Two Wheeler Industry Essay

SECTOR REPORT PRIVATE CLIENT RESEARCH MAY 13, 2010 Arun Agarwal arun. [email protected] com +91 22 6621 6143 Two Wheeler Industry Fundamentals still attractive; valuations…… Over the years the two wheeler sector has played a key role in a country like India where majority of population lives in rural or semi-urban areas without adequate transportation facilities. The Indian two wheeler market with an annual domestic sale in excess of 9mn units is 2nd largest globally and accounts for 75% of the total domestic automobile industry sales volume and that clearly demonstrates the popularity of two wheelers among the Indian consumers.

After facing a slowdown in FY08 and FY09, the two wheeler industry made a remarkable come back in FY10 and we are optimistic about growth prospects in FY11E. Current retail demand is quite robust and this, coupled with new launches and players’ focus on volume generating 100cc segment, would be the main growth driver for the industry in FY11E. Volumes in FY10 grew at a significant pace and on that high base in FY11E industry volumes are expected to grow though at a relatively moderate pace. We expect the domestic two wheeler volumes growth rate to come down from 26% in FY10 to 15% in FY11E.

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Due to relatively lower base and new launches, we expect players like Bajaj Auto (BAL) and TVS Motor (TVS) to outperform the industry volumes growth rate in FY11E. On the other hand, Hero Honda (HH) is expected to underperform on back of enhanced competition and relatively much higher base. We have an ACCUMULATE rating on all three stocks with preference for BAL and TVS. Volume growth to come down but remain decent in FY11E Companies covered Hero Honda Motors Bajaj Auto TVS Motor ACCUMULATE ACCUMULATE ACCUMULATE Industry sales volume (mn units) 12. 0 9. 0 6. 0 3. 0 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 Source: SIAM W Industry – Market Share Top 3 players (%) HH BAL TVSM 50 40 30 20 10 After a substantial volume uptick in FY10, we expect the industry to return to a relatively moderate growth path in FY11E. We expect the demand momentum for two wheelers to continue in FY11E but the rate is likely to be lower than FY10. Robust retail demand, new product launches and lower base effect of 1HFY10 would be the main volume driver in FY11E. However, the relatively higher base of 2HFY10 and absence of one time factors (FY10 had the effect of VIth Pay Commission, farmers loan waive-off etc) will restrict the growth rates to a moderate level, we opine.

Accordingly we expect the two wheeler volumes to grow by 15% in FY11E versus 26% growth recorded in FY10. New launches would remain crucial New launches over the next 6-12 months would be critical for maintaining the growth in FY11E. Successful product launch generally tends to expand the overall market thereby leading to a robust and higher growth for the industry. With overall two wheelers demand drivers in place; new launches would play a significant role in FY11E to achieve our industry volume growth expectation of 15%. Recent new launches like Pulsar135LS, Twister and Jive would aid industry volume growth over the next six months.

Source: SIAM Valuation Matrix (Rs mn) CMP (Rs) HH BAL TVS Motors 1,901 2,145 100 TP (Rs) Revenues FY10E FY11E 180,658 142,011 57,206 Adjusted PAT FY10E 22,318 18,243 1,320 FY11E 24,396 20,609 1,832 EPS (Rs) FY10E 111. 8 126. 1 5. 6 FY11E 122. 2 142. 4 7. 7 PE(x) FY10E 17. 0 18. 3 27. 5 FY11E 15. 6 15. 1 13. 0 EV/EBITDA(x) FY10E FY11E 12. 0 11. 9 9. 8 11. 1 10. 1 7. 0 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 112 1,955 158,312 2,280 119,210 44,240 Source: Companies; Kotak Securities – Private Client Research Registered Office: Kotak Securities Limited, Bakhtawar, 1st floor, 229 Nariman Point, Mumbai 400021 India.

