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MSFL Research

Institutional Business Group, MSFL @p-sec, 306, Gresham Assurance House, 132, Mint Road, Fort, Mumbai – 400 001 India

Tel + 91 22 22690474 / 75 www.marwadionline.com

Shifting into top gear!!

Valuation Snapshot

MSFL Rating

CMP Target price

+/- (%)

Mkt cap

P/E (x) Dividend Yield (%) ROCE (%)

` `

` bln FY11 FY12E FY13E FY11 FY12E FY13E FY11 FY12E FY13E

BAL Buy 1,627 1,893 16% 470.9 16.7 15.0 13.2 2.5% 3.1% 3.4% 76% 72% 66%

TVS Buy 63 73 15% 30.2 15.4 12.1 8.7 1.7% 2.0% 2.5% 15% 19% 25%

HMC Sell 2,206 1,920 -13% 440.5 22.1 21.0 17.8 4.8% 2.0% 2.5% 59% 49% 48%

CMP as on end Sep 20, 2011

POSITIVE

Domestic Volumes and growth

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Volumes % growth

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2007 2008 2009 2010 2011 YTD 2012

Volumes % growth

Market share – Domestic + Export

HMC, 40.67%

BAL, 26.09%

TVS, 14.53%

HMSI, 11.99%

Others, 3.70%Yamaha, 3.02%

We initiate coverage with Buy recommendations on Bajaj Auto Ltd (BAL) with TP – ` 1,893 & TVS Motors (TVS) with TP – ` 73 and a sell recommendation on Hero MotoCorp (HMC) with TP – ` 1,920.

Two wheelers – on solid footing We expect the domestic two wheeler industry to grow at a CAGR of 15% to more than 20mln units over FY 2011-15E driven by rising disposable income, large population base, lower two wheeler penetration, increasing urbanization and robust replacement demand. The two wheelers in India remains more of a necessity as the need for mobility in country has increased considerably and public transport systems have not grown in proportion. We expect exports to grow strongly at 19% CAGR by combination of increasing penetration in current markets, entering into new markets and enhancing the distribution network.

Competition heating up..HeroMotoCorp to be most impacted We expect higher competiton in medium term from HMSI and Yamaha as they increase their operational capabilities and dealership network to garner market share. We expect the executive segment (HMC is the market leader) to be the most competitive and thus declining pricing power. The segment is characterised by high volumes and low margins. On the other hand, we expect the premium segment (BAL is market leader) to remain the fastest growing segment driving high on performance features and branding. We expect the segment to retain relatively higher pricing power and therefore higher margins.

High Margin business The two wheeler OEM’s enjoy relatively higher margins as compared to other players in the automobile industry. Higher contribution from premium segment & exports will support BAL’s operating margins while HMC’s margin to remain under pressure due to increasing proportion of entry and executive level motorcycle. Higher advertisement and promotional expenditure will also weigh on margins for HMC and TVS. We thus expect BAL to continue to record higher margins than HMC. TVS on other hand will see improvement in margins due to positive impact of operating leverage as its sales mix improves.

Record earnings this year We anticipate the two wheeler industry to report record earnings this year. Bajaj and TVS remain attractive given the stable growth and margin environment it enjoys, as compared to the trends seen in the rest of the auto industry. We believe the current valuations do not factor in the growth potential and cash flow characteristics of these companies. Despite outperforming the broader index for past few months, we believe the long-term outlook remain sound and expect valuations to expand.

Initiate coverage on Bajaj Auto (BAL), TVS Motors (TVS) and Hero MotoCorp (HMC) We like BAL and TVS (in the same order) of the lot as they are trading at attractive valuations. We value BAL at a 5% premium to HMC’s three year historical P/E (based on core earnings), while we value TVSL at a 25% discount (lower discount compared to historical levels). We value HMC at nil premiums to its three‐year historical P/E due to lower earnings & cash flow growth. We initiate coverage on BAL (Buy), TVS (Buy) and HMC (Sell).

Auto – Two wheelers Sector Report

Ronak Sarda ronak.sarda@msflibg.in (+ 91 22 3094 7135) Shyamal Dhruve shyamal.dhruve@msflibg.in

September 21, 2011

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Table of Contents

Executive summary ...................................................................................................................................................................................................... 3

Domestic two wheeler market - on solid footing ........................................................................................................................................... 5

Rising disposable income ................................................................................................................................................................................ 5

Urbanization to accelerate demand ............................................................................................................................................................ 8

Domestic consumption pattern… ................................................................................................................................................................. 9

Robust replacement demand ....................................................................................................................................................................... 10

Relatively insulated from higher interest rates… .................................................................................................................................. 10

Fiscal benefits still to accrue for BAL & TVS ........................................................................................................................................... 12

Increasing distribution network – enhancing customer connectivity ......................................................................................... 12

Motorcycle segment – what’s in what’s out!! ................................................................................................................................................. 14

Scooters – Riding high on conviennce factor ................................................................................................................................................. 16

Exports – unlocking value ....................................................................................................................................................................................... 18

Dynamics of key markets ............................................................................................................................................................................... 19

DEPB scheme withdrawal ............................................................................................................................................................................... 21

Competition heating up .......................................................................................................................................................................................... 22

Honda Motors & Scooters Limited (HMSI) – break free from Hero ............................................................................................. 22

Yamaha Motors – gaining traction in premium segment ................................................................................................................ 23

Next Gen bikes for a new generation of riders .............................................................................................................................................. 25

Financial Outlook ........................................................................................................................................................................................................ 27

Recommendation ....................................................................................................................................................................................................... 31

Valuation Methodology ........................................................................................................................................................................................... 32

Appendix ........................................................................................................................................................................................................................ 34

Bajaj Auto Limited - Full throttle!! Our top pick..…………………………………………………………………………………………………..…….37 TVS Motors Limited - A Clutch-free ride!!…………………….………………………………………………………………………………………..……57 Hero MotoCorp Limited - Turning of the tide, valuations expensive…………………………………….………………………………..…..73

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Executive Summary We initiate coverage with Buy recommendations on Bajaj Auto Ltd (TP – ` 1,893) & TVS Motors (TP – ` 73) and a sell recommendation on Hero MotoCorp (TP – ` 1,920).

The two wheeler in India remains more of a necessity as the need for mobility in country has increased considerably and public transport systems have not grown in proportion to accommodate the rising commuters. The domestic two wheeler industry registered a strong growth over the last decade (CAGR of 13%) driven by increasing requirements for personal mobility and affordability. Further, it remains the most economical means of commuting. We expect the domestic two wheeler industry to grow at a CAGR of 15% to more than 20mln units over FY 2011-15E driven by rising disposable income, large population base, lower two wheeler penetration in rural/semi-cities as compared to other emerging markets, growing urbanization, favorable demographics and robust replacement demand.

The increasing disposable income and urbanization has lead to multifold increase in domestic consumption over the past decade and there has been a notable shift in consumption pattern to higher discretionary spending over necessities. The two wheeler industry has also seen a similar experience with shift in spending from low end vehicles to higher end performance driven motorcycles. We believe two wheeler industry relatively insulated from current macro headwinds as affordability levels have increased substantially. Fiscal measures like implementation of GST and DTC will further be a key catalyst for the industry positively influencing both the supply and demand dynamics.

We expect competition to intensify in the domestic markets with unlisted players (especially HMSI and Yamaha) increasing their capacity and distribution reach to tap the fast growing rural markets. We expect the executive segment (HMC’s the market leader) to be the most competitive and thus declining pricing power. The segment is driven high on volumes and lower margins. On the other hand, we expect the premium segment to remain the fastest growing segment driving high on performance features and branding. We expect the segment to retain relatively higher pricing power and margins. Scooters are the preferred family vehicle due to convenience factor and unisex suitability. In the domestic market, scooters grew at a CAGR of 18% over FY07‐FY11 outpacing both motorcycles and mopeds. We estimate scooters to contribute more than 20% of domestic two wheeler sales by FY15E as against 13% in FY06.

We believe exports would continue to grow strongly at c20% CAGR by combination of increasing penetration in current markets, entering into new markets and enhancing the distribution network. The dynamics of most of these markets (except Africa) are very similar to those in India where two-wheelers are primarily used for personal transportation. Thus we do not anticipate any major impact of global macro headwinds. We however expect export growth in 2HFY12 and to some extent in FY13E to be impacted as players are expected to increase prices after DEPB benefits are withdrawn.

We have comprehensively analysed the competition scenario from the unlisted players especially Honda Motors and Yamaha. There has been a notable change in their business strategies and we expect stiff competition from both the players as they increase their operational capabilities and dealership network. The increasing competition in the two‐wheeler segment has resulted in lower pricing power for existing players (especially HMC due to highest exposure to executive motorcycle segment).

We have seen a new interest in the super bikes segment which we term as next generation bikes for the next generation riders. With improving standard of living and aspirational level, demand for these vehicles have increased multifold. We have seen most of the domestic players and many foreign players entering this segment/increasing their presence. We expect that with increasing customer awareness, demographic advantage and most importantly disproportionate growth in income levels in hands of urban India, the segment will grow exponentially in near-medium term.

The two wheeler OEM’s enjoy relatively higher margins as compared to other players in the automobile industry. Higher contribution from premium motorcycle segment & exports will support BAL’s operating margins while HMC’s margin to remain under pressure due to increasing exposure to entry and executive level motorcycle. We thus expect BAL to continue to record higher margins than HMC. TVS on other hand

Two wheelers – an

affordable solution for

commuters

Higher discretionary spending, relatively insulated from macro headwinds

Rising Competition in executive segment, premium segment drives high on brand Scooters growth robust

Export markets present immense opportunities

Imminent threat from HMSI and Yamaha

Gen X motorcycle for next generation riders

BAL to record highest margins, TVS’s margins to improve while HMC’s margins to stay under pressure

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will record improvement in margins as its sales mix improves. Further, higher advertisement and promotional expenditure will weigh on margins for HMC and TVS.

The domestic two wheeler industry is highly concentrated with top three listed players holding more than 80% of the market. We value these companies based on relative valuation albeit applying premium/discount to the multiple on factors in table below. Further, the two wheeler industry is characterized by high margins and profitability (as compared to other players in the automobile industry and extremely strong cash flows at company’s disposal. We therefore apply our benchmark multiple to the core earnings of the company (before earnings on the cash and cash equivalents) to arrive at the operational value of the company. To this, we add net cash/deduct net debt in the books as at last reporting date to arrive at the fair/intrinsic value of the company. BAL and TVS look attractive given the stable growth and margin environment it currently enjoys. Valuations, in our view, do not factor in the growth and cash flow characteristics of these companies.

Table 1: Factors influencing valuations

FY 2006-11 FY 2011-13E#

HMC BAL TVS HMC BAL TVS

Volume growth 12% 10% 9% 14% 16% 15%

Exposure to exports Negligible High Low Negligible High Medium

Susceptibility to competition Low Medium High High Medium Medium

Margin performance 14.0% 16.8% 5.2% 11.1% 19.2% 7.2%

Adj. NPAT growth 15% 20% 11% 11% 13% 33%

Free cash flow growth 41% 25% NA 5% 24% 52%

Conclusion Strong Moderate Weak Weak Strong Moderate

Premium/Discount to Benchmark Premium Discount High Discount Nil to Discount Premium Less Discount

Source: Company data, MSFL Research, # - MSFL forecasts and expectation Bajaj Auto – Initiate with Buy; target price of ` 1,893 (potential upside of 16%) With a potential upside of 16%, BAL is our top pick of the lot. We believe Bajaj Auto with its current motorcycle portfolio, brand building exercise over past few years and its strategy of focusing on the premium motorcycle segment is reaping rich rewards. We expect BAL’s net revenue to grow at a CAGR of 18% higher than the volume CAGR of 16% over the next two years. We forecast company to post a robust 13% CAGR in its Adjusted NPAT. Given its strong cash flow and return profile, we expect BAL multiples to expand and trade at premium valuations. At a CMP of ` 1,627/share, BAL is trading at 15.0x and 13.2x FY 12E and FY 13E earnings respectively at a discount to HMC.

TVS Motors – Initiate with Buy; target price of ` 73 (potential upside of 15%) The new found aggression in the company’s business strategy and higher contribution from high margin businesses offer favorable return on our valuations. We expect TVS’s net revenue to grow at a CAGR of 19% higher than the volume CAGR of 15% over the next two years. We forecast company to post a robust 33% CAGR in its Adjusted NPAT and be net cash by FY14 given strong cash flows. We thus expect TVS to trade at relatively lower discounts (25%) than it has been trading over past three years (39%). At CMP of ` 63/share, it is trading at 12.1x and 8.7x FY12E and FY13E earnings respectively at a discount to HMC.

Hero Motocorp – Initiate with Sell; target price of ` 1,920 (potential downside of 13%) We expect two-wheeler sales to grow at 15% in FY12E and sales volume to moderate in FY13E. We expect the executive segment, bread and butter segment for HMC, to be most competitive segment as OEM’s launch new models and upgrades to retain buyer interest and expect margins to squeeze. We expect stiff competition from BAL and TVS in the domestic markets (no to forget HMSI’s increasing capacity) going forward and expect HMC’s growth to moderate. Moreover, we do not envisage higher payout ratio as seen in past two years due to higher cash requirement for HMC in the medium term. HMC has outperformed both Index and peers in last one month and currently trades at more than 30% premium to its three year mean P/E multiple and looks expensive on the risk-reward basis. At CMP of ` 2,206/share, it is trading at 21.0x and 17.8x FY 12E and FY 13E earnings respectively.

High return ratios, strong cash generation… valuations attractive for BAL and TVS

Initiate coverage on 3 two‐wheeler companies

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Investment Thesis Domestic two wheeler market - on solid footing We estimate the domestic two-wheeler industry to grow at a CAGR of 15% in volume terms over FY2011 to FY2015E, with motorcycle sales growing at a CAGR of 13-14% and scooters growing faster at a CAGR of 18-20%. Strong growth in the scooter segment, on a relatively lower base, shift in buyer preference towards a family vehicle and increasing motorcycle demand from the rural market is likely to drive the incremental demand for two-wheelers. We forecast export growth at a CAGR of 19% over the same period as Indian OEM’s increase penetration in the existing markets and enter into new geographies. The two wheeler industry (excluding exports) is therefore expected to grow at CAGR of c15% over to FY11-FY15E to over 20mln units by end FY15. The domestic two-wheeler industry clocked a near record growth of 26% in 2010-11 on high base of 2009-10 driven by increasing penetration in rural markets and sustained growth from urban youth. All the segments – motorcycle, scooters and mopeds - recorded robust growth of 23%, 42% and 24% respectively.

Industry demand drivers We expect the domestic two wheeler industry to grow at a CAGR of 15% to more than 20mln units over FY 2011-15E driven by rising disposable income, large population base, lower two wheeler penetration in rural/semi-cities as compared to other emerging markets, growing urbanization, favorable demographics, and the replacement demand.

Rising disposable income The Indian economy has grown at an average of 8.6% over 2005-11E with per capita GDP (current prices) at a CAGR of 14% over the same period. Driven by robust GDP growth, household disposable income has almost doubled to ` 115,000 in the last decade (at 2000 constant prices). We believe that the two wheeler sales going forward will be largely driven by increasing disposable income and ensuing affordability. We expect Indian economy to grow at a robust CAGR of 7.5-8.1% over the next five years driven by high growth in the services and industry segments with per capita income growing at a CAGR of 12% over the same period.

Exhibit 1: India Real GDP & Per capita income growth Population (Mln - RHS)

Exhibit 2: Addressable households (mln)

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Population Real GDP % yoy Per capita income

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Source: Govt agency, IMF, NCAER & MSFL Research

Large population base… As per a study by NCAER, the number of households having annual income between ` 200,000- 500,000, the target customer segment for the two wheeler industry, is estimated to have increased from 8mln in 2000 to 27mln in 2010, a scale-up by a factor of 2.5x. The two wheeler industry has experienced similar volume growth rates over the period. The study expects the number of those households (see chart) to grow at a CAGR of 15% to 55mln by 2015 and further 4% CAGR to 68mln by 2020 representing the huge untapped market size. This paints a highly favorable demand landscape for the domestic two wheeler industry.

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…low penetration levels India is the second largest two wheeler markets in the world in terms of sales volumes after China however the two wheeler penetration level in the country is much lower at 71 per 1000 people lower than some of the other emerging markets such as Indonesia, Thailand and China (see chart). Moreover, the rural penetration levels are still low as compared to the urban penetration. We expect growth in two-wheelers to be driven by increase in the number of addressable households in the rural market and also higher penetration levels in urban markets.

