry in general over the past two years, we expect a full-blown recovery in HML’s sales volume growth over FY15E-FY16E (11.1% CAGR versus just 0.1% CAGR over FY12-FY14). We expect EPS CAGR of 33.4% over FY15E-FY16E, versus a 4% CAGR decline in earnings over FY13-FY14E. At 14.9x FY15E and 12.5x FY16E EPS of Rs148.4 and Rs177.7, respectively, we have assigned Buy rating to HML with a one-year target price of Rs2,968 (16.7x FY16E EPS of Rs177.7 – valuing HML at a PEG of just 0.5x on a two-year EPS CAGR of 33.4%), implying a 34% upside from the current market price.

BUY

Sector: Automobile

CMP: Rs2,219

Target Price: Rs2,968

Upside: 34%

K N Sreenivasan [email protected] +91-22-3926 8110 Saiprasad Prabhu [email protected]

+91-22-39268172

Key Data

Current Shares O/S (mn) 199.7

Mkt Cap (Rsbn/US$bn) 433.1/7.3

52 Wk H / L (Rs) 2,320/1,436

Daily Vol. (3M NSE Avg.) 325,114

Share holding (%) 1QFY14 2QFY14 3QFY14

Promoter 39.9 39.9 39.9

FII 42.8 43.0 43.2

DII 8.8 8.5 8.0

Corporate 1.6 1.6 1.7

General Public 6.9 7.0 7.2

One-Year Indexed Stock Performance

Price Performance (%)

1 M 6 M 1 Yr

Hero MotoCorp 7.3 5.7 47.4

Nifty Index 4.4 9.9 17.6

Source: Bloomberg

Y/E March (Rsmn) FY12 FY13 FY14E FY15E FY16E

Net sales 235,790 237,681 253,942 281,336 314,737

EBITDA 36,188 32,845 34,790 46,139 55,551

Net profit 21,634 18,921 19,942 29,639 35,489

EPS (Rs) 108.3 94.8 99.9 148.4 177.7

EPS growth (%) 17.4 (12.5) 5.4 48.6 19.7

EBITDA margin (%) 15.3 13.8 13.7 16.4 17.7

PER (x) 20.5 23.4 22.2 14.9 12.5

EV/EBITDA (x) 11.6 12.6 11.5 8.5 6.7

RoCE (%) 43.5 34.8 37.3 52.1 51.9

RoE (%) 65.6 45.6 36.0 43.2 41.3

Source: Company, Nirmal Bang Institutional Equities Research

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Hero MotoCorp NSE CNX NIFTY INDEX

21 April 2014


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Business overview and investment arguments

No holds-barred approach on new product development in a sputtering market

While rival Bajaj Auto (BAL) has put its ammunition in reserve and is waiting for better times to emerge in the broad-based Indian two-wheeler market; HML, in sharp contrast, has aggressively stepped on the gas, particularly in the area of new product development. After parting ways with Honda in 2011, HML’s top management is single-mindedly focused on long-term strategies, and is undeterred by the current macro-weakness or lull in the domestic two-wheeler market. In fact, it sees the lull as a good time to focus big time on new products and new product development strategies. After emerging from the shadows of Honda, HML’s top management is showing a great sense of urgency and determination to gain technology leadership. We believe the burning desire of HML’s management to prove the company’s technological and new product development capabilities is highly likely to translate into superior shareholder value. We see HML’s new product portfolio and its technological capabilities as a cup half-full currently, and not half-empty. We believe no one can accuse HML of inaction and indecisiveness on the new product development front.

HML not fixated only on motorcycles as it sees scooters also as a growth segment

While we see some economic merit in BAL’s assertion that within two-wheelers, it would remain a pure motorcycle player with a razor-sharp focus only on motorcycles, we equally believe the strategies of players like HMSI and HML provide interesting counterpoints. BAL’s contention is that its industry high operating margins in the 19%-20% band are a direct derivative of its decision to stay razor-sharp focused exclusively on motorcycles at the exclusion of scooters.

Globally, if one looks at two-wheeler players like Honda and others, they are present in motorcycles as well as scooters. We believe HML is following a similar strategy, and it is understandable given that it has been a Honda JV partner in its earlier avatar as Hero Honda. Our take is that notwithstanding the likely lower operating margin in scooters, we believe the scooter business is economic value accretive as we are convinced that a decently scaled-up scooter business generates superior capital returns in excess of CoC (Cost of Capital), and the growth is therefore profitable. In the pursuit of superior profitability, it appears players like BAL are actually missing out on the growth in the scooter segment.

Over FY12-FY14, the domestic demand downtrend in various automobile OEM (Original Equipment Manufacturer) segments including two-wheelers has been only in scooters, which was growing at an attractive pace earlier. While both motorcycles and mopeds registered lacklustre-to-negative growth, the scooter industry’s domestic volume grew 14.2% YoY in FY13 and 23.2% YoY in FY14. HML remains the second-largest player in scooters (19.2% domestic market share in scooter in FY14), next to market leader HMSI (52.8% domestic market share in scooters in FY14). HML’s new scooter models/prototypes on display at the Auto Expo 2014 (held in Delhi in February 2014) like the 110cc ‘Dash’, the stylish 125cc ‘Dare’ and the muscular 150cc ‘Zir’ , are clearly harbingers of new aggression and innovation that HML brings to the scooter market.

