Build-up of inventories in system; buyer trend changing

We remain sellers on the Indian 2-wheeler sector for the following reasons:

A. Near-term negative catalysts: Our conversations with company managements and channel financiers indicate that there is a build-up of inventories in the system. Depending on whom we?ve spoken with, the indicative range of the rise in inventory levels is 4?6 weeks, when the average should be 3-4 weeks.

B. Collections for farmers on vegetables/ cash crops are coming off. We did a call with a participant in the Mumbai APMC (Agricultural Produce Market Committee). Realisations are generally depressed ? down 40-50% across a swathe of vegetables and cash crops. This data is hard to quantify but, anecdotally, there is a strain with respect to cash flows of farmers ? which has impacted tractor sales too. This phenomenon is probably cyclical (rather than secular) in nature ? while it could impact H1FY13 sales, we don?t expect it to impact H2FY13 volumes ? at least not for two-wheelers.

Whether this trend continues will also be influenced to a certain extent on the government?s attempts to curb food inflation over FY13/FY14, in the backdrop of a general election in 2014 and also in the backdrop of rising inflation from higher oil prices.

C. The impending launch of HMSI?s 109cc bike?the Dream Yuga?in May 2012 is also an event that we?ll have to closely monitor. It signals Honda?s foray into the mass end of the commuter bike (executive segment) space. Pricing is something that needs to be monitored, as it will give a direction to Honda?s medium-term plans with regard to the positioning of its bikes in the commuter segment.

We don?t expect HMSI (Honda Motorcycle and Scooter India) to compete initially on pricing ? but rather on the merits of the product itself ? around 1- 1.5bhp more than competing models, with a fuel efficiency that is expected to be around 70kmpl (on road conditions, not under test conditions). As per dealers, Hero?s bikes today deliver around 60kmpl under road conditions in the city. If the Yuga can actually deliver on the claims, there is potential that customer conversion will commence rapidly.

HMSI is also ramping up distribution?as per our checks, the primary dealer network is a shade less than 500 (in comparison to 750 for Hero MotoCorp). Including sub-dealers, HMSI?s dealer network is around 980 ? compared to around 5,000 for Hero Moto.

HMSI is committed to growing its network of primary dealers by around 100 each year (so 20% growth), to support growth and market share ambitions. If the bike is successful, it could generate sales volumes of at least 500k-750k units of the Yuga in FY14. The incremental market share HMSI would capture within the commuter bike segment in FY14 would thus be around 6-9%.

D. Medium term, there are two mix shifts in the industry which aren?t beneficial for the incumbents. The first is a mix shift towards scooters, which benefits HMSI. The share of the scooter continues to rise ? from 16% in FY10 to 19% at present ? the product continues to gain acceptance, not merely as a mode of transport for women and girls, but also as a second vehicle for homes that already have a bike ? essentially positioned as a vehicle that effectively cuts across gender and age differences.

This benefits HMSI, given its market share in scooters is 50% (average of Jan-Feb 2012), and to a certain extent Hero MotoCorp?Hero?s market share is 17% in scooters (Jan-Feb 2012), but scooters as a % of volumes are only 7%. Hero remains predominantly a motorcycle company. The second mix shift is adverse for both Hero and Bajaj?but more so for Bajaj? there is a downward shift in the proportion of premium bikes being sold. The segment which had increased steadily from 8% to 18% of bike volumes (over FY05?11) is now coming off due to high gasoline prices (17% for FY12YTD-year-to-date).

Consumers are downshifting to economy/executive segment bikes. At the margin, this is more negative for Bajaj, less so for Hero, given that the premium segment is 27% of Bajaj?s domestic bike volumes while it is only 6% for Hero (our estimates).

Industry forecasts

Managements are guiding to 10-12% volume CAGR (compound annual growth rate)/year over the next 2-3 years. We forecast around 7% in FY13 and around 11% in FY14. We expect FY13 to be slightly lower, given current trends, and given an expected price hike of R5/l on petrol in April.

Within 2-wheelers, we expect scooters to continue to gain share from bikes/ mopeds ? directionally, the trend is upwards, given its universal appeal between genders and across ages?but whether it is 19% or 20% or 22% is difficult to ascertain. The share of bikes is thus expected to come off slightly to around 75%. Within bikes, we expect the share of the premium segment to decline into FY13 as higher fuel prices impact consumer demand. Whether this trend continues long term is difficult to discern but, given that there is a trend of premiumisation across sectors in the consumer sector, we think it is plausible that demand could rebound into FY14, once consumers are reconciled to the higher fuel prices.

While reiterating our negative stance on the 2-wheeler OEMs (original equipment manufacturers) under our coverage, our preference between Bajaj Auto and HMCL (Hero MotoCorp Ltd) differs over the short and long term. Relatively, we prefer Hero MotoCorp over Bajaj Auto in the short term given i) expectations of healthy dividend payout by HMCL for FY12 and

ii) headwinds for Bajaj’s Q4’12 and first quarter 2013 earnings due to moderation in volume growth for domestic 3W (3-wheeler) and domestic bikes. Long term, we prefer Bajaj for its i) high margin 3-wheeler business, ii) balanced export business that has a focused product strategy (2W and 3W) across frontier and emerging markets. Both Bajaj Auto and Hero MotoCorp are valued at 13x Sept 2013 EPS (we roll from Mar 2013).