Exhibit 3: Global 2W penetration vs per capita GDP Exhibit 4: Pan India 2W penetration (%)

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Rural Towns Tier III Tier II Metro

Source: OECD (2008), Company data & MSFL Research Favorable demographics India currently has a very favorable demographic profile with average age of less than 25 years, which is 9 years younger than China, more than 12 years and 19 years younger than the US and Japan, respectively. Our calculations based on available data suggest that around 33% of India’s 2011P population of 1.2 billion is from the age bracket of 20-40 years. We assume sex ratio of 2001 census data and estimate male population size to be 205 million (17% of the population) which is the key target segment for motorcycles. The population of females, the key target segment for scooters, is estimated at 189 million, suggesting existence of large size of the addressable market for the two wheeler industry. Further the male youth population is estimated to increase to 228 million by 2015E, an increase of 11% over 2011, suggesting a robust long term two wheeler outlook demand in the country. Table 2: Indian demographic structure (mln)

2011E 2015E

Male Female Male Female

20 to 24 65 59 65 60

25 to 29 53 46 64 58

30 to 34 46 43 53 45

35 to 39 41 41 46 43

Total youth 205 189 228 206

Source: Govt Agencies & MSFL Research, Assumed 1% mortality As mentioned earlier, we expect growth in two-wheelers to be driven by increase in the number of addressable households in the rural market and possible increase in penetration levels as OEM’s increase their focus to tap fast growing rural markets. The following factors have been the prime factors contributing to higher rural household disposable income:

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Increasing agricultural credit Agricultural credit is allocated yearly by the government in the Union Budget to support the agricultural sector. It is an indirect measure influencing purchasing power and hence has a multiplier impact on income generating ability of a farmer.

Exhibit 5: Agri credit (` bln) Exhibit 6: MSP for crops

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Dal Wheat Rice Sugarcane

Source: Govt Agency, RBI & MSFL Research Rising MSP for farm output Rural economy has shown robust performance led by high yield of rural products, agri credit and other rural development initiatives. MSP of most products grew by 10-14% CAGR over the last 6 years. The MSP for wheat stood at ` 1,120/ql in FY12 v/s ` 625/ql in FY06. Similarly, for sugarcane the MSP has increased from ` 80/ql in FY06 to ` 145/ql in FY12. This rising trend of MSP coupled with increasing crop output indicates healthy income generation in the hands of rural consumers, thereby increasing affordability. Government assistance for non-farm labors The government has taken several initiatives to support non-farm labors. The National Rural Employment Guarantee Scheme (NREGA) was launched in February 2006 and currently covers 614 districts across the country. The objective of the Act is to provide every rural household with a guarantee of at least 100 days of employment during a financial year by providing opportunities for unskilled manual work. We note that there has been exponential increase in agricultural wages over the last two years and have averaged more than 60% in the period much higher than the general inflation in the comparable period. Exhibit 7: Two year Wage growth rate % (2009-2011) in different states

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Rural infrastructure… The Indian government initiated various schemes to improve rural infrastructure by building road, houses, irrigation facilities and power supply in the rural areas. We believe these efforts on part of govt. will generate employment leading to an overall growth and therefore higher disposable income for people in those areas. Pradhan Mantri Gram Sadak Yojna – it aims to improve road connectivity in rural areas. It plans to connect 66,802 habitations with 1,46,185 km of all-weather roads. It also envisages upgradation/renewal of 1,94,130 km of the existing rural road network. The scheme started in 2000 and has added 2,74,000 km of new roads since then. The World Bank recently approved US$1.5bn in credit and loans for PMGSY. Bharat Nirman Policy – it is primarily focused on rural infrastructure development. Under the scheme, the government will connect all villages that have a population of 1,000 (or 500 in hill/tribal areas) to the road network by March 2012. The table below list the amount appropriated for rural development by the GOI: Table 3: Expenditure for Rural Department (in ` bln)

Particulars FY08 FY09 FY10 FY11 FY12P

MGNREGA 163 375 391 401 400

SGSY 17 23 24 30 29

Rural Housing 39 88 88 100 100

PM Rural Roads Programme 65 78 120 120 200

Total expenditure for Rural Department 288 569 627 661 741

Source: Govt Agency ….urbanization to accelerate demand Increasing population and rising per capita income will lead to a higher degree of urbanization. The estimated population of India has increased from 1.02bn in FY01 to 1.20bn in FY11P and the proportion of urban population is projected to be 30% in 2010E from 28% in 2001. It is further expected to rise to 34% by 2020E. Thus, the need for mobility in Tier 1, Tier 2 cities and towns has increased considerably and unfortunately public transport system has not grown in proportion to accommodate the rising commuters. As per study by McKinsey Global Institute, the current share of public transportation is just c30% of total trips while basic service standard demands 50% of transportation through public transport. This shortcoming in the transportation infrastructure has led to increase in demand of a two wheeler as the most reliable and affordable mode of private commuting. Exhibit 8: State wise population and urbanisation rate

Source: McKinsey Global Institute

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Moreover, highly urbanized states show higher two wheeler penetration as GDP contribution of these states is higher and consequently higher disposable income. For eg penetration in states like Tamil Nadu, Maharashtra and Gujarat is higher than the pan-India penetration due to the higher degree of urbanization in these states and a relatively better standard of living. McKinsey Global Institute estimates that by 2030 five states are likely to be more than 50 percent urbanized with more than 40% of total population living in cities. Table 4: State Wise Population & GDP contribution (Top 10)

State Rank

State/Union Territory

Population (2011) in ‘000

Indian Rupee (Ten mln)

% age of Total GDP

Per-capita Income (INR)

1 Maharashtra 112,373 901,330 14.46% 74,027

2 Uttar Pradesh 199,581 519,899 8.34% 23,132

3 Andhra Pradesh 84,666 475,267 7.63% 51,025

4 Tamil Nadu 72,139 464,009 7.45% 62,499

5 Gujarat 60,384 429,356 6.89% 63,961

6 West Bengal 91,348 400,561 6.43% 41,469

7 Karnataka 61,131 335,747 5.39% 50,676

8 Rajasthan 68,621 255,440 4.10% 34,189

9 Kerala 33,388 230,316 3.70% 59,179

10 Madhya Pradesh 72,598 216,958 3.48% 27,250

Source: Govt Agency & MSFL Research Domestic consumption pattern… The increasing disposable income and urbanization has lead to increase in domestic consumption over the past decade (chart below). There has been slight slowdown seen in domestic consumption as macro headwinds weigh on consumer sentiments. We however believe the domestic consumption story remains strong and it will not experience a sharp fall as seen back in 08-09. While a slight moderation is imminent, we do not expect it to impact the domestic two wheeler industry.

Exhibit 9: Domestic consumption growth (% y-o-y) Exhibit 10: Consumption break up

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2000 2002 2004 2006 2008 2010

59 5642 34 25

6 5

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7 1117

1920

12 3

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2 3 5 69

4 4 7 9 13

1985 1995 2005E 2015F 2025F

Food & Beverages ApparelHousing & Utilities Household ProductsPersonal Products & Services TransportationCommunication Education & RecreationHealthcare

Source: CSO, McKinsey Global Institute & MSFL Research ...consumption shifts towards discretionary items Our view is also reinforced by various studies which explain that the higher urbanization also leads to a change in consumer consumption pattern. Mckinsey Global Institute expects the overall Indian consumer market is set to quadruple over the next two decades. This will largely be driven by rising disposable income (80%) followed by increasing population (16%) and improved savings (4%). It expects that the growth across the consumption categories to be uneven and there will be structural change in share of

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each category. As seen in other growing economies (say China) share of ‘necessities’ (food, beverages and apparel) in average household consumption is expected to decrease progressively with ‘discretionary’ spending growing to 60% by 2015 from currently around 50%. Transportation and communication segment will enjoy the highest growth in consumption over the period with increase in share of transportation spending to 17% in 2005 and to further 20% in 2015. Robust replacement demand The factors which influence the two wheeler replacement demand in urban area are new attractive features and styling, better performance and latest technology. Our channel check suggests that two wheeler replacement period have shortened considerably in such areas to less than five years while it is about six to seven years in rural areas. A simple analysis of two wheelers sold in last decade give us an indication of huge potential of replacement demand coming through every year. We also do not ignore the fact that a chunk of old buyers would have upgraded to four wheelers as prosperity and needs change over the period. The replacement sales therefore very well compliment the sales made to first time buyers as it generates a future replacement opportunity for companies. Moreover, a general tendency has been observed to replace old vehicles with vehicles having improved features and superior technology thus creating a higher demand for executive and premium vehicles. According to estimates, around 50% of the total domestic sales of two wheeler are now made to first-time buyers, 30% to customers looking to upgrade from their existing vehicle, and 20% to buyers seeking a second vehicle for the household. Relatively insulated from higher interest rates… The two wheeler industry is relatively less cyclical than the other automobile peers and is thus insulated from the increasing interest rate scenario. In FY08-09, the two wheeler industry crashed (-8% and 3% in FY2008-09 respectively) as interest rates increased, banks withdrew from financing and fuel prices touched record high. We however believe that concern about two-wheeler volume growth in the current rising interest rate environment is excessive as dependence on financing has reduced considerably from highs observed in 2008-09. Our channel checks and discussion with management suggests that the two-wheeler dependence on external financing has reduced to 25% from 50% back in 2006-07, thus we do not expect a similar impact on volumes.

Exhibit 11: Proportion of 2W financed Exhibit 12: RBI Repo rate (%) and monthly 2W growth (y-o-y)

0%

10%

20%

30%

40%

50%

60%

2006-07 2007-08 2008-09 2009-10 2010-11

Proportion of Financed 2W

Source: RBI, SIAM, Company data & MSFL Research Moreover, NBFC’s proportionately charge higher interest rate i.e. they have enough spread on the vehicle loan rates and tend to avoid increasing rates in tandem to the increasing cost of funds. Also the impact of increasing interest rate is more sentimental as an impact by way of increasing EMI’s is very negligible. Our analysis shows that a percentage increase in interest rates may result in an EMI increase of only ` 18-40 for buyers. The two wheeler OEM’s (BAL & TVS) have also injected liquidity through in house financing arms with attractive financing schemes boosting sales. The two wheeler industry has shown no

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considerable slowdown with volumes growing c17% y-o-y in YTD FY12 which substantiates our view. We expect interest rates to peak out in end FY12 as inflation taper down and consequently the impact of such increases may be short lived if any. Higher inflation – a possible barrier? We believe that high inflation and the continuing higher inflation expectation can impact two wheeler sales as customers can defer purchases as priority changes. This is possible if a person already has other expenses tied up (eg. Home loan EMI, marriage, etc). However there has been no clear evidence to support this view that high inflation has impacted two wheeler demands in the past two years. The two-wheeler industry has grown at more than 25% over the last two years in spite of higher inflation (especially food inflation). However we note that in past two year’s average disposable income has grown at a rate higher than the inflation and consequently not much impact was seen. Also the growth rate has been from a low base of 2008-09 when industry actually declined. The impact has been largely on the passenger car segment vis-à-vis two wheeler as two wheeler has been more of a necessity for transportation than a status symbol. …Cheaper operating cost We believe two wheeler remains the most economical of the personal mobility option as compared to a four wheeler or leasing a taxi (see table below). Our calculation, assuming a 15Km/day usage in Mumbai, suggests that travelling by a two wheeler is almost 67% cheaper than travelling in taxi. This coupled with rising per capita income of a person in urban area has encouraged a person to own a two-wheeler. Table 5: Comparison between operational costs of two wheeler vs leasing a taxi

Travelling Cost Scenario 1 Scenario 2 Scenario 3

Usage per day (Km) 15 15 15

Mileage (Km/ltr) 50 50 50

Petrol price (` per litre) 75 80 85

Fuel cost (` per month) 675 720 765

Annual maintenance (`) 4,000 4,000 4,000

Monthly maintenance (`) 333 333 333

EMI (`) 1,337 1,337 1,337

Two-wheeler ownership cost (` per month) 2,345 2,390 2,435

Two-wheeler ownership cost/ km (`) 5.2 5.3 5.4

Travelling per day (Km) 15

Taxi fare Mumbai (` 16/Km)/ day 240

Taxi fare - per month (`) 7200

Taxi fare per Km (`) 16

Source: MSFL Research Introduction of GST and DTC to support demand Currently a motorcycle manufactures passes through various stages of indirect taxes – 1) excise duty (10%) at manufacturing facility 2) VAT/CST – retail outlet (rates dependent upon state in which outlet is present) 3) Octroi and other auxiliary charges – once on road. The impact of several indirect taxes has a cascading impact on the sales price of the vehicle resulting in a higher burden on customer. In the GST framework, tax will be collected only at the point of sale. Both components (the Central and state GST) will be charged on the manufacturing cost ensuing in lower incidence of tax and reduced on-road price of vehicles. Similarly introduction of DTC possibly by next financial year will introduce new mollified tax slabs and rates for individuals thereby reducing the total tax outgo. The code intends to provide benefits to individuals with salaries sub 10lacs levels; it has also increased the investments limits which will bring

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12

down overall taxable income. This will particularly benefit the addressable households (defined earlier) in our view and will further increase discretionary spending. We expect the automobile industry especially the two wheeler industry to be the beneficiary once the code is implemented. Fiscal benefits still to accrue for BAL & TVS All the three players had opened new manufacturing facilities in excise free areas over 2007-2008, which helped them drive down excise duty as production was ramped up in these facilities. Our analysis shows that HMC has been the largest beneficiary from the fiscal incentives as it had quickly ramped up its production capacity at its Haridwar plant. With utilisation near 100% levels, we do not expect any incremental impact to flow from FY12E. On the other hand, BAL and TVS are still to reach the installed capacity which leaves room for increasing benefits. Further, BAL has been producing the Platina series, the entry level bike, which is on the lower end of its product portfolio. It is planning to shift entire production of the fast growing Discover series now to the excise free Pantnagar plant, we thus expect an increase in excise benefit to flow through the financials, thus supporting margins (see page 50) Installed capacity and additions To keep up the pace with increasing two wheeler demand, the capacity of the top three players viz., Hero Honda Motors Limited (HHML), Bajaj Auto Limited (BAL) and TVS Motor Company Limited (TVS), which together command a market share of over 80% in the domestic two wheeler market, rose from 8.4mln units in 2005-06 to 12.7mln units in 2010-11. The capacity of the top seven players is further expected to increase 20% on average to 19.45mln units by FY12-13. Exhibit 13: Capacity additions at various OEM’s (mln units)

0

3

6

9

12

15

18

21

Capacity FY11 Total capacity by FY13E

HH BAL TVSM Honda Yamaha Suzuki M&M RE

Source: Company data & MSFL Research Over the last five years, average capacity utilisation of the two-wheeler companies was around 72%. However, in 2010-11, the domestic two-wheeler industry’s sales volumes recovered significantly with utilization rate increased to 78%. We expect utilisation levels to stay high as economy continues to grow at a healthy rate of 15% over the next five years. On our forecasts, we expect HMC to operate at 98% utilisations in FY13E and remains vulnerable to supply side disruptions. Increasing distribution network – enhancing customer connectivity We believe the two wheeler industry to be driven by increasing rural demand. Considering that the overall two wheeler market continues to be under penetrated, most OEMs have maintained their focus on expanding their customer touch points especially in the rural areas and semi-cities. The rural sales now account for nearly 45% of total sales from 38% in FY08. Setting up a dealer involves a huge investment from both company and dealer point of view and thus lower volumes in the initial periods may discourage new dealer inclusions. This is one of the key challenges confronting the foregin players (HMSI, Suzuki and Yamaha) who have been concentrating on gaining market share in particular markets as against increasing their market coverage.

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Exhibit 14: Dealership network Exhibit 15: Customer touch points

0

100

200

300

400

500

600

700

800

900

HMC BAL TVS HMSI

Dealer

0

1000

2000

3000

4000

5000

6000

HMC BAL TVS HMSI

Touch points

Source: Company data & MSFL Research As can be seen from the chart, HMC, BAL and TVS the top three players have the largest dealer network spread across the country and service stations to manage the after sales service requirements. This has been one of the key reason for the strong brand HMC and BAL have in country. Thus capacity expansion by the smaller players should be well compliemented by suitable dealer network which will help them to scale up their operations and make an meaning full impact in the industry. We expect HMSI and Yamaha to be the key competitors in the domestic markets and they are aggressively increasing their presence across the country with popular products in their kitty. HMSI plans to increase dealership network by 200 annually in regional cities and rural districts and also plan to introduce new products suited for the mass market and targeted at rural consumers.

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Motorcycle segment – what’s in what’s out!! The domestic two wheeler industry can be broadly divided into three categories namely the entry level (costing less than ` 40,000), executive level (range of 40-50,000) and the premium/sports segment (>50,000). Over the period, as affordability has increased and with changing customer need, we have seen a shift from the entry level bike to executive (largest segment) and further to sports segment. We see a new category being added to the existing ones – the super bike segment which comprises of high end bikes with better technology and designs for fast growing urban segment.