While HML continues to focus aggressively on motorcycles (70.8% segmental share in FY14 domestic two-wheeler industry volume), it is playing equally aggressive and innovative in the scooter market (24.3% of FY14 domestic two-wheeler market). This strategy is in sharp variance to that of BAL, which has not eschewed any kind of presence in the scooter market.

Exhibit 1: Domestic motorcycle and scooter industry sales volume trends

Source: Society of Indian Automobile Manufacturers or SIAM, Nirmal Bang Institutional Equities Research

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New models seen as key

HML has already embarked on big-ticket and comprehensive new model roll-out initiatives. Its management has ambitious plans to successfully address the issue of life after Honda. At Auto Expo 2014, HML showcased a few of its new model prototypes in the motorcycle as well as scooter segments, just to give a general feel of what one can look forward to from the company. The vehicle display at Auto Expo 2014 certainly gave a reasonable glimpse of HML’s new model capability, but not the full picture.

Since the parting of ways with Honda in April 2011, a lot has happened at HML. The company upgraded 11 of its older models and would start launching new models from 1QFY15. In these modern times, no automobile OEM develops everything in-house. Automobile OEMs are increasingly systems aggregators and, therefore, it just does not come as a surprise that HML tied up with a slew of foreign partners, viz. AVL of Austria for engine, Erik Buell Racing (EBR) of the US for developing motorcycles with higher engine displacement, Magneti Marelli of Italy for fuel injection system and Engines Engineering (EE) of Italy for two-wheeler design. At this point of time, we believe that HML has ~15 genuine new models in its development pipeline, and commencing 1QFY15, these new models (both motorcycles and scooters) are expected to be rolled out over the next 24 months or so.

Engine – the acid test for HML

“Fill it, shut it, forget it” was one of the catchiest advertising slogans from Hero Honda (HML’s earlier avatar as a JV partner of Honda) which captured the imagination of Indian customers in the 90s and 2000s, and even now this slogan has resonance and greater recall value with value-conscious buyers. It captured the essence of what Hero Honda motorcycles stood for – an unbeatable combination of reliability, lowest lifecycle costs and superior value. At the heart of the Hero Honda motorcycle was the highly reliable Honda engine, which gave superior mileage and the lowest operating costs over the product lifecycle. In the 90s and even in the 2000s, the competition found it very difficult to come anywhere near the superior branding/technology/value proposition offered by Hero Honda. In many respects, HML is now faced with beating the value proposition benchmark set by Hero Honda.

Can HML develop its own new engine platform that can either match or even outperform Honda’s offerings? That’s the million dollar question. More specifically, can HML’s engine development exercises undertaken jointly with AVL of Austria and Erik Buell Racing (EBR) result in superior lower cc (cubic capacity) engines in 100cc/110cc/125cc displacements, which the Indian two-wheeler/motorcycle markets are mostly identified with (100cc/110cc/125cc accounted for 83.6% of FY14 Indian domestic motorcycle industry sales volume of 10.48mn units, and motorcycles accounted for 70.8% of FY14 aggregate domestic industry’s two-wheeler sales). In our view, HML stands a good chance of winning the battle. As already stated earlier, HML has embarked on the path of actively seeking the help of globally acclaimed boutique design and development firms. HML’s aim is to be a successful systems integrator, rather than trying to develop everything in-house. HML’s top management is on record stating that technology leadership is an important goal that the company has set for itself.

Is HML’s goal of achieving technology leadership too difficult a challenge? Our take is that it is tough, but very well within the realms of possibility. To draw a parallel, in the late 90s, both industry observers and the street had written off rival BAL’s chances of making it on its own in the motorcycle market. But by mid-2000s, BAL strongly bounced back with strong value proposition in the 150cc-180cc premium motorcycle segment. HML’s top management, in February 2014, stated that the company had already tested three engine families – in the 100cc, 110cc, and 250cc categories. The management said that each of these new engines performed better than their existing models (i.e. Honda engines) and they were also highly fuel-efficient. The key point to note is that while HML, over the past two years, had to be content mostly with refurbishment of earlier models, the next few years would be characterised by the launch of a slew of genuine new models.

Strong pan-India distribution network and the highest rural reach among two-wheeler players

HML continues to enjoy the largest and widest distribution footprint in India. Its deep distribution reach, particularly in rural India (accounting for 47% of sales), definitely gives it significant breathing time and space when it comes to countering the heightened aggression from HMSI. HML has one of the most extensive customer reach with 5,800 plus pan-India touch points, with a deep presence in more than 100,000 villages.

What is pertinent to note is that HML’s dealers have mostly remained loyal and committed, notwithstanding the incursions made by an aggressive HMSI. While HML tries to really catch up fast and close its gap vis-à-vis HMSI on the technology leadership front, HMSI can also be expected to progressively expand its distribution strength and pan-India reach. We believe the two different paths taken by HML and HMSI would eventually converge.

