Visit us at www.sharekhan.com March 13, 2015

Hero MotoCorp Reco: Buy

Revving up CMP: Rs2,643

Company details Key points  Poised to defend market share: Hero MotoCorp Ltd (HMCL) is the market leader in the Price target: Rs3,400 domestic two-wheeler industry with a market share of 41.6%. Two-wheelers are expected Market cap: Rs52,774 cr to remain the preferred mode of transportation in India, given the low cost of ownership and lower penetration levels especially in rural India. We expect the two-wheeler industry 52-week high/low: Rs3,271/2,056 to grow at a 10% CAGR over the medium term. HMCL, with strong brands, a relatively NSE volume: 7.0 lakh larger presence in rural India and increasing contribution from the scooter segment, is (No of shares) poised to defend its market share in the motorcycle segment and is targeting to increase its market share in the scooter segment. BSE code: 500182  Strengthening presence in the scooter segment: With the scooter market consistently NSE code: HEROMOTOCO outpacing the motorcycle market, HMCL has enhanced its focus on scooters. In H1FY2015 the company’s volume sales from scooters were hampered by capacity constraints. Sharekhan code: HEROMOTOCO However, the company is increasing the manufacturing capacity for scooters. At the Free float: 12.0 cr same time it is on schedule to launch two new products which will enable it to strengthen (No of shares) its market share in the fast-growing scooter segment.  Opening of new vistas with exports: The agreement with erstwhile partner Honda was Shareholding pattern the biggest impediment to reaching out to the overseas markets. Now with the opening up of opportunities after the split with Honda, the management has drawn an ambitious Public & Others plan to establish presence in 50 countries by 2020 as well as set up assembly operations 11.5% Corporate Bodies in Bangladesh, Columbia and Kenya. HMCL plans to increase the export contribution 1.8% from 2% in FY2014 to 10% by FY2020. Promoters 39.9%  LEAP programme to boost bottom line: HMCL has embarked upon an ambitious programme, LEAP, to improve its profitability by improving efficiency across the value chain. On a like-to-like basis, the management expects to expand the OPM by 150- FIIs 200BPS through LEAP. We expect a margin expansion of about 50BPS in each of the next 39.3% two years largely driven by the benefits of the programme. Institutions 7.4%  Valuations: The steady growth in volumes and revenues, expectations of a margin expansion and the ending of amortised lump sum royalty payments to Honda are expected to boost Price chart the bottom line of HMCL. We expect a 23.6% earnings CAGR over FY2014-17 with RoE of over 45% and a high dividend pay-out ratio. Consequently, we initiate coverage on the stock with a Buy rating and a price target of Rs3,400, giving a 17x P/E multiple based on the FY2017E earnings.  Risk: Weakening of consumer sentiment translating in a lower than expected growth for the industry and competitive pressures affecting the margins and bottom line of HMCL.

Valuations

Particulars FY2013 FY2014 FY2015E FY2016E FY2017E Net sales (Rs cr) 26,691.5 28,528.5 30,994.6 35,133.6 40,393.1 Growth (%) 0.9 6.5 9.6 12.5 14.1 EBITDA (Rs cr) 3,294.1 3,554.1 3,622.9 4,342.5 5,252.6 EBITDA margin (%) 13.9 14.1 13.1 13.9 14.8 Price performance PAT (Rs cr) 2,118.2 2,109.1 2,574.7 3,255.0 3,986.8 Growth (%) -10.9 -0.4 22.1 26.4 22.5 (%) 1m 3m 6m 12m FD EPS (Rs) 106.1 105.6 128.9 163.0 199.6 P/E (x) 24.9 25.0 20.5 16.2 13.2 Absolute -5.9 -15.4 -4.2 32.9 P/B (x) 10.5 9.4 8.2 7.0 5.6 Relative -6.4 -20.2 -10.7 -1.1 EV/EBITDA (x) 15.0 13.7 13.6 11.1 9.0 to Sensex RoE (%) 45.6 39.8 42.8 46.4 46.7 RoCE (%) 46.4 52.0 59.5 64.5 64.7 stock idea Hero MotoCorp

