Hero Honda Motors Limited Recommendation: Long Term Buy

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BSE Code: NSE Code: Reuters:

Registered Office: 182 HEROHONDA HROH.BO
Industry: Automobiles : Two-wheelers
34 Community Centre, Business Group : Hero Group
Basant Lok Vasant Vihar,
CEO : Mr. Pawn Kant
New Delhi- 110057.
Munjal
Telephone: 91-11- Face Value : Rs 2
6142451/4121
Fax: 91-11-6143321
Listing: Ahmedabad, BSE, Calcutta, Delhi,
Website:www.herohonda.com Ludhiana, NSE.

7 Nov, 2002
Recommendation : Long Term Buy
Closing Price : Rs. 240.15
Sensex :2975.26
Market Capitalization : Rs 4795.6 Cr
Share in issue : 19.97 Cr
Estimated free float : 48%
Major shareholders : Munjal Group (26%), Honda Group (26%)

Summary

Industry and demand

India’s robust motorcycle demand, having shown 28% Cagr between FY99-02, is set
for a 20% Cagr in the next three years. Favorable demographics, rising affordability,
superior commuting economics, the emergence of motorcycles as a must-own utility,
an irreversible shift in consumer preference to motorcycles and accelerated growth in
replacement demand and upgradation (scooters or mopeds to motorcycles) will be the
key drivers for this demand growth.

Market Leader continuing on growth path

Hero Honda Motors revved up its bike sales by 24.6% in October. It had sold 165,066
bikes in October, up 24.6% from the 132,516 units it sold in the same month last year.
In the year ended in March, Hero Honda's motorcycle sales soared 38.45% to
1,425,302. That gave it a 49% share of new bike sales in the past year in India, the
world's largest motorbike market after China.
Hero Honda showed robust half-yearly financial results1 for the period April-
September 2002, despite competition.
The company's Profit After Tax (PAT) for the period soared to Rs. 279.00 crore, a
growth of 57 per cent over Rs. 177.15 crore in the corresponding period last year. The
profit before tax has also gone up from Rs. 273.44 crore to Rs. 428.48 crore,
registering an impressive increase of 57%.

1
New Delhi, October 18, 2002 Hero Honda announces outstanding half-yearly financial results
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The operating margin in the first half of the year was an impressive 15.54%, a
substantial increase of 22% over the corresponding period in the last FY (12.73%).
The company's total turnover (sales plus other income, net of excise) for the period
also grew to Rs. 2548.56 crore, a growth of 27 per cent over Rs. 2010.46 crore in the
corresponding period last year.

Stable margins despite competition

Hero Honda.s market share declined by 300bps in the last year, but its strategy of
competitive pricing and new launches in key product segments will help it sustain its
market share at the current 45%. It continues to enjoy the strongest brand equity and
offers an unmatched product portfolio. A mix of 18%+ growth in volume and a big
reduction in its cost structure will help the company offset the negative impact of
lower product prices and maintain its margins at around 15%.

Valuation: Fair value upside of 46%

We have used a 3 stage discounted cash flow approach to find the fair value of the
stock. Taking conservative estimates in growth of 18% (Hero Honda revenue growth
over last year was 56%) over the next three years, 10% for five years after this period
and a terminal growth rate of 6% we arrive at a fair value of Rs 360. This shows a fair
value upside of 46% from its current price of Rs 240. Assuming terminal growth of
six percent, the market is today implying a sub 10% growth in Stage I. This is
excessively pessimistic in our view. Hero Honda's capital efficiencies (ROE 70%,
ROCE 93%) and cash payout (70%) are high. At a 7% dividend yield, the stock offers
deep value. The stock is currently trading at P-E of 8.8 2003(E2) earnings and 7.2 of
2004(E) earnings. A dissipation of concerns on the renewal of the technology
agreement with Honda Japan will be key re rating driver for the stock.

