Margin expansion to be muted; recent steps not enough to improve prospects
Despite Hero’s inventory correction drawing to close, which had partially depressed sales and stock value, we downgrade our rating to Underperform from Buy on structural concerns. Our revised price objective of R1,650 (earlier R1,980) is driven by (i) a sharp 11% cut in EPS for FY14-15e (10-20% below consensus), and (ii) a de-rating to 14x FY14e P/E (from 15x), to re-align with peers on growth differential as well as narrower premium to historical average.
Despite the recent successes of Hero’s products, we expect its domestic sales to remain muted and in single digits. This is due to (i) a skewed dependence on 100cc commuter bikes (80%), where better options are available with competitors, and (ii) a likely structural shift to 150cc+ premium bikes (6%), where the company’s franchise is weak.
Over the next five years, Hero targets to export 1m units. However, it will need to overcome the following challenges: (i) promotion of a new brand identity, including in markets where it already has a presence (e.g., Bangladesh, Sri Lanka), and, (ii) a delayed entry in under-penetrated markets (e.g., Africa, LatAm), which are dominated by established rivals. We cut our export assumptions by 40%/year to factor in the six-month delay in its overseas foray. We cut Ebitda margin assumptions by 70bp/year to 11.4/13.1%, to factor (i) in competitive pressures, as evident in the recent marketing blitz for its largest selling bike Splendor, and (ii) INR’s weakness, which will hurt imports.
We cut EPS forecasts by 5% in FY13e and 11% for FY14/FY15e, driven by lower volume/margin assumptions, on rising competition. Post-revision, we expect profit to register 7.5% CAGR over next two years, which is slower than sales and Ebitda, being restricted by loss of tax incentives.
Based on our forecasts, Hero trades at 15.5x FY14e. We expect stock to de-rate on: (i) Re-alignment to peers on EPS growth differential (8% CAGR vs 18% CAGR over FY14-15e). (ii) Sharp decline in RoE (return of equity), from 47% to 37% during this period.