While over FY12-FY14, HMSI gained ~910bps of domestic two-wheeler market share by taking away rivals’ sales (HML’s market share loss was 390bps in the same period, but mostly front-ended) through a combination of aggressive dealership expansion and the launch of ‘Dream Yuga’ and ‘Dream Neo’ 110cc models. But as we had stated later, we believe that based on our channel checks the bite and sting of HMSI’s aggression is fading. We strongly believe that the retail network as also the work force at the manufacturing facilities of HML are more loyal and committed than those of HMSI. We believe the Munjals enjoy a superior emotional connect with retail-level distribution partners as well as shop floor-level workers at its manufacturing facilities. We expect this to hold HML in good stead. All that the Munjals need to do on a sustained basis is to ensure that HML’s technologies stay at par with HMSI, or even surpass. And that is precisely what the Munjals are working on, and Auto Expo 2014 gave some interesting and valuable glimpses of HML’s initiatives in this regard.


Hero MotoCorp 4

Likely recovery in two-wheeler demand- HML may be a significant beneficiary

The combined effect of high petrol prices, high interest rates, weak macro-economic conditions and consequent negative consumer sentiment resulted in lacklustre demand for two-wheelers over the past two years. Seasoned observers of the politico-economic scenario are increasingly talking of a fairly strong possibility of stable and decisive government at the Centre after the ongoing general elections. It appears that there is likely to be a revival in the investment cycle if such a government is formed. Inflation figures seem to be on a slow but south-bound path, and interest rates could start softening, although with a significant time lag. While FY13 and FY14 have been tough years for two-wheeler sales, we believe FY15/FY16 could likely witness a recovery in domestic two-wheeler demand. With mass urban transportation projects lagging behind in many key Indian metros, cities and towns, the relevance and convenience of a two-wheeler as a personal transport vehicle (PTV) cannot be underestimated.

After a lacklustre 0.6% CAGR in domestic vehicle sales volume of HML over FY13-FY14 (FY14 domestic sales volume at 6,115,197 units), we expect its domestic sales volume to strongly bounce back and register a 11.2% CAGR over FY15E-FY16E (FY16E sales volume at 7,558,434 units).

Market share loss of HML to HMSI slows down considerably

Exhibit 2 below shows that over FY12-FY14, an aggressive HMSI took away two-wheeler market share away from BAL as well as HML, but much more from BAL. While HMSI gained 910bps of market share over FY12-FY14 (4.0% in FY13 and 5.1% in FY14), HML lost 380bps of market share over FY12-FY14 (2.2% in FY13 and 1.6% in FY14).

Twp principal models from the HMSI stable that drove heightened market aggression were ‘Dream Yuga’ and ‘Dream Neo’ entry-level models. Our channel checks indicate that the initial excitement around HMSI’s above two models has died down. Some two-wheeler dealers we spoke to pointed out that notwithstanding the Rs4,000-Rs4,500 lower price tag of HMSI’s above models (10% cheaper than HML’s counterpart models), HMSI is really labouring to wean incremental customers away from HML’s ‘Splendour’ and ‘Passion’ range. One cannot wish away the power of HML’s ‘Splendor’ and ‘Passion’ models and should also not underestimate the depth and reach of its rural distribution network.

Our belief is that HMSI’s deep discounting of ‘Dream Yuga’ and ‘Dream Neo’ models is not sustainable, and all the more so if such discounting does not yield any significant incremental market share gain at the expense of HML. We believe that sooner or later, HMSI would revert focusing on profitability and move away from its current path focusing only on market share gains. While BAL still has significant vulnerability, we genuinely believe HML’s vulnerability has declined considerably and all its high-decibel new model launches in the coming quarters could actually rake up the heat on rivals like HMSI and BAL.

Exhibit 2: Changes in domestic two-wheeler market share

Domestic two-wheeler market share FY12 FY13 FY14 Change (%)

Bajaj Auto 19.1 17.9 14.2 (5.0)

Hero MotoCorp 45.1 42.9 41.3 (3.8)

TVS Motor Company 14.1 12.8 11.8 (2.3)

HMSI 14.9 18.9 24.0 9.1

Others 6.8 7.6 8.6 1.9

Source: SIAM, Nirmal Bang Institutional Equities Research

Amortisation of lumpsum licensing fee to Honda ends by June 2014

The lumpsum licensing fee of Rs24.79bn that the erstwhile Hero Honda (now HML) paid to Honda has been amortised equally over 14 quarters beginning with 4QFY11, and the same ends in 1QFY15. The quarterly amortisation over the 14 quarters ending 1QFY15 stands at Rs1.77bn per quarter. One has to note that the above one-time licensing fee is not to be confused with royalty payment. Ceteris paribus, beginning 2QFY15E, the disappearance of the line showing amortisation of lumpsum licensing fee would give a natural uplift to reported earnings by Rs1.77bn per quarter.