Financial Highlights

Year to march 31 2001 2002 2003(E) 2004(E) 2005(E)

Revenues (Rs Cr) 3171 4466 5271 6219 7339
Net Profit (Rs Cr) 241 463 544 657 791
EPS (Rs) 12.4 23.2 27.3 32.9 39.7
EPS Change (%) 28.5 87.1 17.6 20.7 20.4
P-Ex(@240) 19.4 10.3 8.8 7.3 6.1
Price to Book x 7.4 7.0 5.6 4.6 3.7
EVA 185.4 360.4 390.7 423.8 460.7

2
E here stands for expected
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Industry:

Hero Honda belongs to the automobile industry (two- wheelers) and operates mainly
in motorcycles.

India.s motorcycle demand saw a robust Cagr of 28% during FY99-02. A number
of changes occurred during this period. There was a rapid increase in the availability
of cheaper credit, rising affordability, cheaper product prices, a shift in preference to
motorcycles, and a rising proportion of services in GDP were the key factors that
contributed to this growth. We believe most of these changes are enduring and
structural in nature, and will thus continue to drive long-term demand growth. For the
value-conscious Indian consumer, motorcycle transport offers superior economics and
we believe that its emergence as a must-own utility coupled with favourable
demographics are potent factors that will continue to drive penetration (still a low
15%). Even on a higher base, a moderated demand Cagr of 20% over FY02-05 is
realistic.

The Key Demand Drivers in the industry are:

Favorable demographics
We believe that rapidly changing demographics have been one of the key factors
that have driven the strong demand growth over the past decade. These factors,
which include rapid expansion in the target consumer base, the emergence of the
services sector as the fastest-growing segment in the economy, as well as rising
urban migration, will continue to drive sustained growth in motorcycle demand.
Nearly 47% of India.s population is now in the 15-45 years age group. This is
precisely the target group of motorcycle users. By 2006, the target group will rise to
50% of the population. Even assuming a low 1% growth in population, this is
tantamount to an addition of 49m people in the target population. Thus the target
demographic base itself is expected to rise by 2% Cagr in the next five years. The
consumer class households (annual income in excess of Rs60,000) are seeing even
stronger 6% annual Cagr.

Rising affordability due to falling prices, availability of credit

Another driver for motorcycle demand in the country will be rising affordability
on the back of deflating prices and cheaper credit availability. These will lead to
demand growth rates to outstrip the personal income growth rates in India. Nominal
motorcycle prices have remained unchanged over the past 10 years and in real terms,
prices are down 23%. Furthermore, the price of the cheapest available motorcycle
has dropped 15% over the past five years. This is leading to a rapid migration of
customers to this segment. We expect average motorcycle prices to drop by over
5%, driven by improving efficiencies.

Higher availability of cheaper credit is yet another growth driver. Consumer

credit is still nascent in India and, until recently, it was dominated by non-
banking finance companies. With corporate credit demand on the wane, most banks
are now aggressively targeting the retail segment for asset growth. Two-wheeler
financing is currently high on the agenda of most banks including ICICI Bank and
HDFC Bank. These banks are clocking 50%+ growth rates in this segment. In just

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three years, the share of credit to total motorcycle purchases has gone up from 15% to
35%.

Superior commuting economics

As public transportation costs have started to rise, the gap between the cost of owning
and running a motorcycle versus the cost of using a public transport has
substantially narrowed. As highlighted in Figure 13, the all- inclusive per person per
km cost is Rs0.75 (including running, maintenance, financing and loan amortisation
costs), while the cost of urban transport varies from Rs0.55-0.85 per person per
km. For the value-conscious Indian consumer, motorcycle commuting is working
out to be an increasingly attractive option, rendering penetration that much easier.

Shift in consumer preference to motorcycles

A host of factors like superior fuel efficiencies, better aesthetics and a larger wheel
base (making it better suitable for use in rural areas, which generally have poor road
infrastructure) have resulted in motorcycles growing at the expense of scooters
and mopeds. Motorcycles account for over 75% of India.s two-wheeler sales (as
compared to 30% in FY96), and 38% of the two- wheeler population. With the
market clearly demonstrating a marked preference for motorcycles, we expect this
trend to continue in the foreseeable future. A 20% Cagr in motorcycle demand
would mean only a lower 14.5% Cagr in overall two-wheeler demand between FY02-
05.