Exhibit 16: Motorcycle sales volume and growth Exhibit 17: break up of motorcycle segment

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

0

2,000,000

4,000,000

6,000,000

8,000,000

10,000,000

12,000,000

14,000,000

2006 2007 2008 2009 2010 2011 2012E 2013E

Motorcycles Growth - % (RHS)

0%

10%

20%

30%

40%

50%

60%

70%

FY06 FY07 FY08 FY09 FY10 FY11

Economy Deluxe Premium

Source: SIAM, Bajaj Auto & MSFL Research We have discussed below in detail each category on several factors namely contribution to sales, market leader, pricing power, increasing competition and segments role on margins/profitability for OEM’s Entry segment – segment sales shrinking so are margins! Motorcycles of ticket size up to ` 40,000 constitute the entry segment and largely consist of sub 100cc bikes. This segment is currently composed of the CD Dawn and CD Deluxe models of Hero Honda, Platina of Bajaj Auto, Star Sport of TVS Motors and Crux model of Yamaha. The category comprises low pricing power, low margins/profit products. The segments share in the domestic two wheeler market has been decreasing over the last several years and was the worst hit during the credit squeeze in H2 2007-08 and the economic slowdown of 2008-09. Its share has declined progressively to 16% in 2010-11 from 43% in 2005-06 due to various factors ranging from gradual shift in preference of consumers towards the more stylish executive and premium segment, decreasing increase credit exposure in this segment. We also note that the weak growth in the segment has been partly aided by moped growth as some potential customers have downgraded to mopeds due to lower financing availability. Table 6: Entry level motorcycle

Product Price# Power Weight Power / Wt ratio Start Brakes Mileage

HH CD Dawn DLX 35,000 7.71 BHP @ 7500 rpm 107 kgs 0.072 Kick Front Shoe, Rear Shoe 58.5

HH CD Delux 37,000 7.11 BHP @ 7500 rpm 107 kgs 0.072 Kick Front Shoe, Rear Shoe 55.5

Bajaj CT 100 34,000 8.20 BHP @ 7500 rpm 109 kgs 0.075

Front Shoe, Rear Shoe

Bajaj Platina 35,000 8.20 BHP @ 7500 rpm 113 kgs 0.072 Kick Front Drum, Rear Drum 67.8

TVS Star City 35,800 8.29 BHP @ 7500 rpm 104 kgs 0.079 Kick Front Disc, Rear Drum 65

TVS Sport 38,878 7.40 BHP @ 7500 rpm

Kick

67

Yamaha Crux 32,900 7.60 BHP @ 7500 rpm 103 kgs 0.058 Kick Front Drum, Rear Drum

Source: Company data, media & MSFL Research, # - ex-showroom Mumbai

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HMC retains the lion share (>50%) in the segment with its CD Dawn brand and Bajaj Auto at second position with 16% share through the Platina series. This segment being a highly interest rate and price sensitive and thus expect the entry segment volumes to grow at a much slower pace than the overall two wheeler industry. HMSI & Suzuki do not have any offering in this segment given its falling share and lower margins. However HMSI plans to launch a motorcycle in this segment after terminating JV with HMC which could further intensify competition. Executive segment – strong volumes but margin pressure increases Motorcycle models with a price ranging from ` 40,000-50,000 make up the executive segment, which largely comprises of the 100-125cc models. With shifting preference of consumers from fuel efficient to stylish and powerful models, the executive segment has grown exponentially over the last 5 years. This segment also has a greater share from the replacement demand. The segment’s share in the domestic motorcycles segment has thus increased from to 65% in 2010-11 from 48% in 2005-06. The segment has also seen the largest number of new model launches and model revamp by all players to ensure customer loyalty. We expect the segment to be the most competitive and see the maximum number of launches by players in the segment offering higher value at similar price range. We thus expect strong volumes in this category however at declining margins. Table 7: Executive level motorcycle

Product Price # Power Weight Power / Wt ratio Start Brakes Mileage

HH Super Splendor 47,000 9.13 BHP @ 7000 rpm 121 kgs 0.075 Electric Front Disc 52.5

HH Passion Plus 51,800 7.48 BHP @ 8000 rpm 116 kgs 0.064 Kick Front Disc, Rear Shoe 72

HH Glamour 50,000 9.13 BHP @ 7000 rpm 125 kgs 0.073 Electric Front Drum, Rear Drum 51

Bajaj Discover 100 41,250 7.70 BHP @ 7500 rpm 115 kgs 0.066 Electric Front Drum, Rear Drum 66

Bajaj XCD 135 50,000 9.53 BHP @ 7000 rpm 113 kgs 0.084 Kick Front Drum, Rear Drum

TVS Flame 49,170 10.5 BHP @ 7500 rpm 126 kgs 0.083 Kick Front Disc, Rear Drum 62

TVS Jive 41,000 8.40 BHP @ 7500 rpm 105 kgs 0.080 Electric Front Drum, Rear Drum

Honda Shine 44,198 10.3 BHP @ 7500 rpm 122 kgs 0.084 Kick Front Drum, Rear Drum 53

Honda Stunner 51,650 11.6 BHP @ 8000 rpm 129 kgs 0.089 Electric Front Disc, Rear Disc

Source: Company dat, media & MSFL Research, # - ex-showroom Mumbai Hero Honda remains the major player in the segment with its brand Splendor & Passion. It recorded highest market share during the slowdown of 2009 with subdued competition from both the large players (Bajaj Auto and TVS Motors). Since then, both Bajaj Auto and TVS introduced new products - Bajaj Auto launched the Discover 100, Discover 150 and TVS launched the Jive (110cc bike). Bajaj Auto’s Discover series has been a runaway success since its launch and has captured a significant market share in less than two years of its launch (currently clocking monthly volumes of more than 1 lac units) thus causing Hero Honda’s market share in this segment to fall below 50% in 2010-11. Premium Segment – in sweet spot driven by brand Motorcycle models with a price of over ` 50,000 comprise the Premium segment, which consists of greater than 150cc engine capacity bikes. This segment has been the fastest growing segment with its share in total motorcycle sales growing to 18% in 2010-11 from 9% in 2005-06. As discussed earlier, with expected increase in students starting college/degree courses and increasing youth workforce, we expect this segment to remain the fastest growing over the medium term. Further, the segment is driven by positioning of a brand in minds of buyers thus providing relatively higher pricing power. This category remains the most segmented and includes: a) Performance bikes consisting of Bajaj Auto’s Pulsar family, Hero Honda’s Glamour, Achiever, CBZ

Extreme, Hunk and Karizma; Honda Motorcycles & Scooters’ Unicorn Dazzler, and TVS’ Apache RTR, besides models from the stables of Suzuki and Yamaha

b) Cruiser bikes such as Royal Enfield’s Bullet and Bajaj Auto’s Avenger

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Table 8: Premium segment motorcycle

Product Price Power Weight Power / Wt ratio Start Brakes Mileage

Bajaj Pulsar 150 62,600 15.06 BHP @ 9000 rpm 143 kgs 0.105 Self Front Disc, Rear Drum 52

Bajaj Avenger220 68,000 16.50 BHP @ 8000 rpm 154 kgs 0.107 Kick Front Disc, Rear Drum 38.6

Suzuki GS 150R 60,300 13.80 BHP @ 8500 rpm 149 kgs 0.093 Self Front Disc, Rear Drum 47

HH Karizma 76,500 17.24 BHP @ 7000 rpm 150 kgs 0.114 Self Front Disc, Rear Shoe 35

HH CBZ Extreme 60,550 14.40 BHP @ 8500 rpm 143 kgs 0.101 Self Front Disc, Rear Drum 55

Yamaha FZ 65,000 13.81 BHP @ 7500 rpm 135 kgs

Self Front Disc, Rear Drum 50

TVS Apache 67,770 15.70 BHP @ 8500 rpm 139 kgs 0.112 Self Front Disc, Rear Drum 45

Honda Unicorn 60,773 13.30 BHP @ 8000 rpm 139 kgs 0.095 Self Front Disc, Rear Drum 50.6

HH Hunk 57,816 14.40 BHP @ 8500 rpm 143 kgs 0.100 Self Front Disc, Rear Drum

Source: Company data & MSFL Research, # - ex-showroom Mumbai The positioning of the premium segment bikes is attached on the performance attributes unlike executive segment which are positioned as commuter products and family bikes providing basic transportation. Moreover, the distinction between the executive and premium segment is becoming obscure as companies are targeting consumers with new differentiating products and unique marketing strategy. This can be seen from Bajaj launching Pulsar 135cc and Discover 125cc (launched in April 11) targeted at the conventional buyer aspiring to experience sports biking. BAL remains the market leader in the segment with market share more than 50% with its key brand Pulsar. Yamaha motors have been catching up BAL with its market share growing quickly (c10% market share). Scooters – Riding high on convenience factor Scooters, once the most affordable commuter vehicle, have undergone a complete makeover over the last decade. With shifting preference of consumers from the low tech, low power two stroke engines scooters to high end stylish motorcycles its share in overall two wheeler sales fell from more than 35% in 1999-00 to a low of 12% in 2006-07. The first generation scooter models of Vespa, Kinetic, Bajaj and LML were all taken out of production due to declining demand. However with introduction of new age scooters by Honda and TVS, with powerful and refined engines, modern styling and automatic gears, it clocked a record volume CAGR of 18% over the last five years to reach 2.1mln units in 2010-11. During this period, its share in the total domestic two wheeler market has also increased to 18% in 2010-11. We expect scooters to grow at a CAGR of 19% over FY11-13E on the back of demographics advantage and brand positioning.

Exhibit 18: Scooter sales & growth (% RHS) Exhibit 19: Share of scooter segment (%)

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

2007 2008 2009 2010 2011

Scooter sales % growth y-o-y (RHS)

5%

10%

15%

20%

25%

30%

35%

Source: SIAM & MSFL Research

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Demand drivers Demographic advantage: The target market for ungeared scooters in urban areas has mainly been the female population in the age group of 18-30 years and, to some extent, the male population shifting from old styled scooters. Players are also increasingly trying to expand their addressable market by targeting the young urban male population (age 16-45 years) with launch stylish of heavy and more powerful ungeared scooters. Urban focus: The urban and semi-urban markets contribute to more than 90 per cent of total scooter sales. Lower penetration levels provide higher potential for growth in the scooter segment in the long term. Brand positioning: Households increasingly prefer scooters as the second vehicle to be purchased after cars translating in higher demand for scooters. Ungeared scooters have started affecting the motorcycle replacement market in urban areas, which is further likely to boost its demand. Current Scenario & Competition Overall, Honda Motorcycles & Scooters maintain its pole position in the Scooters segment, through its flagship brand Activa (besides Aviator and Dio) enjoying a market share of 43% in 2010-11, followed by TVS at 22% (overall market share). Hero Honda also entered the scooter segment with its maiden launch ‘pleasure’ targeting young female population and recently launched a 110cc scooter ‘Mastero’ to grab market in the fast growing scooter segment. Suzuki has quickly increased its market share in the scooter segment taking advantage of capacity constraints at HMSI with its 125cc model ‘Access’. Strong demand expectation for scooters has also increased other players interest in this segment. Yamaha recently announced its plans to introduce a scooter model in the domestic market in 2012 and LML is planning to re-enter the segment with launch of Star 200 4T scooter in India. Piaggio (manufacturer of Vespa model) too has announced that they are looking for agencies for their creative launch campaigns for the re-launch of their scooter model in India.

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Exports – unlocking value We believe exports would continue to grow strongly at 19-20% CAGR by combination of increasing penetration in current markets, entering into new markets, brand positioning and enhancing the distribution network. Two wheeler exports from India reported a CAGR of 25% over the period 2005-06 to 2010-11 to reach 1.5 million units in 2010-11. Bajaj Auto is the largest two wheeler exporter from India, followed by TVS Motors, with both companies exporting to a large number of countries. Together, BAL and TVS accounted for 79% of all two wheeler exports from India in 2010-11.

Exhibit 20: World demand (‘000 units) Exhibit 21: Export Volume & growth (% RHS)

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

China India Asia -Other

Brazil RoW Europe North America

Japan

2005 2010

0%

5%

10%

15%

20%

25%

30%

35%

40%

0

500,000

1,000,000

1,500,000

2,000,000

2006-07 2007-08 2008-09 2009-10 2010-11

Bajaj Auto TVS

Hero Honda Honda Motorcycles & Scooters

Yamaha Others

Growth (y-o-y %, RHS)

Source: Yamaha, Company data, SIAM and MSFL Research Export markets offer a strong growth opportunity to Indian companies, given India’s low-cost manufacturing capabilities and superior quality over its Chinese peers. We believe with increasing competition in the domestic market and reducing pricing power, companies with higher exports have an edge over other players as it not only results in revenue diversification but also relatively stable margins. Thus increasing export market share has been a key component of their growth plans. The key export markets for Indian OEM’s have been the South Asian, African and Latam countries. The companies are also aggressively targeting South East Asian countries where Japanese OEM’s dominate the markets. Table 9: Key export markets and products sold

Company Destination Markets Key Brands Exported

Hero Moto Corp Bangladesh, Sri Lanka, Nepal and Columbia CD Dawn, Splendor, Passion, Glamour,

CBZ Xtreme, Hunk, Pleasure

Baja Auto Present in over 36 countries; Africa & Middle East: 51%; South Asia: 25%; Latin America: 15%; South East Asia: 9%

Boxer, Discover, Pulsar

TVS Present in around 55 countries; Africa, Latin America, South-East Asia Apache, RockZ, Neo

HMSI Exports to over 50 countries including developing countries and Europe

Yamaha Direct exports to developing/emerging countries

Source: Company data & MSFL Research The dynamics of most of these markets (except Africa) are very similar to those in India where two-wheelers are primarily used for personal transportation rather than lifestyle products. Increasing population and urbanisation, inadequate public transport systems make them key markets for two wheelers. As can be seen from the chart below, the markets are under penetrated and there is a large room from growth.

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Exhibit 22: Population and Vehicle per capita ratio

Source: Honda Presentation Lower penetration as compared to China and Japan The proportion of exports to total sales has over the period increased from 7.3% in 2005-06 to c16% in 1Q FY12 as the export market has been growing at a higher rate than the domestic market. But we note that the proportion is still lower than Japan and China which export almost 75% and 25% of the production respectively. We believe two reasons have restricted growth earlier 1) buoyant domestic markets 2) challenge of setting up distribution network. Dynamics of key markets African countries: Africa has recently emerged as the one of the fastest-growing markets with Nigeria accounting for nearly 40% share. It has an annual demand of over 1.2mn two-wheelers and is one of the important market for BAL. In Africa, however, the industry is still at a stage where two wheelers are primarily used for commercial purposes. As a result, the market is largely geared towards low-cost vehicles, while brands are only slowly assuming importance. As economy grows and so does the affordability levels, the Indian OEM’s will target these countries with higher technology products. Thus it represents a huge export opportunity over the next five years for Indian OEM’s. We expect exports to be majorly driven by higher growth traction in key African markets.

Exhibit 23: Real GDP growth (%) Exhibit 24: Per capita Income (US$)

0%

2%

4%

6%

8%

10%

12%DR Congo Nigeria Uganda Kenya

0

500

1,000

1,500

2,000

2,500

DR Congo Kenya Nigeria Zambia

2005 2010 2015E

Source: IMF & MSFL Research

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South East Asian countries The developing economies of Indonesia, Vietnam and Thailand are the largest growing countries with increasing population and higher urbanisation driving the two wheeler demand.

Exhibit 25: South East Asian demand Exhibit 26: Key players & market share

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

CY04 CY05 CY06 CY07 CY08 CY09 CY10 CY11E

Indonesia Thailand Vietnam

53%37%

8%2%

Honda Yamaha Suzuki Others

Source: Honda presentation & MSFL Research Both BAL and TVS had opened subsidiaries to target the third largest two wheeler Indonesian and nearby markets. However due to global slowdown in FY2008-09 and stiff competition by Japenese counterparts, both companies have been unable to break even till date. Latam countries Indian OEM’s export premium bikes to Latam countries with Colombia and Central America being the key markets. These markets recovered strongly after facing slowdown in CY2009 on the back of global slowdown. Our interaction with management of companies indicated that export potential is huge and there are several territories yet to be explored. The key market where Indian OEM’s have little presence is that of Brazil which happens to be the largest market in Americas. The industry has shown similar growth traction as compared to India. Moreover, the market is dominated by 100cc-150cc motorcycles which imply a key positive for Indian OEM’s who have established products in this category. Honda Motors & Yamaha control nearly 90% of the markets with Honda having more than 75% of the share.

Exhibit 27: Brazil sales and growth (% RHS) Exhibit 28: Motorcycle sales mix

-20%-15%-10%-5%0%5%10%15%20%25%30%

0200,000400,000600,000800,000

1,000,0001,200,0001,400,0001,600,0001,800,0002,000,000

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

YTD

Jun'

11

Sales Growth - % (RHS)

7%

81%

3%6%

2%

< 100c 101cc - 150cc 151cc - 250cc 251cc - 400cc > 401cc

Source: Abraciclo & MSFL Research

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Higher acceptability for quality products Indian products are priced lower than their Japanese counterparts and are perceived to be better than those of China, thus offer a mix of technology and price. Chinese two-wheelers are relatively price competitive as compared with other counter products available in the market. With key African markets experiencing slowdown in previous two years, demand for quality products increased over low priced inferior quality Chinese products. Competition Indian companies face stiff competition from its Chinese counterparts in the African markets while Japanese players namely Honda and Yamaha dominate the S Asian & Latin American markets. We expect competition to intensify as 1) Yamaha has recently unveiled plans to enter the growing African & Latin markets. 2) Hero Honda after terminating its JV with Honda will get aggressive on the export front. Until now Hero Honda exports was constrained to countries in which Honda was not present. Though it will take some time to set up the required dealership network and focused products for the export markets. 3) Indian companies do have cost advantage as compared to the Japanese players, however with Honda expanding its manufacturing capabilities in the India and China it will rob off some advantage from these players. ….DEPB scheme stands withdrawn The DEPB scheme stands withdrawn by Sep 2011 and is replaced by a Duty Drawback scheme (DDS) with rates of drawback lower than originally received under DEPB scheme of 9%.The rtaes are expected to range from 5-6% for automobile industry. We have removed DEPB entitlements from our forecasts and replace them with DDS rates of 5% going forward. We have used similar DDS rate for purpose of valuations. The impact of lower rates will be higher on BAL followed by TVS due to higher exposure to exports. On our forecasts, BAL earns c30% of its revenues from exports and expect company’s operating margins to be hit by 120bps in near term. TVS, on the other hand, earns c15% of its revenues from exports and expect company’s operating margins to be hit by 60bps. We expect both BAL and TVS to pass on the impact of lower rates through the supply chain i.e. onto buyers and distributors. The company has decided to increase prices after Sept-11 to compensate for the withdrawal of DEPB. The high traction seen in the export markets must have been partly due to some stocking made by distributors before the deadline of 30th Sep 2011 with uncertainity on the applicability of DEPB scheme. Further, an increase in vehicle price will have multiple effect on final prices in export markets. We thus expect export volumes in 2HFY12 and to some extent in FY13E to be impacted as a result of the pricing action.

