High input prices falling sales growth may hit co hard

Hero Honda, the country’s largest two-wheeler maker, is facing headwinds from rising input costs and a slowdown in sales growth. The company’s net
profit in June 2010 quarter declined by 1.7% on a year-on-year basis to Rs 492 crore despite a 12% increase in net sales and nearly four percentage-points decline in its direct tax burden.

But the company’s revenue of Rs 4,265 crore was broadly in line with market estimates. This dichotomy was due to a sharp rise in operating expenditure led by a spike in raw material costs.

Hero Honda’s raw materials bill during the first quarter shot-up by 20%, twice as fast as the increase in sales volume during the first quarter. This resulted in a nearly 500 basis points increase in the company’s raw materials intensity as defined by the ratio of raw material cost to net sales. During the quarter, raw material cost accounted for 72.3% of its net sales compared to 67.6% during the corresponding period a year ago.

This adversely affected the operating margin and it declined to its lowest level in past six quarters. It reported an operating margin of 13.2% (of net sales) in June quarter compared to 16.8% during the corresponding period a year ago. Other operating expenses including staff cost and royalty payment to its Japanese partner were, however, remained in control and grew in line with the increase in sales volume.

However, a higher-than-expected 59% increase in other income including other operating income and fall in the company’s direct tax burden saved the day for the company. In past three years there has been a progressive decline in the company’s tax burden to nearly 19% from 31% in FY08 as the company has moved a significant portion of its incremental production to its tax-free unit in Pantnagar. But the gains have begun to peak out and will stop aiding its bottomline from December 2010 quarter onwards.

Going forward, a rejuvenated competition and rising metal prices will put the company’s profitability under pressure. Given the recent successes of Bajaj Auto and TVS Motors in outgrowing the market, many observers expect a recurrence of price war in the motorcycle industry. This could prove costly for Hero Honda, which dominates the industry with over 50% market share.