Royalty payment not to disappear from 2QFY15, but to stay minimal

The terms of separation of the JV partners (ie. Honda and Hero Group) stated that any royalty payable by HML to Honda would only be on new products till 30 June 2014, and the royalty payable on such new models would not exceed 5% of the sales of new models. No existing models that the Hero Honda JV had prior to April 2011 would attract any royalty payment to Honda after 30 June 2014. However, it appears that any new model obtained from Honda between April 2011 and end-June 2014 would attract royalty payment even after 30 June 2014. Royalty payment, which stood at Rs500.2mn in FY13, is expected to progressively trend downwards going forward.


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Research and development (R&D) expenses likely to move up

HML’s R&D focus rests on four key planks - refurbishing existing product platforms, developing new products with alternate fuel options, complying with stringent safety and environment norms and finally, achieving cost competitiveness through value engineering and innovative cost reduction measures. In its earlier avatar as a JV with Honda, the company never had to undertake big-ticket R&D on its own, as parent Honda used to provide the technology. But with HML now on its own, one should expect heightened R&D expenditure going forward. From 0.27% of revenue in FY13, we believe HML’s annual R&D spending (including payout to boutique development firms like AVL and EBR) should be upwards of 1% of its revenue.

Major cost-cutting initiatives under way to lift margins

HML has embarked on major cost-cutting initiatives that cover three key areas: components, processes and sourcing. We believe that international management consultancy firm McKinsey & Co is advising HML on the above initiatives. In processes, HML is apparently revisiting the processes of ~70% of its dedicated vendors. In the area of sourcing, HML is opting for import of some components from China. As regards components, HML is expected to cut costs through value engineering and component redesign. In its earlier avatar as Hero Honda, the company did not enjoy the flexibility to source components at a lower cost from China because of certain agreements and contracts with JV partner, Honda.

Over the next two years, HML plans to cut costs out significantly, and thereby uplift EBITDA margin on two- wheelers to the level of 17%-18%, comparable to those of BAL which enjoys the highest EBITDA margin in motorcycles within the industry. Our numbers capture the likely benefits of HML’s cost reduction initiatives.

Exports could provide fillip to long-term growth

Prior to April 2011, there were significant territorial restrictions imposed by Honda on Hero Honda’s two-wheeler exports and consequently, exports prior to April 2011 were only to Sri Lanka and Nepal. After the parting of ways with Honda in 2011, HML expanded its presence to 20 new markets by March 2014. While HML has already been despatching two-wheelers to new markets like Tanzania, Uganda, Burundi, Egypt, Ecuador and Bangladesh, it just forayed into Ethiopia, Turkey and Nicaragua. In Tanzania, Uganda, and Bangladesh, HML plans to have local assembly operations, just as it has in Kenya. In Colombia, HML plans to set up a manufacturing unit as a JV with a local partner, as Colombian local regulations insist on local manufacturing to a certain extent. Eventually, HML plans to use the Colombian facility to cater to other LatAm markets as well. Over the next one year, contingent upon the realisation of the above plans, HML is likely to have 4-5 assembly facilities and one manufacturing facility outside India. By 2020, HML aims to be in 50 export markets, and targets 10% of its annual revenue to come from export markets by then. The management’s basic aim is to strengthen the company’s presence in Africa, Central/Latin America, Sri Lanka and Nepal.

Exports have the potential to be a strong long-term growth driver, but in the near to medium-term, the macro-economic slowdown in traditional export markets like Sri Lanka and Nepal would continue to weigh on HML’s exports. We are projecting very conservatively, given the macro-economic slowdown in importing countries. Against HML’s exports of 192,303, 161,043, and 130,763 two-wheelers in FY12, FY13, and FY14, respectively, we expect its exports in FY15E and FY16E at 140,710 units and 160,585 units, respectively.

HML not to face any capacity constraints

As of end 3QFY14, HML had a combined production capacity of 6.9mn units, between its three plants located at Gurgaon, Dharuhera and Haridwar. Aggregate capacity has since then expanded to 7.65mn units as of end-March 2014, given the de-bottlenecking exercise undertaken. Meanwhile, the construction work at HML’s new plant in Gujarat has already commenced. In the first phase, a capacity of ~ 0.9mn is likely come on line in FY15E, and eventually the full capacity of 1.8mn should be on line by FY16E. The total capex on the Gujarat plant is estimated at ~ Rs10.75bn. We believe HML will not face any capacity constraints and the growth that we are projecting over next two years at least can be met by the company’s existing capacity and the incremental capacity coming on line.

Better industrial relations track record means lower risk premium

Even in the traditionally militant industrial belts of Gurgaon and Manesar, HML enjoyed better industrial relations track record over the past few decades. Unlike other marquee automobile OEMs like MSIL, HMSI etc. which have, at times, faced turbulent and even very violent labour/industrial relations in the past, HML has been able to maintain a fairly peaceful and harmonious relationship with its work force. There have been occasional strikes by its workers, and as in any industrial enterprise, there have been differences between the management and the trade unions. However, unlike MSIL and HMSI, these differences never turned violent at HML. To cite an example, the last strike by its workers (September 2013) at the Haridwar plant lasted for only two days, and the problems between the management and the trade unions were resolved amicably. We view HML’s better industrial relations track record as a positive factor that reduces the risk premium on the stock.


