Hero MotoCorp Limited | Automobile

Initiating Coverage | 1st June, 2012

CMP` 1821
Market Data Bloomberg Code Reuters Code SENSEX NIFTY Dividend Yield (%) 52 Week High/ Low(`) Equity Capital(`mn) Face Value (`) Market Cap (`mn) Avg. 10 day Vol. NSE
Source: Ace Equity, R K Global Research, as on

BUY
HMCL IN HROM BO 15965.2 4841.6 2.4 2278.5/1482.3 399.4 2.0 367824.4 483877.1
20 th Apr12

TP-` 2178

Hero MotoCorp after splitting JV with Honda Motorcycle and Scooters India is now aiming to explore the global market. Hero MotoCorp plans to make investments of `45000mn over the next five years to become an independent and global 2wheeler company. The company also plans to set up two new plants in India, adding to its existing three that have a total annual capacity in excess of six million 2-wheelers. New launches to help main market share: Hero MotoCorp has unveiled three new models that are expected to give a forceful push to its journey after its break-up with Honda. The new models will hit the Indian market over the next few months. The company has launched two new bikes -- 100 CC bike Passion XPro and a 125 CC Bike Ignitor along with a 110 CC scooter named Maestro. The two new motorcycle models will hit the market later this year. Maestro will be targeted at male customers in the age group of 18 to 24 while the Ignitor and XPro will be looking for executives and college going students. 2W export to boost HMCL volume: We expect 2W exports to grow at a healthy 15% in FY13E. We think the growth in exports will be led by income growth in the key export markets, low penetration of motorcycles in Africa and South Asian countries. In addition, the acceptance of Indian 2Ws to Latin America has been steadily rising. We believe growth will get a boost from Hero MotoCorps plan to enter new geographies, where they previously were not exporting due to the agreement with their erstwhile JV partner, Honda. In the last five years, 2W exports have grown at a CAGR of 25%. The key export markets for the Indian companies are lower-income developing countries on a high per capita GDP growth trajectory from a low base. Valuation: At CMP of `1821, stock is trading at EV/EBIDTA of 9.6x and P/E of 15.4x. We initiate our coverage on the company with BUY rating and target price of `2178.
Descriptions Revenue EBITDA PBT PAT EPS BVPS ROE ROCE P/BV EV/EBIDTA P/E FY'11 193979 25586 168393 20077 101 148 63% 59% 14 16.7 21.4 FY'12E 235790 36187 199603 23672 119 215 66% 56% 9.6 11.8 17.5 FY'13E 264707 39737 224970 26939 135 299 58% 60% 6.9 10.8 15.3 FY'14E 294415 45327 249088 29091 146 393 51% 61% 5.3 9.4 14.2

Key Market Ratios TTM Latest EPS (`) TTM Book Value (`) TTM PE (x) TTM P/BV (x) TTM EV/EBIDTA (x) EV/TTM Sales (x) Mcap/TTM Sales (x)
Source: Ace Equity, R K Global Research, as on 20 th Apr12

119.1 214.8 15.5 8.6 9.6 1.6 1.6

Share-Holding Pattern (%)

Promoters FII's DII's Others

8.8% 5.7%

33.5% 52.2%

Price vs Sensex
135.0 125.0 115.0 105.0 95.0 85.0 75.0 May-11 Aug-11 Nov-11 Feb-12 May-12 Sensex Hero MotoCorp

Research Analyst Aditya Vikram Jha aditya.jha@rkglobal.in

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Investment Rationale: HMCL a mixed bag of opportunity and uncertainty. Huge capex plans Hero MotoCorp plans to make investments of `45000mn over the next five years to become an independent and global 2-wheeler company. The company also plans to set up two new plants in India, adding to its existing three that have a total annual capacity in excess of six million 2-wheelers. The first new plant will be set up in one of the southern states with an initial capacity of 7.5 lakh units and will address the domestic market. The second plant will be set up in the west with unspecified capacity and would address both domestic and global markets. The company has identified 30 global markets, covering Southeast Asia, Latin & Central America, and Africa. To address these markets, the company is expected to start assembly plants outside India though the initial exports will be from its Indian plants. Capacity addition among major 2-wheeler players in India
Company Bajaj Auto Hero MotoCorp TVS Motors HMSI Royal Enfield Suzuki Motorcycle M&M Yamaha India
Source: Company, R K Global Research Estimates

