Saturday, October 31, 2009


Why buy now? Improving fundamentals, lagging valuations
There are four reasons that trigger our more positive view on the sector:

1) Volume surprise – YTD yoy volume growth of 23% for Hero Honda, and sequential recovery for Bajaj Auto have so far been significantly above our, consensus, and managements’ stated expectations. We believe the industry is experiencing a demand growth upcycle, with double-digit growth likely to continue for the next 2-3 years, driven by rising penetration, investments in infrastructure and macroeconomic recovery.

2) Margin surprise – As shown by two consecutive quarters of significant margin surprises, we believe the market is underestimating the impact of operating leverage and companies’ ability to defend above-trend margins. As a result of these two points, we believe an earnings upgrade cycle for the sector is likely to continue for the next four quarters.

Earnings upgrade cycle to continue; U/G Hero Honda, Bajaj Auto

3) Lagging valuations – Based on our revised estimates, Indian 2-wheeler stocks are trading at mid-cycle valuations and at a steep discount to the MSCI India index. We believe this offers a compelling entry point into high cash-flow-generating businesses that have strong franchises in an oligopolistic market. We also observe that 2w stocks outperformed the index during early stage of economic recovery during 2002-04.

4) Concerns on monsoon and commodity costs – In our view, valuation case is most appealing for Hero Honda, which has underperformed the BSE Auto Index (by 30%) and BSE Sensex (by 12%) over the last three months. The stock is now trading at mid-cycle multiples and a 25% discount to MSCI India. We believe market may be overly concerned about monsoons and rising commodity costs, as we discuss in this report.

We upgrade Hero Honda (HROH.BO) to Buy from Neutral and raise our 12m target price to Rs1,912 (from Rs1,399) based on 16X FY11E EPS. We also upgrade Bajaj Auto (BAJA.BO) to Neutral from Sell, and raise our 12m target price to Rs1,566 (from Rs705), also based on 16X FY11E EPS. We raise FY10E-12E EPS for Bajaj Auto by 53%-70%, and for Hero Honda by 22%-37%.

Downside: 1) Labor unrest, 2) slowing macroeconomic growth, 3) greater than- expected success of competitors. Upside (Bajaj): 1) Continued labor unrest at Honda Motors, 2) re-entry of private banks in 2-wheeler financing business.

To see the full report: AUTOMOBILES SECTOR