Expectations from Hero Honda Motors Ltd were riding high after the company reported a 24% jump in sales volumes earlier this month. The company didn’t disappoint, at least as far as revenue growth was concerned.

Revenue grew by 32% year-on-year (y-o-y), aided by price increases in April and June. With stronger volumes and the resultant operating leverage kicking in, one would have imagined that the company’s profitability would have also improved considerably.

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But Hero Honda’s operating margins at 14.4%, compared with 14% a year ago, were below expectations. This is despite a change in treatment of royalty expenses since the March quarter.

The company has stopped paying royalty for all existing and modified products and parts and has instead made an upfront payment to Honda Motor Co. Ltd, which will be amortized until fiscal 2014 (FY14). Margins would have been lower at 11.3% if the company had continued to pay royalty expenses like it did last year.

On a comparable basis, therefore, margins were under pressure owing to raw material cost pressures. Raw material cost as a percentage of sales at 74.7% was about 1.9 percentage points higher from the preceding quarter. Incidentally, raw material cost pressure was higher compared with what rival Bajaj Auto Ltd faced during the quarter.

Because of the change in payment of royalty expenses, depreciation and amortization charged shot up from Rs48 crore in the year-ago June quarter to Rs240 crore last quarter. It’s best to look at Hero Honda’s performance after accounting for depreciation for an accurate comparison with last year’s results. Earnings before interest and tax rose by just 4.3% y-o-y.

The company’s performance got a fillip from treasury operations. Other income rose by 26% from the year ago. Further, Hero Honda’s tax rate at 16.7% was the lowest in the last few quarters. Both these factors shored up net profit, which grew 14% y-o-y and 11% from the preceding quarter.

Meanwhile, in an analysts’ conference call, the management reiterated additional outflows on account of research and development, re-branding and distribution expenses, following the severance with its Japanese partner. This could certainly affect Hero Honda’s profitability.

Of late, the company has been able to ramp up volumes and maintain its market leadership. This is perhaps the reason why the stock has outperformed both the benchmark Sensex and the BSE Auto Index in the past one month, after a period of underperformance.

However, valuations seem to be rich at 15 times its FY13 earnings. Analysts’ consensus estimates an earnings growth rate of around 10% over the next 18 months, which leaves little scope for an upside in the stock. In a post-results note, Brics Securities Ltd said it has reduced the target price for the stock by about 20% from the present level on account of stress on margins and moderation in earnings growth rate until FY13.

Graphic by Yogesh Kumar/Mint

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