Hero MotoCorp Ltd. (HML) has been one of the biggest wealth creators in the Indian stock market history.
Over the last 10 years, the stock has returned around 24% per year, which is an amazing long term average.
On the business front, the company has been at the forefront of the 2-wheeler revolution in the country. Since 2001, it has been the largest 2-wheeler manufacturer in the world.
As far as its financial performance is concerned, its sales and profits have grown at average annual rates of 18% each over the past 10 years.
This growth has been without any damage to the balance sheet. Debt remains minimal, its working capital cycle is small, and cash generation has been tremendous.
In fact, the company has not seen a single year with negative free cash flow over the past 15 years, which in itself is commendable.
So the past ten years, as a whole, look beautiful.
Now, as an investor, it is easy for me to draw patterns from the past – especially if the past has been a great one – and expect the future to be the same.
This pattern-forming skill gets enhanced when you work too much on the excel sheet, which gives you the flexibility to “tweak” future growth rates any way you want!
Anyways, here is a view an analyst friend of mine recently shared with me about HML – “A company that has grown its sales and profits at 18% per year across market cycles is bound to do good in the future. If not 18%, even if it achieves 15% growth, I can earn a handsome return on my investment.
“You see the balance sheet is clean,” he continue, “…the cash flows are solid, the brand is well-known, and now the valuations are also decent.”
HML’s P/E, by the way is at around 16.4 times its trailing 12 months earnings, which is almost near its average P/E for the past three years.
As compared to this, its closest competitor Bajaj Auto is trading at almost 20x P/E, or at a 22% premium to the former’s valuation.
So, on a relative basis, HML looks much cheaper than Bajaj Auto.
“What is more, HML is near its 52-week low price,” my friend told me. “I have thus bought the stock and expect to make a lot of money from it!”
Now, I am not a sadist. But my fried may start hating me when he reads what follows next.
Is Hero MotoCorp a value trap?
If you have been reading me for some months now, the right side of your brain tells you – “Oh, you know the crap Vishal writes when he analyses companies! You’re already reeling in deep losses from his ‘recommendation’ on Opto Circuits. And now, he says that a great stock like HML can be a value crap…oh sorry, value trap!”
But then, the left side of your brain tells you – “What’s wrong in knowing Vishal’s reasoning for the same? He’s always told you to do your own research before buying stocks because it’s your responsibility as an investor. So, at least listen to him and then do what you think is fine.”
Now I can see you holding both your brains together, and then reading out the three reasons I, Vishal Khandelwal, think HML can be a value trap.
Here I go…
1. Exit of Honda, and especially when it was driving all innovations at HML, will continue to be painful for the latter.
Just look at the history of TVS Motor. After the exit of Suzuki from a joint venture, the company took many years to find its bearings.
I think it will be worse for HML as Honda has already become a strong name in the motorcycle market in India, and is leaving no stones unturned to shake up the hegemony of HML.
HML is also facing immense competition from Bajaj Auto, which has emerged as a more profitable 2-wheeler company, and thus commands a greater pricing power than the former.
After Honda’s exit, HML has faced trouble in retaining its core customer group. This I think will remain a challenge, again led by rising competition and better product launches by rivals.
2. HML is not defending its leadership. As Mr. Chetan Parikh highlighted in the second part of his interview, the company has not launched any marquee models for long. Splendour was HML’s trump card when I was in college, and it’s still the trump card.
Bajaj was guilty of doing this – not defending its leadership – with its Chetak model years ago, and paid a heavy price of it. In a market that is even more competitive and fast evolving, HML’s slow steps can cost it heavy.
What is more, HML, with a 32% share ,does not have a market leadership in the most vibrant segment of the Indian motorcycle market – the 125-150cc range. In fact, Bajaj Auto and Honda are tightening the noose here.
In the premium range (bikes more powerful than 250cc), Hero is a very small player anyways.
The company is now also getting squeezed in its dominant business of selling entry-level bikes (75-110cc), where it has a near-70% (and declining) market share.
Sales here are getting impacted for two reasons:
- Despite high interest rates and rising fuel prices, but due to improved income levels, more first time consumers are settling for the middle-of-the-road bikes (110-125cc) instead of entry-level bikes (75-110cc). Bajaj Auto and Honda are dominant players in the former category.
- Scooters, which carry engine power comparable to entry-level bikes but with a much cheaper price tag, are gaining market share. HML’s scooter market share at 16% is just half of Honda’s and isn’t serving a major purpose for the former.
3. HML is losing its moat. After the exit of Honda in FY11, HML has raised its spending on advertising. In other words, it is resorting to spending more and more money to protect its moat, which is weakening.