Accelerated growth in replacement demand:

An estimated 26% of the scooter population and 29% of the moped population is
more than 10 years old. About 23% of motorcycle population is more than five years
old. In India, the obsolescence period for two-wheelers is over 12 years. As a result,
replacement demand for these consumer durables has been virtually non-existent so
far. However, going forward, replacement demand will start kicking in. The
obsolescence period is also shrinking, given the spate of new product launches
and fast-changing consumer preferences.

Rural Demand
The demand in the rural areas is also rising as the people are moving over to
motorcycles. The sturdiness, durability, big tyres are certain characteristics which are
important for rural customers due to the poor road conditions in these areas.

Rising proportion of services in GDP

Employment in the services sector has risen from 23% of the total workforce in 1994
to 28% in 2000, rising by 3.3% Cagr during this period. In comparison, there was
negative job creation in the agricultural sector, and a lower 1.8% growth in the
industrial sector. The trend of higher job creation in services will accelerate further
in coming years, as average growth in this segment is nearly 2x that of industry
and agriculture. While emerging services like courier, home delivery and direct
marketing all require mobility, for the smaller businessmen, traders and shopkeepers
(this segment is typical of India), two-wheelers came as a viable commuting option.

Supply Scenario
The high demand potential is attracting a lot of new players to this industry. Even
older players are gearing up for the demand with new products. In 2002, two Japanese

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companies broke up with their joint-venture partners. Yamaha acquired 100%

ownership of Yamaha Escorts as it bought out the Indian partner, Escorts. On the
other hand, Suzuki sold out its stake in the erstwhile TVS Suzuki to its JV partner,
TVS Group. Freed of their joint venture partners, both TVS and Yamaha are
planning to launch new models as well as new variants of existing models. Even the
late entrant LML is planning to launch as many as four new models over the next two
years. Hence we feel that even if the demand potential is high supply will be able to
match or outstrip demand.

Key Success Factors in the industry

Considering the high demand and supply dynamics in the industry we feel that the
following will be the key success factors in the industry: (1) Customer Knowledge,
(2) Strong distribution network and after sales, (3) Technology, (4) Ability for quick
and successive introduction of new products, (5) Operating efficiencies to offset the
effect of pressure on prices. We will analyse where Hero Honda stands on the above
parameters in the company overview.

Company Overview

History

What started out as a Joint Venture between Hero Group, the world's largest bicycle
manufacturers and the Honda Motor Company of Japan, has today become the
World's single largest two wheeler Company. Coming into existence on January 19,
1984, Hero Honda Motors Limited gave India nothing less than a revolution on two-
wheels, made even more famous by the 'Fill it - Shut it - Forget it ' campaign. Driven
by the trust of over 5 million customers, the Hero Honda product range today
commands a market share of 48% making it a veritable giant in the industry. Add to
that technological excellence, an expansive dealer network, and reliable after sales
service, and you have one of the most customer- friendly companies. Customer
satisfaction, a high quality product, the strength of Honda technology and the Hero
group's dynamism have helped HHML scale new frontiers and exceed limits.

In the words of Mr. Brijmohan Lall Munjal, the Chairman and Managing Director,
"We will continue to make every effort required for the development of the
motorcycle industry, through new product development, technological innovation,
investment in equipment and facilities and through and through efficient
management."

Product Portfolio

Hero Honda's motorcycles account for over 45% of the entire motorcycles market.
The various brands of Hero Honda are Splendor, CBZ, CD100, CD100SS, Passion,
Sleek, and Street. Splendor enjoys nearly 30% of the total motorcycles market. CD
100SS and CD 100, each accounts for nearly 5% of the motorcycles market. Dawn
and Ambition have also exceeded expectations after their launch in April 2002 and
September 2002. The companies products cover the entry-level segment (Rs30-
40,000), The executive/commuter segment (Rs40-50,000) and Premium/luxury
segment (Rs50,000 upwards).