Company profile Two-wheeler household penetration levels

HMCL, formerly known as Hero Honda Motors, is the largest 40 two-wheeler producer in the world and has retained this title for the past nine years. Over the years, it has built a 30 robust product portfolio across categories, continuously improved operational efficiency and aggressively 20 expanded its customer reach by investing in brand- building activities. Moreover, it operates with four 10 facilities through an extensive sales and service network spanning over 6,000 customer touch points and dealer- 0 appointed outlets across the country. The company enjoys Rural Urban Total a 41.3% market share in the domestic two-wheeler 2001 2011 segment, largely on the back of its two popular brands, Source: India Census 2011 Splendor and Passion. The Splendor launched two decades ago remains the single largest selling two-wheeler brand Doubling of scooter capacity and strong brands to in the country. enable high growth in the segment History at a glance Although HMCL had launched its first scooter, ie Pleasure, HMCL, or Hero Honda as it was earlier known, had started in 2006, its primary focus had been on the motorcycle out in 1984 as a joint venture between the Hero group segment. With the Pleasure targeted at the female (owned by the Munjal family) and Honda Motor Company, customer, HMCL (then Hero Honda) had avoided direct Japan. HMCL had started its manufacturing operations at competition with its erstwhile partner Honda Motor Dharuhera in north India. Despite scooters being the Company’s Activa, which was a unisex product and market dominant sub-segment, the company focused on the leader. After the separation from Honda Motor Company, motorcycle segment that had models popular for their HMCL had launched the Maestro (developed by Honda low cost and high fuel economy. The company’s iconic Motor Company) as a male and unisex scooter. With two tagline, “Fill it, shut it, forget it”, as well as the launch strong products in the folio and a high-decibel brand of the Splendor in 1994 caught the imagination of the promotion campaign, by July 2013 HMCL had overtaken customers. With the contribution of the motorcycle TVS Motor Company to claim the second spot and market segment steadily increasing, HMCL took the pole position share in excess of 20%. However, in H1FY2015 in the domestic two-wheeler industry and was handicapped by capacity constraints and coupled with subsequently crowned the largest two-wheeler aggressive push from competitors, HMCL’s share in the manufacturer in the world, a title the company has fast-growing scooter segment contracted to a low of 12.6% retained for the last nine years. by August 2014. However, by increasing the capacity the company has been able to claw back its market share Investment arguments and in Q3FY2015 its market share was at 17.2% vis-à-vis Market leader HMCL expected to maintain numero uno 15.7% of TVS Motor Company in the same period. position; rural India to drive sales With the public commuting system still under developed, Scooter segment’s monthly volumes the low cost of ownership tilts the scales in favour of 90,000 26.0 two-wheelers as the preferred choice of transport. The 80,000 24.0 penetration levels for two-wheelers in India especially in 70,000 22.0 60,000 20.0 rural India remain low. As per the 2011 census, rural India 50,000 18.0 has a two-wheeler penetration of 14.3% of the total 40,000 16.0 households as compared with 35.2% in urban India. We 30,000 20,000 14.0 expect the rural market to be the driver of growth through 10,000 12.0 increased penetration of two-wheelers. HMCL with brands 0 10.0 Splendor and Passion enjoys strong brand equity in rural Jul/12 Jul/13 Jul/14 Jan/12 Oct/12 Jan/13 Oct/13 Jan/14 Oct/14 Jan/15 India and derives roughly 47-48% of its sales from non- Apr/12 Apr/13 Apr/14 urban areas. With a 41.3% market share HMCL is the leader Monthly Runrate (LHS) Marketshare (%) (RHS) in the domestic two-wheeler industry and is poised to Source: Company maintain its market share at around the 40% mark.

