Dawn of a new era?

SPECIAL REPORT

'Objects in the rear view are bigger than they appear' was a lesson that Hero Honda learnt the hard way after its complacency saw its competitors narrow the huge gap that existed between them in the last few years.

And now it may be investors' chance to learn the same lesson. Well, we are referring to the extra-ordinary - 1,000 per cent - dividend paid out by Hero Honda for fiscal 2003-04.

Hero Honda has been for long admired for being shareholder-friendly by promptly handing out its excess cash in the form of dividends. This time around there are doubts setting in about its policy of hiking dividends eternally.

Some market experts infer that the Munjals may be in an exit mode. And what makes the case stronger in favour of the conspiracy theory is that there is a stark contrast in the dividend policy followed by Hero Honda and its peers. Is Hero Honda truly shareholder-friendly or is there more to it than what meets the eye?

Dividend buzz
The two-wheeler major announced a dividend of Rs 20 for every share of Rs 2. This includes a special interim dividend of 500 per cent paid earlier.

The total dividend pay-out to Hero Honda shareholders for the year works out to be Rs 454 crore. As a 26 per cent stakeholder in the company, the Munjal family's share is Rs 118.04 crore.

The magnitude of the dividend has been almost unprecedented by a player intending to stick with its ongoing business. Hero Honda became the second company in India to declare a 1,000 per cent dividend.

In 1998-99, Max India had paid a 1,045 per cent dividend to become the largest dividend paying company in India. Max India had paid a special dividend of 1,000 per cent after it sold a 41 per cent stake in Hutchison Max for Rs 563 crore.

To compound the situation, the company's long-standing agreement with Honda Motors is at the end of the tether, after which it could well go on its way with the production of motorcycles. So, naturally the buzz started building up around the beehive of the BSE whether the company is in an exit mode.

Analysts say it is not quite the case. "The company always had a legacy of being a high-dividend-paying stock given its abundant cash chest and that has been one of the reasons why the Hero Honda stock always commanded a premium among auto stocks," says a company watcher. The company had paid a dividend of 900 per cent to its shareholders in 2002-03 and 850 per cent in 2001-02.

Numbers tell a different story. Hero Honda has consistently increased its pay-out ratio over the last five years (see table).

Its competitors Bajaj Auto and TVS Motors have been rather relatively conservative in declaring dividends.

Looking at the rather sedate pay-out ratios of Bajaj Auto and TVS, the maximum pay outs have never exceeded 38 per cent. Compare that to the 60 plus pay-out ratio that Hero Honda has been having since 2002 and one wonders why such a humongous difference exists between the company and its peers.

Hero Honda said it has substantially increased the dividend pay-out over the last few years to reward its shareholders and also to flush out the excess money it generates every year from its operations.

"We have taken a very conscious decision over the last four-five years. Post-2000, our cash generation went up due to higher sales. Volumes went up four times in five years. The only cash we need is working capital which is about Rs 100-150 crore every year," says Ravi Sud, vice president, Hero Honda Motors. He said it was upto other companies who have more cash reserves to decide on rewarding their shareholders.

The company had put in money in mutual funds but these were generating low returns of 12-13 per cent against the motorcycle business which was generating higher returns. So, the whole return on capital employed got affected.

Hence, the company decided to keep money for its annual investment plans and other contingencies and give the rest to shareholders.

Analysts, also derive comfort from the fact that the business continues to get its due share. The company's burgeoning war chest (it generated a cash flow close to Rs 1,200 crore from its operations in FY03) is also being used for acquisitions.

Moreover, with the company's two plants in Haryana running at full steam, it has embarked upon a green-field capacity-expansion plan and has earmarked Rs 200 crore for the same.

The company's strong cash flows will enable it to undertake such expansion entirely through internal accruals. Apart from that, recent reports that Honda Motors is likely to renew its 10-year-old technical alliance with Hero Honda after the present technical agreement between the two companies expires in June 2004 should lend some succour to analysts.