SECTOR REPORT May 13, 2010 Pick up in exports Exports form around 11% of the overall sales of the two wheeler industry. During the global slowdown, two wheeler players witnessed a dip in export volumes. Since then, exports have picked up on account of partial economic recovery in various export countries. Major export players like BAL and TVS Motor have witnessed positive movement in export volumes post global slow down. After a blip in early 2009, the volumes have regained positive momentum and are once again back on the growth track.

Despite poor 1HFY10, export volumes in FY10 grew by 14% and we expect 12% growth in FY11E. Margins to be impacted; but not significantly Raw material cost forms a major proportion of the overall cost for the two wheeler industry and thereby the margins for the industry are dependant on commodity prices movement to a large extent. Since April 2009 the raw material prices in the spot markets are on an upward trend that threatens the current margin sustainability during FY11E. However, robust volume growth of 15% and benefit of plants in tax free zone would lessen the impact to a certain degree.

We believe that the impact will be in the range of 50 – 100 bps for the industry. Valuation On back of lower volume growth and pressure on margins, we expect the two wheeler sector to trade at a lower PE multiple as compared to its trading band in the past one year. In our view, HH’s growth rate will be lower and we see limited upside opportunity from current levels. On the other hand both BAL and TVS are expected to report relatively higher growth in earnings and market shares in FY11E. We have valued BAL on par with HH given the company’s strong comeback in 100cc segment and higher growth rate.

Despite strong earnings growth rate of 40% in FY11E expected for TVS we have given a valuation discount of 10% on back of company’s smaller scale and higher geographical concentration. We initiate coverage on HH, BAL and TVS with an ACCUMULATE rating with positive bias towards BAL and TVS, in that order. Kotak Securities – Private Client Research Please see the disclaimer on the last page For Private Circulation 2 SECTOR REPORT May 13, 2010 INVESTMENT ARGUMENT Volume growth to come down but remain decent in FY11E After a substantial volume uptick in FY10, we expect the industry to return to a relatively moderate growth path in FY11E.

We expect the demand momentum for two wheelers to continue in FY11E but the rate is likely to be lower than FY10. Robust retail demand, new product launches and lower base effect of 1HFY10 would be the main volume driver in FY11E. However, the relatively higher base of 2HFY10 and absence of one time factors will restrict the growth rates to a moderate level, we opine. Accordingly we expect the two wheeler volumes to grow by 15% in FY11E versus 26% growth recorded in FY10. q Industry had a dream run in FY10 Two wheeler players had a dream FY10 where volumes showed remarkable increase coupled with sharp fall in raw material prices

Auto industry in general and two wheeler industry in particular witnessed unprecedented growth in volumes in FY10. Two wheeler players had a dream run where volumes showed remarkable increase coupled with sharp fall in raw material prices. Both these factors led to substantial increase in profitability for the two wheeler players and the same was reflected in manifold increase in two wheeler stock prices in the past 12 months. Domestic 2W volumes (units) 1,000,000 750,000 500,000 250,000 Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar FY09 FY10 Source: SIAM q ……. ut situation would be back to normal in FY11E Factors responsible for FY10 growth included one time events like sixth pay commission payouts and farm loan waiver According to us, situation in FY11E would be back to normal for the two wheelers players after the outburst in volumes witnessed during FY10. Our belief rests on the fact that reasons that led to overwhelming volume growth in FY10 would be missing in FY11E. Factors responsible for FY10 growth included one time events like sixth pay commission payouts and farm loan waiver and low base effect/pent up demand.

While we expect structural demand drivers for two wheelers to remain firm in FY11, one time events that led to above-normal growth would be absent. Further the effect of low base / pent up demand would start tapering off from 2HFY11E. However the underlying strong consumption would help the industry grow by 15% in FY11E, we believe. Kotak Securities – Private Client Research Please see the disclaimer on the last page For Private Circulation 3 SECTOR REPORT May 13, 2010 Domestic volume and growth 12 8 4 (4) FY07 FY08 FY09 FY10 FY11E Domestic Volumes (Mn units – LHS) % growth (RHS) 20. 10. 0 (10. 0) 30. 0 Source: SIAM, Kotak Securities – Private Client Research q One time factors During FY10 various one time factors like arrear payout on account of sixth pay commission, government stimulus package (lowering of excise duty from 12% to 8%) and farm loan waiver contributed to strong volume growth. Domestic volumes (Thousands units) 1,000 850 Growth post stimulus pacakge Sixth Pay Commission Government stimulus package Farm loan waiver 700 550 400 Feb-09 Jul-09 Feb-10 Mar-09 May-09 Nov-08 Dec-08 Nov-09 Aug-09 Dec-09 Sep-09 Mar-10 Jan-09 Jun-09 Apr-09 Jan-10 Oct-08 Oct-09

