Hero Motocorp Limited

Mispriced Opportunity Note

HERO MOTOCORP LIMITED

Independent Equity Research

18th April, 2020

Equentis Wealth Advisory Services (P) Ltd

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HERO MOTOCORP LIMITED (HMCL) Synopsis table Recommendation BUY Current price (17th April, 2020) Rs. 1,837 Buying Range Rs. 1,790 - Rs. 1,890 6-12-month fair price range Rs. 2,280 – Rs. 2,443 Upside from CMP (%) 24% - 33%

Event translating in ‘Mispriced Opportunity’

1-year Price movement Price Movement wrt Period Date Price (Rs.) 1-yr Forward P/E to current price Recent high 31-Jan-20 2,502 14.5 -27% 52 Week high 23-Sep-19 3,021 20.4 -39% 2yr high 17-Apr-18 3,770 23.8 -51% Current market price 17-Apr-20 1,837 10.6 NA

Phase II – Gross under- Phase I – HMCL performance due to outperformed peers due to rural income disruption, price hikes, rural lower exports and buoyancy and product inventory correction mix

Source: Yahoo Finance, Equentis Research

As seen in the chart above, HMCL has under-performed peers in terms of stock price over the past 1 year. However, a closer look reveals that this can be divided into two phases, each spanning nearly six months. The stock of HMCL fared better than peers in Phase – I while it grossly under-performed its peers in the second half. Reasons for the same are discussed below:

Explanation of phases over the past one year

Phase-1 (1st April, 2019 – 15th October, 2019) – Outperformance

In this phase, which spanned little more than first half of FY20, HMCL outperformed peers Bajaj Auto (BJAUT), TVS Motor Company (TVSM) and Maruti Suzuki India (MSIL) owing to the following reasons:

 Favorable product mix – HMCL derives greatest proportion of its volumes (more than 68%) from motorcycles less than 125cc engine capacity. April, 2019 marked the beginning of braking-related norms (ABS and CBS) for 2Ws. The quantum of cost increase due to these braking-related norms was to be lower for motorcycles with lower engine capacity, hence price increase was lowest. This put HMCL at an advantage over BJAUT and TVSM.  Rural buoyancy – Rural incomes were strong in the earlier part of the year (H1FY20) due farm loan waivers by several states, Budget support to farmers (PM-KISAN doles) and strong rabi harvest. Given that HMCL derives ~45% of total volumes from rural areas; highest among peers; the stock saw an improvement in sentiment.  Favorable price hike – HMCL managed to take a price hike to the tune of 1% (blended, varying across models) in July, 2019 to pass on rise in input, insurance and regulatory costs. However, TVSM and BJAUT took price cuts between 5-6% across models despite higher costs, in order to combat subdued volumes.

Phase 2 (16th October, 2019 till date) – Under-performance

In this phase, which spanned remainder of FY20 and continues till date, HMCL has under-performed peers owing to the following reasons:

 Lower exports – Exports contribute only 5% to HMCL’s total volumes against 52% for BJAUT and 35% for TVSM. Exports are seen as a sound diversification for Auto OEMs when domestic sales come under pressure. Given that HMCL does not have strong export presence, it has limited capacity to sell unsold BS-IV inventory in export markets, where BS-VI implementation does not hold.  Rural under-performance – Rural incomes were under stress in the latter half of FY20 owing to disruptive monsoon patterns (delayed arrival, extended stay and non-uniform distribution). HMCL’s heavy dependence on rural economy led to correction in stock price.  BS-VI related transition cost highest for entry level motorcycles –BS-VI related cost increase for entry level motorcycles is expected to be 12-13% versus 5-6% for premium motorcycles. Entry level motorcycles contribute 68% to HMCL’s volumes versus 29% for BJAUT and 13% for TVSM. In a scenario where demand is already subdued, these price hikes could hurt HMCL the most.

Our view

In our opinion, HMCL is best poised to stage a recovery post recent under-performance. The stock has corrected more than peers over the past 12 months, owing to the reasons mentioned above.

