End of Joint Venture with Honda

END OF JOINT VENTURE WITH HONDA

The end of the joint venture between Hero Moto Corp and Honda has made Hero moto corp more vulnerable in the years to come and has weakened its future expected performance in the time of inflation and is likely to hurt its bottom line in the years to come.

The challenges for Hero in the time to come are as follows-

1) To strengthen R&D operations to churn out new models and upgrade vehicles for the next level of emission norms.

2) HH faces margin pressure due to a rise in R&D, royalty and advertising expenditures as

a result of the split.

3) The company's sales growth is limited by production constraints and slowing launches.

ESTIMATE SALES GROWTH TO TAPER TO A CAGR OF 11% OVER FY12F‐FY14F.

As a result of the split, HH faces margin pressures in the form of an increase in R&D (0.3% impact on EBITDA margin), royalty (0.5% impact on PBT margin) and re‐branding (0.5% impact on EBITDA margin) expenditures in FY12f. We estimate total income, EBITDA and PAT to grow at a CAGR of 13.7%, 13.6% and 8.5%, respectively, over FY12f‐FY14f.

We arrive at a Jun12 share price is targeted at INR1,616 using a P/E of 12.8x, which is 10% lower than the five‐year historical P/E of 14.2x.

PARTING OF WAYS WEIGHING ON EBITDA GROWTH

Margins in the two‐wheeler industry are affected by commodity and wage inflation. As a result of the split with Honda, HH is also facing margin pressure due to the following factors:

 Expenditure towards strengthening in‐house R&D operations: An increase in R&D expenditure is

likely to result in a 0.3% impact on the EBITDA margin in FY12f. The impact is likely to be higher at

0.5% and 0.7% in FY13f and FY14f, respectively.

 Increase in royalty: HH has entered into a new licensing agreement with Honda, which allows the

company to use Honda's technology till 2014. The royalty is agreed at INR24.8bn, to be amortized over 14 quarters till 1QFY15. Royalty as a percentage of total income is likely to increase to 3.1% in

FY12f and 2.8% in FY13f, higher than the historical average of 2.6% over FY07‐FY11

The company's margins are least affected by the likely changes in export incentives, as HH only derives 2% of sales from exports. The government has announced the withdrawal of the Duty entitlement pass book