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Financial Performance
Hero Honda showed robust half-yearly financial results3 for the period April-
September 2002, despite competition.
The company's Profit After Tax (PAT) for the period soared to Rs. 279.00 crore, a
growth of 57 per cent over Rs. 177.15 crore in the corresponding period last year. The
profit before tax has also gone up from Rs. 273.44 crore to Rs. 428.48 crore,
registering an impressive increase of 57%.
The operating margin in the first half of the year was an impressive 15.54%, a
substantial increase of 22% over the corresponding period in the last FY (12.73%).
The company's total turnover (sales plus other income, net of excise) for the period
also grew to Rs. 2548.56 crore, a growth of 27 per cent over Rs. 2010.46 crore in the
corresponding period last year.

Share holder Value Creation

The company has focused on creation of shareholders value. The economic value
added as a percentage of capital employed is more than 40%4 in the last year, which is
one of the highest in the country. The company has increased dividend payout ratio
substantially during the last 3 years. The market capitalisation has grown more than
11 times in the last 5 years. The company has taken various steps for shareholders
value creation including a share split in March 01, special dividend of 250% in
October 01, and a final dividend of 350% & celebration dividend of 250% in 01-02,
taking the total payout ratio to 75.53% of the profits of the Company for the year
2001-02.

Positives

Hero Honda has a dominating presence

For years now, Hero Honda has dominated the motorcycle segment, with volume
growth outpacing that of the broad market. FY98 through FY02, total motorcycle
volumes have seen a 27% Cagr from 1.1m to 3m. Over the same period, Hero
Honda.s volumes have grown at a faster 37%. Going forward, we believe Hero Honda
will continue to be the key beneficiary of strong growth in the overall motorcycle
market.

After the success of Ambition Hero Honda next plans to launch a high-end
motorcycle in 4QFY03. The company is expected to maintain this pace of launches
over the next two years and this will sustain market excitement for Hero Honda
products. Hero Honda.s current product rollout plan is based on an extensive survey
of 71,000 customers. The company had undertaken a similar exercise three years
ago to chalk out its product strategy. We believe Hero Honda.s ability to understand
customer preference early has been a key to its success.

Hero Honda enjoys the strongest brand equity

Our belief of Hero Honda.s ability to sustain market share rests heavily on its strong
brand equity. Over the past decade, the company has nurtured its brand equity on the

3
New Delhi, October 18, 2002 Hero Honda announces outstanding half-yearly financial results
4
Source: Company website
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back of superior quality products that have not only delivered the promised
performance but also exceeded customer expectations in most cases.
Over this period, Hero Honda has also developed a strong distribution network of
450+ dealers spread across the country. This makes its products easily available and
serviceable at almost any location. An indication of Hero Honda.s strong brand equity
is the fact that credit sales of Hero Honda models are the lowest in the industry. This
clearly indicates high demand-pull for its products, unlike the credit-led, aggressive
marketing push of other companies. This is particularly noteworthy, considering
Hero Honda products are priced at a premium to competition.

High Cash Generating Capability

Hero Honda is also a strong cash generator with annual free cashflow in
excess of Rs6bn. Strong operating profit, a negative working-capital cycle and
minimal capex requirements are the key drivers for its strong free cash generation.
The good news for shareholders is that the company has demonstrated a willingness
to pay out this cash. With over 97% of manufacturing outsourced, the capex
requirements are also minimal. Annual capex for the company over the past five years
has averaged only Rs1bn and has created brownfield capacity of 0.3m. Even the
cost of greenfield capacity is low and the proposed 50% augmentation of production
capacity likely in FY04 will cost only Rs2bn. In the last financial year, the company
generated free cash of Rs6bn - 84% higher than the previous year.

Stable margins despite competition

Over the past couple of years, the competitive landscape of the Indian motorcycle
market has significantly changed. Bajaj and TVS Motors, the two other major players
in the segment have turned quite aggressive forcing Hero Honda to cut its product
prices by 3% in April-02. Hero Honda has also taken the competition head on with the
launch of its new economy model Dawn in April-02. Ambition has also exceeded
expectations since its launch in september. These two products will flank Hero
Honda.s best-selling executive segment motorcycles Splendor and Passion, and
help check market-share erosion. The benefit of its aggressive cost-cutting exercise
has started to kick in. In 1QFY03, despite a 4% fall in YoY price realisation,
margins expanded by 280bps YoY. An 18% volume Cagr, economies of scale and
rationalisation of raw material costs will help Hero Honda to offset expected price
declines (assuming 4.5% decline in price realisation in FY03) and still sustain its
Ebitda margins in the 15%+ range up to FY05.