Phase - I Phase - II Stock 1yr return 1Apr19 - 15Oct19 16Oct19-17Apr20 HMCL -33% 5% -29% TVSM -42% -15% -27% BJAUT -22% 3% -21% MSIL -26% 2% -21% Source: BSE Website, Equentis Research

Following are the key reasons that will lead to resurgence in HMCL’s stock price in the near to medium term:

 The global economy is expected to stay weaker for longer compared to India. European and American countries have been hardest hit due to COVID’19 pandemic, while African, South American and Middle-Eastern economies continue to suffer from lower crude oil prices. Given weak expectation for global growth, we do not expect crude oil prices and consequently export economies to recover in a hurry. In such a scenario, HMCL, owing to its largely India-centered portfolio, will stay the most resilient.  Post lock down and some normalization in the near future, demand could recover first in 2Ws and that too in the entry level, given entry level cars and premium motorcycles are still seen as “discretionary” or “luxury” items in most parts of India. Entry level motorcycles are more need-based and hence will see a faster bounce back.  Personal mobility could be preferred by customers vis-à-vis shared mobility post the COVID episode, stimulating auto (car and bike) sales.  HMCL has an extremely robust balance sheet with cash and liquid investments worth ~Rs. 60bn as on 30th September, 2019, translating into cash per share of Rs. 284. This is the highest among peers and higher than most other companies (across sectors). It is enough to cover its fixed costs during the lock down phase and beyond. In addition, HMCL has extremely strong free cash flow generation and dividend yield to the tune of 5-6% each, a factor which is favored by investors in the current tumultuous market phase.

We are confident of HMCL posting a smart recovery over the near to medium term owing to the reasons mentioned above. Apart from these reasons, we continue to be utmost confident regarding HMCL’s execution capability, management pedigree and financial strength. Hence, we recommend the stock in our Mispriced Opportunities Product.

Risks to our recommendation

1) Worsening of Corona Virus pandemic– Any further worsening of corona virus pandemic in terms of higher reported cases / deaths in current phase or relapse of the pandemic post lock down could lead to further demand destruction. However, impact for HMCL will be limited to India (where severity of the outbreak has been low so far) given that it has limited exports.

2) BS-VI related price hike – Introduction of BS-VI emission norms will lead to 9-12% increase in prices of 2Ws, thereby dampening demand. This is true for all auto OEMs

3) Weakness in rural demand – HMCL derives ~45% volumes from rural areas, hence weakening of rural income due to inadequate rainfall will affect HMCL the most. However, the recent IMD forecast predicts normal monsoon for India this season.

4) Competitive intensity – Higher-than-expected competitive intensity could result in loss in market share and / or margin deterioration.

Fundamental Business Strengths

Hero MotoCorp Limited (HMCL) was incorporated in 1984 as a 26% : 26% JV between the Munjal family and Honda Group, Japan called Hero Honda Motors. In 2010, Honda moved out of the JV and Munjals bought their stake, leading to creation of HMCL. The company is world’s and India’s largest manufacturer of 2Ws, with a market share of 51.5% in domestic motorcycles and 35.5% in overall domestic two wheelers.

We highlight some of HMCL’s business strengths below:

1) Strong rural presence to aid growth and recovery – HMCL derives ~45% of total volumes from rural areas, which are believed to lead recovery post stabilization of COVID impact. Rural incomes would be aided by strong kharif / rabi sowing, a normal monsoon (basis IMD’s recent forecast) and Government’s focus on keeping rural economy intact in the wake of the current crisis.

2) Strength in entry level motorcycles – HMCL has market share of 61% in economy bikes and 70% in executive bikes. These segments are somewhat viewed as “non-discretionary”, since purchases in these segments are more “need-based” compared to higher segments. In the event that individual incomes (salaried as well as business) take a hit due to the corona virus related issues, purchases in these segments are expected to precede those in premium bikes. Also, preference might move towards personal mobility from shared mobility due to continuation of social distancing. Hence, we expect HMCL to benefit from these conditions.

