In hot pursuit

Hero’s margins have bottomed,in our view. We expect the recovery to be driven by cost-cutting initiatives directed towards increased localisation and control over marketing,logistic spends etc. We therefore raise our Ebitda margin assumptions by a cumulative 125bp (basis point) over FY14-15 estimates to 14.8%.

Hero is likely to hold market share. Hero has corrected channel inventory to about four weeks,thanks to 15% YTD (year-to-date) increase in retail sales. We expect the recovery to sustain following rejuvenation of franchise aided by new marketing initiative i.e,five-year warranty,and lowered dependence on legacy models thanks to recent product successes (contribute about 10%).

Our domestic growth assumption of 6% in FY14 estimates and 8.5% in FY15 estimates therefore seems achievable.

Compared to earlier expectations of muted profit due to cost and competitive pressures,Hero’s growth visibility has improved. This is due to Hero’s new initiatives in marketing (extended warranty across products) and recent launches (Maestro Scooter,Ignitor bike) as well as upcoming models from H2 and margin recovery through comprehensive cost-cutting programme i.e. localisation and control over spends.

Hero has renewed its export foray,both to existing (Sri Lanka,Bangladesh) and newer markets (Latam,Africa). The company is in the process of establishing distributors,and later this year,plans to launch new models based on in-house R&D.

Post its split from Honda,Hero is in the process of establishing its own distributors and will later launch in-house developed models for a renewed export foray across global markets. While management has targeted one million sales by FY16 (under 10%),our assumptions are modest and we expect the contribution to double to 6% by FY16.

The pricing pressure is unlikely as despite ongoing slowdown,industry has been disciplined on pricing in the domestic market. Also,competitor strategy seems to be directed towards premium products,either as an alternative to existing range or targeting a different set of customers. The only aggressive intent we can expect is to introduce low-priced variants of successful brands e.g. Honda 110cc Dream Neo,which could cap pricing in the sector. The mix deterioration is marginal. Over the past year,Hero’s sales have shifted towards low-priced bikes e.g. HF Dawn and newer models. We assume further mix deterioration cushioned by improving demand for profitable models Splendor/Passion Pro.

Apart from this,the warranty expenses are expected to be only slightly negative. Historically,warranty claims have been low for the company,and even an extended five-year warranty introduced this year may limit the incremental claims by R350-400 million per year—i.e.,15-20ps on Ebitda margins.

Higher R&D costs have already been factored in. We estimate R&D expenses to increase to 1.2% of sales (from 0.4%).

Although Hero is vulnerable,it is recovering. The 3% decline last year compared to growth for peers was due to significant launches by Honda (Dream Yuga) and Bajaj Auto (Discover ST). However,neither has been able to sustain the initial gains as Hero has come back strongly after its marketing initiative of an extended warranty. Although competitors are expected to launch new variants this year,we expect Hero to be able to hold on to its segmental share due to a proven superior franchise,which typically gains prominence during economic uncertainty,and reasonably successful 125cc model Ignitor,which should provide some impetus to volumes.

Over the next two years,we expect Hero’s Ebitda to register 15% CAGR and profit much faster 22% CAGR,but mainly due to completion of royalty payments post-June 2014. We therefore expect a sharp increase in the company operating flows,which should enable it to maintain its liberal dividend payout policy.

BofAML