Installed Capacity FY'11 4.50 6.20 2.55 1.60 0.07 0.25 0.60 0.60

Capacity Expansion FY'12 0.30 0.40 0.39 1.20 0.03 0.15 0.00 0.20

Capacity Expansion FY'13 0.00 0.75 0.16 1.20 0.06 0.00 0.00 0.20

HMCL market share in 2-wheeler

41.8% 41.4% 41.0% 39.4%

40.4%

Q4FY11

Q2FY12

Q4FY12

New launches in the near future to boost sales Hero MotoCorp has unveiled three new models that are expected to give a forceful push to its journey after its break-up with Honda. The new models will hit the Indian market over the next few months. The company has launched two new bikes -- 100 CC bike Passion XPro and a 125 CC Bike Ignitor along with a 110 CC scooter named Maestro. The two new motorcycle models will hit the market later this year. Maestro will be targeted at male customers in the age group of 18 to 24 while the Ignitor and XPro will be looking for executives and college going students. Hero MotoCorp to grow domestic 2W volumes by 7.5% in FY13 We expect a slowdown in two-wheeler sales growth this year due to price hikes, high fuel cost, slower rural income growth and weak consumer sentiment. After growing at a CAGR of 26% over FY09-11, 2W sales growth has started to moderate over the last few months. Last year was mixed for 2W sales, as the first half was very strong with growth of 17% but in the second half, sales growth moderated to 11%. Further, the sales growth trend was mixed for 2W companies depending on their exposure to the executive motorcycle segment and scooters.

HMCL Volume growth ('000)

1589 1530 1454 1544 1572

Q4FY11

Q2FY12

Q4FY12

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Racing for technology: Hero MotoCorp has formed a strategic partnership with Erik Buell Racing (EBR) of the US, encompassing multiple areas of collaboration. As part of the, partnership, HMCL will receive support in terms of cutting-edge technology and design to develop future models from EBR - the East Troy, Wisconsin-based firm, which specializes in designing and manufacturing powerful and high-speed motorcycles. Through this alliance, HMCL, for the first time, enters the exciting world of international motorcycle racing. The company will mark its foray into the racing arena by sponsoring two teams-Team Hero and AMSOIL Hero-a first by any Indian two-wheeler company at the AMA Pro Racing National Guard Superbikes Championship. Further, HMCL is also developing the concept hybrid scooter called 'Leap', showcased at the recently-concluded Auto Expo, in collaboration with EBR 2W export to boost HMCL volume We expect 2W exports to grow at a healthy 15% in FY13E. We think the growth in exports will be led by income growth in the key export markets, low penetration of motorcycles in Africa and South Asian countries. In addition, the acceptance of Indian 2Ws to Latin America has been steadily rising. We believe growth will get a boost from Hero MotoCorps plan to enter new geographies, where they previously were not exporting due to the agreement with their erstwhile JV partner, Honda. In the last five years, 2W exports have grown at a CAGR of 25%. The key export markets for the Indian companies are lower-income developing countries on a high per capita GDP growth trajectory from a low base. These markets are also characterized by a large working-age population, declining dependency ratios, growing urbanization and paucity of public transportation infrastructure. Scooter sales growth
26% 13% 19% 17% 13% 1% 23% 12% 10% 13% 50% 40% 30% 20% 10% 0% -12% FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 -10% FY04 FY05 -2% FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 6% 4% 4% 12% 9% 27% 25% 23%25% 41%

2-Wheelers Volume growth ('000)

3922 3693 3476 3878 3889

Q4FY11

Q2FY12

Q4FY12

HMCL's export % of total sales

2.4% 2.7% 2.7% 2.1%

2.0%

Q4FY11

Q2FY12

Q4FY12

Motorcycle sales growth

30% 25% 20% 15% 10% 5% 0% -5% -10% -15%

Rising fuel price to impact growth In the initial phase, 2W sales are positively impacted by the high fuel prices given their superior fuel economy compared to entry level cars. However, if the fuel prices sustain at high levels, 2W sales growth will be negatively impacted. OMCs are currently losing `7.0/l on petrol and `11/l on diesel retailing. We believe petrol price increases are inevitable given the governments fiscal situation, which is likely to hurt 2W demand.

