Hero Honda - Honda Motor Split - Implications for Hero Honda

Standard Chartered Equity Research's Analysis

A new beginning, a new era

Following months of speculation, the Munjal family of Hero Honda Motors (HH) finally signed an MoU to buy out the entire 26% stake of Honda Motor in the joint venture. The deal signed for an undisclosed amount, is expected to be at a substantial discount to HH's current market price.

Going forward, we expect the company to employ a three-pronged strategy. While it will continue to collaborate with Honda Motor on technical and product sides until FY14, it is also expected to set up its own R&D and scout for a new venture partner by that time.

The royalty payments will remain constant on existing products, and for new products, they could be anywhere between 3% and 5%. Also, we expect the company to source vehicle parts locally at better prices, which will reduce costs and improve operational performance going forward. We upgrade the stock to IN-LINE and increase price target to Rs. 1,920 (from Rs. 1,875 earlier).

Technical support from Honda Motor to continue until FY14

According to the new license agreement, Honda Motor will provide technical assistance to Hero Honda till FY14. We expect HH to develop its own R&D facilities by that time to retain its leadership position. It is expected to spend heavily to build its own R&D. While powerful brands like Passion and Splendor can give HH a smooth ride for the next few years., it will eventually need to enhance its product base through its own R&D.

HH would continue to use the Hero Honda brand name till FY14, after which it may undergo rebranding. This may impact its margins and earnings going forward. Changes in the existing models are also expected to follow the change in the branding of that particular model as per the MoU.

 
Royalty payment issue put to rest

Although the market was expecting royalty payments to increase following the news, management has clarified that royalty payments on existing products will be either constant or lower than FY10 levels of 2.6% and will eventually stop after FY14. For the new models, as per management, royalty will be in the range 3% - 5%.

HH paid a total of Rs. 4,164m (2.6%) or Rs. 905 /bike as royalty in FY10. It expects the blended royalty on existing products to be 2.75-2.85% for FY11E.

 
Export ramp-up

So far, HH has been a marginal player in the export market, with exports totaling only 2% of its total volume. There were restrictions which did not allow HH to export to Honda Motor's established markets. This has ended and HH is now looking to expand its reach to South East Asia, Latin America, Africa and the Middle East.

HH had limited opportunity in the export market, which gave Bajaj Auto a chance to become the market leader in exports with a 74% market share. However, after signing the definitive licensing agreement, HH is expected to expand into newer geographies and catch up with Bajaj Auto.

 
In the transition phase, HH will be allowed to use the Hero Honda brand, but we get a sense that the company will re-brand its export products before marketing them abroad.

HMSI, on the other hand, is expected to get aggressive in the Indian markets where it has been a marginal player in the 2W segment with 12% market share. It commands a marginal 6% market share in the motorcycle space. Although technologically superior, HMSI is far behind HH in terms of reach and distribution across the country. HH has, over the years, built an extremely strong and well-penetrated network.

HH to source parts locally at cheaper prices

HH sourced components only from approved vendors. The company can now source better priced deals locally for vehicle parts from other vendors.

 
The JV agreement led to 6% of ancillaries (as a % of raw material) being imported by HH, exposing it to currency risk. As the company is under no such obligation now, we expect it to increase its local content per bike, thus lowering its exposure to currency risk. This would make it cheaper than the imported content. Also, since the products are highly indigenized, there is little scope for import substitution.

Hence, we expect localization to reduce HH's costs.

Valuation

We value the stock at 14x FY12E earnings, which is in line with its five-year historical one-year forward multiple. The imputed EV/EBITDA is 10x FY12E at our price target. The valuation is justified given its strong distribution network, export outlook and lower costs due to localisation.

 
 
The stock, we believe, is fairly valued at current levels and we upgrade it to IN-LINE with a price target of Rs. 1,920 (from Rs. 1,875 earlier).