Led by higher advertising costs, the company’s profitability is on a consistent decline. This – declining margins – is one of the key factors to identify a potential value trap.
With competition intensifying, rising advertisement spends, and no major development on new launches, margins may remain under pressure. A lower margin will also reduce the company’s pricing power.
So, what to do with HML?
Considering the above factors, I believe HML’s valuations at 16.4x training 12-months earnings, which seem cheap and especially in comparison to Bajaj Auto’s valuations, are not so cheap for the kind of prospects I see for the company over the next five years (at least).
Also, my intrinsic value calculations (you can see my last StockTalk report for greater discussion on the methods I use) suggest that the intrinsic value for HML (after adjusting for 25% margin of safety) is around Rs 1,350. This is around 25% lower than the stock’s current price, which suggests that I value at the current price anyways.
As far as HML’s business is concerned, any reduction in interest rates and an improvement in consumer sentiment (especially in the rural areas where HML’s entry-level bikes are in greater demand than in urban areas) can help HML return to a high growth part in the future, competition poses a huge risk for the company.
I see intensifying competition hurting HML on two major fronts:
- Margins will remain weak as it continues to spend money towards advertising. Competition is eating into its market. Will HML’s profit margin recover sustainably? Well, that is a “too-hard” question. You should avoid situations where you have to answer this question.
- Sales growth to taper down as first time consumers shift to cheaper but equally power scooters, or to more powerful but slightly expensive bikes than what HML sells.
The company will also be spending a large part of its cash flows towards R&D (for most Indian companies, R&D is a sophisticated term for T&A, or trial & error) in a bid to come out with marquee models, so dividend may no more be a lure to buy the stock.
In all, I think HML has the potential to become a value trap unless it gets its act together. At least that is what the direction of its business is hinting at.
But please don’t believe me!
With the growing influence of stock analyst recommendations and the proliferation of financial bloggers, there is good reason to question their usefulness.
Here are two reasons you must doubt my above analysis of HML:
- Your level of conviction differs from mine. While I may be convinced based on whatever little analysis skills I have, that HML has the potential to become a value trap, you must not based your conviction on mine. This is simply because of the second reason.
- I make mistakes… and a lot of them! I don’t have a flawless process of analysing companies or stocks. I have a process that remains in evolution, and thus I am prone to make mistakes. But that must never hurt you because you must take my analysis with a pinch of salt, do your own research, and then add your won spices to the story. Then, if the story turns sad, please do not blame me for you ate your own cooking. 🙂
I also subscribe to same school of thought. Just want to add that it takes 2-3 years minimum to develop and bring out a new model altogether. Even then, market may or may not like their new product and also with the management not giving a clear picture of future, its always better to risk on the safer side. I always remember that return of money is more important than return on money :).
Advertising to buy revenue by itself does not work … it sucks and sucks a lot of cash. It has to be complemented by product innovations (regular improvements including) which keep competition on its toes. I would agree with your analyses, unless one sees product innovation just advertising is mere brute force.
Vishal.. Another Nice Article.. One more request.. You can some other Companies for analysing Value Traps….
TVS… Well .. they are better in two stroke vehicles like TVS50 which has a good market in south india and Scooty too..
but with competition intensifying from hero and honda.. their margins are under severe stress..
HML.. It needs a great boost from rural sectors.. And where ever i had seen TVS50 in south india.. they are also shifting towards Hero/Honda/Bajaj.. So tough times ahead for TVS also…
A timely piece adding to my confusion!! I have been procrastinating for the past few months- hold/sell Hero which has been a ” multibagger” not only in terms of capital appreciation, but hold your breath- Dividends. Look at their dividend history in the past 7 years: Unbeatable. The dividends alone has given back my initial investment
many times over!!
Year Month Dividend (%)
2012 May 2,250
2011 May 1,750
2011 Apr 3,500
2010 Apr 1,500
2010 Mar 4,000
2009 Apr 1,000
2008 Apr 950
2007 May 850
2006 May 1,000
2005 Apr 1,000
Now you know why i have delayed taking a decision. I do understand the implications of the divorce with Honda and the competitors like Bajaj and Honda breathing down their neck. When the situation has changed dramatically for a stock in my core portfolio, i normally resort to partial disinvestment or systematic selling plan. Looks like i found my answer while replying to your blog!!
Most of the bearish cases for Hero also apply to Bajaj except that Bajaj is showing better margins as of now.Bajaj also doesn’t have any new models except and its current successful models are in the market for more than 7 years now.But people often confuse by equating premium in share price to the quality of the company.