Besides, both companies have said they would continue to work together and jointly decide the future launch of products and that the products of both the companies would be complementary to each other.

The story of Bajaj Auto is similar in the sense that the company is sitting on liquid reserves close to Rs 4,500 crore. Last year, it generated cash flows close to Rs 900 crore and has plans to spend Rs 108 crore on capex in FY05.

Of the reserves, about Rs 3,500 crore was deployed in mutual funds units last year which would have earned a return of 13-15 per cent at best.

In spite of this, Bajaj Auto has not been as generous in its pay-out policy as Hero Honda. Sanjiv Bajaj, vice president of Bajaj Auto, says though the company's declaration of a 250 per cent dividend in FY04 is not stingy, Bajaj has a different ideology when it comes to declaring dividends.

"Bajaj's cash chest is much bigger than Hero Honda's but we prefer to keep it for the future when cash infusion would be needed," says Bajaj.

On the contrary, Hero Honda has little reason to be worried about its war chest as long as the company's joint venture with Honda Motors is intact.

Analysts say there is no reason for Honda Motors to pull off from the venture as the company still remains a cash cow with a strong marketing and distribution set-up across the country.

Honda Motors will focus on over 150 cc segment and leave the under 150 cc segments to be targeted by Hero Honda. In any case, Honda Motors should be more than happy with the current arrangement as the pay-offs for reinventing the wheel may not be enticing considering the time and cost involved.

Also, given the fact that it gets its due share in the form of dividends every year, Honda Motors may not have any reason to be unhappy.

The rather generous dividend policy has seen the stock become a favourite with the FIIs, too. In fact, the FII holding in the company stands at 24.07 per cent, much higher than 17.15 per cent of Bajaj Auto and 9.81 per cent of TVS.

All said and done, analysts are on the side of Hero Honda. "Bajaj's dividend policy is a result of the management's ideology, although I would be much happier under Hero Honda's management policy," says Rashi Talwar, auto analyst at Motilal Oswal Securities.

Talwar says it is traditionally recommended to pay out the surplus cash by way of dividends which turns out to be much better than reinvesting the cash elsewhere.

The point is echoed by Sachin Patil, auto analyst at SSKI Securities who says Bajaj's cash corpus of Rs 4,000 odd crore is as large as a decently sized mutual fund in India.

Analysts say Hero Honda's dividend strategy may not necessarily mean that the promoters are on an exit mode. They still look at it as a shareholder-friendly gesture.

On the other hand, Bajaj Auto and TVS are probably conservative in their pay-outs on account of insecurities on account of competition from global players with deep pockets.

The fact is: Hero Honda would continue to command premium valuations over its competitors as it can manage to keep its return on equity higher. Bajaj Auto and TVS have a return on equity (ROE) of 16.7 per cent and 30.25 per cent respectively. However, Hero Honda has an ROE of 67.45 per cent.

Having said that, analysts are focusing on the business prospects to take a call on the stock.

The good news is that the company's reaction by launching new variants of its bread and butter executive segment offerings has borne fruit. The robust March quarter results of the country's largest two-wheeler manufacturer is a testimonial to this fact.

Volumes pick up
One of the reasons why they are gung ho about the company going forward is the pick-up that the company effected in its volumes for the year.

After a rather sedate start to the year, sales headed north with the launch of the company's new variants - Splendor Plus and Passion Plus - in September.

The fact that the period also marked the onset of the festive season saw the company's sales pick up amid three strong months of October, November and February where two-wheelers sales touched the 2 lakh mark.

As a result, the company not only inched ahead of industry in terms of unit sales, it also achieved the distinction of being the first auto company in India to sell more than 20 lakh vehicles in a single year.

The market share of the company in the motorcycles segment also saw an increase of 4 per cent and currently stands at 48 per cent as compared to 44 per cent a year ago.