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The Game Play: Intensifying completion After splitting the JV with Hero, Honda Motorcycle and Scooters India (HMSI) is now aiming to become the largest player in the Indian 2W market. The company has been aggressively expanding production capacity and dealer network over the last one and half years. The competitive intensity is expected to rise, as Honda is likely to aggressively price its new mass bike, Dream Yuga, which the company claims will offer the best fuel-efficiency and power in the segment. Honda plans to expand production capacity by 60% and add 100 new dealerships annually (500 dealers, 1,000 touch-points currently). HMCL overall market share vs peer s
BJAL 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Q1FY11Q2FY11Q3FY11Q4FY11Q1FY12Q2FY12Q3FY12Q4FY12 Source: Company, R K Global Research HMCL HMSI Yamaha TVS 60% 50% 40% 30% 20% 10% 0% Q1FY11Q2FY11Q3FY11Q4FY11Q1FY12Q2FY12Q3FY12Q4FY12

HMCL core segment market share vs peers

BJAL HMCL HMSI Yamaha TVS

As Honda has already reached 2 level in executive segment (and~20% market share), their aim to become 1 by 2020 should not be taken lightly. Over reliance on two brands HMCL depends majorly on two brands (Splendor & Passion) for volume growth. Currently Splendor and Passion together bring more than 65% of the volumes. HMCLs models such as CBZ Xtreme & Hunk competes with Bajajs Pulsar & Discover and HMSIs Unicorn in 150 cc segment but unfortunately many attempts to garner higher share in that segment have been futile. However Karizma has been successful competing with Avenger & Pulsar 220 cc. going forward, we expect HMCL will create new brands to compete with ever increasing competition in 2W industry in Indian market. Competition in scooter segment intensifying Increasing working class of women along with higher acceptance for gearless scooters has resulted in CAGR of 18% for the scooter industry in last 5 years as compared to motorcycle industry growth of 9% in the same period. Honda enjoys 43% market share with Activa which is highly successful in the domestic market. Based on rising class of working women in metropolitan cities, Yamaha is also planning to launch scooter in India. HMCL enjoys 17% market share in scooter segment with its only product - Pleasure (Launched in Oct, 2005). Strong growth of HMCL in FY12 of 26% in scooter segment Vs industry growth of 17.7% has enabled 1.6% increase in market share on YoY basis. To fuel the growth, HMCL has unveiled a gearless scooterMaestro 110 CC - to compete with Activa, Aviator, Scooty, and Access.

Currently Splendor and Passion together bring more than 65% of the volume of HMCL.

Hero MotoCorp launched Maestro 110cc to compete with Hondas Activa and Aviator.

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2-Wheeler Industry: Racing on Indian roads Two wheeler sectors is the most important segment of the Indian auto sector accounting for 75% of the total sales volume in the auto industry. The two wheeler industry is dominated by the motorcycle segment which contributed 80% to the sales volume in FY12. Hero MotoCorp, Bajaj Auto, TVS Motors and Honda Motorcycle are the major players in this sector. Indias 2-wheeler sector A) Motorcycle segment
Entry level segment generally offers features like kick start, four gear and spoke wheel

The motorcycle segment contributed ~80% to total sales volume within the two wheeler sector

I)

II)

III)

Executive segment caters buyers who have selection criteria like fuel economy, style and purchase price of a model

Entry level (upto 100cc): BJAL dominate economy segment with Platina and CT100 holding ~50% market shares. Hero MotoCorp holds ~30% with CD Dawn as its key model in the segment. Executive level (100cc -150cc): This is the largest segment in the motorcycle space and HMCL is the leader in this segment with Splendor and Passion account ~ 70% market shares BJAL with its Discover provides competition to HMCL. Premium level (above 150cc): BJAL dominates premium segment with Pulsar holding ~50% market share. Though, the gap is contracting with the increasing presence of Apache of TVS Motors and FZ 16 of Yamaha. This segment is important from the prospective of improving overall operating margin for any 2-wheeler company.

B) Scooter segment Scooter segment accounts for about 16% of the overall domestic two wheeler market. HMSI (Honda) is the market leader in the gearless scooter segment and accounts for more than 55% of the total market. Hero MotoCorp's only model in the scooter category is "Pleasure" which is targeted to the urban female segment. Activa model of the Honda is the largest selling model in this segment. C) Mopeds Moped segment accounts for approximately 5.0% of the market share of Indian two wheeler markets with TVS motors dominating the segment with over 90% market share. This segment is small in terms of both volume and value and only has limited number of players. Mopeds have seen a downward trend in sales and we expect similar trend to continue in future.

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Business Overview: Haar Gaon, Haar Aangan
HMCL hold strong presence in executive (below 125 CC) B2 segment. B3 & Scooter segment supporting growth.