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Continues to be a good dividend yield play

HML’s management has given guidance of steady dividend payout, with the payout ratio remaining in the 35%-45% band. In FY13, HML declared a special higher dividend of 3,000% against FY12’s 2,000%. Consequently, the FY13 dividend payout ratio rose to 66.2% compared to 43.9% in FY12. The capex intensity of the two-wheeler business is significantly lower than that of the four-wheeler automobile OEM business, and this is definitely a factor that goes in favour of all two-wheeler companies including HML. In our view, it is quite reasonable to believe that HML’s solid business franchise would continue to generate and throw up significant amounts of cash, and much more than what is needed by the company’s capex and other capital requirements. We believe that HML would continue to be an excellent dividend play going forward, just as it has been for the past several years.

Exhibit 3: Dividend yield

Source: Company annual reports, Bloomberg, Nirmal Bang Institutional Equities Research

Financial highlights

We expect HML’s revenue and EBITDA to significantly recover and register 11.3% and 26.4% CAGRs, respectively, over FY15E-FY16E. Going forward, the macro-economic headwinds that HML faced during FY13-FY14 are expected to ease and likely give way to a favourable environment. We are projecting a 395bps expansion in EBITDA margin over FY15E-FY16E on the back of a recovery in top-line, major cost control initiatives and significant downtrend in royalty payment to Honda. With a significant portion of the tax breaks on the Haridwar plant gone post 1QFY14, we expect HML’s tax rate for FY14E-FY16E to be in the 27%-30% band. Notwithstanding the heightened capex over FY14-FY15, we expect HML’s FCF, or free cash flow, to remain strong and we also expect it to maintain its superior dividend payout ratio in the vicinity of 40%. We project earnings CAGR of 33.4% over FY15E-FY16E, driven by likely superior top-line growth, major uptick in margins, and the absence of amortisation of licensing fee (beginning 2QFY15).

Sales recovery and EBITDA growth

We believe the worst is already behind HML, with its FY13 performance bearing the brunt of the combined impact of a macro-economic slowdown and heightened competition. The pressure caused by HMSI’s aggressive promotion of ‘Dream Yuga’ and ‘Dream Neo’ models has eased considerably. Notwithstanding the current overall weak macro demand conditions, ‘Gudi Padwa’ (new year in states like Maharashtra and Andhra Pradesh) sales witnessed strong traction for HML.

On the fuel price front, i.e. petrol price, we believe the worst is already over. With the United Progressive Alliance–II government finally acting on progressively freeing up diesel price, the earlier pricing distortions which skewed the burden unduly in favour of petrol consumers have already started easing. On the interest rate front, while a secular decline in rates is still far away, a gradual cool down in consumer inflation is quite likely over the next tw--four quarters. We concede that the glide down path may not be all that smooth, and could be bumpy. Nevertheless, barring an El Nino effect, interest rates can be expected to ease, although with a significant time lag.

After a very tepid YoY growth of just 0.9% in net sales and a YoY decline of 9.2% in EBITDA in FY13, we project HML’s sales and EBITDA to grow 7.7% and 5.9%, respectively, in FY14E. Further, over FY15E-FY16E, we expect its sales and EBITDA to post 11.3% and 26.4% CAGRs, respectively. On the PAT growth front, we expect PAT to register a 33.4% CAGR over FY15E-FY16E.

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Exhibit 4: HML’s net sales, EBITDA and PAT growth trends

Source: Company annual reports, Nirmal Bang Institutional Equities Research

A solid 395bps uptick in EBITDA margin likely over the next two years

The combined impact of macro demand weakness and stepped up competition from HMSI resulted in HML’s EBITDA margin slipping to 13.9% in FY13 from a high of 16.9% in FY10 and from 15.5% in FY12. Going forward, on the back of HML’s aggressive cost-cutting initiatives, a likely full-fledged demand recovery and with the competitive dynamics vis-à-vis HMSI settling down into a more stable equilibrium, we believe HML’s EBITDA margin should witness a full-blown 395bps uptick over the next two years, ending at a likely 17.7% in FY16E. The other factors that would aid the above likely margin expansion are the downtrend in royalty payment to Honda and marketing expenses staying at a normal level. We have factored in the impact of likely higher R&D expenses in our projections. Even if we assume that FY14 EBITDA margin stands depressed by 20bps on account of an one-time excise duty cut-related hit taken by HML in 4QFY14 on the pipeline stock of two-wheelers, the projected uptick in EBITDA margin over FY16E-FY14E would be 375bps.

Exhibit 5: HML’s EBITDA and EBITDA margin trends


Tax rate to go up progressively

HML’s Haridwar plant enjoyed full tax rebate till the end of 1QFY14, and since then it enjoys only partial tax rebate (only on 30% of Haridwar plant’s revenue). Consequently, HML’s tax rate, which was 16.3% in FY13, rose to 26.9% in 9MFY14. We expect HML’s tax rate to progressively increase from the FY14E level of 27.0% to ~30.0% by FY16E.

