Hero Honda likely to ride past its worst this quater

We believe the current quarter will mark the bottom for Hero Honda’s market share and margins. While we cut our FY11E EPS by 8%, we raise our FY12-13E by 15-19% (earnings to grow 24% pa over FY11-13E) and raise our DCF-based target price to Rs 2,365. We believe HH is the best play on Indian consumers as of now.

Bottoming out: HH has lost market share in the past one year (-775 bp YTD), giving up the extraordinary share gains it had registered the previous year. Its share price movement was more on account of weakness and subsequent correction of Bajaj’s portfolio rather than any changes in HH’s positioning.

We believe the market shares have now reverted to sustainable levels and expect HH to start growing in line with the market. During the past year, HH’s margin has contracted sharply (-440 bp YTD) as the firm has been reluctant to pass on cost inflation even though its competitors have already done so. We expect this situation to be remedied soon as the current supply situation and competitive structure leave HH with tremendous pricing power.

Catalysts: We expect key near-term triggers to be strong volume growth and potential price increases later this year.

A key event that’s been widely discussed in the media is a potential exit of Honda from the joint venture. This could be sentimentally negative but we do not expect Honda’s potential exit to be meaningfully detrimental to HH’s prospects.

Valuation: We value HH on a DCF basis and set a target price of Rs2,365, after factoring in earnings changes.

At our target price, HH would trade at 18x FY12E, at a substantial discount to most other consumer stocks in the domestic market. We upgrade HH to an outperformer.