Hero MotoCorp - Dismal margin performance - Ambit

Results overview: Hero MotoCorp's margin performance in 3QFY13 was significantly below our expectations. Revenues (including other operating income) increased 3% YoY and 19% QoQ (1% ahead of our expectations). EBITDA margin for the quarter (after considering amortisation of royalty to Honda Motors) was at 9.4%, implying a YoY decline of 257bps and a QoQ decline of 54bps (271bps below our expectations). The margin performance was affected by pressure points in two particular costs: (a) raw materials and (b) 'other expenses'. Raw material costs as a percentage of revenues increased 124bps YoY and 143 bps QoQ (181bps higher than our expectations). 'Other expenses' as a percentage of revenues increased 143bps YoY (150bps higher than our expectations). While absolute EBITDA was lower than our expectations by 21%, net earnings at Rs4,879 mn for the quarter was below our expectations by 23%.

Key takeaways from the conference call:

Volumes and revenues: After a subdued period between mid-December 2012 and mid-January 2013 (in line with seasonal trends), the company's demand growth has seen some improvement in the past 3-4 days, and the company expects improved demand until February. However the company expects the slowdown in industry to continue till 1QFY14. Hero MotoCorp has received a good response to its recent launches, Maestro (scooter) and Ignitor (motorcycle). The company will continue to bank on new launches, the scooter segment and rural areas to drive volume growth in the future. The company had increased prices marginally wef October 2012 but has no immediate plans to increase the prices further. Whilst the slowdown in the export markets has led the company to review of the timing of its entry into some export markets, it continues to target 1mn export units by FY17.

Margins: The Company attributed the increase in raw material costs to higher mix of new products (such as Ignitor, Maestro, etc) during the quarter. As per the Company, new products tend to have higher raw materials/sales ratio in the initial period of their launches and this ratio comes down with pick up in volumes. The 'other expenses' for the quarter was impacted by increased marketing initiatives particularly targeted towards the new launches (Maestro, Ignitor, Glamour). However, the company indicated that no discounts, incentives or freebies were given during the quarter. Going forward, the company expects some relief on raw material costs from the recent Yen depreciation, which should bring down the indirect import costs. However, the company expects some of the marketing initiatives to sustain in 4QFY13.

Capex: The Company has commenced construction of the new Rajasthan plant, which is scheduled to be operational by 2HFY14. The new plant at Gujarat (the company's fifth plant) is scheduled to be operational by FY15.

Where do we go from here?

We remain concerned of the increased competitive intensity in the 2W space, particularly in the commuter bike segment, which is the bread-and-butter segment for Hero MotoCorp. We believe Hero MotoCorp is the most susceptible to increased competition, especially emanating from the aggressive expansion plans of Honda Motor (HMSI). Hero MotoCorp has already lost a market share of ~287bps YTD FY13 in the domestic motorcycles space. After the split with Honda, Hero MotoCorp still faces a lot of uncertainty regarding its new product development capabilities and brand building activities. This has necessitated elevated spending, which in turn has affected margins (manifested to some extent in 3QFY13 through the lower-than-expected margin performance of the company). At the same time, brand building and setting up distribution networks in the export markets involves long gestation periods and would not mitigate the risks of market share loss in the domestic motorcycles segment in the near to medium term. Whilst we expect the domestic motorcycle industry to recover and increase by 13% in FY14, we expect a market share loss of 190bps for Hero MotoCorp in the domestic motorcycle segment in FY14. As a result, we expect the YoY growth for Hero MotoCorp's overall volumes to be restricted to 10% in FY14.

Our current estimates factor in an EBITDA margin (after amortisation of royalty to Honda Motors) of 11.4% for FY13 and 11.9% for FY14 (YTD FY13 EBITDA margin of 10.3%). Given the weak margin performance in 3QFY13, we believe our EBITDA margin assumptions face significant downward risks. A 100bps cut in our EBITDA margin estimate through the forecast period in our DCF-based model results in 9% cut in our FY14 net earnings estimate and 8% cut in the target price.

At the CMP, the stock is trading at 14.7x our current FY14 net earnings estimate. We retain our SELL stance on the stock.

Source : Equity Bulls

Keywords