Hero MotoCorp's Q2FY20 results (Outperformer) - Gross margins surprise

Q2FY20 results

• Operating performance ahead: Hero MotoCorp’s Q2FY20 reported PAT of Rs 9.3bn (down 4%yoy) was ahead of estimates on account of higher than estimated realisations, better than expected gross margins and a lower tax rate.
• Gross margins improve: Revenues at Rs 75.7bn (-17% yoy) was ~4% ahead of estimates on higher realisations. Realisations (+3% qoq) benefited from a higher share of spare parts (9.5% of sales in Q2 versus 7.7% in Q1), modest price hikes (~45 bps) and a better product mix. On a sequential basis gross margins improved by 190bps due an increase in the company level finished goods inventory (we estimate a benefit of 70-100bps) apart from lower commodity costs (benefit 40bps) and an improvement in product mix (including higher share of high margin spares). We note that the benefit from inventory increases could reverse in the coming quarters with a reduction in company inventory levels. The gross margin improvement was offset by a negative operating leverage (other expenses/employee costs rose by 140/40bps sequentially). Consequently, EBITDA margins at 14.5% (down 62bps yoy; flat qoq) were a bit ahead of expectations (est: 14.0%). The PAT further benefitted from a reversal in tax charges.
• Concall highlights: (a) Volumes during the festival season have shown a low single digit growth vis-a-vis the comparable period in the previous year.  (b) The demand in the rural area is better than urban segments partially due to the normal monsoons and better crop realisations (c) The festival season volumes may have benefitted from pent up demand as customers had postponed purchases with uncertainty surrounding GST rates (d) While the company is hopeful of demand improving, it believes that a sustainable recovery could take sometime. (e) The company targets a dealer inventory of 30 days by the end of the festival season and will gradually increase BSVI vehicles from November.

Key positives: Higher than expected gross margins 

Key negatives: Higher other expenses

Impact on earnings: We marginally increase our FY20/21 EPS as a weaker volume growth is offset by a reduction in tax rate.

Valuations & view

While there has been m-o-m improvement in the demand, a sustainable recovery is likely to be gradual.  Further, the risk of BSVI cost hikes increases the volume risk for H1 FY21. However, we believe that HMCL’s current valuations at ~15x FY21 EPS seems to reflect these concerns. Also, HMCL will benefit from a monsoon linked recovery in rural demand Maintain an Outperformer with a target price of Rs2900 (16xFY21).