3) Strong balance sheet flush with liquidity –HMCL has nearly Rs. 60bn worth of cash and liquid investments and even higher reserves. These can be used to tide over the current crisis and support its dealers and vendors. Also, it has a zero debt balance sheet. HMCL has enough liquidity to tide over the crisis and come out unscathed. HMCL has cash per share of Rs. 284. The cash component is higher than most other companies (across sectors) and can easily cover its fixed costs during the lock down phase and beyond. In addition, HMCL has extremely strong free cash flow generation and dividend yield to the tune of 5-6% each, a factor which is favored by investors in the current tumultuous market phase.

4) Bane of lower exports turns into boom – Among the three major 2W companies (HMCL, TVSM, BJAUT), HMCL has the lowest proportion of volumes coming from exports. HMCL derives only 5% of total volumes from exports against 52% for BJAUT and 35% for TVSM. Export markets for TVSM and BJAUT (Middle East, Africa, Latin America) are significantly dependent on crude oil for propelling their economies. Hence, HMCL is positioned to benefit from its India-centric business model.

5) Lower commodity and crude prices to benefit at gross level – The Auto sector on the whole is set to benefit from lower prices of crude oil (~70% correction YTD) and stable prices of steel and aluminum (single-digit decline, but expected to decline further due to slower economic activity in China). The lower input prices will help companies partially absorb BS- VI related cost escalations. Hence, OEMs are expected to be better positioned on the cost side, with demand being a key monitorable.

Quarterly Financial Snapshot

Particulars Q3FY17 Q4FY17 Q1FY18 Q2FY18 Q3FY18 Q4FY18 Q1FY19 Q2FY19 Q3FY19 Q4FY19 Q1FY20 Q2FY20 Q3FY20 Q4FY20E (Rs. Mn.) Revenue 63,646 69,228 79,805 83,717 73,142 85,640 88,098 90,909 78,648 78,850 80,303 75,707 69,967 60,423 yoy -11.9% -7.8% 7.9% 7.4% 14.9% 23.7% 10.4% 8.6% 7.5% -7.9% -8.8% -16.7% -11.0% -23.4%

EBITDA 10,797 9,576 12,959 14,557 11,580 13,706 13,773 13,787 11,048 10,693 11,580 11,011 10,390 7,091 yoy -4.5% -19.5% 5.4% 6.3% 7.2% 43.1% 6.3% -5.3% -4.6% -22.0% -15.9% -20.1% -6.0% -33.7% EBITDAM 17.0% 13.8% 16.2% 17.4% 15.8% 16.0% 15.6% 15.2% 14.0% 13.6% 14.4% 14.5% 14.8% 11.7%

PBT 10,853 9,390 12,931 14,357 11,282 13,872 13,427 14,485 11,384 10,811 11,364 10,979 10,115 7,097 yoy -1.9% -21.1% 4.8% 2.5% 3.9% 47.7% 3.8% 0.9% 0.9% -22.1% -15.4% -24.2% -11.1% -34.4%

PAT 7,720 7,178 9,140 10,105 8,054 9,674 9,092 9,763 7,691 7,303 8,572 8,837 8,804 5,312 yoy -2.7% -13.9% 3.5% 0.6% 4.3% 34.8% -0.5% -3.4% -4.5% -24.5% -5.7% -9.5% 14.5% -27.3%

 We expect revenues to decline 23% yoy in Q4FY20, in line with 25% yoy decline in volumes for the quarter.  EBITDA margin will contract to a multi-quarter low of 11.7%, due to negative operating leverage and higher discounts offered to sell-off BS-IV inventory. The contraction in operating margin would have been more severe had commodity prices not corrected as they have