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55,000


EBITDA EBITDA margin

(Rsmn) (%)


Hero MotoCorp 8

Exhibit 6: HML’s rising tax rate


Strong FCF generation to continue

As the chart below indicates, HML is expected to register attractive free cash flow, notwithstanding the heightened capex likely over FY14E-FY16E. We have factored in likely capex of Rs12bn in FY14E, Rs18bn in FY15E, and Rs10bn in FY16E. The heightened capex likely over FY14E-FY15E is on account of the upcoming plant in Gujarat and also because of the new R&D centre for scooters.

Exhibit 7: HML’s FCF to remain strong going forward


Exhibit 8: Dividend payout likely to remain attractive

(Rsmn) FY10 FY11 FY12 FY13 FY14E FY15E FY16E

Dividend 5,991 20,967 8,986 11,981 8,191 11,714 14,053

Dividend payout (%) 29% 114% 42% 63% 40% 40% 40%


Impact of foreign exchange fluctuations

As per FY13 annual report, HML’s outgo on direct import of components, raw materials, and capital goods was ~Rs 11.54bn (;less than 5% of FY13 net sales revenue), against net revenue from operations of Rs237.68bn. The forex earnings in FY13 from two-wheeler exports stood at Rs 6.25bn.

In the post 3QFY14 results conference-call, the management had stated that both direct and indirect imports would account for ~12.0%-12.5% of raw material costs (which are at ~ 70%-72% of sales). By indirect imports, what is being referred to is imports undertaken by HML vendors. Put together, this means that direct and indirect imports together account for ~8%-9% of sales. Of this 50% is USD-denominated, and the remaining 50% is Japanese yen or JPY- denominated. Most vendors’ imports are JPY-denominated.

21.2 19.8

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Hero MotoCorp 9

If we adjust for the natural cover provided by exports, then HML’s exposure to forex fluctuations may only be to the extent of ~5% of net sales (i.e. on imports), and of this 50% may be treated as USD-denominated and the balance 50% JPY-denominated. Just to get a broad feel of the currency impact, if we hypothetically assume that USD and JPY were to be, on an average, stronger by 10% against the Indian rupee in FY15E against FY14 average, the negative impact of the same on EBITDA margin can only be 50bps (against HML’s traditional EBITDA margin of ~14%).

A glimpse of likely 4QFY14 performance

Exhibit 9 below shows our 4QFY14 estimates and they are mostly self-explanatory. The only point we wish to highlight as regards 4QFY14 performance is that we have factored in a ~Rs500mn of shave-off/ hit taken by HML on its pipeline of finished goods inventory as a consequence of the cut in excise duty on two-wheelers announced by the Centre as part of budgetary announcements in mid-4QFY14. We have factored in this hit by incorporating it in ‘other expenses’.

Exhibit 9: 4QFY14 projections

Y/E March (Rsmn) 3QFY14 9M FY13 9M FY14 YoY(%) 4QFY13 4QFY14E YoY(%) FY13 FY14E YoY(%)

Sales 1,680,940 4,548,232 4,656,498 2.4 1,527,351 1,589,462 4.1 6,075,583 6,245,960 2.8

Net sales 68,459 175,103 186,692 6.6 61,458 66,016 - 235,827 - -

Other operating income 309 1,121 933 (16.8) - 300 - 1,854 - -

Total operating income 68,768 176,224 187,625 6.5 61,458 66,316 7.9 237,681 253,941 6.8

RM consumed, costs thereof 49,787 129,493 135,634 4.7 - - - 173,649 135,634 -

Purchase of stock-in-trade/ change in inventory 203 88 (134) (251.5) - - - 328

-

Total RM costs 49,989 129,581 135,501 4.6 44,395 47,845 7.8 173,977 183,346 5.4

RM costs as % of net sales 72.7 73.5 72.2 - 72.2 72.1 - 73.2 72.2 -

Employee costs 2,439 5,950 6,944 16.7 2,259 2,452 8.5 8,209 9,396 14.5

Employee costs as % of net sales 3.5 3.4 3.7 - - - - 3.5 3.7 -

Other expenses 7,360 16,345 18,722 14.5 6,306 7,688 21.9 22,651 26,410 16.6

Other expenses as % of net sales 10.7 9.3 10.0 - - - - 9.5 10.4 -

Total expenses 59,788 151,877 161,166 6.1 52,960 57,985 9.5 204,836 219,151 7.0

Total expenses as % of net sales 86.9 86.2 85.9 - - - - 86.2 86.3 -

EBITA 8,980 24,347 26,459 8.7 8,498 8,331 (2.0) 32,845 34,790 5.9

EBITDA margin (%) 13.1 13.8 14.1 - 13.8 12.6 - 13.8 13.7 -

Other income 957 2,939 3,234 10.0 1,045 754 (27.8) 3,984 3,988 0.1

PBIDT 9,937 27,286 29,693 8.8 9,543 9,085 (4.8) 36,829 38,778 5.3

Depreciation 2,732 8,762 8,345 (4.8) 2,655 2,995 12.8 11,418 11,340 (0.7)