Negatives

Competition
Hero Honda is now facing resurgent competition. Thanks to excellent prospects
in the motorcycle sector, new players are being attracted. With annual volumes of
four million, the Indian motorcycle market is the second largest in the world, after
China. Over the past five years, Hero Honda dominated the market as it led the shift
towards four-stroke motorcycles. It gained leadership on the back of its high- quality,
trouble-free products. With the advent of four-stroke engines, players such as TVS,
Bajaj Auto and Yamaha were marginalised for quite some time. This situation has
changed over the past two years. The competitive landscape in the sector is now
tougher than ever before. New product launches by Bajaj Auto and TVS have been
well received by the fast-growing market hungry for more product variety. More

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recently, even the smaller players such as Kinetic, Yamaha and LML have signalled
their re-entry via several new model launches. As a result, the motorcycle market
today has more than 30 models on offer, 13 of which are in the executive segment
alone.
Hero Honda has also taken the competition head on with the launch of its new
economy model Dawn in April-02. Ambition has also exceeded expectations since its
launch in september.
Yet, even if the company were to fall short of its volume target, the expansion in
margins means that it could easily achieve an earnings growth of around 305 per cent

Renewal of technology contract with Honda

We feel that Honda will renew the technology support contract with Hero Honda. One
reason is that Hero Honda has a formidable presence in the Indian market and Honda
has also benefited with partnership both having equal share. Hero Honda Motors Ltd.
has become the largest seller of motorcycles amongst all Honda companies and
ventures in the world by selling one million motorcycles during the current financial
year. Honda’s contribution to the success of Hero Honda can also not be ignored. Its
deep understanding of the Indian consumers, distribution network, after sales service,
and marketing tactics have all contributed to where Hero Honda stands today. The
partners share excellent relationship, as stated by the company officials also. “We
share an excellent relationship6 with Honda and have joint plans for future product
developments. So we see no problems in unlimited continuation. Since the
agreements are tenural in nature, we have a date associated with it. It is an enduring
relationship”.
Hero Honda is the most successful joint venture company of Honda. Honda
management has clarified7 that the new products introduced through the Honda
subsidiary (after five years) would be complementary to Hero Honda's products and
not competitive. There would be a joint committee represented by HHML and Honda,
which would decide upon marketing strategies and product selection to ensure the
above. We would like to jointly retain 50% market share of the Indian two-wheeler
industry.
Hence we feel that the market is worrying too much over this contract renewal, which
has led to under valuation of the stock.

Valuation

We have used a 3 stage discounted cash flow approach to find the fair value of the
stock. Taking conservative estimates in growth of 18% (Hero Honda revenue growth
over last year was 56%) over the next three years, 10% for five years after this period
and a terminal growth rate of 6% we arrive at a fair value of Rs 360. This shows a fair
value upside of 46% from its current price of Rs 240.

5
Business Standard, 10th July, 2002 Fresh launches should help Hero Honda meet its FY03 sales
target Cruising along.
6
Source: Company website
7
Source: Company website

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Methodology
We have used a three-stage model to estimate the fair value of the stock.
Capital asset pricing model has been used to estimate the cost of equity using share
price data for the past three years.

Assumptions
We feel that Hero Honda will come-off its high growth phase, to moderate growth
phase before settling to mature long-run growth rates. Over the past five years
earnings growth for Hero Honda was a strong 56% driven by 40% volume growth.
With further market share gains now unlikely, we see volume growth rates coming
down to 10% in the next five years. Over the longer run, the two-wheeler
industry growth rates will also moderate as penetration levels rise. We have assumed
terminal growth rates of 6%, in line with long-run personal income growth. The
key risk to these assumptions is that Hero Honda is primarily a single- product
company and long-run growth rates may be impacted by a shift in consumer
preference or market-share losses for Hero Honda.

