Royalty hurdle for Hero Honda

While the business outlook appears robust, higher payments to the foreign partner till 2014 will hit earnings growth.

The Hero Honda stock fell over 7 per cent on Thursday as compared to its previous close on reports of higher royalty payments to its Japanese partner Honda Motors.

This loss comes on the back of a 3 per cent fall on Wednesday. Analysts attribute the stock’s weakness to the uncertainty on the relationship between the two partners and the November sales numbers, which were below expectations.

Higher royalty outgo

Reports suggest Hero Honda will increase royalty payments to its Japanese partner from the current 2.6 per cent of annual sales (Rs 416 crore) to about 8 per cent. At estimated FY11 sales of Rs 18,400 crore, the royalty payment would be about Rs 1,400 crore. Analysts say assuming the royalty payments double to about Rs 1,000 crore, it could knock off about 15-20 per cent of the company’s earnings.

In return for the higher royalty payments, which will continue till 2014, Honda is likely to supply technology for three new products. In addition, Honda is likely to bring down its stake (from 26 per cent currently) by 6 percentage points initially and sell the remaining 20 per cent to the Munjals at a discount to the market price. While on one side an agreement for new products should put to rest the technology transfer part of the relationship, the markets are more cued in to news on the split and the timeline of the same. The relationship thus far has been a profitable one for both companies. Hero Honda continues to dominate the executive motorcycles segment, with over 70 per cent market share. Honda got revenues to the tune of Rs 1,000 crore through royalty, technical fees and dividends in FY10.

Can it go alone?

Credit Suisse analysts believe Hero Honda’s cash cows Splendor, Passion and CD-Dawn have acquired strength on their own and can sustain themselves independent of the corporate entity backing them. The brands, which have been in the Indian market for over a decade now, command good resale value and are also backed by a strong distribution and service network. Analysts say like its peers Bajaj Auto and TVS Motors, Hero Honda can build its own technology over the next three to four years when its agreement with Honda comes to an end. Further, Hero Honda will also be able to tap the two-wheeler export market growing at over 15 per cent per annum. Currently, it can’t enter that market due to the joint venture agreement with Honda.

Auto sales

Hero Honda’s November sales, which grew a moderate 10 per cent year-on-year on a higher base, were lower than the 13.5 per cent sales growth it achieved year-to-date this financial year. Sequentially, sales fell a sharp 17 per cent as October’s volumes included inventory that was liquidated for the festive season. While this could be an aberration due to seasonal factors, the next few months could give a better picture.

SHORT-TERM PAIN
in Rs cr FY11E FY12E
Sales 18,4000 21,500
% change 16.7 16.8
Ebita (%) 13.0 15.0
change bps - 400 200.0
Net profit 2,188 2,509.0
% change -1.9 14.6
P/E (x) 16.3 14.3

E: Estimates, % change is y-o-y
Source: Bloomberg, analyst reports

For now, the company is facing intense competition from established players like Bajaj Auto, TVS Motors and Honda Motors. Edelweiss Securities estimates that for the period between April and October this year, the market leader has seen a 510 basis points drop (100 basis points is one percentage point) in market share to 53.4 per cent in the domestic motorcycle segment.
Analysts believe Hero Honda’s market share is likely to stabilise as its key brands continue to do well in smaller towns. A stronger rural economy is likely to boost volumes, which are expected to post an estimated 15 per cent year-on-year jump in FY11 to 5.2 million units.

Outlook

Hero Honda’s operating profit margins have been falling over the last few quarters due to higher commodity costs as well as product costs (to meet emission norms) and the fact that the company has not been able to fully pass on the costs despite price increases. Credit Suisse analysts believe the company is likely to recover its margins by passing on a part of the cost inflation. Though the stock has fallen 11 per cent over the last two days and could see some downward pressure in the short term, analysts don’t see much downside from these levels. However, given the lack of clarity over its JV with Honda, their top pick in the two-wheeler space continues to be Bajaj Auto.