Sharekhan 2 March 2015 stock idea Hero MotoCorp

New scooter Dash to take Activa head-on HMCL exports

Honda Motor Company’s Activa has been the undisputed 250 3.5 leader in the domestic scooter segment with a market share in excess of 50%. While HMCL was present in the 200 3.0 scooter segment, it did not have a full metal body scooter 150 2.5 to compete with Activa directly. This is expected to change as the company is expected to launch the new model, 100 2.0 Dash, which would rival the Activa and TVS Motor 50 1.5 Company’s Jupiter. With expected features like a combi- braking system, telescopic shock absorbers and alloy 0 1.0 wheels, we expect the model to receive a positive FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 response. HMCL is also working on a 125cc scooter which Exports ('000 units) (LHS) % of overall sales (RHS) would further boost its product folio and expand its market Source: Company share. Further, as the Dash has been developed in-house, the company will not be paying any royalty on the product Implementation of LEAP programme to translate into as compared with the current model Maestro for which it margin expansion pays a running royalty to Honda Motor Company. HMCL’s management has embarked upon an ambitious programme, LEAP, to improve its profitability by improving Scooter segment’s market share efficiency across the value chain. On a like-to-like basis, 60 the management expects to expand the operating profit 50 margin (OPM) by 150-200 basis points (BPS) through the 40 programme. As per the management, the company has 30 added about Rs400 crore to its earnings before interest, 20 tax, depreciation and amortisation (EBITDA) by (%) 10 implementing the programme. In Q2FY2015 alone, savings 0 accrued to the company due to the LEAP programme were in the range of Rs65 crore. We expect a margin expansion of about 50BPS in each of the next two years largely driven 1-Jun-14 1-Jun-13 1-Jun-12 1-Jun-11 1-Mar-14 1-Mar-13 1-Mar-12 1-Mar-11 1-Sep-14 1-Dec-14 1-Sep-13 1-Dec-13 1-Sep-12 1-Dec-12 1-Sep-11 1-Dec-11 by the benefits of the programme. Honda TVS Motor Hero MotoCorp Profitability trend Source: Industry 16.0 New avenues opening with exports 15.0 The agreement with Honda Motor Company was 14.0 preventing HMCL from spreading its wings to the other 13.0 12.0 geographies. The company in its earlier form, ie Hero 11.0 Honda, exported only to select markets, such as 10.0 Bangladesh, Sri Lanka and Columbia, as Honda Motor 9.0 Company’s presence in the other markets imposed 8.0 restrictions on it. After the separation, HMCL has drawn 7.0 aggressive plans to increase its presence in the export FY11 FY12 FY13 FY14 FY15E FY16E FY17E markets especially in Africa and South America where EBITDA mar gin PA T mar gin peers such as Bajaj Auto and TVS Motor Company have Source: Company, Sharekhan Research had a fair amount of success. HMCL plans to expand its footprints to 50 countries by 2020 and generate more Strong focus on R&D after exit of Honda Motor Company than 10% of its total volumes from exports. Exports HMCL has been entirely dependent on its joint venture currently contribute about 2-3% of the overall volumes partner, Honda Motor Company, for its research and for the company and hence there is a large opportunity development (R&D) needs. After the split, the company for increasing the export contribution. HMCL will be also made strategic tie-ups with Erik Buell Racing (EBR), investing up to Rs900 crore to set up an assembly unit in Austria-based AVL and Italian design firm, Engines Bangladesh and Columbia to boost the volumes. Engineering, to quickly scale up its technology and design

Sharekhan 3 March 2015 stock idea Hero MotoCorp capabilities. Additionally, HMCL invested about Rs400 Risks crore to set up a state-of-the-art R&D facility in Kukas It faces the risks of weakening of consumer sentiment near Jaipur. The company has roped in Markus translating in a lower than expected growth for the Braunsperger, with over 25 years of experience at BMW, industry and competitive pressures weighing down on its to head its R&D function. The company has been margins and bottom line. showcasing products developed in-house at various industry shows and these are to be launched over the Valuations: A steady growth in its volumes and revenues, next few years. We expect the company to scale up its expectations of a margin expansion and the ending of R&D function and be able to launch competitive products the amortised lump sum royalty payments to Honda Motor in the market so as to maintain its leadership position. Company are expected to boost the bottom line of HMCL and we expect its earnings to grow at a compounded Excellent return ratios to be maintained annual growth rate (CAGR) of 23.6% over FY2014-17. A healthy profitability, an asset light model and a high Further, we expect the return ratios to remain healthy dividend pay-out ratio have enabled HMCL to maintain with an RoE of over 45% and a high dividend pay-out ratio. high return ratios consistently over the last 15 years. Consequently, we initiate coverage on the stock with a Continuing forward, we expect the company to maintain Buy rating and a price target of Rs3,400, according it a the trend of high return ratios with a return on equity 17x price/earnings (P/E) multiple based on the FY2017E (RoE) in excess of 45% over the next three years. earnings.

