F1Q17 results—marginally ahead: HMCL reported a top-line of
R74 bn, up 6% y-o-y, Ebitda of R12.3 bn, up 17% y-o-y, and PAT of R8.8 bn, up 18% y-o-y. Ebitda was 2% ahead of our estimate and PAT 5% ahead. The small beat was driven by better margins from lower other expenses. Gross margins, on the other hand, declined 115bps q-o-q due to higher cost of steel and aluminum.
F1Q17 vs. previous June quarters: In an interesting juxtaposition, Hero’s Ebitda margin at 16.6% was the highest for a Q1 in seven years, while its motorcycle market share of 51% was the lowest Q1 in 10 years. We don’t expect competitive intensity to recede and thus margins will normalise to 15.2% by FY18.

No change in EPS but raising multiples: Our FY17 EPS estimate is unchanged and our FY18 EPS declines marginally by 2%, but we raise our target multiple from 16x to 17x, as peers have been re-rated, and we believe rural consumption is at a trough and any recovery therein will benefit Hero the most. We also roll-over our price target from March 2017 to March 2018 EPS to arrive at our base case scenario value. In addition, we now link our price target to our base case scenario value, discarding our probability weighted approach that accorded a 10% weight to each of the bull and bear case scenarios (80% base). This is because we believe uncertainty for both volumes and margins is now lower given stable guidance by the company.
Key risks: Continued slide in market share is the key downside risk for Hero’s multiple, in our view. Any further margin expansion is the key upside risk.
Two wheeler volume growth to pick up from FY2Q17: HMCL believes rural volumes grew 7% in F1Q17 for the industry, and believes that overall growth can pick up from here driven by better rural growth following a better than average monsoon so far. HMCL believes the two wheeler industry can grow in double digits in F2Q17 and in high single digits in H2F17. Hero Motors believes it will gain market share when rural growth picks up.
However, industry-wide retail sales have lagged dispatches in YTD F17: Hero Motors believes two wheeler industry-wide retail sales were lower than dispatches (wholesales) so far in FY17, as some OEMs have already started building up channel inventory for the festive season. HMCL will do so starting now and that should help dispatches as well. HMCL’s inventory currently stands at 6 weeks including 4.5 weeks of inventory with dealers.
Region-wise, Northern and Central areas continue to be weak: Hero Motors reported that the North and Central parts of the country continue to be slow. However, HMCL reported that the East continues to be very strong where it has the highest market shares, even in scooters in some parts.
Scooter retail sales have been better than dispatches for HMCL: Hero Motors highlighted that retail sales have maintained above 70k units monthly for scooters, and dispatches have been lower as channel filling had been carried out in FY4Q16 following the new launches. Incrementally, dispatch volumes should be better as well.

Lean programme continues to help margins but guidance on margins unchanged: HMCL highlighted that the ‘Lean’ programme it has adopted could have saved them R450m (would have added ~60bps of margin) in FY1Q17. The programme had added 90bps to margins in FY2016 and HMCL had guided for another 90bps incremental cushion to FY17 margins. However, HMCL maintains its margin guidance at 14-16%.
Exports guidance is maintained: HMCL maintained its target of 300k units of exports in FY17. While export markets have been weak, Hero is entering new markets that can help to offset the weaker areas. Hero will enter Argentina and Ghana in the next quarter, and in Mexico in F4Q17.

Other takeaways

HMCL clarified that ASPs did not drop q-o-q, but rather the sales of spare parts were lower q-o-q.
Haridwar unit contributed 36% of the volumes in FY1Q17. This facility will see its excise duty waiver run out from FY1Q19.
BS IV Norms could push up prices: HMCL believes CBS and ABS implementation following the move to new emission norms from April 2017 could add up to
R4,000 per bike to costs, though the impact should be much lower for scooters.
But, GST implementation could provide an offset: HMCL believes GST can bring down taxation from the current 23-24% for the two wheeler industry, and this would most benefit the is where the buyers are more price sensitive.
Hero believes about 65% of its customers are first-time buyers currently.
Hero guided for capex of
R8-9 bn for FY17.
Gujarat plant will commence operations by end FY2017.

—Morgan Stanley