Macquarie - Hero Honda

Macquarie Research is bearish on Hero Honda and has recommended an underperformer rating on the stock with 12 months target price of Rs 608.

Macquarie report on Hero Honda:

Initiate coverage with an Underperform

We initiate coverage on Hero Honda, India’s largest two-wheeler manufacturer, with an Underperform recommendation and a target price of Rs 608. Our target price reflects potential downside of 13% from the current market price.

Structural decline in product mix

The proportion of high-margin products in Hero Honda’s portfolio – notably, its cash cow, the Splendor – has been declining. Going forward, we believe new low-profit products will cannibalise the existing product range. Competition has been directly targeted at Hero Honda’s most profitable motorcycles in the executive segment, further affecting profitability.

Market share losses – competition to the fore

Recent market share gains notwithstanding, Hero Honda has consistently lost market share over the past three years. With competitive intensity set to increase, we expect the company to lose market share over the medium term. Ironically, Honda’s subsidiary, Honda Motorcycles and Scooters India, could be its biggest competitor in near to medium term.

Operating margins under pressure

Our earnings estimates for FY3/08 and FY3/09 are roughly 10% and 7% below consensus, respectively, which reflects our bearish view on EBITDA margins. We expect operating margins to decline by another 100bp to 10.9% in FY3/08, but to rebound marginally in FY3/09 and FY3/10 as irrational pricing subsides. Apart from increasing competitive pressures, we expect rising royalty costs and marketing expenses to impact profitability.

Valuations – still too high

Despite the recent underperformance, we believe the stock price does not completely factor in the lower growth prospects for Hero Honda. The stock is trading at a low PER compared with its recent trading history. However, its lower growth prospects (FY3/07–10E CAGR of 7.6% vs FY3/01–07 CAGR of 25%) warrants the lower multiple, in our opinion. We value the stock at Rs 608 on a two-stage DCF methodology. At our multiple, the stock would trade at 12x FY3/09E earnings, which we believe would reflect the weaker growth prospects.

Key risks and catalysts

Apart from the macroeconomic factors, key upside risks for Hero Honda include exceptional success of a new model, curtailment in Honda Motors’ product plans and an increase in the value of investments. Key catalysts include a further decline in market share, an increase in interest rates and a further decline in operating margins.