Source: SIAM Under the sixth pay commission recommendation, the Government of India announced the implementation of revised pay scale wef 1st January 2006. Accordingly the arrear payout worked out to ~Rs290bn which the government decided to pay in two installments. During late FY09, the government paid 40% of the arrear amount and the remaining 60% of the arrears is believed to have been disbursed during 2HFY10. Rural India received ~Rs600bn boost in the form of farm loan waiver during the February 2008 budget.

Both these factors led to additional money into the hands of the consumers thereby leading to increased spending power particularly in rural areas and small towns. In FY11E, we do not expect the government to usher any such one time benefits to rural India especially in the situation where the RBI is looking to absorb excess money from the economy in order to help the government contain inflation. However the reduction in tax rates in the recent budget may provide some fillip to demand. Kotak Securities – Private Client Research Please see the disclaimer on the last page

For Private Circulation 4 SECTOR REPORT May 13, 2010 During December 2008, the government through the stimulus package reduced the general CENVAT by 400 bps and accordingly excise duty on 2 wheelers came down from 12% to 8%. During 4QFY09 (post stimulus package), volumes in the two wheeler segment grew by 10% on sequential basis. We believe this measure by the government had a positive impact on the volume off-take for the two wheeler sector. For FY11E, there are no such benefits available; on the contrary the government in the recent budget announced partial roll back of excise duty. Pent up demand/Low base effect BAL’s exit created a vacuum in the executive segment and that lead to a huge pent-up demand Another reason for high growth of the two wheeler industry in FY10 is believed to be the huge pent up demand in the domestic sub125cc segment. For the two wheeler industry the domestic sub 125cc division is a critical segment as it accounts for 58% of the overall domestic industry volumes. Accordingly, the fortunes of the two wheeler industry depends a lot on the performance of the domestic sub125cc segment.

During FY07-FY09 all the segment and sub-segments in the domestic market registered positive growth except for the sub125cc segment whose volumes came down from 5. 2mn units in FY07 to 4. 1mn in FY09. In the same period, the domestic two wheeler industry showed a de-growth with volumes coming down from 7. 9mn units in FY07 to 7. 4mn units in FY09. Reason for negative volume growth was overall slowdown in the auto sector coupled with BAL’s decision to exit the 100cc segment. With two-wheeler demand picking up and BAL’s re-entry into the 100cc segment in July2009, the sub125cc segment saw huge surge in volumes.

We believe that BAL’s exit created a vacuum in the executive segment and that lead to a huge pent-up demand which according to us was one of the reasons for robust volumes in FY10. Furthermore the high two wheeler industry growth in FY10 was also on account of low base effect of FY09. With volume growth of 26% in FY10, the same would not be the case in FY11, we opine. During 2HFY11 we expect the industry volume growth rate to be lower than 1HFY11 on account of relatively higher volume base of 2HFY10. Domestic 2W volume (mn units) 10 8 6 Domestic sub125cc motorcycle volume (mn units) 5 4 3 2 1 FY06 FY07 FY08 FY09 FY10 Led to pent-up demand 4 2 FY06 FY07 FY08 FY09 FY10 Source: SIAM Source: SIAM Kotak Securities – Private Client Research Please see the disclaimer on the last page For Private Circulation 5 SECTOR REPORT May 13, 2010 Structural demand drivers intact Demand drivers for the two wheeler industry remain intact and accordingly we expect overall industry volumes to grow by 15% in FY11E. With new launches, low base and an entry into new segments, players like BAL, TVS Motor and Honda Motorcycle and Scooters (HMSI) would outperform the industry growth rate in FY11E.