The Splendor Plus variant now accounts for almost 90 per cent of overall volume. The old Passion model has been discontinued since October 2002 while Passion Plus has boosted volumes significantly.

In fact, armed with these two variants Hero Honda was able to record the fastest growth in the executive segment in Q4 FY04 as compared to competitors like Bajaj Auto and TVS Motors.

However, the 50 per cent jump in volumes in the March quarter was primarily led by a surge in the sales of CD Dawn, the company's offering in the entry-level segment which is expected to continue its good form.

The worries
Despite rising input costs, the company has been able to maintain its operating margins at last year's levels, thanks to a reduction in staff costs and other expenses of the company.

Analysts say input costs were kept under control largely on account of long-term contracts with its suppliers. Also, it sources much of its raw material needs from group companies, which holds it in good stead while negotiating prices.

However, the going may not be so good going forward as the company will have to renew contracts at a higher price. Since competition would not allow the company to pass on the price hike to its customers, operating margins are expected to take some hit in FY05.

Add the fact that prices of steel, rubber and plastic have gone up. Besides, increased competition because of the entry of Honda Motors later this year could cause the company to increase sales and marketing spend. In any case, advertising spend is set to be higher, given the company's plans to launch new products this fiscal.

The impending launch of Honda Motors' new products is not expected to impact Hero Honda much since the offerings of Honda Motors are expected to be above 150 cc - not in the bread and butter 100 cc class of Hero Honda.

Hero Honda's Sud says the new 150 cc motorcycle from Honda Motors, which is expected later this year, would not lead to cannibalisation with Hero Honda products but only increase competition.

"Not only Hero Honda, other players like Bajaj Auto and TVS Motor Company would also be targeted," he adds. The market talk is that the 150 cc bike of Honda Motors would be targeted at Pulsar 150 cc, which has witnessed good demand.

The fact that this year's monsoons are expected to be normal augurs well for the company, feel analysts. In fact, they feel that the lag effect of good monsoons on volume growth of two-wheelers should be reflected in the coming quarters.

Hero Honda is also expected to be the biggest beneficiary of a rebound in rural demand, given its strong network. The company is expected to come out with two new motorcycles in FY05 with the first motorcycle likely to be launched in October 2004 and the second one in February 2005.

Its relaunched 133 cc offering, Ambition, with better styling and a higher 135 cc engine without any pricing changes has also started doing well.

The company hopes to continue with its double-digit growth rates in its sales volumes in the coming year also. However, it has chosen not to give a sales target for FY05.

Instead, it has said volumes would grow between 10 and 20 per cent, which, according to analysts, is achievable, given the string growth in CD Dawn from rural and semi-urban areas.

"It is not as much about overt positivity as much as it is about the absence of negativity that the company has going in its favour," says Sachin Kasera, auto analyst at Pioneer Intermediaries. "This along with the positivity in the auto sector would see Hero Honda reaping the gains going forward," he adds.

Analysts feel that in the worst case scenario of the monsoons disappointing, the growth could be at the lower end of the range. The stock is currently trading at Rs 451, at a P/E of 13.39.

Analysts say the strong brand equity and robust cash flows make the company a premier contender to take advantage of any structural shift in the industry over the long term and investors should look to accumulate the stock on declines.

For Bajaj Auto, although analysts feel that the company's dominance in the premium segment augurs well, it is the company's tepid showing in the high volume executive segment that is a cause for concern.

"The company had tried to make a dent in this segment and has failed in the past, however, it is pegging a lot of hope on the impending launch of the CT-100 and the K-60, adds Patil.

Analysts are, however, keeping their fingers crossed for the TVS results, and are hoping that they are a positive surprise unlike the last quarter. However, they feel that valuations are looking expensive at the moment.

The cannibalisation of Victor sales by its new offering Centra also compounds the matter and analysts do not expect an extraordinary performance from the company.