A look at the pros and cons of the Hero Honda split reveals more long-term negatives if at all; in the short term nothing much has changed. Surprisingly, the split does not seem to do much for Bajaj either

Hero Honda clarified yesterday that royalty payments to Honda will be about 3-5% of sales for new models and at the existing level of 2.5-3% for current products. The company believes that these payments (as a percentage of sales) will decrease as volumes increase, so they assume volumes will rise fast over the next three years or so.

A few days ago, the stock price crashed on talk that the royalty outgo would be 8%! The bad news is that Hero Honda (or do we say Hero?) will now have to pay ‘new model fees’ to Honda in addition to royalty. After it buys out Honda’s stake the Munjal family will own 52%, that is double from the current 26%. It seems clear from the nature of the split that while in the near term (2-3 years) it will have no impact on Hero Honda, longer term it is a slight negative. The split does not seem to work in favour of competitor Bajaj Auto either.

Market players are mostly underweight on the stock and they believe that the stupendous 18% rise in the stock price yesterday is a good opportunity to exit the stock.

The positives

• Not much change in the near term for Hero Honda since it continues to get technical support from Honda and gets to use the brand name till 2014.

• Zero royalty payments after 2014.

• Royalty payment will start falling sooner than expected (the management says as early as next month) if the company will develop more models itself.

• Higher exports, as the company can now export to locations where Honda has a presence

• Hero Honda has three years to develop its R&D capabilities—not a very long time, but enough to come up with decent models at least in the entry-level segment from where it gets 70% of its sales.

• Even if Honda reserves its good models for Honda Motorcycle & Scooter India (HMSI), its wholly-owned subsidiary, Hero’s old ‘Splendour’ and ‘Passion’ models constitute 70% of its sales; all new bikes in the last few years add up to only 8% of its sales—so this should not be a huge problem.

Some negatives

• Although Honda needs to provide new models to Hero Honda under the new agreement, there is a possibility it will reserve all the good ones for HMSI.

• Hero will have to pay new model fees, which could be hefty.

• R&D spend for Hero Honda will rise—Bajaj spends about 1.5% of sales and TVS about 2% on this. Although it is not impossible that HH may come up with good models, since it is getting three years to develop them, historical evidence shows it has not been easy. Bajaj had many failures after its split with Kawasaki—like Wind, Caliber, Discover 125CC, XCD 125CC. HH has indicated that it will pay about 1.5%.

• Exports may not rise as fast as expected because it takes time to understand local markets and to build supply chains. Additionally, they cannot use the Honda name for exports. Branding will be a challenge.

• Advertising and selling expenses are likely to shoot up after the split.
Implication for Bajaj Auto

• HMSI is likely to turn more aggressive in its plans—its models and network expansion. Its models compete more with Bajaj Auto’s products and this could erode Bajaj’s market share.

• Hero Honda, too, might turn a bit more aggressive in the next 2-3 years to assure its dealers, vendors, and employees and this again could be a negative for Bajaj Auto.

• Hero Honda will turn more aggressive in the exports market, again a business area that was Bajaj Auto’s domain so far.

In a conference call on 20th December, HH said it will have to create new capacities to meet the growing demand, and in addition to de-bottlenecking it may look at setting up a fourth plant which would entail capital expenditure.

The news of the split drove the stock price down to Rs1,560 on 15th December from a high of Rs2,062 on 30th November—a 24% fall in a fortnight. However, yesterday, the stock rose 18% in a single day and is back to around Rs 2,000.
According to CLSA’s valuations, Hero Honda trades at 13.6 times FY12 price-to-earnings, while Bajaj Auto trades at 14 times. 

(This article is based on secondary research. The report is for information only. None of the stock information, data and company information presented herein constitutes a recommendation or solicitation of any offer to buy or sell any securities. Investors must do their own research and due diligence before acting on any security. Some of the opinions expressed in this article are the author’s own and may not necessarily represent those of Moneylife.)