Return ratios PE

78

66

54

42

30 FY11 FY12 FY13 FY14 FY15E FY16E FY17E ROCE (% ) ROE (% )

Source: Sharekhan research Source: Sharekhan research

Peer comparison

Paritculars Revenues (Rs cr) EPS (Rs) P/E (x) RoE (%) FY15E FY16E FY17E FY15E FY16E FY17E FY15E FY16E FY17E FY15E FY16E FY17E Hero MotoCorp 27,694 31,137 35,513 128.9 163.0 199.6 20.5 16.2 13.2 42.8 46.4 46.7 Bajaj Auto 22,706 24,446 27,447 115.3 122.4 142.0 18.0 17.0 14.6 32.6 30.5 31.0 TVS Motor 10,327 12,607 15,027 7.5 11.8 16.4 38.5 24.6 17.7 23.2 30.1 33.8 Source: Sharekhan research

Sharekhan 4 March 2015 stock idea Hero MotoCorp

Financials Profit & Loss Account Rs cr Cash flow statement Rs cr

Particulars FY13 FY14 FY15E FY16E FY17E Particulars FY13 FY14 FY15E FY16E FY17E

Net sales 23,583 25,125 27,533 30,964 35,327 Pre-tax profit 2,529 2,867 3,576 4,521 5,537 Growth (%) 0.8 6.3 9.6 12.4 14.1 Depreciation 1,091 1,052 538 404 438 Operating profit 3,294 3,554 3,623 4,342 5,253 Total tax paid (487) (981) (1,002) (1,251) (1,535) Other operating income 185 151 161 173 186 Chg. in working capital (1,216) 156 (293) (42) (39) EBITDA 3,294 3,554 3,623 4,342 5,253 Other operating activities - - - - - Growth (%) (9.4) 7.9 1.9 19.9 21.0 Cash flow from oper. (a) 1,917 3,094 2,819 3,632 4,400 Depreciation (1,142) (1,107) (538) (404) (438) Capital expenditure (400) (1,016) (1,588) (667) (1,242) Other income 389 432 506 596 735 Chg. in investments (27) (167) (100) (100) (100) EBIT 2,541 2,879 3,591 4,534 5,550 Other investing activities - - - - - Interest paid (12) (12) (15) (14) (13) Cash flow from inv. (b) (427) (1,183) (1,688) (767) (1,342) PBT (before E/o items) 2,529 2,867 3,576 4,521 5,537 Free cash flow (a+b) 1,491 1,910 1,131 2,865 3,058 Tax provision (411) (758) (1,001) (1,266) (1,550) Equity raised/(repaid) - - - - - E/o income/(Loss) - - - - - Debt raised/(repaid) (709) (278) (24) - - Net profit 2,118 2,109 2,575 3,255 3,987 Chg. in Minority int. - - - - - Adjusted net profit 2,118 2,109 2,575 3,255 3,987 Dividend (incl. tax) (1,044) (1,403) (1,519) (1,747) (2,096) Growth (%) (10.9) (0.4) 22.1 26.4 22.5 Other financing activities - 4 - - - Diluted EPS (Rs) 106.1 105.6 128.9 163.0 199.6 Cash flow from fin. (c) (1,754) (1,676) (1,543) (1,747) (2,096) Diluted EPS growth (%) (10.9) (0.4) 22.1 26.4 22.5 Net chg. in cash (a+b+c) (263) 234 (412) 1,119 963

Balance Sheet Rs cr Key ratios

Particulars FY13 FY14 FY15E FY16E FY17E Particulars FY13 FY14 FY15E FY16E FY17E

Equity capital 40 40 40 40 40 EBIDTA margin (%) 13.9 14.1 13.1 13.9 14.8 Reserves & surplus 4,966 5,560 6,388 7,547 9,438 Net margin (%) 8.9 8.3 9.3 10.5 11.2 Shareholders' funds 5,006 5,600 6,428 7,587 9,478 Dividend yield (%) 2.3 2.5 2.8 3.4 3.4 Minority interests - - - - - Net debt/equity (x) (0.7) (0.7) (0.6) (0.6) (0.6) Total debt 302 24 0 0 0 Net working capital (days) (13) (16) (16) (17) (17) Capital employed 5,308 5,624 6,428 7,587 9,478 Asset turnover (x) 2.4 2.6 2.6 2.6 2.5 Net fixed assets 3,133 3,097 4,147 4,410 5,214 RoCE (%) 46.4 52.0 59.5 64.5 64.7 Cash & cash eq. 3,743 3,977 3,565 4,684 5,647 RoE (%) 45.6 39.8 42.8 46.4 46.7 Net other current assets (1,497) (1,785) (1,705) (2,013) (1,973) EV/Net sales (x) 2.1 1.9 1.8 1.5 1.3 Investments 62 230 330 430 530 EV/EBITDA (x) 15.0 13.7 13.6 11.1 9.0 Net deferred tax assets (132) 106 91 76 61 PER (x) 24.9 25.0 20.5 16.2 13.2 Total assets 5,308 5,624 6,428 7,587 9,478 Price/Book (x) 10.5 9.4 8.2 7.0 5.6