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Competition heating up!! The two wheeler industry has gone through structural changes over the past few years with old players making an exit unable to keep up with the changing trends in the industry while a number of new players entered the market with innovative & superior performing products. International players like Harley Davidson, Hyosung and Ducati have entered the foray to benefit from the booming domestic market. Furthermore, the split between Hero Group and Honda Motors has brought the industry at an inflexion point and, in our view, will further increase the competitiveness in the domestic two wheeler industry. Thus, with the increase in competition and entry of newer players in automotive two-wheeler segment, sustaining the market share remains key issue with auto players.

The two wheeler industry is dominated by Hero Honda, Bajaj Auto and TVS Motors with market share among them of over 80% as on 1Q FY12. We expect the two wheeler industry to undergo intensive competition in the medium term with companies increasing their production capabilities and increased investments in new product development and brand positioning. We flag HMSI and Yamaha India Motors to be major competition which have taken a major expansion program and take a closer look on their strategy in the segment. Honda Motors & Scooters Limited (HMSI) – break free from Hero HMSI, a wholly owned subsidiary of Honda Motor Company, Japan, has been the most dominant player in the scooters segment with having more than 50% market share on average in the past five years. However, its share in the segment fell from 57% in 2008-09 to 44% in 2010-11 facing stiff competition from TVS Motors and Suzuki Motorcycles. It also entered the motorcycles segment with CB Twister - in the executive segment and Unicorn in the premium segment and has presence in the super bike segment with models like CB 1000R and CBR 1000R. Over the period, the company’s share in the motorcycles segment has increased from 1.7% in 2005-06 to 7.3% in 2010-11. Of the other unlisted players, HMSI has the most aggressive strategies for the Indian markets. From being a player in scooters segment it has plans to establish itself as one of the largest players in the domestic two wheeler market. The termination of JV with the Hero group substantiates over view of Honda eyeing the Indian domestic market.

Exhibit 29: HMSI - Sales mix Exhibit 30: HMSI domestic market share

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2006 2007 2008 2009 2010 2011 2012

Scooters Motorcycle

0%

10%

20%

30%

40%

50%

60%

70%

2006 2007 2008 2009 2010 2011 YTD 2012

Honda - Overall Honda - Scooter Honda - Motorcycle

Source: SIAM & MSFL Research, 2012 – actual figures till Aug 2012 Operations HMSI currently operates from two facilities 1) Manesar facility with annual capacity 1.6mln units and 2) Bhiwadi, Rajasthan – with initial annual capacity of 0.6mln units. The newly set up facility in Rajasthan commenced commercial production in July 2011. The capacity can be further expanded by 0.6mn to 1.2mln units per annum. It also plans to set up the third greenfield facility in Andhra Pradesh.

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Strategy… We expect Honda to be more aggressive player after ending its JV with Hero. It is strengthening its R&D facilities in India and plans to developing specific products for the country. It is also planning to launch a 100cc bike in the mass commuter segment in the Indian two wheeler market. It has given 10% y-o-y volume growth guidance for its Asian motorcycle markets in the current year and expects India to the major driver. It plans to open new sales locations in regional cities and rural districts to enhance its connectivity to the fastest growing rural market. To put it in number it has 800 India outlets and it plans to add 200 more outlets annually.

Exhibit 31: China & India to become export hub Exhibit 32: Export market Focus

Source: Company data HMSI also has ambitious plans for the exports markets. It plans to establish Indian and China as the hub for its exports market given significant labor advantage. Honda plans to capitalize on India’s booming infrastructure, tax sop and skilled labor strength to expand its production capabilities. It exported 1 lac bikes in 2011 and has set a target of exporting 2 lac bikes by 2013. …Our view We expect HMSI to clock to achieve growth of 22% y-o-y and 12-13% in FY12E and FY13E on back of increasing capacity and increase its overall market share to 13.8%. Though HMSI has been the fourth largest motorcycle manufacture in India, buying a Honda bike/scooter can take a toll on customer’s patience. Honda Activa, the largest selling scooter in India, demands a 3-month waiting period. Honda bikes such as CB Shine, CBF Stunner, CB Unicorn and CB Twister demand a waiting period that ranges between 1 and 3 months depending on where the dealer is located and the time taken to transport the two-wheelers. We accept that Honda will be a major threat to Bajaj Auto and Hero MotoCorp over the medium term as it ramps up its production capabilities and enhances its dealer network. It ability to adapt to domestic conditions makes it a formidable competitor. It already has dominant share in many emerging economies (eg. Indonesia, Vietnam, Brazil) and it is looking to establish itself in growing markets of India and China. Yamaha Motors – gaining traction in premium segment Yamaha was one of the first global two-wheeler manufacturers to set up base in India in 1985 and the first player to introduce India to genre of superbike (the Next Gen bikes) with launch of YZF-R1 and MT01. Its market share has however reduced to just 2.5% in 1Q FY12 from 5% in 2002 due to high competition in the entry and executive segments from established players like Hero Honda and Bajaj Auto. It has on the other hand gained substantial market share in the premium segment (125cc to 250cc segment) to >8% in 2011. It has also indicated plans to enter the scooter segment with the launch of gearless scooters.

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24

Exhibit 33: Yamaha sales & market share

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

0

50,000

100,000

150,000

200,000

250,000

300,000

2006 2007 2008 2009 2010 2011

Motorcycle - <125cc Motorcycle - >125cc

Market share - Motorcycle

Source: SIAM & MSFL Research Operations Yamaha currently operates from two facilities one at Faridabad (Haryana) and Surajpur (Uttar Pradesh) and has capacity of 0.5mln units. It has plans to increase capacity to 0.6mln units. The capacity at Surajpur facility can be augmented to 1mln units from 0.5mln units currently. Exhibit 34: Yamaha strategy on India – before and after

Source: Company data Strategy… Yamaha Motors now plans to expand its product line up with the affordably priced models (executive segment) to take advantage of the rapidly growing domestic motorcycle market as against its earlier strategy of concentrating on the premium and the super bikes segment (>1000cc models). Yamaha Motors plans to enhance its presence in the country while simultaneously increasing appeal and profitability of its products. It had recently announced its plans of increasing its network strength in tier-2 and tier-3 cities and increasing the number of sub-dealers in rural areas. It targets a 20% y-o-y growth to 310,000 units in current year. …Our view We believe Yamaha is a major force in the sports bike and superbike segment and it has launched the SZ series in the executive segment. It has plans to double its capacity to >1mln units and we believe that it would be imprudent to consider Yamaha as a fringe player. It already is the second largest player in the South East Asian markets and its rise in the premium segment over the period speaks for itself.

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25

Next Gen bikes for a new generation of riders Globally, the two‐wheeler market can be classified into leisure and utility markets with the developed markets of North America and Europe as leisure markets. The bulk of vehicles are however sold in the utility markets which are further classified as the mature and emerging markets. Thailand, Indonesia, Philippines and Brazil constitute mature markets while Africa is an emerging market. As standard of living improves and aspirational level & per capita income increases we see natural replacement of motorcycles with passenger cars which losses its high status symbol. As we see from the chart, as the per capita GDP rises beyond a level, the demand of motorcycles revert to low levels seen in emerging markets but have altogether different product and technology requirements as compared to emerging markets. We term these vehicles as the Next Gen bikes which can be classified into the sports, cruiser and the off the road motorcycles.

Exhibit 35: Global 2W penetration vs per capita GDP Exhibit 36: Addressable households (mln)

0

20

40

60

80

100

120

140

<90 90-200 200-500 500-1,000 >1,000Income Range (` '000)

2000 2010 2015

Source: OCED (2008), NCAER As per NCAER, the number of households earning more than 1,000,000 (global) will double to 4mln households by 2015 from current level seen. It would further increase to 8mln household in 2020 thus representing a large market for sports bikes. Moreover, the products will command higher operating margins. So to cash in on the opportunity most of the OEM’s are now venturing into the new age of stylish sports bikes. Honda has been the most prominent players with its Honda CBR250 already selling 9,000 vehicles in YTD FY12. BAL has announced launch of new Pulsar in Q4 FY12 and we expect it to be on similar line of Honda CBR250 though at lower price levels. The motorcycles can be categorised into three segment based on the price tags 1) upto 3 lacs 2) from 3-8 lacs and 3) above 8 lacs. Honda, Yamaha and Suzuki were already present in the last segment with offerings in the 1000cc segment. The segment being in the nascent stage none of the players manufacture the products in India. The products are imported in the CBU (Completely build units) after receiving order from the customers. Such models attract higher import duties (nearly 110% including the CVD, etc) and thus higher end product prices (double of original price tag). This created a psychological barrier and has been key reason for lower volumes. Table 10: Super Premium motorcycle segment

Models Price Displacement Max Power Gears Weight Type Status

Hero Honda Impulse* 150,000 149.2 cc 13.8 BHP

Off-Road launched in Aug,11

Bajaj KTM Duke 200* 150,000 200 cc 22 BHP 5 Speed

Sports yet to be launched

Honda CBR 250R 164,198 249.6 cc 25 BHP @ 8500 rpm 6 Speed 167 kgs Sports Launched in Oct,10

Bajaj Kawasaki Ninja 250R 303,100 249 cc 32.5 BHP @ 11000 rpm 6 Speed 172 kgs Sports Launched in Oct,09

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Bajaj Kawasaki Ninja 650R 462,000 649 cc 71 BHP @ 8500 rpm 6 Speed 204 kgs Sports Launched in Jun,11

Hyosung GT 650R 497,000 647cc 65 BHP @ 9000rpm 6 Speed 212 kgs Sports Available

HD XL 883 SuperLow 550,000 883 cc 50 BHP 5 Speed 251 kgs Cruiser Available

Hyosung ST7 596,000 678 cc 62 BHP @ 8000 rpm 5 Speed 244 kgs Sports Available

HD Iron 883 650,000 1170 cc 133 BHP @ 8750 rpm 5 Speed

Sports Available

Suzuki Bandit 1250S 880,000 1255 cc 100 BHP 6 Speed 250 kgs Sports Available

Honda CB 1000R 1,123,470 998 cc 126 BHP 6 Speed 217 kgs Naked Launched in Feb,09

Yamaha MT-01 1,193,700 1670 cc 88 BHP @ 4750 rpm 5 Speed 243 kgs Cruiser Available

Yamaha R1 1,281,000 998 cc 175 BHP @ 12500 rpm 6 Speed 206 kgs Sports Available

Suzuki Hayabusa 1,430,000 1340 cc 170 BHP @ 9500 rpm 6 Speed 220 kgs Sports Available

Honda VFR 1200 2,015,000 1237 cc 172 BHP 6 Speed 267 kgs Sports Available

BMW HP2 Sport 2,579,000 1170 cc 133 BHP @ 8750 rpm 6 Speed

Sports Coming Soon

Source – Company data, media & MSFL Research, * details yet not confirmed, HD - Harley Davidson Domestic players in the foray… BAL, however, took the first step in the direction and it decided to assemble the Kawasaki – Ninja 250R at its facility in India. The motorcycle is imported in CKD (Completely knocked down) form and assembled it in its Pune facility. The parts imported under this route attract lower duties and thus restricting the end product prices. The bike launched in 2009 has been a success with more than 1500 vehicles sold till date. In June 2011 it launched the Ninja 650R from its plant. As per newswires, dealers have notched up record bookings for this bike and temporarily put all further bookings of the bike on hold. It also plans to launch the KTM – Duke edition bikes in 200cc segment next year and followed by 350cc Duke bikes a year later. The KTM bikes will be specially crafted for the keeping in mind the Indian buyer and the Indian markets. It has also set up focused “Bajaj Probiking Showrooms” in the major cities for sales of these models and spare parts (including accessories). Hero MotoCorp also recently launched a 150cc on-road-off-road motorcycle, “Impulse” marking its entry in the super bikes segment. Impulse will be the first of its kind for the domestic motorcycle markets. ...Foreign players eyeing Indian markets We note that number of global players have recently entered the Indian two wheeler industry or expressed interest to do in the super bike segments. In the upper-end of the motorcycles segment, three global players namely, Harley Davidson, Hyosung and Ducati entered into the Indian markets with products in the 3-8lacs range. Table 11: Foreign players in Super premium segment

Assembly Plant Models Target Dealership Network Expected

Hyosung Maharashtra GT 650R and ST7 2000 bikes/year Expand to 15 from current 5 Operational

Ducati no plans yet Diavel, 848 Evo, 1198SP 300 bikes/year Expand to 10 Dealers NA

Harley Davidson Haryana Super Low 883 N.A. Expand to 20 Dealers 2011

BMW Chennai HP2 Sport, K1300R 50 bikes/year Expand to 20 Dealers Operational

Source: Media, Company data & MSFL Research We though believe it is too early to envisage high volumes for these motorcycles in the domestic markets partially due to high ticket size for models brought in the CBU route. Nevertheless the vehicles command higher pricing power and higher operating margins. Moreover, sale of spares and other accessories will be a source of revenue generation. We however expect that with an increase in customer awareness, the demographic advantage and most importantly disproportionate growth income levels in hand of urban India this segment will grow up exponentially in near term. We expect BAL and HMSI to be primary beneficiary due to multiple products across prices suiting customer preferences.

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Financial Outlook The two wheeler OEM’s enjoy the highest margins as compared to other players in the automobile industry with BAL enjoying the highest margins as compared to its peers driven by superior product (high contribution from exports and three wheeler) while TVS earns the lowest margins mainly due to higher other expenditure (800bps higher than average of others). On average all players recorded fall in margins as higher commodity price and lower pass through (due to high competition). HMC, however, was the most affected as its product mix was skewed towards low pricing power and low margin executive motorcycle sales. TVS on the other hand registered lowest fall in margins as its product mix improved with higher three wheeler and scooter sales.

Exhibit 37: EBITDA Margin Exhibit 38: Quarterly EBITDA Margin

0%

5%

10%

15%

20%

25%

FY07 FY08 FY09 FY10 FY11

Bajaj Hero Motocorp TVS

0%

5%

10%

15%

20%

25%

Bajaj Hero Motocorp TVS

Source: Company data & MSFL Research Increasing realisations – hard to come With strong demand for two-wheelers in last couple of years, companies were able to take adequate price hikes not only to pass on the increasing input costs on the buyers but also maintaining healthy margins. EBITDA margins for two wheeler companies increased more than 450bps on average during FY08-11 (except for HMC). For all the two-wheeler companies under coverage, average realization grew at a CAGR of 5% over FY08-11 period.

Exhibit 39: Realisations (`) Exhibit 40: Quarterly realisations (`)

15,000

20,000

25,000

30,000

35,000

40,000

45,000

FY08 FY09 FY10 FY11

TVS Motors Bajaj Auto Hero Honda

20,000

25,000

30,000

35,000

40,000

45,000

50,000

Q1FY10 Q2FY10 Q3FY10 Q4FY10 Q1FY11 Q2FY11 Q3FY11 Q4FY11 Q1FY12

BAL HMC TVS

Source: Company data & MSFL Research

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However with demand expected to moderate over the next two years (high base effect) and increasing competition across segments, increasing vehicle prices (even to recover increased input cost) will not be an easy option, in our view. The OEM’s margins fell in FY 2011 as they were unable to fully pass on the input cost inflation. We however note that impact on margins will vary based on the segment’s competitive intensity and not on the company per se (see chart). As noted in our earlier section, we expect competition to be most significant (and consequently lower pricing power) in the largest executive motorcycle and the fast growing scooter segment. We expect competition in the entry and premium motorcycle segment to be relatively less intense, although due to different reasons. Premium motorcycle segment have created a niche market for itself with significantly high brand value. Also, there has been relative shift in consumer preference to premium segment and thus command relatively higher pricing power. Similarly falling volumes in the entry level segment and lowest pricing power makes it less attractive for OEM’s to launch motorcycle in this segment. Exhibit 41: Price hike (`) on different variants (Since Sep 2010)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

Pu

lsar

180

Pu

lsar

150

Pla

tin

a

Dis

cove

r 100

CB

Z X

trem

e

Ple

asu

re

Sple

nd

or

Plu

s

Sup

er S

ple

nd

or

Pas

sio

n P

ro

Un

ico

rn

Act

iva

Ap

ach

e R

TR

Flam

e

Jive

Star

Cit

y

Sco

oty

Source: Dealers, company data, news wires & MSFL Research As can be seen in the chart, price hike across companies have been higher in the the premium motorcycle segment while lowest in the lower end motorcycles. The entry and executive level motorcyle lack the pricing power due to higher sensitivity to increase in prices. Further, the sales are dependent on affordability as compared to premium bikes. We thus believe HMC followed by TVS to be most vulnerable if input costs increase much more than anticipated due to its dependence on the entry and executive motorcycle segment. Thus increasing sales volumes may act as a buffer to cover fixed costs but will be unable to fully recover the variable cost increases.