Key management personnel

With HMCL Management Team Designation Prior Experience Qualification since Chairman, Dr. Pawan Munjal Managing Director Inception - NA - Mechanical Engineer and CEO - CFO, Vedanta Resources Plc (2014 – 2017) - Global Finance Director, Household Care, Unilever Mr. Niranjan Gupta CFO April, 2017 - CA London (2008 – 2012) - Finance Head, HUL (2000 – 2005)

Mr. Markus CTO 2014 - BMW (1989 – 2012) - Mechanical Engineer Braunsperger

6 to 12-month Upside Potential

Fair price range – 6M to 12M  Trading below long-term valuation average- Currently, the stock is trading at FY22E forward P/E multiple of 11xs, compared to the 10-year P/E average of 18xs, discount of 40%.

 High margin-of-safety - At these levels, margin-of-safety is considerably high and makes a strong case for price appreciation.

 6-12-month potential upside 32-41% - By valuing the stock at P/E multiple of 14-15xs on FY22E EPS of Rs. 163, we arrive at the target price range of Rs. 2,280 – 2,443, offering an upside potential of 24 - 33% from CMP- Rs. 1,837 (17th April, 2020) over the next 6 to 12-month period.

 Sector poised for a cyclical recovery – The 10% jump in FY22 PAT will come on the back of 3 years of subdued earnings. There were various reasons for this decline such as braking norms, emission norms, higher insurance cost, weakness in rural demand and most recently, the COVID issue. Usually 2W cycle lasts for 3 – 5 years, which means that FY23E earnings could mirror FY18 peak EPS of Rs. 185, assuming everything else remains same. While PAT is expected to dip nearly 27% yoy in Q4FY20, it could dip almost 40% yoy in Q1FY21. We feel that this is already discounted in the stock price and the remainder of the year could see Q2-Q4FY21 PAT remaining flattish.

 Price and Earnings performance comparison with other peers – As seen below, HMCL’s earnings growth and subsequent stock price growth has lagged peer over 5 and 10 year periods. However, the stock is well placed to regain some of its lost market share, given that its rural presence is far higher compared to peers Hence, we feel that the stock may provide a good “comeback” over the near to medium term.

Earnings Growth (CAGR) Stock Price (CAGR) Name of the Companies 5Yrs 10Yrs 5Yrs 10Yrs Hero MotoCorp 9.92% 10.20% -5.86% -0.38% Bajaj Auto 7.61% 13.58% 2.47% 8.44% TVS Motor 20.69% 26.83% 2.47% 20.43% Average 16.80% 16.87% -0.90% 15.80%

10yr price and P/E band

PE Band - Hero MotoCorp Ltd. 4,500

4,000

3,500

3,000 Price 2,500 13x 2,000 16x 19x 1,500 22x 1,000

500

Apr-10 Apr-11 Apr-12 Apr-13 Apr-14 Apr-15 Apr-16 Apr-17 Apr-18 Apr-19 Apr-20 Source: BSE Website, ACE Equity

Financial snapshot

Key Parameters FY15 FY16 FY17 FY18 FY19 FY20E FY21E FY22E (Rs. Mn.) Sales 2,75,853 2,84,427 2,85,005 3,22,305 3,36,505 2,91,028 2,89,572 3,21,425 EBITDA 34,514 44,550 46,330 52,758 49,295 41,457 38,224 43,071 EBITDA Margin 12.5% 15.7% 16.3% 16.4% 14.6% 14.2% 13.2% 13.4% PAT 23,856 31,602 33,771 36,974 33,849 31,631 29,573 32,530 PAT Margin 8.6% 11.1% 11.8% 11.5% 10.1% 10.9% 10.2% 10.1% EPS 119.4 158.2 169.1 185.1 169.5 158.4 148.1 162.9 ROCE % 48.0% 48.3% 38.0% 37.0% 29.9% 30.2% 26.8% 27.9% ROE % 39.3% 41.1% 35.7% 33.8% 27.5% 25.0% 21.8% 23.9% PE 11.6 12.4 11.3 EV / EBITDA 7.0 7.4 6.3 Source: Company Data, Equentis Research

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