Mounting cost pressures are showing up in slipping profitability at Hero MotoCorp Ltd, explaining why investors are pessimistic. Shares of the two-wheeler maker have declined by almost 18% in this fiscal year so far, underperforming both the BSE Auto and the BSE 100 indices.

Not without reason.

Cost pressures are building up for the sector. Firstly, higher commodity costs—prices of rubber and metals such as steel, aluminium and copper, made worse by a depreciation rupee. Secondly, the Supreme Court’s mandate to increase third-party insurance cover for new motorcycles and scooters to five years increases the purchase price for a consumer. Further, the mandatory implementation of a combined braking system and anti-locking braking system from April 2019 will also mean incremental costs.

What can still work in favour of Hero MotoCorp is if demand growth sustains or even improves, compensating for the impact of rising costs. Its September quarter (Q2) results are not a disappointment but they are not impressive either. Net profit at 976 crore was slightly better than 941 crore that a poll of Bloomberg analysts had estimated, and declined by 3.4% from a year ago. But, it’s worth noting that beating estimates was possible chiefly because of a significant increase in other income, which rose by 90% to 224 crore. Otherwise, net profit would have fallen by much more.

Sales grew by 5.5% in volume terms. That is good considering that the festival season is later in FY19, compared to last year, and some sales will spill over into the December quarter. Hero MotoCorp’s per unit price realization increased about 3% year-on-year, which analysts reckon is in line with expectations. As a result, revenue rose 8.6% to 9,091 crore. However, higher costs meant Ebitda (earnings before interest, tax, depreciation and amortization) fell by 5% to 1,379 crore. Ebitda margin declined 220 basis points over the same period last year to 15.2%. In the June quarter, Ebitda margin was 15.6%.

One basis point is one-hundredth of a percentage point.

The company launched the Xtreme 200R during the September quarter, which is expected to improve Hero MotoCorp’s positioning in the premium motorcycle category. Further, the roll-out of a 125cc scooter in the near term is expected to add to volumes.

Even as the cost environment is challenging, better prospects for demand from rural India, which accounts for a decent share of the company’s volumes, are expected to help. Factors such as a normal monsoon, hike in minimum support prices and farm loan waiver are expected to contribute positively from the demand side.

Nonetheless, the sharp underperformance of the Hero MotoCorp stock means that valuations are baking in a good share of the pessimism. The stock trades at 13.5 times estimated earnings for FY20, based on Bloomberg data. For valuations to expand, investors will want to see if demand growth can compensate for cost pressures and lead to healthier profit margins.

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