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Raw material prices to soften over forecast period… Input costs constitute on average c70% of the total cost for the two-wheeler manufacturers. It reached as high as 75% in FY07 driven by higher commodity prices & local cost inflation before cooling down to around 71-72% level in FY11. We expect raw material costs to cool down in 2H FY12 as commodity prices consolidate with a downward bias and stricter cost efficiency at OEM level.

Exhibit 42: Raw material as % of sales Exhibit 43: Quarterly Raw material as % of sales

62%

64%

66%

68%

70%

72%

74%

76%

78%

FY07 FY08 FY09 FY10 FY11

Bajaj Hero Motocorp TVS

60%

62%

64%

66%

68%

70%

72%

74%

76%

Bajaj Hero Motocorp TVS

Source: Company data & MSFL Research

The primary raw materials required for a two-wheeler are Steel (~40% of cost), Aluminium (~30% of cost) and Plastic (~10% of cost). For FY12, we expect steel price to remain subdued as compared to year before due to slow down in key end sectors and excess supply in international market. Also premium on Indian steel price over international prices have dried up, favoring over case. Though steel prices have increased marginally in 1Q FY12, we expect it to cool down and stabilise at lower levels in the latter part of the year. Aluminium and rubber costs have shown signs of moderation and we do not see any significant upside from current levels.

Exhibit 44: Steel price ($/t) Exhibit 45: Aluminium LME price ($/t)

400

500

600

700

800

900

1,000

1,100

Mar

-09

Jun-

09

Sep-

09

Dec

-09

Mar

-10

Jun-

10

Sep-

10

Dec

-10

Mar

-11

Jun-

11

Hot Rolled Cold Rolled Galvanized

1,200

1,500

1,800

2,100

2,400

2,700

3,000

Apr

-09

Jun-

09

Aug

-09

Oct

-09

Dec

-09

Feb-

10

Apr

-10

Jun-

10

Aug

-10

Oct

-10

Dec

-10

Feb-

11

Apr

-11

Jun-

11

Aug

-11

Source: Company data & MSFL Research Overall for the two wheeler manufacturing, the conversion cost (cost incurred for converting commodities into finished auto parts) is of higher importance as it accounts for a major proportion of total raw material costs. On an average more than 70% of raw material costs are the conversion costs while the balance is the actual raw material costs. We expect the conversion costs to remain strong driven by higher labor cost (at vendor and OEM end) and higher fuel costs. Though crude oil has shown some signs of softening it still remains at elevated levels.

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Based on our analysis of costs, we believe a significant jump in the raw material prices (steel, ally, plastic) will have relatively less impact than a similar push in the conversion cost. We expect stricter cost efficiency methods and increasing scale of operations to help reduce pressure on the operating margins. Table 12: Sensitivity to input and conversion costs

HMC BAL TVS

HMC BAL TVS

Raw material (%) 70.5% 70.8% 73.7% Raw material (%) 70.5% 70.8% 73.7%

Input costs 24% 23% 27% Input costs 24% 23% 27%

Conversion costs 76% 77% 73% Conversion costs 76% 77% 73%

Impact of input costs 17% 16% 20% Impact of input costs 17% 16% 20%

Impact of conversion costs 54% 55% 54% Impact of conversion costs 54% 55% 54%

input costs + 10% 18.6% 17.9% 21.9% input costs - stable 16.9% 16.3% 19.9%

conversion costs – stable 53.6% 54.5% 53.8% conversion costs + 10% 58.9% 60.0% 59.2%

Increased raw material costs 72.2% 72.5% 75.7% Increased raw material costs 75.9% 76.3% 79.1%

Increase 1.7% 1.6% 2.0% Increase 5.4% 5.5% 5.4%

Source: Company data & MSFL Research The other major cost contributor is the advertisement, marketing and the promotional expenses. As the industry is driven by brand name, it is necessary to inculcate a sense of belonging towards company’s brand and products. This also plays an important role in brand loyalty on part of customers. With the intense competition prevailing in two-wheelers segment and the new launches at regular intervals, two-wheeler companies are expected to continue spending on advertisement and marketing expenses to brand building.

Exhibit 46: Other exp as % of sales Exhibit 47: Other exp as % of sales – Quarterly

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

FY07 FY08 FY09 FY10 FY11

Bajaj Hero Motocorp TVS

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

Bajaj Hero Motocorp TVS

Source: Company data & MSFL Research BAL’s advertisement expenditure remains the lowest as it has created a strong brand for its offerings and continues to ride on the success of its key Pulsar and Discover brand, while TVS and HMC spend a high % of their revenues on promotion.

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Recommendation We initiate coverage with Buy recommendations on Bajaj Auto Ltd (TP – ` 1,893) & TVS Motors (TP – ` 73) and a sell recommendation on Hero MotoCorp (TP – ` 1,920). Our analysis suggests that the BAL and TVS have significant potential upside to market price and a downside of 13% for HMC. Based on upside potential to our target prices our top pick is Bajaj Auto ahead of TVS Motors. Table 13: Valuations – peer group comparison

MSFL Rating

CMP Target price

+/- (%)

Mkt cap

P/E (x) Dividend Yield (%) ROCE (%)

FY

2011 FY

2012E FY

2013E FY

2011 FY

2012E FY

2013E FY

2011 FY

2012E FY

2013E

Bajaj Auto Buy 1,627 1,893 16% 470.9 16.7 15.0 13.2 2.5% 3.1% 3.4% 76% 72% 66%

TVS Motors Buy 63 73 15% 30.2 15.4 12.1 8.7 1.7% 2.0% 2.5% 15% 19% 25%

Hero Motocorp Sell 2,206 1,920 -13% 440.5 22.1 21.0 17.8 4.8% 2.0% 2.5% 59% 49% 48%

Source: Company data & MSFL Research, CMP as on end September 20, 2011 Bajaj Auto – Initiate with Buy; target price of ` 1,893 (upside of 16%) With a potential upside of 16%, BAL is our top pick in the lot. We have a positive view on the two wheeler industry and expect industry to grow at healthy CAGR of 15% over next two years (with an upward bias). We believe Bajaj Auto with its current motorcycle portfolio, brand building exercise over past few years and its strategy of focusing on the premium motorcycle segment is reaping rich rewards. We expect BAL’s net revenue to grow at a CAGR of 18% higher than the volume CAGR of 16% over the next two years. We forecast company to post a robust 13% CAGR in its Adjusted NPAT. Given its strong cash flow and return profile, we expect BAL multiples to expand and trade at premium valuations. At a CMP of ` 1,627/share, BAL is trading at 15.0x and 13.2x FY 12E and FY 13E earnings respectively at a discount to HMC. TVS Motors – Initiate with Buy; target price of ` 73 (upside of 15%) We have a positive view on the two wheeler industry and expect industry to grow at healthy CAGR of 15% over next two years (with an upward bias). The new found aggression in the company’s business strategy and higher contribution from high margin businesses offer favorable return on our valuations. We expect TVS’s net revenue to grow at a CAGR of 19% higher than the volume CAGR of 15% over the next two years. We forecast company to post a robust 33% CAGR in its Adjusted NPAT. Given strong cash flow and return profile and lower capex requirements in near term we forecast TVS to be net cash by FY14. We expect TVS to trade at relatively lower discounts (25%) than it has been trading over past three years (39%). At CMP of ` 63/share, it is trading at 12.1x and 8.7x FY12E and FY13E earnings respectively at a discount to HMC. Hero Motocorp – Initiate with Sell; target price of ` 1,920 (downside of 13%) We expect two-wheelers to grow at 15% in FY12E and sales volumes to moderate in FY13E. We expect the executive segment, bread and butter segment for HMC, to be most competitive segment as OEM’s launch new models and upgrades to retain buyer interest and expect margins to squeeze. We expect stiff competition from BAL and TVS in the domestic markets (no to forget HMSI’s inceasing capacity) going forward and expect HMC’s growth to moderate. Moreover, we do not envisage higher payout ratio as seen in past two years due to higher cash requirement for HMC in the medium term. HMC has outperformed both Index and peers in last one month and currently trades at more than 30% premium to its three year mean P/E (based on core earnings) and looks expensive on the risk-reward front. At CMP of ` 2,206/share, it is trading at 21.0x and 17.8x FY 12E and FY 13E earnings.

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Valuation Methodology The valuations of the BAL and TVS look attractive on our numbers with P/E multiple at a discount of 25-50% respectively to HMC. On a 12-month view, we forecast 15-16% upside to our target prices for BAL and TVS. Despite outperforming the index for past few months, we believe the long-term outlook for the companies remain sound and expect valuations to expand. Valuation methodology The domestic two wheeler industry is highly concentrated with top three listed players holding more than 80% of the market. We thus value these companies based on relative valuation as against the absolute valuation as we believe these companies should trade at comparable multiples as companies moves through different stages of the business cycle. Further, the two wheeler industry is characterized by high margins and profitability (as compared to other players in the automobile industry), typically negative working capital, lower capex intensity (low maintenance capex) converting into extremely strong cash flows at company’s disposal. We therefore apply our benchmark multiple to the core earnings of the company (before earnings on the cash and cash equivalents) to arrive at the operational value of the company. To this, we add net cash in the books as at last reporting date to arrive at the fair/intrinsic value of the company. Target price assumptions We use HMC’s P/E multiple to core earnings (mean of last three years) as the benchmark as it is the market leader with ~45% share in the domestic markets, has a long history in the domestic two wheeler industry and is therefore an apt representative of the two-wheeler industry. We however apply premium and discount to the benchmark P/E multiple as we take into account several factors which we believe are imperative to the two wheeler industry (discussed below). Our target price valuation uses the forecasted core earnings for FY13. We define core earnings as adjusted NPAT before interest income on current investments (adjusted for tax). This gives us the operational value of business to which we add net cash in the books as at last reporting date to arrive at the fair/intrinsic value per share. We have derived the standalone valuation for the companies using HMC’s long term P/E multiple as benchmark. We however apply premium and discounts to the benchmark ratio on several factors which we believe have changed over the period and should flow through the valuations. We value these companies after considering the following factors: Table 14: Factors influencing valuations

FY 2006-11 FY 2011-13E#

HMC BAL TVS HMC BAL TVS

Volume growth 12% 10% 9% 14% 16% 15%

Exposure to exports Negligible High Low Negligible High Medium

Susceptibility to competition Low Medium High High Medium Medium

Margin performance 14.0% 16.8% 5.2% 11.1% 19.2% 7.2%

Adj. NPAT growth 15% 20% 11% 11% 13% 33%

Free cash flow growth 41% 25% NA 5% 24% 52%

Conclusion Strong Moderate Weak Weak Strong Moderate

Premium/Discount to Benchmark Premium Discount High Discount Nil to Discount Premium Less Discount

Source: Company data, MSFL Research, # - MSFL forecasts and expectation We initiate coverage on BAL (Buy) at a TP of ` 1,893, TVS (Buy) at a TP of ` 73 and HMC (Sell) at a TP of ` 1,920.

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We value BAL’s standalone business at 16.2x FY13E core earnings, a premium of 5% to HMC’s three‐year mean P/E (based on core earnings), as BAL’s business model has undergone positive changes, in our view, and clearly scores the highest on the factors considered above. This gives us standalone value of ` 1,874/share (including cash per share of ` 145/share). We value the company’s strategic investments in KTM at 25% discount to its current market cap (valuing at ` 18/share) and investment in BAI at current BV (valuing at ` 1/share). Our one year target price based on SOTP valuation is ` 1,893/share with an potential upside of 16%. At our target price, the company is expected to trade at 17.5x and 15.3x FY12E and FY13E earnings respectively. We value TVS standalone business at 11.6x FY13E core earnings, a discount of 25% to HMC’s three‐year historical mean P/E (based on core earnings). The discount applied is lower than what the company has been trading in past three years on average (39% discount) as we see a transformation in the company’s business model (higher exports and three wheeler contribution) and higher profitability. The multiple gives TVS standalone business a value of ` 84/share from which we deduct net debt of ` 14/share as on last reporting date thus giving valuation of ` 71/share. We value companies strategic investment in Indonesian subsidiary at ` 2/share. Our one year target price based on SOTP valuation comes to ` 73/share with an potential upside of 15%. At our target price, the company is expected to trade at 13.9x and 10.0x FY12E and FY13E earnings respectively. We value HMC’s standalone business at 15.4x FY13E core earnings, which is in line with HMC’s three‐year historical mean P/E (based on core earnings). We do not give any premium valuation to HMC as the company underscores to its peers on most of the points (except strong volume traction). However, we expect strong competition from BAL and TVS in the domestic markets (no to forget HMSI’s increasing capacity) and expect HMC’s growth to moderate. Moreover we do not envisage higher payout ratio as seen in past two years due to higher cash requirement for HMC in the medium term (two new manufacturing facilities, R&D set-up and higher expenditure on export business). HMC has outperformed both Index and its peers in last one month and currently trades at more than 30% premium to its three year mean and we believe that on the risk-reward scenario it looks expensive. The multiple gives us fair value of ` 1,920/share (including cash per share of ` 257/share). At our target price, the company is expected to trade at 18.3x and 15.5x FY12E and FY13E earnings respectively.

Initiate Hero MotoCorp with Sell rating, TP - ` 1,920

Initiate TVS Motors with Buy rating, TP - ` 73

Initiate Bajaj Auto with Buy rating, TP - ` 1,893

MSFL Research

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Appendix Table 15: Industry growth assumptions

Domestic FY 2009 FY 2010 FY 2011 FY 2012E FY 2013E 2 yr CAGR

Scooters 1,145,798 1,462,547 2,073,797 2,552,025 2,952,164 19%

% y-o-y 14% 28% 42% 23% 16%

Motorcycles 5,835,145 7,341,133 9,020,964 10,394,745 11,654,728 14%

% y-o-y 1% 26% 23% 15% 12%

Mopeds 431,214 564,584 697,418 809,000 910,000 14%

% y-o-y 0 31% 24% 16% 12%

Total Domestic 7,437,670 9,371,265 11,792,179 13,755,770 15,516,891 15%

% y-o-y 3% 26% 26% 17% 13%

Exports 1,004,174 1,140,184 1,539,590 1,858,000 2,185,000 19%

% y-o-y 23% 14% 35% 21% 18%

Industry Volumes 8,441,844 10,511,449 13,331,769 15,613,770 17,701,891 15%

% y-o-y 25% 27% 17% 13%

Source: SIAM, Company data, MSFL Research

Market share charts

Exhibit 48: Scooters - Domestic Exhibit 49: Scooters - Export

-10%

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2006 2007 2008 2009 2010 2011 YTD 2012

Hero Honda TVS Honda - ScooterMahindra Suzuki

-10%

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2006 2007 2008 2009 2010 2011

Hero Honda TVS Honda - Scooter Mahindra

Source: SIAM & MSFL Research

Exhibit 50: Motorcycle - Domestic Exhibit 51: Motorcycle - Export

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2006 2007 2008 2009 2010 2011 YTD 2012

Bajaj Auto Hero HondaTVS Honda - MotorcycleYamaha

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2006 2007 2008 2009 2010 2011 YTD 2012

Bajaj Auto Hero HondaTVS Honda - MotorcycleYamaha

Source: SIAM & MSFL Research

MSFL Research

35

Exhibit 52: Total two wheelers - Domestic Exhibit 53: Total two wheelers - Export

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2006 2007 2008 2009 2010 2011 YTD 2012

Bajaj Auto Hero HondaTVS Motor HondaYamaha

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80%

2006 2007 2008 2009 2010 2011 YTD 2012

Bajaj Auto Hero Honda TVS Motor

Honda Yamaha

Source: SIAM & MSFL Research

Exhibit 54: Three wheelers (PC) - Domestic Exhibit 55: Three wheelers (PC) - Export

0%

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2005 2006 2007 2008 2009 2010 2011 2012

Bajaj TVS Piaggio M&M

0%

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40%

60%

80%

100%

120%

2005 2006 2007 2008 2009 2010 2011 2012

Bajaj TVS Piaggio

Source: SIAM & MSFL Research

Exhibit 56: Three wheelers (GC) – Domestic Exhibit 57: Three wheelers (GC) - Export

0%

10%

20%

30%

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2005 2006 2007 2008 2009 2010 2011 2012

Bajaj Piaggio Atul Auto

M&M Scooters India

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40%

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60%

70%

80%

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100%

2005 2006 2007 2008 2009 2010 2011 2012

Bajaj Piaggio M&M

Source: SIAM & MSFL Research

MSFL Research

36

Company Section

[Type text]

MSFL Research

Institutional Business Group, MSFL @p-sec, 306, Gresham Assurance House, 132, Mint Road, Fort, Mumbai – 400 001 India

Tel + 91 22 22690474 / 75 www.marwadionline.com

Full throttle!! – our top pick of the lot

Summary Financials ` in Mln FY10 FY11 FY12P FY13P

Net Sales 119,210 166,089 201,948 230,101

EBITDA 25,926 33,849 38,595 44,535

Net Profit 17,036 33,397 31,344 35,695

Reported EPS 62.8 97.4 108.3 123.4

Networth 29,283 49,102 63,518 80,592

Debt 13,386 3,252 3,052 2,852

Fixed Assets 15,211 15,483 16,785 17,732

Net Current Assets -12,740 -10,827 -4,961 966

BUY CMP ` 1,627 Target Price ` 1,893 Upside Potential 16%

Price Performance 52 wk Hi/Lo 1695/1166 All time Hi/Lo 1695/131 6 month Average Vol 405097 Stock Beta 0.76

Valuation FY11 FY12E FY13E

P/E (x) 16.5 14.9 13.1 P/BV (x) 9.5 7.3 5.8 RONW (%) 53 49 44 ROCE (%) 76 72 66

Peer Valuation – FY12E Hero TVS Mot PE 21.0 12.1 P/BV 10.9 2.6

Equity Data Market Cap. (` bln) 470.9 Face value (`) 10 No of shares o/s (mln) 289

Jun’10 Jun’11 ∆% Promoters 49.65 50.02 0.75 DFI's 6.06 8.10 33.66 FII's 18.58 15.80 -14.96 Public 25.71 26.08 1.44

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Bajaj Auto BSE Auto

We believe Bajaj Auto with its current motorcycle portfolio, brand building exercise over past few years and its strategy of focusing on the premium bike segment is reaping rich rewards. It has new launches lined up across vehicle portfolio including a new Pulsar in Q4 FY12. We forecast BAL’s net revenue and adjusted NPAT to grow at a CAGR of 18% and 13% respectively over the next two years. We expect margins to remain strong at 19-20% driven by superior product mix, higher excise tax benefits from the Pantnagar plant and softening commodity prices. Our one year target price stands at ` 1,893/share (upside of 16%). We initiate coverage with a Buy rating.