We expect the current buoyant retail demand for two wheelers to continue in FY11E on back of improving domestic macro picture. In the short to medium term we believe factors like renewed focus on volume generating sub125cc segment, low base of 1HFY10, robust retail demand, reduction in income tax rates and improved macro environment would drive volumes. Structural demand drivers like increasing household income, better access to credit, increased focus on rural growth and overall improving demographic profile would keep the two wheeler demand intact in the long term. Two wheeler – Demand drivers

Immediate term n Focus on 100cc segment n Robust retail demand n Pent up demand n New launches n Additional money because of change in tax slabs n Rural growth n Improved macro environment Source: SIAM n Change in demographic profile n Huge difference between 2W and 4W prices Medium/Long term n Increasing income levels n Better access to credit n Fast paced urbanization n Expanding middle class n Inadequate public transportation system Current buoyant retail demand for two wheelers would continue in FY11E on back of improving domestic macro picture q New launches will remain crucial

New launches would play a significant role in FY11E to achieve our industry volume growth expectation of 15% New launches over the next 6-12 months would be critical for maintaining the growth in FY11E. Successful product launch generally tends to expand the overall market thereby leading to a robust and higher growth for the industry. During FY10 we witnessed that new launches by different players did not have a major impact on the competitors’ volumes. In fact new launches created their own market and that actually led to broadening of the overall two wheeler market.

In the scooters segment, demand for Activa remains strong (with high waiting period) despite couple of successful launches by M&M. Similarly, in the motorcycle segment, we believe the BAL’s strong re-entry into the 100cc segment (Discover 100cc monthly average volumes is ~65,000 units) had a marginal impact on HH’s volumes. With overall two wheelers demand drivers in place; new launches would play a significant role in FY11E to achieve our industry volume growth expectation of 15%. Recent new launches like Pulsar135LS, Twister and Jive would aid industry volumes growth over the next six months. Excise duty hike not to impact volumes in a major way Players like HH, BAL and TVS have one manufacturing unit in tax free zone In order to revive the economy the government had announced a stimulus package in Dec-08 to Feb-09 and as a part of that the excise duty was reduced from 14% to 8%. Post stimulus package the entire auto industry including the two wheeler segment witnessed revival in volumes. Now with partial roll back of excise duty, we do not expect any sharp downfall in volumes because of overall revival in the economy and the automobile sector in particular.

Even though the companies have decided to pass on the entire burden of the additional excise duty onto the customers; robust underlying demand is expected to negate its impact. Further players like HH, BAL and TVS have one manufacturing unit in tax free zone. During FY11E, we expect 30% of their production would be from the tax free zones which would not be impacted by the 2% excise duty hike. Kotak Securities – Private Client Research Please see the disclaimer on the last page For Private Circulation 6 SECTOR REPORT May 13, 2010

Pick up in exports provides an alternative Industry exports have grown at a CAGR of 22% since FY06 as against 7. 4% CAGR volume growth in the domestic market. Because of under-penetration in various developing and underdeveloped countries, exports provide tremendous growth opportunities as compared to the domestic market. Currently exports forms around 11% of the overall two wheelers sales by the industry. Major export market includes African countries, Latin America and South East Asia. Motorcycles forms about 97% of the overall two wheeler exports with sub125cc and 125cc+ segment accounting for 64% and 33% respectively.

Balance 3% is accounted by scooters and mopeds. During FY10 BAL accounted for ~64% of the industry exports followed by TVS Motor (~14%) and HH, HMSI and Yamaha accounting for less than 10% each. Export volumes have seen revival during 2HFY10 with pick up in average monthly export run-rate Export volumes have seen revival during 2HFY10 with average monthly export runrate increasing to ~105,000 units versus average monthly export run-rate of 85,500 units and 83,700 units during 1HFY10 and FY09 respectively. Exports have picked up on account of partial economic recovery in various export countries.

