Following the stock’s strong performance, we downgrade Hero to neutral from buy. This is driven by a 2-6% cut in our recurring EPS forecasts over FY15-16E as we expect limited pricing power to delay benefit of cost-saving initiatives. Our PO of Rs 2,500 implies limited potential upside despite rollover of multiple. But we still prefer Hero MotoCorp over Bajaj Auto in the space.
Early last year, management guided for 300bps expansion in Ebitda margin by FY17E, driven largely by cost savings. We believe this target is difficult to achieve in an environment of rising competition and deteriorating pricing power. Still, after a cut in margin assumptions, we expect 140bps cumulative increase to 15% by FY16E. Compared to a tepid FY14, we expect Hero to register 10% annual sales growth (6.9 m in FY15E and 7.6 m in FY16E), led by improved domestic showing, due to a slew of indigenously developed products, and ramp-up in exports.
The reason for ‘underperform’ includes superior franchise, which poses upside risk to domestic volumes if economic recovery is stronger, and fair valuations, as we expect the stock to trade at least on a par with historical averages. Based on our forecasts for the next two years, the stock is fairly valued compared to both the historical average and peers.
Over the past decade, Hero has traded in a wide band, witnessing a sharp de-rating during the global crisis and split with Honda. However, over the last five years, the stock has traded in a much narrower band of 12x-15x with average of 13.8x. On 1-year forward basis, the stock currently trades at 15x our estimate, a 14% premium to historical average.