Domestic motorcyle business – strengthens further BAL’s business model is well diversified and earns more than 45% of its revenue from ex-domestic two wheeler markets. The company has launched Boxer 150cc (positive initial reaction) in the entry segment and plans to launch a new Pulsar in 4Q FY12 which will reinforce its dominance in the premium segment in our view. It is also targetting the super-bike segment with KTM and Kawasaki Ninja bikes. We forecast BAL to record domestic volume CAGR of more than 15% over FY11-13E.

Export business – it never looked better! BAL is the largest exporter of two and three-wheelers and we expect it to maintain excellent growth in the export market. We expect company to register robust growth of overall 24% in FY12 (23% in 2W and 27% in 3W). The company plans to leverage KTM & Kawasaki’s global distribution network to expand further in new geographies. We don’t expect DEPB withdrawal to have a major impact on margins as the company has decided to increase prices after Sept-11 to compensate for the shortfall in new scheme. We expect export volumes in 2H FY12 and to some extent in FY13E to be slightly impacted as a result of the pricing action but maintain our overall positive stance.

Three wheeler – a cash cow We expect overall three-wheeler sales to grow 19% to 520,000 units in FY12E on the back of easing capacity constraints (four stroke engines), strong demand visibility with opening of permits in various states and robust exports. The three-wheeler business does not contribute >10% to BAL’s FY12E revenues but yields highest EBITDA margin (c30%) and increasing three wheeler sales results in higher profitability in absolute terms. BAL is in process to extend its three-wheeler platform and plans to design a four-wheeler vehicle to be launched in 3Q FY13 (not included in valuation).

Initiate with Buy, TP of ` 1,893 (upside of 16%) We value BAL’s standalone business at 16.2x core FY13E earnings, at a premium of 5% on HMC’s three year historical mean P/E (based on core earnings). We have valued BAL’s strategic investments at ` 19/share. Our SOTP based TP for BAL stands at ` 1,893 with an upside potential of 16%. We initiate coverage with a Buy rating. Risks to valuation are slowdown in key business segments and irrational competition while key catalysts higher than expected growth in the super-bike segment and higher payout ratio.

Initiating Coverage Bajaj Auto Ltd.

Ronak Sarda ronak.sarda@msflibg.in (+ 91 22 3094 7135)

Shyamal Dhruve shyamal.dhruve@msflibg.in September 21, 2011

MSFL Research

38

Executive Summary We believe BAL with its current vehicle portfolio (higher three wheeler contribution), brand building exercise over past few years and its strategy of focusing on the premium motorcycle segment is reaping rich rewards. We expect export markets to register strong growth even after DEPB withdrawal. With upside potential of 16% to our target price, we initiate with a Buy rating. BAL’s business model is well diversified and earns more than 45% of its revenue from ex-domestic two wheeler markets which in our view insulates its earnings from slowdown observed in any particular segment. We forecast BAL’s domestic two wheeler sales to grow at 16% in FY12E as it ramps up its production from Pantnagar plant and new launches (Boxer 150cc and a Pulsar) further cement its position in the domestic motorcycle industry. We expect BAL’s sales mix to improve further as we expect its premium segment to grow faster than the executive segment. BAL, in the domestic motorcycle market, is focusing on all price points through two key brands – Discover and Pulsar. The former is targeted at the average Indian commuter, while the latter at performance driven buyer who also rides motorcycles for the thrill and adventure. BAL is also targeting the super premium segment through the renowned KTM and Kawasaki - Ninja brand. BAL plans to launch next generation version of its star brand Pulsar (rumored to be a 250cc sport bike) with design expected to be inspired from KTM’s technology. BAL and KTM will launch its first 200-cc Duke super bike developed at BAL’s manufacturing unit early next year. BAL currently has two products in the super bike category with its JV partner Kawasaki – the Kawasaki – Ninja 250R and a Kawasaki – Ninja 650R. We expect overall three-wheeler sales to grow 19% to 520,000 units in FY12E on the back of easing capacity constraints (four stroke engines), demand visibility with opening of permits in various states and robust exports. The domestic three-wheeler business does not contribute >10% to BAL’s FY12E revenues but yields highest EBITDA margin (c30%) and increasing three wheeler sales results in higher profitability in absolute terms. BAL is in process to extend its three-wheeler platform and plans to design a four-wheeler vehicle which is expected to be launched in 3Q FY13. BAL is India’s largest exporter of two and three-wheelers and continues to maintain excellent growth in the export market. We expect company to register robust growth of overall 24% in FY12 (23% in 2W and 27% in 3W), higher than management expectation of 20%. The company plans to leverage KTM & Kawasaki’s global distribution network to grow further in new geographies of Europe & Americas. We don’t expect DEPB withdrawal to have a major impact on margins as the company has decided to increase prices after Sept-11 to compensate for the shortfall in new scheme. We expect export volumes in 2HFY12 and to some extent in FY13E to be impacted as a result of the pricing action but maintain our overall positive stance. BAL plans to increase its penetration in the rural markets by boosting up its dealer network. The company increased its dealership network by 159 dealers in FY 2011, of which about 55-60% would be in areas where the company did not have any presence earlier. It has also set up focused “Bajaj Pro-biking Showrooms” in the major cities to support sales of the premium motorcycle segment. BAL has, over the period, systematically invested in building its internal R&D capabilities as a key competitive strength for over last decade. BAL’s tried & tested R&D set up and technology partnerships with KTM and Kawasaki are its key competitive advantage. We expect BAL’s net revenue to grow at a CAGR of 18% more than the overall volume CAGR of 16% and adjusted NPAT to record a CAGR of 13% over the next two years. We expect margins to hover around 19-20% driven by superior product mix, increasing excise tax benefits from the Pantnagar plant and softening commodity prices. We value BAL’s standalone business at 16.2x FY13E core EPS (before earnings on the cash and cash equivalents), at a 5% premium to HMC’s three year mean P/E (based on core earnings), as BAL’s business model has undergone positive changes in our view (see table below). Our TP based on SOTP valuation for the company is ` 1,893/share. At a CMP of ` 1,627/share, BAL is trading at 15.0x and 13.2x FY 12E and FY 13E earnings respectively at a discount to HMC.

Diversified business model and superior sales mix

Focused strategy - Discover and Pulsar across price points. Strengthens position in super-bike segment through KTM and Kawasaki-Ninja brand

Three wheeler business – a cash cow

Exports business to sustain momentum after DEPB

Increasing dealer network to boost sales Strong R&D setup a key advantage

Buy with TP of ` 1,893-upside of 16%

MSFL Research

39

Table 1: Factors influencing valuations

FY 2006-11 FY 2011-13E#

HMC BAL HMC BAL

Volume growth 12% 10% 14% 16%

Exposure to exports Negligible High Negligible High

Susceptibility to competition Low Medium High Medium

Margin performance 14.0% 16.8% 11.1% 19.2%

Adj. NPAT growth 15% 20% 11% 13%

Free cash flow growth 41% 25% 5% 24%

Conclusion Strong Moderate Weak Strong

Premium/Discount to Benchmark Premium Discount Nil to Discount Premium

Source: Company data & MSFL Research, # - MSFL forecasts and expectation Risk factors are failure of launches, lower than expected demand in domestic & overseas markets, higher than expected competition or irrational price competition and low than expected return on strategic investments. Key catalysts higher than expected growth in the super bike segment, successful launch of the four wheeler vehicle and higher payout ratio (increasing dividend yield). Our forecasts for the company are higher than consensus on all the three accounts as we remain confident of company’s strong business model and cost stucture. Our forecast at EBITDA levels are ahead of consensus as we factor in higher excise benefits from Pantnagar plant. While lower depreciation charges and higher yield on investments increase our EPS forecasts. Table 2: MSFL Forecasts v/s Consensus

FY12E FY13E

Particulars (` mln except per share data)

MSFL forecasts

Consensus % chg MSFL

forecasts Consensus % chg

Revenues 201,948 195,025 4% 230,101 223,835 3%

EBITDA 38,595 37,701 2% 44,535 42,335 5%

EPS 108.3 102.5 6% 123.4 115.0 7%

Source: Company data, Bloomberg & MSFL Research

Key Risk & catalysts to valuation

How we differ from consensus

MSFL Research

40

Diversified business model BAL’s business model is well diversified and its dependence on any one segment is low. It earns more than 45% of its revenue from ex-domestic two wheeler markets which in our view insulates its earnings from slowdown observed in any particular segment. So while domestic market growth is expected to moderate after two years of high growth, buoyant exports and rapid expansion in new geographies are expected to maintain earnings momentum. We forecast company to earn 56% of sales from domestic 2-wheelers, 10% from domestic 3-wheelers, 28% from exports and balance from sale of spares in FY12E.

Exhibit 1: Revenue Mix – FY12E Exhibit 2: Domestic 2W sales and growth (% RHS)

Domestic Motorcycle,

56%

Domestic three

wheeler, 10%

Exports, 28%

Spare sales, 6%

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FY07 FY08 FY09 FY10 FY11 FY12P FY13P

Domestic Two-wheeler sales % y-o-y

Source: Company data & MSFL Research Stable growth in domestic motorcycles We expect the domestic two-wheeler industry to grow at a moderate rate of 15% CAGR from FY11-13, after a period of high volume growth of over 25% in FY10-11, driven by high growth in the >125cc segment. We forecast BAL’s domestic two wheeler sales to grow at 16% in FY12E as against 10% seen in YTD12. Q1 is traditionally a weak quarter for BAL and the host of new launches planned in the year should pick up sales. BAL has successfully created a brand for its Pulsar and Discover vehicles and we expect the company to hold on to its current domestic two-wheeler market share despite a higher level of competition. The company has launched Boxer 150cc (positive initial reaction) in the entry segment and plans to launch a new Pulsar in 4Q FY12 which will reinforce its dominance in the premium segment in our view. The company has also come up with financing support schemes through its grop company Bajaj Finserve (BAF). About 30-35% of the company’s sales are funded by loans, of which BAF financed almost 20% in FY11. The company has a target of funding c50,000 motorcycles per month from BAF (I.e. 20% of target sales). To support demand, BAL has initiated special finance schemes like loans offered by BAF with direct cash collection facility in rural areas to induce buyers to purchase motorcycles through loans. Product Mix - Motorcycle BAL’s product mix underwent a significant change in last 5 years with the company exiting the scooter segment (where it once enjoyed pole position) and now focusing on its twin brand strategy of Pulsar and Discover in the motorcycle segment. BAL was one of the worst affected manufacturers during the slowdown in the 2008 and 2009 with domestic two wheelers volumes falling more than 20% in the domestic market and scooters sales drying up. It lost significant market share to Hero Honda in that period falling from 26.8% in FY2007 to 17.3% in FY2009. It however it gained back half of the market share to 20.5% in FY11 with launch of Discover 100cc bike 1Q FY10 (see chart) and a Pulsar variant later in the year. It clocked more than 100% growth in FY10 in the sub 125cc bike segment on the back of success of its Discover 100cc.

MSFL Research

41

Exhibit 3: Domestic 2W market share Exhibit 4: Domestic motorcycle – sales mix

15%

17%

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27%

29%

2006 2007 2008 2009 2010 2011

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FY09 FY10 FY11 FY12P FY13P

<125cc 125cc - 150cc

Source: SIAM & MSFL Research

This we believe was an inflection point in the domestic two wheeler industry as consumer preference shifted from fuel efficient bikes to more stylish and power bikes. From FY 2008, the share of entry level segment fell from 31% to just 17% in FY 2011. BAL further strengthened its product portfolio by launching Discover 125cc in April 2011 to induce buyers to step away from the traditional 100cc bikes. This shift from entry level segment to premium level segment and BAL’s strategy on focusing on its successful twin brand of Discover and Pulsar gives it an edge over its competitors who are still establishing their products in this segment. The current monthly run rate of the Discover and Pulsar series is about 135,000 and 75,000 respectively and it contributes to more than 70% of BAL’s total motorcycle sales. Boxer 150cc – the Bharat bike The company launched the Boxer 150cc model, a low range multipurpose vehicle targeting rural customers, in August 2011. As per management, the bike will provide benefits of 150cc bike at cost of 100cc bike i.e. higher power and durability suitable for the rural conditions. It feels Boxer will not cannibalize market share of the Discover series though some overlap is unavoidable as Boxer is made for a completely different market segment albeit priced similar to the Discover 100cc model. Boxer is quite a popular brand in the African markets and the company plans to replicate the success story in the Indian rural markets. If successful, it will create additional segment and be another growth driver for the company. BAL will progressively launch the model in India and we forecast a monthly rate of 10,000 bikes per month initially (sales of 9,000 motorcycles in the month of launch) and 15-18,000 bikes per month as its acceptability in the market increases. We also note that market concern over dilution in margins due to Boxer being launched is overdone. We do believe it to be margin dilutive as far domestic two wheeler segment is concerned however it adds to profitability on absolute basis with very low incremental capital invested (thus superior return ratios). Moreover the share of 2W domestic is expected to be 56% and thus impact of margins dilution will be very low (we estimate – 0.3%-0.5% dilution in margins). Focused strategy on twin brands… BAL is focusing on all price points beyond ` 40,000 through two key brands – Discover and Pulsar. The former is targeted at the average Indian commuter, while the latter at performance driven customer who also rides motorcycles for the thrill and adventure. Discover is more of a mass motorcycle and is lower margin product than Pulsar however company believes it relatively earns higher margins than its peers. Pulsar – priced mostly at + ` 65,000 yields superior margins (c20%) and enjoys superior pricing power owing to the brand name and the target consumer segment. This is evident from the fact that in FY08, when the industry declined ~8%, the premium segment actually grew 14%.

MSFL Research

42

…Across price segments The key differentiating point between BAL and its competitors is that it focused creating a strong brand name and then offering these successful brands with price steps rather than developing its product lines. This in our view not only results in cost savings in term of branding expenditure but has also created brand awareness or positioning in mind of customers (and thus brand loyalty). The management said that it will continue to focus on building its existing brand and carving market for its product. It reiterated that it has no plans to enter back in the scooter segment. Exhibit 5: Domestic motorcycle portfolio – across prices segments

30,000

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110,000

Source: Company data & MSFL Research, *-expected in Q4 FY12 New Pulsar on the horizon BAL plans to launch next generation version (rumored to have a 250cc engine) of its star brand Pulsar in a totally new avatar. This launch will fill the only void seen in its motorcycle portfolio and will directly compete with Honda and Hero Honda in that segment. Its design is expected to be based on the styling of latest Pulsar 135 LS (light sports) variant and cues will be taken from Bajaj’s Austrian partner’s KTM. The new Pulsar is expected to be bigger, more technologically advanced engines, a totally reworked chassis-suspension, fatter rubber, a mono-shock and totally reworked styling. BAL has been aggressively marketing its Pulsar brand saying it sells 5 times than that of Japanese bikes to set up a platform for the new launch. We expect the launch to reinforce company’s strong hold in the domestic premium motorcycle segment and open new avenues in the domestic industry. New focused product launches BAL is also targeting the super premium segment which we believe are the next generation bikes through the renowned KTM and Kawasaki - Ninja brand. As per the management, the super bike market can be categorized in 3 product and price spectrums – up to 3lacs (less than 250cc), 3lacs to 8lacs (>250cc and less than 100cc) and above 8lacs (>1000cc). This segment currently has products from the unlisted Japanese players like Yamaha, Suzuki and Honda. The motorcycles are currently brought in India through the CBU (Completely built unit) route and attract high import duties (nearly 110%). This results in high prices for the motorcycles creating a psychological barrier for domestic buyers. BAL will have a first mover advantage, bikes manufactured in India (components will be imported in CKD form and assembled in BAL’s facility) which results in low end product prices. It has also set up focused “Bajaj Pro-biking Showrooms” in the major cities for sales of these models and spare parts (including accessories). It has 32 such centers currently to cater to the demand for these vehicles. We though believe it is too early to envisage strong traction for these models in the domestic markets, however with growing income levels in the urban India and demographic advantage, the company will be able to gain significant market share as compared to its listed peers in medium term. Also, this segment will be driven by lower volumes but will enjoy higher margins (vehicle sales and spare sales). This in our view gives the company a striking advantage over its domestic peers.