PBIT 7,204 18,524 21,348 15.2 6,888 6,090 (11.6) 25,411 27,438 8.0

Finance costs 30 88 89 0.6 31 31 - 119 120 0.7

PBT (before exceptional items) 7,174 18,435 21,259 15.3 6,857 6,059 (11.6) 25,292 27,318 8.0

Exceptional items

PBT (after exceptional items) 7,174 18,435 21,259 15.3 6,857 6,059 (11.6) 25,292 27,318 8.0

Tax 1,928 2,996 5,712 90.7 1,115 1,664 49.2 4,110 7,376 79.5

Tax, % PBT 26.9 16.3 26.9 - 16.3 27.5 - 16.3 27.0 -

PAT 5,247 15,439 15,547 0.7 5,742 4,395 (23.5) 21,182 19,942 (5.9)

Extra-ordinary item (net of tax expense)

Reported PAT 5,247 15,439 15,547 0.7 5,742 4,395 (23.5) 21,182 19,942 (5.9)

Equity shares (mn) 200 200 200 - 200 200 - 200 200 -

EPS (unannualised) (Rs) 26 77 78 0.7 29 22 - 106 100 (5.9)



Hero MotoCorp 10

Valuation and rating

As already stated, we expect HML to post a CAGR of 11.3% in top-line and a hefty 33.4% CAGR in PAT over FY15E-FY16E. This represents a sharp inflection from flattish-to-negative earnings growth trend over FY12-FY14E.

With a likely 33.4% CAGR in EPS over FY15E-FY16E, we believe that a year from now, HML stock should trade at 16.7x FY16E EPS of Rs177.7, translating into a one-year target price of Rs2,968. We have derived our target price multiple of 16.7 based on a very conservative Lynch (PEG) ratio of just 0.5x against a projected two-year forward EPS CAGR of 33.4%. The stock currently trades at a P/E ratio of 14.9x FY15E EPS of Rs148.4 and 12.5x FY16E EPS of Rs177.7. Our FY15E and FY16E EPS of Rs148.4 and Rs177.7, respectively, are at the higher end of street estimates. We have assigned Buy rating to HML taking into account a likely 34% appreciation over the next one year.

Exhibit 10: P/E band

Source: Bloomberg, Company annual reports, Nirmal Bang Institutional Equities Research

We are quite ahead of Bloomberg consensus mean and close to top-end of street EPS estimates

Bloomberg estimates reveal that mean EPS for FY15/FY16 are at Rs137.1/Rs161.6, respectively. Street high/low EPS estimates for FY15/FY16 are at Rs156.2/Rs123.7 and Rs192.6/Rs136.8, respectively. Obviously, our EPS estimates for FY15/FY16 at Rs148.4/Rs177.7, respectively, are at the top-end of street estimates.

