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15th December 2013 |
Hero MotoShiv Puri
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- Hero Moto is the largest two wheeler manufacturer in the country.
- The market opportunity for 2-wheelers in India remains huge. Currently, there are 14 million two wheelers sold each year on an installed base of 150 million. Over the next 10 years, we should see the total base doubling to 300 million, driven by rising incomes, inadequate public transportation and surge in the key demographic segment (18 to 30 year olds). Hero with a market share of 45% will be the key beneficiary of this growth.
- Our recent due diligence involved making several field trips to dealerships across rural India and conducting proprietary surveys with existing and potential customers. Our work made it quite clear that the moat for the company lay not in the Honda technology but in the strong brand recall and trust in its two dominant models - "Splendor" and "Passion".
- The strong relationship that Hero has with its 2,500 exclusive dealer base, meant that this would remain a huge barrier to entry for any new player.
- The quality, durability and trust of the Hero motorcycle built over three decades means the propensity to switch to a competitor is very low. As result, a customer that owns a Hero motorcycle will replace it with another Hero motorcycle 90% of the time!
- Hero Moto trades at 13x earnings, with a 7% FCF yield growing at 16%. Its return on equity is 40%. The company has zero debt and $650M of cash (roughly 10% of its market capitalization). The company has never raised debt or equity since it went public in 1984. The promoters, along with a couple of private equity firms, own 52% of the company ensuring alignment of interest.
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Hero Moto is the largest two wheeler manufacturer in the country. It sold 6.3 million motor cycles in 2013 at an average price of Rs40,000 or roughly $700. The company will make an operating profit before tax of $85 per motorcycle. The market opportunity for 2-wheelers in India remains huge. Currently, there are 14 million two wheelers sold each year on an installed base of 150 million. Over the next 10 years, we should see the total base doubling to 300 million, driven by rising incomes, inadequate public transportation and surge in the key demographic segment (18 to 30 year olds). The market opportunity therefore consists of 150 million new motorcycles, in addition to replacement motorcycles. Hero with a market share of 45% will be the key beneficiary of this growth.
By way of background, the Hero group was started as a cycle manufacturing company in 1956 by Mr. Brijmohan Munjal (the current Chairman) and became the largest bicycle manufacturer in the country. In 1983, the company entered into a joint venture agreement with Honda to manufacture motorcycles and scooters in India using Honda technology, under the Hero Honda name. The company executed well and by 2003, they had a dominant market share of 45% that they have since maintained because of their strong brand name and a wide distribution network of 2,500 dealers in rural India.
In December 2010, Hero group bought out Honda's 26% stake in the JV. This caused significant concern among investors resulting in a 25% correction in the stock price, which drew our attention. Our conversations with investors and sell side analysts highlighted two major concerns - i) Hero would cede a lot of market share to its erstwhile partner Honda, who planned to expand into India independently, and, ii) Honda would cut prices to take share.
Our recent due diligence involved making several field trips to dealerships across rural India and conducting proprietary surveys with existing and potential customers. Our work made it quite clear that the moat for the company lay not in the Honda technology but in the strong brand recall and trust in its two dominant models - "Splendor" and "Passion". One survey conducted by us confirmed our hypothesis that over 80% of first time buyers of motorcycles based their decision on the motorcycle brand that peers in the village (family member, uncle, friend) owned rather than on any special bells and whistles that a new entrant was putting into its product. In addition, building a distribution network in rural India (which accounts for 75% of motorcycle volume) is very difficult. The strong relationship that Hero has with its exclusive dealer base (average dealer partner has been with them for over 14 years), meant that this would remain a huge barrier to entry for any new player. This was confirmed in our field trips, where we found dealers remaining very loyal to Hero and Honda lacked any presence in many large towns in rural India. Even today, Honda has struggled to add good dealerships and has less than 180 dealerships in rural India after 3 years. Finally, the quality, durability and trust of the Hero motorcycle built over three decades means the propensity to switch to a competitor is very low. As result, a customer that owns a Hero motorcycle will replace it with another Hero motorcycle 90% of the time! Our surveys conducted with end users also revealed that Hero's key competitor - Bajaj Auto had a weaker product and would be more vulnerable to market share loss against Honda.
We used our relationships with the regional sales people of Honda in the North and West, as well as a number of Honda dealers across the country to understand their pricing strategy. Our meetings with them highlighted that Honda was positioning its product called the "Dream" series as a premium product, with "superior" technology, and in their view, engaging in price competition would cheapen the brand name and consumer experience. Our field trips to several rural areas and conversations with customers we have not yet seen a discounted Honda motorcycle. We did find that trust and reliability played a strong role in deciding which motorcycle to buy and a modest difference in pricing was unlikely to shift market share. Hence, a 10% price discount over Hero Moto would likely be the minimum for some movement of market share and at that price Honda will not be making any money. While that is a strategy Honda may still pursue, we do not see them as a price disruptor. But it remains a risk and is something we are monitoring very closely.
Hero Moto trades at 13x earnings, with a 7% FCF yield growing at 16%. Its return on equity is 40%. The company has zero debt and $650M of cash (roughly 10% of its market capitalization). The company has never raised debt or equity since it went public in 1984. The promoters, along with a couple of private equity firms, own 52% of the company ensuring alignment of interest. A final point here is that Hero is also targeting the export market and over the last two years, their exports have gone from 50,000 to 300,000 motorcycles annually. This will become meaningful over the next few years. We feel the fundamental risk reward is well in our favor for such a wonderful business and we expect this structural growth story to remain for many years to come.
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