Hero Honda: Rock bottom

Expect the valuations to be compressed as margins fall and earnings become linked to volumes.

Hero Honda, India’s largest two-wheeler company, has only reinforced analysts’ fears with its earnings report. Margins had been falling consistently all through 2010-11 and the fourth quarter was no different. The company clocked margins of 12.1 per cent for the quarter ended March 31. In comparison, margins ranged between 17 per cent and 18 per cent in 2009-10.

Clearly, the company lacks pricing power and the profitability is volume dependent.

In the fourth quarter, year-on-year revenues rose by 31 per cent to Rs 5,391 crore, while net profit fell by 16 per cent to Rs 504 crore.

Analysts are also concerned about the company’s dependence on the executive, or, the sub-125 cc segment. Almost 69 per cent of the company’s revenues are derived from this segment. While this is the meat of the market, low margins imply the company may not have much headroom to absorb a further cost push. Analysts believe margins have touched rock bottom levels and earnings have become rather volume dependent.

Also, if auto demand slackens, as it is expected, profitability will further be impacted.

In situations like these, companies typically look at lowering other expenses. However, analysts say these expenses have been rising for Hero Honda despite the growing volumes. In the first quarter of 2004, other costs per vehicle stood at Rs 3,300. However, they increased to Rs 4,300 in the third quarter of 2010-11. Analysts say volumes rose from 4.5 lakh to 14 lakh units in this period.

Typically, other costs should have come down when volumes rose, but they did not. This reflects the company’s ability to control expenses. Given that prices of raw material cannot be controlled, analysts were hoping the company would tighten other costs. Expenses on promotion, advertising and brand building will only increase, given the company’s split form Honda.

With the firm investing in cricket properties, the advertising and promotional spends, too, have been higher in the last quarter.

The spectre of increasing competition, coupled with the fact that the auto sector, as a whole, is in its mid-cycle (margins have peaked, earnings have become volume dependent), implies valuation multiple compression.

Issues like thinning margins, lack of visibility on the product pipeline and technology will remain an overhang on the stock.