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Hero MotoCorp 11

Financials

Exhibit 11: Income statement


Net sales 235,790 237,681 253,942 281,336 314,737

% growth 21.6 0.8 6.8 10.8 11.9

Raw material costs 172,816 173,977 183,346 201,155 221,889

Employee costs 7,355 8,209 9,396 8,440 8,655

Other expenses 18,305 21,359 24,886 24,195 27,067

Total expenditure 199,603 204,836 219,152 235,197 259,186

EBITDA 36,188 32,845 34,790 46,139 55,551

% growth 42.9 (9.2) 5.9 32.6 20.4

EBITDA margin (%) 15.3 13.8 13.7 16.4 17.7

Other income 3,646 3,984 3,988 3,208 3,918

Interest 213 119 120 42 60

Gross profit 39,621 36,710 38,658 49,305 59,409

% growth 41.1 (7.3) 5.3 27.5 20.5

Depreciation 10,973 11,418 11,340 8,139 8,710

Profit before tax 28,647 25,292 27,318 41,166 50,699

% growth 19.1 (11.7) 8.0 50.7 23.2

Tax 4,866 4,110 7,376 11,526 15,210

Effective tax rate (%) 17.0 16.3 27.0 28.0 30.0

Reported net profit 23,781 21,182 19,942 29,639 35,489

% growth 23.4 (10.9) (5.9) 48.6 19.7

Extraordinary items (2,147) (2,260) - - -

Adjusted net profit 21,634 18,921 19,942 29,639 35,489

% growth 17.4 (12.5) 5.4 48.6 19.7

EPS (Rs) 108.3 94.8 99.9 148.4 177.7

% growth 17.4 (12.5) 5.4 48.6 19.7


Exhibit 13: Balance sheet


Equity 399 399 399 399 399

Reserves 42,499 49,663 60,272 76,040 94,921

Net worth 42,898 50,062 60,672 76,440 95,320

Short-term loans 7,194 6,416 - - -

Long-term loans 10,114 3,022 3,022 3,022 3,022

Total loans 17,308 9,437 3,022 3,022 3,022

Deferred tax liability 2,083 1,324 1,324 1,324 1,324

Liabilities 62,289 60,824 65,018 80,786 99,666

Gross block 63,083 66,851 79,472 97,472 107,472

Depreciation 25,228 36,141 47,481 55,620 64,330

Net block 37,855 30,710 31,991 41,851 43,141

Capital work-in-progress 388 621 - - -

Long-term \investments 6,740 6,145 6,145 6,145 6,145

Inventories 6,756 6,368 8,349 8,479 8,623

Debtors 2,723 6,650 4,174 3,854 4,311

Cash 33,671 31,904 40,101 48,976 69,351

Loans and advances 10,092 13,336 12,523 13,874 15,521

Total current assets 53,906 58,941 65,148 75,183 97,806

Creditors 22,932 18,733 20,872 23,124 25,869

Other current liabilities 13,668 16,859 17,393 19,270 21,557

Total current liabilities 36,600 35,593 38,265 42,393 47,426

Net current assets 17,306 23,349 26,882 32,790 50,380

Total assets 62,289 60,824 65,018 80,786 99,666


Exhibit 12: Cash flow


EBIT 25,214 21,427 23,450 38,000 46,841

(Inc.)/dec in working capital (23,268) (7,810) 4,663 2,968 2,784

Cash flow from operations 1,947 13,618 28,113 40,967 49,625

Other income 3,646 3,984 3,988 3,208 3,918

Depreciation 10,973 11,418 11,340 8,139 8,710

Deferred liabilities (385) (759) - - -

Interest paid (-) (213) (119) (120) (42) (60)

Tax paid (-) (4,866) (4,110) (7,376) (11,526) (15,210)

Dividends paid (-) (10,444) (14,018) (9,333) (13,871) (16,609)

Net cash from operations 658 10,014 26,613 26,875 30,374

Capital expenditure (-) (7,915) (4,505) (12,000) (18,000) (10,000)

Net cash after capex (7,256) 5,509 14,613 8,875 20,374

Inc./(dec.) in short-term borrowing 261 (779) (6,416) - -

Inc./(dec.) in long-term borrowing (4,597) (7,092) - - -

Inc./(dec.) in borrowings (4,336) (7,871) (6,415) - -

(Inc.)/dec. in investments (2,645) 595 - - -

Cash from financial activities (6,981) (7,276) (6,415) - -

Others - - - - -

Opening cash 47,909 33,671 31,904 40,101 48,976

Closing cash 33,671 31,904 40,101 48,976 69,351

Change in cash (14,237) (1,767) 8,197 8,875 20,374


Exhibit 14: Key ratios

Y/E March FY12 FY13 FY14E FY15E FY16E

Per share (Rs)

Reported EPS 119.1 106.1 99.9 148.4 177.7

Adjusted EPS 108.3 94.8 99.9 148.4 177.7

DPS 45.0 60.0 39.9 59.4 71.1

BV/share 214.8 250.7 303.8 382.8 477.3

Profitability & return ratios

EBITDA margin (%) 15.5 13.9 13.7 16.4 17.7

EBIT margin (%) 10.8 9.1 9.2 13.5 14.9

Net profit margin (%) 9.3 8.0 7.9 10.5 11.3

RoE (%) (on avg. book) 65.6 45.6 36.0 43.2 41.3

RoCE (%) (on avg. CE) 43.5 34.8 37.3 52.1 51.9

Efficiency ratios

Asset turnover (x) 6.1 7.5 7.9 6.7 7.3

Net WC (days) (8.3) 3.3 6.0 4.0 3.0

Receivable (days) 3.1 7.3 6.0 5.0 5.0

Inventory (days) 9.4 10.2 12.0 11.0 10.0

Payable (days) 34.1 32.2 30.0 30.0 30.0

Current ratio (x) 1.5 1.7 1.7 1.8 2.1

Quick ratio (x) 1.0 1.1 1.2 1.2 1.6

Valuation ratios

EV/sales (x) 1.8 1.8 1.6 1.4 1.2

EV/EBITDA (x) 11.6 12.6 11.5 8.5 6.7

P/E (x) 20.5 23.4 22.2 14.9 12.5

P/BV (x) 10.3 8.9 7.3 5.8 4.6



Hero MotoCorp 12

Disclaimer

Stock Ratings Absolute Returns

BUY > 15%

HOLD 0-15%

SELL < 0%

This report is published by Nirmal Bang’s Institutional Equities Research desk. Nirmal Bang has other business units with independent research teams separated by Chinese walls, and therefore may, at times, have different or contrary views on stocks and markets. This report is for the personal information of the authorised recipient and is not for public distribution. This should not be reproduced or redistributed to any other person or in any form. This report is for the general information for the clients of Nirmal Bang Equities Pvt. Ltd., a division of Nirmal Bang, and should not be construed as an offer or solicitation of an offer to buy/sell any securities.

We have exercised due diligence in checking the correctness and authenticity of the information contained herein, so far as it relates to current and historical information, but do not guarantee its accuracy or completeness. The opinions expressed are our current opinions as of the date appearing in the material and may be subject to change from time to time without notice.

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Institutional Equities - Nirmal Bang Coverage-21 April 2014.pdf · Institutional Equities g erage ... the scooter business is economic value ... HML has already embarked on big-ticket