MSFL Research

43

KTM sports motorcycles BAL and KTM will launch its first 200-cc Duke super bike developed at BAL’s manufacturing unit at the Auto Expo to be held early next year. It expects to sell 25,000 to 30,000 units in India in the first year of launch. After one year, its plans to launch the 350-cc Duke in India. These will mark the launch of sports bike specially crafted for Indian customers and domestic market conditions in the ` 1lac to ` 3lac price range. We expect that the KTM brand will unlock higher value in the domestic markets. This will be the first of its kind bikes specially designed for Indian markets and consumer segments which has been hitherto untouched by any Indian player. Kawasaki – Ninja series already doing well BAL has two products in the traditional super bike category with its JV partner Kawasaki – the Kawasaki – Ninja 250R and a Kawasaki – Ninja 650R. Both are in the different price and customer segments, one in the less than 3lacs and the other in 3-8lacs. The bike will be brought to India via the CKD (Complete Knocked Down) route and assembled by BAL at its Chakan facility. The newly launched Ninja 650R, on the back of success of its sibling Ninja 250R, has received good response. The company targets around 30-40 Ninja 650R per month. The Ninja 250R launched last year has crossed the 1,500 sales mark within a year. It will also try to bring in localization and certain components manufactured in India to maintain the cost advantage without discounting on the quality aspect.

MSFL Research

44

Three wheeler business – a cash cow We expect three-wheeler sales to grow 10% to c226,500 units in FY12E on the back of easing capacity constraints (four stroke engines) and demand visibility with opening of permits in various states. Increasing substitution of old petrol/diesel three wheelers with CNG based engines is also a major driver for growth. We believe the company will be able to clock stable growth irrespective of additional permits coming from State government through higher replacement demand (15,000 units pm, management estimates).

Exhibit 6: Domestic 3W sales & growth (% RHS) Exhibit 7: 3W market share

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PV mkt share GV mkt share

Source: Company data, SIAM & MSFL Research BAL is the dominant player in the domestic three-wheeler segment, especially in the passenger segment. This segment accounts for 98% of Bajaj’s domestic 3 wheeler sales. The three wheeler domestic market has grown at a CAGR of 16% over FY2005-11 against BAL growth of 8% in the same period. BAL lost significant market share due to capacity constraints at its operations and stiff competition from other players. Its market share fell from 76% in FY05 to 48.5% in the first quarter of the financial year. But with increased capacity in hand, we expect it to increase its market share in the near term. In the past, the passenger segment has been a permit dependent market, with most sales being replacement sales, and fresh sales driven by issuance of new permits. As a result of this, volume growth in this business typically occurs in spurts and has been largely unpredictable in the past. States of Karnataka and Gujarat had opened permits in FY11 and going ahead, we expect other states to follow suit. The domestic three-wheeler business does not contribute >10% to BAL’s FY12E revenues but yields highest EBITDA margin (c30%) and increasing three wheeler sales results in higher profitability in absolute terms. The return ratios for three wheeler segment is higher than 110% on our calculation and we believe this increases the importance of three wheelers in the company’s portfolio from view of competition, especially when there is substantial pressure on margins in other segments. Table 3: Robust returns on 3W business (assuming 100% utilisation)

Average realisation 110,000 Capex 20,833

EBIT margin 26% WC requirement (days) (9)

EBIT / vehicle 28,600 WC per unit -2,712

Tax rate 28% Capital employed 18,121

NOPAT (EBIT - tax) 20,592

ROCE (%) 114%

Source: Company data & MSFL Research

MSFL Research

45

Goods Carrier Segment (Cargo) loosing charm… The 3W goods carrier segment has long lost the charm as preferred short distance goods transporter and the segment sales have declined over the period from FY 2005 (CAGR of –ve 5%). The key reason has been the launch of ultra light commercial vehicles (ULCV) such as Tata Motors Ace family and M&M’s Maxximo and Gio. The three‐wheeler goods segment contributes 1% of BJAUT’s three‐wheeler sales. The growing acceptance of ULCVs has resulted in a CAGR of 19% in light commercial vehicle (LCV) segment sales over FY07‐FY11. …BAL to innovate – remain an upside risk to valuation BAL is in process to extend its three-wheeler platform and plans to design a four-wheeler vehicle. The vehicle is expected to be launched by 3Q FY13. While management is tightlipped over its project, it says the new product will be better looking, more spacious, comfortable and much more fuel efficient than the current range of three-wheelers. We currently do not value the project due to unavailability of tangible information, however presents an upside risk to our valuations. It will use the same four wheeler platform, which the company is currently building, for manufacturing low cost car likely to be launched jointly by Nissan/Renault and BAL.

MSFL Research

46

Exports markets continue to outperform… BAL is India’s largest exporter of two and three-wheelers and continues to maintain excellent growth in the export market. In FY11, the company exported 1.2mn vehicles – representing a growth of 35% over the previous year. Exports sales were ` 45,520mln (US$ 974.6 million), which accounted for 27% of the company’s gross sales. It has set up a target of 2mn vehicle sales in exports over next three - four years. We expect company to register robust growth of overall 24% in FY12 (23% in 2W and 27% in 3W), higher than company guidance of 20% partially offsetting slight slowdown in the domestic markets. Exhibit 8: BAL’s export destinations

Source: Company data BAL export market is spread across geographies with Africa & Middle East accounts for 48% of export sales, South Asia (excl India) - 28% Latin America – 17% and South East Asia – 9%. It has put in place strategy for specific markets and has clearly benefitted from the same. Exhibit 9: Export mix by destination

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Africa & Middle East

South Asia (excl. India)

Latin America South East Asia

FY08 FY11

Source: Company data & MSFL Research

MSFL Research

47

Two wheelers BAL motorcycle exports have grown at a CAGR of 41% over FY 2006-11 to 1mn units motorcycles. Earlier, the product mix was skewed more towards the entry level motorcycles primarily sold in the African continent. However with its entry into new geographies, the sales of more than 125cc bikes have caught up and have resulted into higher realisations. Gross realisation for BAL’s export sales are higher than gross realisation for HMC’s domestic sales thus converting into higher margins.

Exhibit 10: 2W Export sales and growth (% RHS) Exhibit 11: Export 2W sales mix

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FY07 FY08 FY09 FY10 FY11 FY12P FY13P

> 125cc < 125cc

Source: Company data & MSFL Research It sells entry level bikes (Boxer and CT100) in less developed African markets where bikes are used for public transportation and not personal commuting. It faces stiff competition from low cost Chinese bikes in this market. However over the period, BAL has emerged as a superior product in terms of fuel efficiency and durability, helping BAL garner significant market share from the Chinese. BAL now sells Boxer bikes at premium to Chinese bikes as compared to similar price level. The company sells almost 45,000 Boxer brand motorcycles per month in Africa. With increasing acceptability and thus penetration levels in the key Nigerian markets, the company now plans to enter other African countries namely Uganda, Kenya, and Tanzania which will be key growth areas for future periods. It sells Discover and Pulsar family bikes in the Latam and other Asian countries which have affordability levels similar to India. In FY11, sales in South Asia touched a new high with Sri Lanka and Bangladesh recording growth of 76% and 34% y-o-y respectively. The Latin American markets bounced back, with Colombia and Central America showing a major recovery in FY11. Overall growth in the region was 47%. These markets are dominated by Japanese companies like Honda, Suzuki and Yamaha. It targets the developed economies of Europe with KTM 125cc super bikes developed at its Waluj plant. Strategic investment in KTM Sports – Austria BAL has invested over ` 9,000mln over the last few years in purchasing 39.71% stake of KTM Power Sports a listed entity in Austria. KTM is a niche European motorcycle producer, which manufactures high end off-road and street motorcycles. BAL’s intent on becoming a motorcycle specialist is synonymous with its decision in buying equity stake in KTM. The two companies are jointly developing a new range of water cooled engines, which can be used in the next generation bikes (125 cc bikes to 200cc/300cc bike). It has already launched KTM Duke 125cc bike fully manufactured in its Chakan plant for the European markets (bike has received great response). It will further leverage KTM’s distribution network to gain market share in those markets. The management has indicated that the company will likely increase its investment to 49% with Cross Industries (holding company) retaining the majority stake of 51%. We believe this step will put in place a definite strategy for the next generation super bikes similar to its Japanese peers but at lower price tag suitable for the Indian markets. We expect future growth will be led by the entry into new markets such as

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Argentine (in a year), Brazil (in 2-3 years) and exploiting Kawasaki’s and KTM’s global network. It also plans to introduce the Discover and the Pulsar brand in the African countries as the level of disposable income increases and there is a shift in the consumer spending pattern. We value the investment at ` 18/share at 25% discount to KTM’s CMP due to exposure to slowing European markets & significantly high gearing. The company has been able to turnaround its operations and record cash profits in last quarter. It has given an upbeat outlook for the company despite challenging macro environment and remains an upside risk to valuation.

Untimed investment in Indonesia subsidiary.. PT BAI was incorporated in FY2007 as a subsidiary in Indonesia with a share capital of US$ 12.5 million. Bajaj Auto added further capital by US$ 17 million in FY10 and increasing its stake to 98.9% in PT BAI. The total investment in PT BAI stands till date at US$ 29.5 million (1,378mln). The subsidiary assembles and markets Pulsars in Indonesia. It sold 21,586 motorcycles in FY11 a growth of 81% y-o-y. Loss for FY2011 was down to ` 112mln as compared to a loss of 159mln in FY10. Considering continuing losses and longer than anticipated gestation period (due to higher competition faced by Japanese players) BAL determined an impairment amount of ` 1,023 mln as a diminution in the value of investment by taking a hit in P&L account in FY10.

…things are changing though The product requirement in Indonesia is totally different from that seen in India. The market is dominated by step-throu’s and the management feels that increasing awareness and dealer network will support sales for Pulsar. The company has plans to increase the number of sales & service show rooms from 84 to 130 in the current year. It also introduced Pulsar 220 in 1Q FY12 and the vehicle is receiving good response. We value the investment at just ` 1/share due to high gestation period and continuous losses, but remains an upside risk to valuation.

Three wheelers – momentum strong BAL three wheeler exports have grown at a CAGR of 25% over FY 2006-11 to nearly 2.3 lakh units and accounts for more than 85% of total three wheelers exported from India. It primarily exports passenger vehicles and negligible amount of goods carrier.

Exhibit 12: 3W export sales and growth (% RHS)

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Source: Company data & MSFL Research

Most of its exports are to SriLanka, Bangladesh and Egypt, followed by Guatemala, Peru and Mexico. SriLanka exports have grown post the breakup of the LTTE. It has close to a 90% market share in Sri Lanka, which accounts for about 40% of its exports in this segment. 3W exports are also expected to increase to Africa. BAL faced capacity constraints for their three wheeler exports due to unexpected demand for 3W in the domestic markets (opening of permit in few states) but it expects these constraints to normalize in FY12 with increase in total 3W capacity to 5,40,000 units. Going forward, we expect Bajaj to maintain a market share of higher than 85% till FY13.

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….DEPB scheme withdrawal may dampen demand The current status of DEPB scheme is that the scheme shall be withdrawn by Sep 2011 and will be replaced by a Duty Drawback scheme (DDS) with rates of drawback (5.5%) lower than originally received under DEPB scheme of 9%. We have removed DEPB entitlements from our forecasts and replace them with DDS rates of 5.5% going forward. On our forecasts, it earns c30% of its revenues from exports and expect company’s operating margins to be hit by 60bps for FY12E. BAL plans to pass on the impact of lower rates through the supply chain i.e. onto buyers and distributors. The company has decided to increase prices after Sept-11 to compensate for the withdrawal of DEPB. The high traction seen in the export markets must have been partly due to some stocking made by distributors before the deadline of 30th Sep 2011 with uncertainity on the applicability of DEPB scheme. Further, an increase in vehicle price will have multiple effect on final prices in export markets due to higher indirect taxations. We thus expect export volumes in 2HFY12 and to some extent in FY13E to be impacted as a result of the pricing action, however maintaining our positive stance.

Increasing dealer network BAL plans to increase its penetration in the rural markets by boosting up its dealer network. The company increased its dealership network by 159 dealers in FY 2011, of which about 55-60% would be in areas where the company did not have any presence earlier. At present, BAL’s distribution network is well placed as far as the Pulsar, a premium brand with an urban focus, is concerned. This network expansion programme was directed mainly towards the smaller towns and villages where its mass commuter bike Discover and now Boxer (to be launched in August 2011) can get a boost. We expect demand trends in the rural markets to remain reasonably good, supported by rising income levels and relatively lower two-wheeler penetration.

We therefore expect it to significantly add value for BAL. Though BAL does not provide specific disclose break up between rural and urban sales, figures from other players indicate rural markets contribution has increased in past few years. With the success of the Discover brand & now introduction of Boxer and its expanding reach, we expect BAL to gain rural market share in the near term. It has also set up focused “Bajaj Pro-biking Showrooms” in the major cities for sales of these models and spare parts (including accessories). It has 32 such centers currently to cater to the demand for these vehicles.

Strong R&D capabilities key to newer markets and segments BAL has systematically invested in building up the internal R&D capabilities as a key competitive strength for over last decade. We believe Bajaj Auto’s strategy of building internal R&D capabilities rather than relying on foreign partners for product development has helped company in launching newer models quickly and effectively in the market. In current market scenario with changing consumer preferences, declining product life and rising competition from international players – Bajaj’s R&D capabilities and technology partnerships are its strongest competitive advantage. It has also set up JV with international players like Kawasaki and KTM which has provided it with the opportunity to enter the super bike segment and also hitherto untapped premium bike markets of Europe & America.

Table 4: Vehicle launches

Year Launches 2001 Eliminator, Pulsar 2003 Caliber115, Wind 125, Pulsar, Endura FX 2004 CT 100, New Chetak 4‐stroke with Wonder Gear, Discover DTS‐i

2005 Wave, Avenger, Discover 2006 Platina 2007 Pulsar200, Kristal, Pulsar220 DTS‐Fi, XCD125 DTS‐Si

2008 Discover135 DTS‐i sport, Discover125, Platina125

2009 XCD135, Pulsar180 DTS‐i UG IV, Discover100 DTS‐Si

2010 Pulsar135, Pulsar150 DTS‐i UG IV, Pulsar220 DTS‐i, Discover150, Avenger220, Pulsar180

2011 Discover125, Boxer150, Ninja 250R and KTM Duke 125 (expected) 2012E Pulsar 200/250cc and KTM Duke 200cc, four wheeler vehicle

Source: Company data, media & MSFL Research

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Capacity expansion and capex plans The current capacity at BAL’s manufacturing plants is near 5.04mln units (2W capacity – 4.5mln units, 3W – 0.54mln units) increased from 4.26mln units in FY11. The plant is currently ramping up capacity at its Pantnagar plant and plans to achieve a run rate of 1.6mln units (90% of capacity) by end of the year. At the exit capacity end FY11 & FY12E and our volume forecasts, utilisation levels would be around 90% and 94% of achievable capacity. The company plans to incur capex of approximately 2,000-2,500mln each over the next two years, the majority spends being KTM tooling’s and the new four-wheeler project. Bajaj is also planning to set up a new manufacturing facility in Gujarat (as per media reports) near the Mundra port at an investment of 10,000mln. This facility is expected, to manufacture BAL upcoming Renault-Bajaj-Nissan ultra low cost passenger car and a new four wheeler vehicle. Excise benefits to flow as Pantnagar plant ramps up The company is ramping up its production capacity at its Pantnagar facility (from 1.2mln units to 1.6mln units by Sept 11) which falls in zero excise duty zone. Until now, the company primarily manufactured the Platina model (low value product) from this plant and the positive impact of such excise benefits was not visible. BAL has now shifted the whole of its Discover and Boxer production to this facility, which should be beneficial for overall profitability as it is the highest selling motorcycle for the company. Accordingly, ramp up at Pantnagar plant from current utilisation levels will increase the excise duty benefits for the company which flows directly to EBITDA margins (as price of end products remain same) thus improving the overall profitability.