During FY11E we believe that export demand to remain robust after the initial pickup witnessed during 2HFY10 and accordingly we have factored 12% volume growth in exports. Share in export volumes – FY10 Export Volumes (Thousand units) 120 FY09 FY10 90 Export volumes and growth Volumes (Thousand Units – LHS) % growth (RHS) 1,200 900 600 36 27 18 9 FY06 FY07 FY08 FY09 FY10 Yamaha 6% Hero Honda 9% TVS Motors 14% Others 8% 60 Bajaj Auto 63% 30 300 Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar – Source: SIAM Source: SIAM Source: SIAM Kotak Securities – Private Client Research Please see the disclaimer on the last page

For Private Circulation 7 SECTOR REPORT May 13, 2010 Price war – a possibility Competition is expected to get more intense with players looking to increase their market share by launching products in the executive segment. For HH the sub125cc segment is of high significance as it generates 90% of its volumes from that segment and is the largest player with FY09 market share of 80%. BAL’s reentry into the executive segment saw HH market share coming down to 75% in FY10. We did not witness any price cuts then because the industry was growing at a rapid pace and HH’s volumes were not impacted in a major way.

However with industry growth looking to normalize in FY11E and other players looking to further grab market share from the market leader; price war in order to protect market share cannot be ruled out. HH has huge cash reserves and cash cow products which can help them sustain at a minimum level of profitability. Even BAL has huge cash reserves and high profit margin product which it can cross-subsidize to sustain price war. In case the players resort to price cuts to tackle competition; profitability is expected to take a huge hit especially in a scenario where the industry is already feeling the heat of rising input cost. W Industry – Domestic market share (%) Hero Honda TVS Others Bajaj Auto Honda Motors Price war in order to protect market share cannot be ruled out Motorcycle – sub 125cc segment market share (%) 100 75 50 25 0 Oct Jul Feb May Sep Nov Aug Dec Mar Jun Apr Jan Narrowing gap HHML BAL TVS Others 60 45 30 15 0 } Oct Jul Feb May Sep Nov Source: SIAM Source: SIAM Margins to be impacted; but not significantly q Rising input cost a concern Margins for the industry are dependant on commodity prices movement to a large extent

Raw material cost forms a major proportion of the overall cost for the two wheeler players and thereby the margins for the industry are dependant on commodity prices movement to a large extent. For the two wheeler industry major raw materials include steel, aluminum and rubber which account for more than 75% of their overall raw material cost. Since April 2009 the raw material prices in the spot markets are on an upward trend, and these threaten the margin sustainability during FY11E. Raw material cost as a % of sales 82 HHML 79 76 73 70 67 1QFY08 2QFY08 3QFY08 4QFY08 1QFY09 2QFY09 3QFY09 4QFY09 1QFY10 2QFY10 BAL TVS

Aug Dec To increase from here on Source: Companies 3QFY10 Mar Jun Apr Jan } Please see the disclaimer on the last page For Private Circulation Kotak Securities – Private Client Research 8 SECTOR REPORT May 13, 2010 On LME the spot price for steel has increased from the low of $291 per ton during March 2009 to $497 per ton during February 2010, translating into a sharp hike 70 % in a year. Similarly aluminum spot prices have shot by 65% from $1335 per ton to $2205 per ton during the same period. Rubber prices have also shot up 80% over the past one year. Alumium price movement – LME 2,400 $2,200 $2,000 $1,800 $1,600 $1,400 $1,200 Feb-09 Feb-10 May-09 Nov-08 Nov-09 Aug-09 Steel price movement – LME $550 $500 $450 $400 $350 $300 $250 Feb-09 May-09 Nov-08 Nov-09 Feb-10 Aug-09 Rubber price 15,000 12,750 10,500 8,250 6,000 Jan-09 Jul-09 Apr-09 Jan-10 Oct-08 Oct-09 per ton per ton per100 kg Source: LME Source: LME Source: Rubber Board of India q …. margins have peaked out Future contracts to be re-negotiated at a higher price Majority of the players enter into medium to long term contracts ranging from 3 months to 12 months for their raw material procurement.

