Hero-Honda split: valuations hinge on future market presence

Hero-Honda split: valuations hinge on future market presence

Even as the split between equal stakeholders—Japan’s Honda Motor Co. and the Hero group—in Hero Honda Motors Ltd (HHML) was formalized, uncertainty on the financial contours of the deal still remains. Details of the new licensing agreement, the exact royalty on existing and new models and the actual size of the deal in which Hero will buy the 26% held by Honda, have not been disclosed. Yet, shares of the world’s largest two-wheeler maker rose 3.6% on the Bombay Stock Exchange after being beaten down nearly 17% since its peak levels in July, when the market got a whiff of the upcoming exit.

One reason is that the Hero group will buy out the stake of Honda, which won’t affect the financials of HHML. Another reason is that those who predicted a jump in royalty from the present 2.7% of revenue to anywhere between 5% and 8% were proven wrong. The management sprung a positive surprise, saying that the royalty outgo would start declining from January 2011. Nevertheless, this raises some questions, too. Is this a factor of higher sales revenue? Or, would the new licensing agreement provide for any one-time technology transfer fee?

What one must factor into valuations is that while the road ahead for HHML without its technology partner of 26 years throws open new avenues, it could be a bumpy ride in the near term. So far, the joint venture did not permit HHML to set foot overseas. An industry peer such as Bajaj Auto Ltd exports about 30% of its motorcycles in a year. Under the new licensing agreement, HHML won’t have geographic constraints. But for this the firm will have to invest in research and development (R&D) or scout for a new technology partner. Analysts say that Honda’s R&D spend in FY10 has been 5.6% of its global motorcycle business revenue amounting to about $12.2 billion (Rs55,388 crore).

Another challenge would be to compete effectively in the domestic marketplace. Of course, its two key brands, Splendor and Passion, are firmly entrenched in the market. However, Bajaj Auto’s share has increased from 22% to 28% in recent times as HHML lost ground from 57% to 52%. Quick positioning of the new firm name and brand are marketing challenges.

Meanwhile, it would need to raise production from its present 5.3 million vehicles per annum. A strong positive is that the firm has cash of about Rs4,500 crore on its books to meet any capex going forward.

But pain is inevitable. A case in comparison could be TVS Motor Co. Ltd. When Suzuki exited the joint venture in September 2001, the shares fell 20% to Rs72 apiece. However, the firm made a comeback on its own with its market capitalization improving nearly 20 times to the present Rs3,400 crore. Of course, HHML is on a stronger wicket in terms of its market share, vendor network, distribution reach, brand equity and even technology absorption strengths.

Analysts have maintained estimates as the split does not affect short-term financials. The current market price of Rs1,680 discounts the estimated fiscal 2011 earnings about 16 times. The key would be for HHML to prove its prowess in terms of sustaining market share in a growing motorcycle market on home turf, while entering new markets overseas. Until then the stock could see a lot of volatility depending on news announcements.