R&D cost to strain profitability Hero Honda (HH) posted another disappointing set of numbers with a profit de-growth for the third successive quarter. On a volume growth of 28.5%, revenues rose 35% to Rs51.6bn. Adjusted for exceptional and prior quarter expenses, margins nose-dived 560bps YoY (170bps QoQ) to 11.7%, a level last seen in FY07. Rise in input costs and an increase in other expenditure were the main culprits. Adjusting for a provision of Rs0.8bn, profits slumped 9% to Rs4.8bn as against our estimate of Rs5.8bn.

All time high volumes: The company surpassed the 0.5mn units/monthly mark twice during the quarter. A robust festive season and onset of the marriage season helped volumes surge 28.5% to 1.4mn units. In the process, the company clawed back market share in the domestic motorcycle market by 260bps QoQ. Price hikes under taken enabled a 2.1% sequential growth in realisations to Rs36k/unit. Revenues were up 35% to Rs51.6bn.

Margins southbound: Margins slumped 610bps YoY to 11.2% as against our estimate of 14.1%. Raw material cost per vehicle increased 13.6% YoY. However, the biggest impact was due to spike in other expenditure led by Rs460mn provisioning for National Calamity Contingent Duty (NCCD) for Haridwar facility and sponsorship cost for Commonwealth Games. The company also made a provision of Rs0.8bn towards the excise duty claim at its Haridwar facility for previous years. Post the same reported profits were lower 20% YoY at Rs4.3bn.

Outlook: Due to strong demand, we have revised our volume estimates by 4% to 5.4mn and 5.9mn units for FY11 and FY12 respectively. Due to additonal burden of NCCD, higher marketing expenses and likely increase in R&D cost, we have reduced margin estimates for FY12 by190bps to 12%. This has led to downward revision in our earnings estimate for FY11 and FY12 by 4.5% and 9% to Rs99 and Rs106 respectively.

VALUATIONS AND RECOMMENDATION

The stock is currently trading at 14.7x its FY12E earnings. We maintain a ‘HOLD’ rating on the stock with a revised target price of Rs1,699 (earlier Rs2,097) discounting FY12E earnings 16x.

Concall Highlights

During the concall, the management clarified on the nature of the provisioning. The exceptional item of Rs0.8mn pertains to the provision for National Calamity Contingent Duty for previous years FY08-10. The other expenditure for the current quarter includes provisioning of Rs460mn on the same account for 9MFY11 out of which Rs180mn is for Q3FY11. The company expects the litigation to continue and hence has provided for this duty.

Margins during the quarter were also affected due to the expenses related to promotional activities at the Commonwealth Games held in October’10.

Going forward too promotional and advertising expenses are expected to remain high with the impending Cricket World Cup and Indian Premier League (IPL) to be held in India over the next four months.

The company has taken a price hike in the range of Rs500-Rs1500 in the first week of December. This hike is expected to cushion the impact of higher raw material cost.

Royalty Issue

The management clarified the stand on the royalty issue. Currently HH pays a variable rate of royalty on the existing models ranging from 3-5%. However, on its flagship product the company pays a flat royalty of Rs300/unit. As a result the average royalty charge for the company is in the range of 2.5-2.8%.

Going forward the royalty on existing models will continue at the same rate till June’14. Thereafter royalty on existing models will cease to continue.

As part of the separation agreement, HH will get new models from Honda for launch. These new models will have to be under a new brand. The company will have to pay royalty on these brands at existing rates (3 - 5%) till Jun’17. There after the agreement will be up for renewal.

The company can use the ‘Hero Honda’ brand on existing models till Jun’14. This is subject to condition of no modifications on the models.

HH will have ownership of all brands including Splendor and Passion, but will have to forgo CD-Deluxe and CBZ brands which are owned by Honda.

Outlook

The company has expanded capacity at Haridwar by 0.3mn/annum to 2.1mn units. The overall installed capacity currently is 5.8mn units. HH is in the process of finalising location for its fourth plant and decision on the same is expected soon.

The management guided to a volume growth of 15% for the industry in FY12 and is confident of maintaining marketshare.

On the margins front, the management guided for a weakness ahead. The major costs entailed in future include increased R&D Expenses, re-branding cost post separation with Honda and market development expenses for exports.

Due to additional expenditure, profitability is expected to remain under pressure in the medium term. However, in the longer term profitability target is in the range of 14-15%.