However for lot of these players the long term contracts have expired. Due to rise in commodity prices, companies will have to negotiate the new contracts at a higher price leading to pressure on margins. We therefore expect to see margins for two wheeler players coming down from the peaks of 2HFY10. EBITDA margin (%) 24. 0 18. 0 12. 0 6. 0 1QFY08 2QFY08 3QFY08 4QFY08 1QFY09 2QFY09 3QFY09 4QFY09 1QFY10 2QFY10 3QFY10 At their peak HHML BAL TVS Source: Companies Kotak Securities – Private Client Research Please see the disclaimer on the last page For Private Circulation 9 SECTOR REPORT q ….. ools available to curtail the impact May 13, 2010 Plants in tax-free zone and 15% industry volume growth to mitigate the impact While we expect the margins for two wheeler players to be impacted by the rise in input prices, we believe that the impact would be limited. Players like HH, BAL and TVS have a plant each in the tax free zone. In the scenario of complete pass through of excise duty hike across product line, we expect HH and BAL to benefit to the tune of ~Rs600mn and Rs1,200mn respectively and this should help them reduce the impact of rising input costs on their margins.

We expect the two wheeler industry volumes to grow by around 15% during FY11E which would alleviate the impact of higher input cost. We also believe that the two wheeler majors would pass on a certain portion of higher input prices onto the consumers in order to maintain their margins at a particular level. Furthermore cost cutting measures and improvement in operational efficiencies would further limit the margin downfall. We believe that the impact would be in the range of 50 – 100 bps for the industry. Industry Analysis Indian two wheeler market have gone through a structural shift in demand in the past one decade.

Demand for scooters have come down drastically giving way to motorcycles which are more fuel efficient. Today motorcycles accounts for 80% of the overall two wheeler volumes with scooters and moped accounting for 14% and 6% respectively. Among the industry players, HH continues to dominate the two wheeler segment and is way ahead of other major players like Bajaj Auto, TVS Motor and HMSI. Industry mix Scooters 100% 75% Motorcycles Mopeds 2W Industry – volume and growth 12 9 6 Volume (mn units – LHS) growth (% – RHS) 28 21 14 7 (7) FY04 FY05 FY06 FY07 FY08 FY09 FY10 0% 3 25% – 0% FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 (3) Source: SIAM Source: SIAM Kotak Securities – Private Client Research Please see the disclaimer on the last page For Private Circulation 10 SECTOR REPORT q Scooters segment May 13, 2010 HMSI is the market leader in the segment with ~50% market share Scooter segment primarily comprises of the gearless scooters with 5 major players. HMSI is the market leader in the segment with ~50% market share while the remaining 50% share been held by TVS Motor, Hero Honda, Suzuki Motor and M&M.

HMSI’s Activa model is the most successful model in this category and has a current waiting period of 2-3 months. M’s ventured into the two wheeler business in FY10 and has already grabbed 7% market share in less than a year’s time. TVS marked its presence in the 100cc+ segment with the launch of Wego and the company is looking at further consolidating its position in the scooters segment. We expect this segment to report 19% volume growth in FY11E due to lower base, new launches and increasing popularity of gearless segment in the urban areas and with younger generation.

Market share movement – Domestic scooter segment 28 21 14 7 Scooter segment – volume and growth 1. 6 1. 2 0. 8 0. 4 (0. 4) FY04 FY05 FY06 FY07 FY08 FY09 FY10 Scooters (mn units – LHS) growth rate (% – RHS) 80 60 40 20 HHML SMSI TVSM Others HMSI – 0 1QFY08 2QFY08 3QFY08 4QFY08 1QFY09 2QFY09 3QFY09 4QFY09 1QFY10 2QFY10 3QFY10 3QFY10 (7) Source: SIAM Source: SIAM q Motorcycle segment Entry level segment No clear market leader with BAL, HH and TVS Motor accounting for majority of the stake Entry/economy level segment is the lowest priced (

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