Sharekhan 5 March 2015 stock idea Hero MotoCorp

Annexure Passion, and commands a two-third of the market share Indian two-wheeler industry in this segment. Bajaj Auto with its Discover range The Indian two-wheeler industry is the largest in the world and Honda Motorcycles and Scooters India (HMSI) with with domestic annual sales of nearly 14.8 million units in its Shine are the other major players in the executive FY2014. The industry is a mix of home grown companies segment. TVS Motor Company has been a marginal and foreign players predominantly from Japan, like Honda player in the segment with products such as Star City+ Motor Company, Suzuki Motor Corporation and Yamaha and Flame. Motor Company.  Premium segment: This is the aspirational segment Till 1993, the industry was dominated by scooters and with a motorcycle priced in excess of Rs60,000. Due mopeds with contributions of 47% and 28% respectively. to the current scenario of poor customer sentiment, Bajaj Auto was the market leader with a strong presence the segment’s contribution has shrunk from nearly 18- in both these segments. With fuel efficiency becoming a 19% a couple of years ago to 15-16% in FY2014. key consideration for purchase, the industry moved However, there has been an improvement in sentiment towards the motorcycle segment. Hero Honda Motors along with new launches which has pushed up the (now Hero MotoCorp) took the numero uno position in contribution for the segment. Bajaj Auto with its Pulsar the market with strong brands like Splendor and Passion. range and market share of about 45% is the market In FY2007, the contribution of scooters had dipped to leader in this segment. TVS Motor Company with its 12.3% and that of motorcycles had risen to 83% for the Apache range is a significant player in the segment industry. Scooters made a comeback of sorts with the and commands a market share of about 9-10%. HMCL advent of Honda Motor Company’s Activa and have been has remained a fringe player in this segment with the fastest growing segment over the last five years. products such as Extreme and Hunk. The other significant competitors in the segment are Yamaha Motorcycles Motor Company (the FZ range) and HMSI (Trigger and The Indian motorcycle industry has grown in low single Unicorn). digits in the last couple of years. The principal reason Segmentwise break-up for motorcycles for the slowdown has been poor customer sentiment. However, the growth in the rural markets remains strong, given the low penetration levels of two-wheelers and Pr emium Entr y increasing affordability of the rural population. 16% 18%

The motorcycle industry can be sub-divided into entry- level, executive and premium segments. Segment-wise contribution of domestic motorcycles  Entry-level segment: HMCL is a strong player in the entry-level motorcycle segment with brands such as Executive HF Dawn and HF Deluxe. The principal competitors in 66% this segment are Bajaj Auto’s Platina and Hero Source: Industry MotoCorp’s HF Deluxe. The motorcycles are priced in the range of Rs38,000 to Rs42,000 per unit. The entry- Scooters level segment accounts for about 19% of the overall While in yesteryear scooter was identified by Bajaj Auto’s motorcycle sales in the industry. The margins are products, the scooter segment as we know today is defined typically lower in this segment. HMCL has a market primarily by HMSI’s Activa. The contribution of the scooter share of about 50% in this segment. segment to the overall two-wheeler volumes dropped to  Executive segment: This is the largest in the domestic a low of 12.3% in FY2007 prompting players like Bajaj motorcycle segment accounting for roughly 65% of the Auto to exit the segment. However, the changing domestic volumes. Hero MotoCorp is the largest player perception about scooters regarding fuel efficiency, ease in this segment with brands such as Splendor and of operation and high utility value has propelled the

Sharekhan 6 March 2015 stock idea Hero MotoCorp scooter demand and currently it is the fastest growing Scooter segment’s volumes segment in the two-wheeler industry. Today there are 40 45.0 seven manufacturers vying for a piece of the scooter 35 40.0 market and all major players with the exception of Bajaj 30 35.0 25 Auto have products in the segment. 30.0 20 25.0 HMCL has two strong brands in this segment. The Pleasure, 15 10 20.0 launched in 2006, is powered by a 102cc engine, is a light Lakh units 5 15.0 scooter and targets the female customer. On the other 0 10.0 hand, the scooter Maestro was launched in 2012 and is

powered by a 109cc engine. The company has been FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14

actively promoting both the brands with high-profile YTDFY15 celebrity endorsements for both the scooters. Scooter sales (lakh units) Contribution % (RHS) Source: Industry

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