Uncertainty over JV clouds Hero Honda

If Hero Honda Motors goes on its own, it would have to invest significant amounts into research and development to keep pace in the marketplace

Shares of the world’s largest two-wheeler maker, Hero Honda Motors Ltd (HHML), have fallen sharply in the last few months as media reports signal the exit of its Japanese technology partner, Honda of Japan. While the company has not confirmed this, the key question is: Will Hero Honda be able to retain pole position against such a development?

Analysts say that despite its large vendor base and indigenization, HHML almost entirely depends on Honda for engine technology. Its power-packed brands—Splendor and Passion— that have catapulted the firm’s brand equity, have Honda’s engine technology. If HHML goes on its own, it would have to invest significant amounts into research and development (R&D) to keep pace in the marketplace. Another option will be to scout for a new technology partner. But this would warrant a brand relaunch, which, in turn, could mean marketing costs and risk of product acceptance.

Graphic: Yogesh Kumar/Mint

Graphic: Yogesh Kumar/Mint
But the flip side is not too rosy either. If technology transfer continues for sometime after Honda exits, it could come at a higher cost. At present, HHML pays around 2.5% of sales as royalty fees every year—Rs420 crore in fiscal 2010, slated to rise to around Rs500 crore in 2011. Take the case of Maruti Suzuki India Ltd, where royalty expenses increased from 3.6% to 7.5% of sales in the June quarter. As it stands though, the terms of agreement, which are reviewed every 10 years, are valid up to 2014.

In fact, industry experts say the stalemate between the two companies is on issues relating to royalty payments, HHML’s desire to expand in new overseas markets and its intent to set up a third greenfield factory, where Honda seems to be delaying on granting permission.

Even the timing for such an altercation is wrong. At a time when India is among the fastest growing two-wheeler markets, and when HHML with top-of-the-line products, is already constrained for capacity, these issues would hinder growth.

Due to component shortages, HHML’s market share has dropped from 51% to 44% in the last few months. And competitors such as Bajaj Auto Ltd and TVS Motor Co. Ltd have been quick to capitalize on this.

Of course, reports suggest that Honda’s Indian arm—Honda Motorcycle and Scooter India Pvt. Ltd (HMSI), may want to go it on its own. So far, the firm had focused on scooters in India. Now it is aggressive in motorcycles, too. It is investing around Rs500 crore to ramp up its two-wheeler capacity from 1.5 million to 2.2 million units a year.

This is nearly the size of TVS, while it is still only one-third of HHML. An IDFC Securities Ltd report says, “It would take at least three to four years for HMSI to scale up to a level to challenge the two domestic market leaders. Honda may also have to forgo income in terms of dividend, royalty as well as its share of profit after tax from its most profitable joint venture.”

More importantly, the Munjals would have to cough up around Rs9,000 crore at the current market price of around Rs1,700 to buy out the 26% stake of Honda. The promoters are reportedly trying to rope in private equity players, to partly fund the same. Given these odds, some analysts hope the 25-year partnership will continue.

The imbroglio bears a resemblance to the exit of Japan’s Suzuki Motor Corp. from TVS about a decade ago, when TVS shares plummeted. The firm gathered momentum on its own in a couple of years, but not without pain.

In comparison, HHML is on a stronger wicket in terms of its market share, distribution reach, brand equity and even technology absorption. Yet, a severance would affect performance of the company and the share price in the short-term. In the last three months, HHML shares have lost 13% on rumours of Honda’s exit coupled with a drop in revenue growth and profitability. Uncertainty about the future has brought down its price-earnings multiple of around 16-17 times to around 12 times fiscal 2012 earnings.