Target Market Out of 6.5 mn units sold in B2 segment (below 125 CC) in FY11, 4.6 mn units were produced by HMCL. The company is the market leader in B2 segment with strong brands such as Splendor, Passion & CD series. Over the years, competitors have failed to bring such a product in the market and the same to happen in the future is extremely difficult. Hero Honda's dependence on credit sales is lower as compared to its peers. The company has a strong rural network and cash sales in rural areas are higher as compared to urban areas. Share of B3 & scooters in the overall sales volume has consistently increased from 6% in FY07 to 13% in FY11 (CAGR-37%). Higher expenditure on marketing & advertising for brand conscious B3 segment has well paid to HMCL.

Rural market contributes about 45% Volume play of Hero MotoCorps total domestic Preference towards higher volumes as compared to realization per bike has resulted into HMC focusing on B2 segment by launching low sales.

cost & fuel efficient bikes. Maximum number of customer touch points in rural areas help to garner 45% of the revenue.

HMCL has emerged as strong player in scooter segment through special outlets for women - just 4 her.

Establishing new brand will require higher expenditure Over the last 5 years HMCLs advertising expenses are in the range of 2 to 2.4% of net sales. However management expects to spend additional `1000 mn for brand building purpose. Through advertising campaign of HUM MEIN HAI HERO, company has initiated brand building process. Company has targeted youth through the modes of sports, music & entertainment. Company has been sponsoring MTV Roadies, SA RE GA MA PA & Mumbai Indians in IPL etc. specially to target youth which is their main target audience. Apart from sponsoring events, advertisement with slogan like YAARI KI GAADI, DESH KI DHADKAN HUM DUNIYA HILA DENGE, HERO HONDA DHAK DHAK GO etc. deepens the level of emotional connect between the company and its customers. We expect Advertising expense as % of net sales to increase by 0.4% to 3.2% in FY13.

Hero MotoCorp timeline..

Source: Company, R K Global Research

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Key Concerns: The bumpy road ahead High interest rates Sustained inflation forced RBI to tighten monetary policy. While Hero MotoCorp has not been significantly affected by higher interest because of its strong balance sheet and healthy cash flows, some of the smaller vendors of the company could face expansion constraints if the cost of finance continues to remain high. The company is now pursuing an aggressive policy of multiple sourcing to counter this challenge. Last year, the government launched a
new scheme, following the withdrawal of the Duty Entitlement Passbook (DEPB) Scheme, under which around 9% of free-on-board (FoB) value of exported two-Wheelers.

Weak world economy Global uncertainty didn't significantly affect past performance as the company's operations were mostly concentrated in domestic markets. With widening transcontinental footprint, the susceptibility to geo political events can escalate significantly. However, considering the company's product profile and planned focus on emerging and nascent markets similar to India, the management believes the challenge of uncertainty can be overcome.

Dependence on fiscal incentives means higher risk to profitability The Government of India offers various incentives to encourage and make exports viable from India. A Special Focus Market scheme (wherein 3.5% benefit is made available on exports destined for certain distant markets) has been expanded to include most of the target countries for Indian 2W manufacturers. Important existing and emerging markets such as Angola and several other African countries, Colombia, Mexico and Peru are covered under the scheme. Secondly, exports are dependent on the import duties and local factors in the target countries. Sri Lanka has recently raised import duties on 2Ws from 61% to 100%. Sri Lanka accounts for ~10% of 2W exports from DEPB scheme was replaced by a Duty India and we believe such a large price hike will hit demand in the Drawback Scheme, offering 5.5% medium term. We believe similar risks exist for other key markets in incentive on FoB value with an Africa and LATAM.
additional 1% special incentive for exports until March 2012.

Challenges post split with Honda After splitting the JV with Hero, Honda Motorcycle and Scooters India (HMSI) is now aiming to become the largest player in the Indian 2W market. The company has been aggressively expanding production capacity and dealer network over the last one and half years. In the past, HMSI had refrained from launching any product in direct competition to Hero MotoCorp. However, this will change now, as HMSI is likely to launch multiple bikes in the executive segment (100110cc) over the next two years. Market shares unlikely to change in near term, but risks ahead. HMSIs Dream Yuga is to be positioned against Heros Splendor and Passion (75% of HMCLs volume). Honda, which was constrained for capacity, is likely to dedicate ~600-800k (of 1.8mn new capacity by March 2013) of additional capacities to motorcycles and primarily Dream Yuga. We believe HMSIs aggressive intent to ramp up volume and distribution will first impact Discover due to its weak brand compared to HMCLs Splendor. However, market share loss risks for HMCL still exist if HMSIs new brands succeed in the market.