Hero Honda Motors Limited Mar-01 Mar-02 Mar-03 (E) Mar-04 (E) Mar-05(E)
Rs.Crore 12 mths 12 mths 12 mths 12 mths 12 mths
Net Sales 3,171.22 4,466.48 5,270.45 6,219.13 7,338.57
Total Operating Income 3,181.85 4,513.11 5,317.08 6,265.76 7,385.20
Total Operating Expenses 2,766.57 3,806.74 4,465.39 5,246.67 6,167.23
Net Operating Profit 415.28 706.37 851.68 1,019.09 1,217.97
NOPLAT 271.97 470.92 567.80 679.41 812.00
Operating Fixed Assets 434.90 481.05 567.64 669.81 790.38
Net Block 453.85 490.74 577.33 679.50 800.07
Operating Working Capital (80.97) (354.39) (412.65) (482.38) (564.39)
Gross Investment 240.52 228.20 127.37 144.01 164.59
ROIC-opg OIC 40% 55% 61% 67% 74%
Free Cash Flow 75.72 293.73 495.29 600.12 723.79

P-E analysis
The stock is currently trading at P-E of 8.8 2003(E8) earnings and 7.2 of 2004(E)
earnings and hence seems to offer great value.

Comparison with peers

Company Sales (rs cr.) PAT (rs cr.) Market Cap (rs cr.)
Hero Honda Motors Ltd. 4,469.09 462.93 5,075.38
Bajaj Auto Ltd. 3,639.00 404.09 4,444.49
TVS Motor Ltd. 1,930.48 53.91 922.38
LML Ltd. 470.42 -44.32 158.25
Maharashtra Scooters Ltd. 103.76 5.33 73.03

8
E here stands for expected
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Resources used
The report draws on the following resources for industry and company related data:

Company website www.herohonda.com

CLSA Emerging Markets Equity Research Report on Hero Honda; research analysts
Ashish Gupta and Anupam Gupta; 13 August 2002
www.Indiainfoline.com
www.equitymasters.com
www.icicidirect.com
www.karvy.com
www.indiabulls.com
www.moneycontrol.com
www.nseindia.com
www.bseindia.com
www.myiris.com

Newspaper articles, company press releases

CMIE ( Center for monitoring Indian economy) Prowess database

Disclaimer
The opinion expressed and valuations done in the report are the opinions of the
analyst. The analyst is not responsible for the actions taken by the reader on the basis
of the report.

Appendix

Profit And Loss Statement

Hero Honda Motors Limited

Profit And Loss Statement Mar-01 Mar-02 Mar-03 (E) Mar-04 (E) Mar-05(E)
Rs.Crore 12 mths 12 mths 12 mths 12 mths 12 mths
Income
Sales 3177.2 4471.87 5276.8066 6226.632 7347.426
Other income 10.63 46.63 46.63 46.63 46.63
Change in stocks 18.17 -5.81 -5.81 -5.81 -5.81
Non-recurring income 11.42 38.54 0 0 0

Expenditure
Raw materials, stores, etc. 2344.39 3131.14 3701.601 4367.889 5154.109
Wages & salaries 117.96 161.57 190.6526 224.9701 265.4647
Other manufacturing expenses 30.55 57.93 119.475 140.9805 166.357
Indirect taxes 5.98 5.39 5.39 5.39 5.39
Excise duties 2.26 2.78 2.78 2.78 2.78
Selling & distribution expenses 122.27 179.12 211.3616 249.4067 294.2999
Miscellaneous expenses 75.22 166.86 187.4504 198.6974 210.6193
Non-recurring expenses 14.65 17.61 10 10 10

PBDIT 456.32 778.31 900.116 1078.538 1290.425

Interest 2.53 1.51 1.51 1.51 1.51
Lease rent 32.57 31.41 31.41 31.41 31.41
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PBDT 421.22 745.39 867.196 1045.618 1257.505

Depreciation 44.27 51.01 54.85137526 64.72462 76.37505
PBT 376.95 694.38 812.3446247 980.8933 1181.13
Tax provision 130.08 231.45 268.0737262 323.6948 389.773
PAT 246.87 462.93 544.2708986 657.1985 791.3574
Appropriation of profit
Dividends 66.01 349.67 380.989629 460.039 553.9502
Retained earnings 180.86 113.26 163.2812696 197.1596 237.4072

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