According to me Bajaj and Hero are in the same boat as of now.Honda and other companies will increase the market share at the expense of these 2 companies.
In one of the methods for calculating intrinsic value of a stock you use 10 year average P/E. Would you tell how and from where to get this number?
sarthak kumar says
I have a question regarding opto circuits. I know what you might be thinking! But let me assure you I did not buy it based on your “advice”. Nevertheless, I have ended up investing a good part of my portfolio in it. I wanted to ask if its intrinsic value remains at ~”Rs 130″ or has there been some development to alter the fundamentals.
Hoping you will answer my questions inspite of the highly irritating and objectionable responses you received. Thanks and regards
Sarthak, I am on the same boat, and i think we should give some more time to see what happens, However as you said, it would be nice to have vishals prospective.
Vishal Khandelwal says
Sarthak, Vikrant – No doubt the management integrity has taken a big knock!
If I were invested in this stock, I would have cut my losses instead of seeing a permanent destruction of capital. Things are getting murkier here. Regards.
Why exactly did you buy Opto Circuit?
Your analysis looks bang on target.
Unfortunately they are hurtling on the slop.
As of now HML’s biggest issue is the leadership.
This Post makes it more difficult for people like me, This clearly shows that you have to keep reviewing the Stock that you hold, and now i am thinking if i had bought this stock, what should be done with it in the current case, Should i hold or exit, i am not expecting a answer weather hold or exit, i am talking hypothetically if i was holding it i would not know what to do with it now. I need some clarity on what should be the process or decision making in this scenario?
Vishal Khandelwal says
Vikrant, it’s always about “Buy-Review-Hold/Sell”.
You need to know where the business is heading as you are a part-owner of the same. It’s good to review a company’s business in six months. To make the job easier, it’s important to own few stocks. Regards.
Great and timely post. I personally think the only think that make or break the company is leadership team or lack of it. How do you view leadership of Hero Moto? Does Hero leadership has the mindset to spend billions on a product just to see it fail and hence abandon it and look for new product with the same vigor?.
The saving grace for Hero is highly margin focused Bajaj Auto, otherwise Hero would have been in trouble already. So as long as Bajaj makes it margin, Hero is safe albeit at the lower margin level. But if Honda tries to threaten Bajaj in its profitable segment then Hero will face the music. And the first salvo we have seen in the launch of Discover 100T. If it succeed the most profitable product of Hero “Passion” is directly under attack. It will be interesting watch how Discover 100T is accepted int he market. We will have an answer to your question about “Value Trap” in next three months if Discover T is successful.
Vishal Khandelwal says
I second your view, AVV. Honda is indeed calling the shots. Regards.
Rajiv Bajaj is on record saying that Honda will accept no less than 50% marketshare in any market it competes and he expects India to be no exception. Which means we are for a bloodbath in Indian two wheeler market soon.
Vishal Khandelwal says
Now that’s bad news for Hero, as well as Bajaj! Competition is going to get brutal here, more so because low-priced scooters and cars (like Nano) will continue to drive aspirational buyers towards them.
Thank you for educating use on the value investing and also useful value investing methods. After learning about the instrinsic value concept, I have the following queries
If we have bought a stock at a price lower than its intrinsic value (after adjusting MOS) ,
1. What should be our action plan once the stock moves above its intrinsic value ? Should we continue to hold it or sell it
2. Do we have to re calculate the instrinsic value on periodic basis (once in a year or so) to incorporate the curent performance of the company in our calculations so that we can decide whenther to buy more or hold it
I also think that HHML is going to go through a difficult cycle – I can see analogies from Maruti about a decade back – the launch of one model swift just turned around its entire fortunes. Save for the swift and swift based models, maruti would be at < 15% market share in volumes and would have had a really poor margin record (since there is not much money in altos, wagon r's ). That happened because suzuki took control of maruti and started bringing in the latest global models. However, I see the converse with Hero – given that they were lackadaisical in launching new products for the last decade, I think it is going to be challenge for them to launch a "volumes" model. my sense is that this migration from "volumes" to "value added mid-market" is happening across the world across multiple categories – samsung vs nokia in phones, premium hatches vs entry hatches in cars and Hero is a little late to realize it. I see a 25-30% downside from here and then based on any success of their models, we could see a turnaround. Any views ?
I think you have a valid point in case of HML. Their moat is nearing. Unless they just can’t bask in their past glories.
I am admiror of your approach, and study ur articles as learner.
I read ur article today on 21st June,2014. :D…
See.. How time changes.. and market statistics and opinions about Bajaj Auto and Hero. I feel both are feeling pressure on sales front today, still committed as reasonable players. Time proves many things on its own…