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Outlook and Valuation HMCL expects the industry to grow at ~10% for the year FY13 and has guided to outperform the industry. However, we believe company might face certain problems achieving its target given the expansion by the unlisted players of international repute. Going by robust sales volume in FY12 (6235475 units), Current capacity of HMCL is around 6.6 mn and would go upto 7 mn in next two quarters. The capacity of Haridwar plant is 9500 units/day from 8000 units/day and contribution from Haridwar plant would be 40%. We expect FY13E EBITDA margin to 16%. We do not anticipate major threat from Honda Motors in Sub-125 cc segment despite increase in capacity for Honda Motors. HMCL P/E trend
25 20 15 10 5 0 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12

HMCL EV/EBITDA trend

18 16 14 12 10 8 6 4 2 0 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12

We estimate more executive launches from Honda Motors by the end of FY13 and believe competition to intensify and escalate by end of FY14 rather than in FY13. By the time competition intensifies, Hero MotoCorp will be ready with its export strategy. At the CMP of `1821, the stock is trading at P/E of 15.4x FY13E, EPS of `119.2 and EV/EBITDA of 9.6x. We recommend a BUY on the stock with target price `2178.

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Company Financials:
Income Statement (`Mn) FY'11 FY'12E FY'13E 193979 168394 25586 3442 158 25428 4024 24846 4769 20077 235790 199603 36187 3646 213 35974 11082 28538 4866 23672 264707 224970 39737 4011 200 39537 11478 32070 5131 26939 Balance Sheet (` Mn) FY'11 FY'12E Sources Of Funds 399 399 29161 42504 29560 42903 14912 10113 44472 53016 Application Of Funds 55385 14582 40803 1251 19072 51288 -46402 -2468 44472 62655 25664 36991 1251 715 39643 -22792 -2083 53011

Descriptions Revenue Expenditure EBITDA (ExOI) Other Income Interest PBDT Depreciation PBT Tax PAT

FY'14E 294415 249088 45327 4412 200 45127 12002 37537 8446 29091

Descriptions Share Capital Total Reserves Shareholder's Funds Total Debt Total Liabilities Gross Block Less: Acc. Dep. Net Block CWIP Cash At Bank Investments Net CA Diff. Tax Asset Total Asset

FY'13E 399 59113 59512 5613 65125 69695 37141 32513 1251 768 45000 -11562 -2083 65120

FY'14E 399 77874 78273 1123 79396 77655 49143 28512 100 15404 55000 -3028 -2083 79401

Financial Ratios Description Adj.EPS CEPS DPS Book value EBIDTM Pre-Tax Margin PATM CPM ROE ROCE Sales/FA Revenue Growth EBIDTA Growth PAT Growth EPS Growth EV/EBIDTA EV/Sales P/BV P/E FY'11 FY'12E Per Share (Rs) 101 119 121 174 105 45 148 215 Margin Ratios (%) 13% 13% 10% 17% 15% 11% 10% 21% FY'13E 135 193 45 299 16% 14% 11% 19% 58% 60% 380% 12% 10% 14% 13% 10.8 1.6 6.9 15.3 FY'14E 146 206 45 393 15% 17% 11% 21% 51% 61% 379% 11% 14% 8% 8% 9.4 1.5 5.3 14.2

PAT Depreciation Change in WIP Others

Cash Flow Statement (` Mn) 20077 23672 26939 4024 7616 800 31720 11082 -23172 0 11582 11478 3407 0 41823

29091 12002 9941 0 51034 -7749 -10000 -17749 -4490 -10330 -14820 18475 15404 33879

Cash from Operation

Performance Ratios (%) 63% 66% 59% 56% 350% 376% Efficiency Ratios (%) 22% -8% -10% 22% 41% 18% 19% 11.8 1.8 9.6 17.5

Cash Flow From Investments CAPEX -28845 -7270 -7000 Change in Investments -12030 11645 -5357 Cash from Investing -40875 4375 -12357 Cash Flow From Financing Inc/ Dec in Debt Dividends Paid Cash from Financing Net Change in Cash Cash at the Binging Cash At The End 0 -9401 -9401 -18356 19072 716 -4799 -10330 -15129 70.8 715 786 -4500 -10330 -14830 14636 768 15404

Valuation ratios(x) 16.7 2.2 14 21.4

DuPont Analysis Description PAT/PBT PBT/EBIT EBIT/Sales Sales/TA TA/NW FY'11 0.8 1.0 0.1 4.4 1.5 FY'12E 0.8 1.0 0.1 4.4 1.2 FY'13E 0.8 1.0 0.1 4.1 1.1 FY'14E 0.8 1.0 0.1 3.7 1.0

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