Table 5: Tax benefits at Pantnagar plant

FY09 FY10 FY11 FY12E FY13E

Normal Capacity 0.90 1.20 1.20 1.60 1.80

Production 0.32 0.58 0.91 1.12 1.60

Utilisation (%) - a 35% 48% 76% 70% 89%

Excise Duty (%) - b 10% 10% 10% 10% 12%

Benefits % (a*b) 2% 3% 5% 5% 6%

ASP (`) 30,000 30,000 32,000 33,000 35,000

Excise Benefits (` mln) 201 501 1,448 1,811 4,181

Source: Company data & MSFL Research Assuming input localisation of 60-75% and current excise duty rates

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Financial Outlook Net sales forecast to increase by a 18% CAGR from FY11-13 We expect BAL’s net revenue to grow at a CAGR of 18% more than the overall volume CAGR of 16% over the next two years to 234,160mln in FY13E. We believe the ASP gains seen over the past two years on account of a superior product mix to continue and expect a 3% CAGR from FY11-13E (on high base). We expect exports (gross) to grow at a CAGR of 23% to 68,500mln in FY13E and account for 29% of sales.

Exhibit 13: Sales Volume and growth (% RHS) Exhibit 14: Net Revenue (mln) and growth (% RHS)

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Source: Company data & MSFL Research Input costs lead by conversion costs to stabilize margins As discussed in earlier section, we expect commodity prices to soften in second half but still remain at elevated levels and fall marginally in FY13E. The raw material cost as a percentage of total income is expected to increase from 71.5% in FY11 to 72.2% in FY13E driven by higher conversion costs (fuel and labor costs at vendor’s end). Increasing competition and macro headwinds impacting customer sentiments will lead to less than 100% pass through of cost inflation (though higher than its peers).

Exhibit 15: Cost and EBITDA break up Exhibit 16: EBITDA (mln) and EBITDA margin (% RHS)

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Source: Company data & MSFL Research We forecast EBITDA margins to hover near 19-20% levels for FY12-13E lower than EBITDA margin in excess of 20% recorded by company in the past six quarters. In our view, exponential growth in 2009-10, higher volume mix from the Pulsar range and the three wheeler sales coupled with soft input costs have supported the margin trend. However, given that these factors have largely played out, we forecast stable

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margins over the next two years. We do not rule out quarterly fluctuation in margins caused by seasonality in the domestic two wheeler industry and lag impact of commodity prices.

Exhibit 17: EBITDA and NPAT Margin (%) Exhibit 18: Adj NPAT (mln) and growth (% RHS)

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Source: Company data & MSFL Research Net profit expands, cash flows strong We estimate a favorable trend in other income (on back of rising cash in company books) and depreciation (as lower capex in past two years) translating into significantly higher NPAT growth. We estimate adjusted NPAT to record a CAGR of 14.1% over FY11-13E to 36,655mln. We forecast adjusted EPS to be 126.7/share in FY13E from 97.4/share in FY11. We expect BAL to report record earnings this year and free cash flow to grow at a two year CAGR of 24% to ` 41,540mln on our forecast. The company has paid off interest free loan last year due to high cash at disposal and attractive discount rates. We expect high free cash flow growth to turn into higher payout ratio. We forecast DPS of ` 50/share and ` 55/share (on conservative side) converting into dividend yield of 3.1% and 3.4% for FY12E and FY13E respectively.

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Valuation methodology and Recommendation Bajaj Auto – Initiate with Buy; target price of ` 1,893 (upside of 16%) We have a positive view on the two wheeler industry and expect industry to grow at healthy CAGR of 15% over next two years (with an upward bias). We believe BAL with its current motorcycle portfolio, brand building exercise over past few years and its strategy of focusing on the premium motorcycle segment is reaping rich rewards. We expect BAL’s net revenue to grow at a CAGR of 18% higher than the volume CAGR of 16% over the next two years. We forecast company to post a robust 13% CAGR in its Adjusted NPAT. Given its strong cash flow and return profile, we expect BAL multiples to expand and trade at premium valuations. Table 6: Factors influencing valuations

FY 2006-11 FY 2011-13E#

HMC BAL HMC BAL

Volume growth 12% 10% 14% 16%

Exposure to exports Negligible High Negligible High

Susceptibility to competition Low Medium High Medium

Margin performance 14.0% 16.8% 11.1% 19.2%

Adj. NPAT growth 15% 20% 11% 13%

Free cash flow growth 41% 25% 5% 24%

Conclusion Strong Moderate Weak Strong

Premium/Discount to Benchmark Premium Discount Nil to Discount Premium

Source: Company data, MSFL Research, # - MSFL forecasts and expectation We Initiate coverage on the stock with a Buy rating with our SOTP based one year target price at ` 1,893 which provides a potential upside 16%. Risk factors are failure of launches, lower than expected demand in domestic & overseas markets, higher than expected competition or irrational price competition and low than expected return on strategic investments. Key catalysts are higher than expected growth in the super bike segment, successful launch of the four wheeler vehicle and higher payout ratio (increasing dividend yield). Exhibit 19: Price band chart (1 year forward earnings)

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Source: Bloomberg, Company data & MSFL Research We value BAL’s standalone business at 16.2x FY13E core EPS (before earnings on the cash and cash equivalents), at a 5% premium to HMC’s three year mean P/E (based on core earnings), as BAL’s business model has undergone positive changes, in our view, and clearly scores the highest on the factors considered above. This gives us standalone value of ` 1,874/share (including cash per share of ` 145/share).

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Table 7: Standalone valuations

Core EPS - NPAT - Int income (net of tax) FY13P

NPAT 35,695

Interest income (net of tax) 4,818

Core PAT 30,877

Core EPS 106.7

P/E multiple 16.2

Standalone Operating value 1,729

Cash in book (incl liquid invs) 42,000

Cash per share 145

Fair value 1,874

Source: Company data & MSFL research We value the company’s strategic investments in KTM at 30% discount to its current market cap (valuing at ` 18/share) and investment in BAI at 30% discount to the current BV (valuing at ` 1/share). Table 8: Investment in KTM

Valuation of Invs in KTM

BAL stake in KTM 4.0

CMP (Euro) 39.4

M Cap (Euro) 158.3

M Cap (INR) 7,125

Holding company discount 25%

Invs value (mln) 5,343

Invs value/share 18

Source: Company data, Bloomberg & MSFL research Our one year target price based on SOTP valuation comes to ` 1,893/share. At a CMP of ` 1,627/share, BAL is trading at 15.0x and 13.2x FY 12E and FY 13E earnings respectively at a discount to HMC. At our target price, the company is expected to trade at 17.5x and 15.3x FY12E and FY13E earnings respectively. Table 9: Target price calculation

Standalone valuations 1,874

Investment in KTM 18

Investment in BAI 1

Fair value 1,893

Source: MSFL research

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Financial Summary Profit & Loss Particulars (` in mln) 2008 2009 2010 2011 2012P 2013P Sales 88,286 88,104 119,210 166,089 201,948 230,101

Total Expenditure 77527 76080 93284 132241 163354 185566

EBIDTA 10,759 12,023 25,926 33,849 38,595 44,535

EBIDTA Margin (%) 12.2% 13.6% 21.7% 20.4% 19.1% 19.4%

Depreciation 1,740 1,298 1,365 1,228 1,527 1,651

EBIT 9,020 10,725 24,561 32,620 37,068 42,884

Interest cost 52 210 60 17 0 0

Operating Profit 8,968 10,515 24,501 32,603 37,068 42,884

Other Income 3,403 1,117 1,225 3,658 5,870 6,692

Extraordinary Item -1,024 -2,051 -1,615 7,246 0 0

PBT 11,347 9,581 24,111 43,507 42,937 49,576

Tax 3,754 3,016 7,075 10,110 11,593 13,881

PAT 7,593 6,565 17,036 33,397 31,344 35,695

Basic EPS 28.53 27.87 62.80 97.35 108.32 123.35

Sales Growth (%)

0% 35% 39% 22% 14%

OP Profit Growth (%) 12% 116% 31% 14% 15%

PAT Growth (%)

-14% 160% 96% -6% 14%

Source: Company data & MSFL Research

Balance Sheet Particulars (` in mln) 2008 2009 2010 2011 2012P 2013P Sources of Funds Share Capital 1,447 1,447 1,447 2,894 2,894 2,894 Reserves & Surplus 14,429 15,417 27,837 46,209 60,625 77,699 Networth 15,876 16,864 29,283 49,102 63,518 80,592 Total Loans 13,343 15,700 13,386 3,252 3,052 2,852 Deferred Tax Liability 110 42 17 297 297 297 TOTAL 29,329 32,606 42,686 52,651 66,867 83,741

Application of Funds

Net Fixed Assets 12,928 15,481 15,211 15,483 16,785 17,732 Investment 18,572 18,085 40,215 47,952 55,000 65,000 Current Assets 16,497 23,253 15,838 28,726 40,569 52,844 Current Liabilities 18,773 24,376 28,579 39,553 45,530 51,877 Net Current Assets -2,276 -1,123 -12,740 -10,827 -4,961 966 TOTAL 29,329 32,606 42,686 52,651 66,867 83,741

Source: Company data & MSFL Research

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Cash Flow Particulars (` in mln) 2009 2010 2011 2012P 2013P

Internal accruals 7,863 20,225 34,625 32,871 37,346

(Inc)/Dec in Net Current Assets 345 -11,263 -2,638 -6,437 -6,792

Cash flow from Operations 7,518 31,488 37,263 39,308 44,138

Inc/(Dec) in Debt 2,357 -2,314 -10,134 -200 -200

Cash flow from Financing 2,482 -2,452 -10,372 -200 -200

Fixed Asset formation 3,371 648 400 2,829 2,598

Dividend Payment 3,724 6,771 13,543 16,928 18,621

Inc/(Dec) in Investment -486 22,130 7,737 7,048 10,000

Cash flow from Investment 6,609 29,549 21,679 26,805 31,219

Net Change in Cash 3,391 -513 5,212 12,303 12,719

Source: Company data & MSFL Research

Ratios Valuation Ratio 2009 2010 2011 2012P 2013P P/E 58.4 25.9 16.7 15.0 13.2

P/BV 14.0 8.0 9.6 7.4 5.8

EV/EBIDTA 20.8 9.6 13.8 12.3 10.6

EV/Sales 2.8 2.1 2.8 2.3 2.1

Dividend Yield (%) 1.4% 1.2% 2.5% 3.1% 3.4%

EPS adjusted 27.9 62.8 97.4 108.3 123.4

DPS 22.0 20.0 40.0 50.0 55.0

Book Value 116.6 202.4 169.7 219.5 278.5

Adj. ROE (%) 51.1 63.7 53.3 49.3 44.3

Adj. ROCE (%) 38% 68% 76% 72% 66%

Solvency Ratio (x)

Debt/Equity 0.84 0.45 0.06 0.04 0.03

Debt/EBIDTA 1.31 0.52 0.10 0.08 0.06

Turnover Ratio (x)

Asset Turnover 2.3 2.5 2.8 2.7 5.5

Fixed Asset Turnover 6.2 7.8 10.8 12.5 13.3

Current Ratio 1.0 0.6 0.7 0.9 1.0

Inventory (days) 14 12 11 9 8

Debtors (days) 13 9 7 7 6

Creditors (days) 73 96 78 80 85

Source: Company data & MSFL Research

[Type text]

MSFL Research

Institutional Business Group, MSFL @p-sec, 306, Gresham Assurance House, 132, Mint Road, Fort, Mumbai – 400 001 India

Tel + 91 22 22690474 / 75 www.marwadionline.com

A clutch-free ride!!

Summary Financials ` in Mln FY10 FY11 FY12E FY13E

Net Sales 44,301 62,913 76,451 89,721

EBITDA 3,499 4,659 5,277 6,723

Net Profit 1,343 1,956 2,502 3,454

Adjusted EPS 2.5 4.1 5.3 7.3

Networth 8,652 9,994 11,789 14,375

Debt 10,033 7,854 6,554 4,804

Fixed Assets 9,828 9,950 9,560 9,014

Net Current Assets 2,311 2,244 2,530 3,511

BUY CMP ` 63 Target Price ` 73 Upside Potential 15%

Price Performance 52 wk Hi/Lo 87/44 All time Hi/Lo 93/3 6 month Average Vol 1956590 Stock Beta 1.27

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TVS Motor BSE Auto

Valuation FY11 FY12E FY13E

P/E (x) 15.4 12.1 8.7 P/BV (x) 3.0 2.6 2.1 RONW (%) 20 21 24 ROCE (%) 15 19 25

Peer Valuation – FY12E Hero Bajaj PE 21.0 15.0 P/BV 10.9 7.4

Equity Data Market Cap. (` bln) 30.2 Face value (`) 1 No of shares o/s (mln) 475

Jun’10 Jun’11 ∆% Promoters 60.45 59.31 -1.89 DFI's 13.28 14.65 10.32 FII's 7.13 3.46 -51.47 Public 19.14 22.58 17.97

TVS Motors (TVS) has a diversified business model with presence both in the domestic and export market offering multiple vehicles in each segments. We have seen a transformation in company’s strategy in the past two years and we believe the new found aggression will lead to improvement in its market share/ overall profitability over the forecast period. We expect TVS’s revenues and net profit to grow at a CAGR of 19% & 33% respectively over the next two years. Our target price stands at ` 73/share (upside of 15%). We initiate coverage with a Buy rating.

Scooters – niche business segment TVS remains one of the largest players in the scooter segment with its Scooty and Wego offering. Wego, launched last year, has gained market share in highly competitive segment. YTD FY12 it has increased its market share by 30bps driven by the robust demand for its scooters and plans to launch another scooter later in the year. We remain positive on the outlook for the Scooter segment and expect TVS to register a CAGR of 19% over FY2011-13E.

Three wheeler business ramping up TVS entered the lucrative three wheeler passenger carrier segment in 2008 and has significantly increased its presence in the segment in a short span of time. We expect overall three-wheeler sales (domestic+exports) to grow 28% to 51,200 units in FY12E driven by strong traction in the export markets. The three-wheeler business contributes just 7% to TVS’s FY12E revenues but yields higher margins & superior return ratios. TVS is planning to expand its three wheeler capacity by 50% to 90,000 units by end FY12 which will add to profitability in absolute terms.

Exports leading the growth We forecast exports to record robust CAGR of 21% over FY11-13E and exports contribution to total sales to rise further to 14% by FY13E. The sales mix is expected to improve with >125cc bikes and three wheelers accounting for 45% of export sales. The company has not yet disclosed its strategy post DEPB withdrawal and we expect it to increase prices as expected in case of BAL. We take into account lower DDS rates post September and expect export volumes in 2HFY12 and to some extent in FY13E to be slightly impacted as a result of the pricing action.

Initiate with Buy, TP of ` 73 (upside of 15%) We value TVS’s standalone business at 11.6x core FY13E earnings, at a discount of 25% on HMC’s three year historical mean P/E (based on core earnings). The applied discount is lower than the discount it has been trading to HMC’s multiple over past three years (39%) as TVS’s business model has undergone positive changes in our view and expect discount to narrow. Our SOTP value for the company is ` 73/share (after net debt of ` 16/share). We initiate coverage with a Buy rating.

Initiating Coverage

Ronak Sarda ronak.sarda@msflibg.in (+ 91 22 3094 7135)

Shyamal Dhruve shyamal.dhruve@msflibg.in September 21, 2011

TVS Motors Ltd.

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Executive Summary TVS Motors (TVS) has a diversified business model with presence both in the domestic and export market offering multiple vehicles in each segments. TVS lost significant market share in both the motorcycle and the scooter segment from FY05-10 due to lower frequency of launches. It however gained back some market share in FY11 on back of successful vehicle launches. It now plans to continuously refurbish/upgrade its vehicle portfolio to consolidate its position in the domestic two wheeler industry. We have seen a transformation in company’s strategy in the past two years (ramping up three wheeler segment) and we believe the new found aggression will lead to improvement in its market share/ overall profitability over the forecast period. TVS is one of the major players in the domestic scooter segment, with market share of 21.5% till date FY12. It offers two products in the segment 1) Scooty targeting the female customers and 2) Wego – an unisex model. Both models have done well, with Scooty remaining the most preferable vehicle for the young female population. It plans to launch another scooter later this year. YTDFY12 it has increased its market share by 30bps, driven by the increased demand for the Wego model. We remain positive on the outlook for the Scooter segment and expect TVS to register a CAGR of more than 19% over FY2011-13E. Though competition is expected to increase in the segment with new players entering the market (Yamaha) and new launches by existing players (HMC & Mahindra), we believe TVS will be able to increase its market share. We expect TVS’s motorcycle segment to grow at CAGR of 11% over FY11-13E and expect the sales mix to improve with higher growth in the premium segment. TVS entered the lucrative three wheeler passenger carrier segment in 2008 and has significantly increased its presence in the segment in a short span of time. We expect overall three-wheeler sales (domestic+exports) to grow 28% to 51,200 units in FY12E driven by strong traction in the export markets. TVS is planning to expand its three wheeler capacity by 50% to 90,000 units by end FY12 on the back of domestic demand visibility with opening of permits in various states and robust export markets. The overall three-wheeler business contributes c7% to TVS’s FY12E revenues but yields higher margins & superior return ratios. Export volumes for TVS have been on an upward trend from FY06 and have witnessed a CAGR of 20.5% from FY06-FY10 led by growing acceptance of Indian vehicles in the overseas markets (value for money). The exports contribution as a percentage of overall sales volumes has also increased. It accounts for 13% in FY11 as against 6% in FY06. Overall, we expect export sales to grow at 31% for FY12E and 22% for FY13E and contribution of it to total sales to rise further to 14% by FY13E. The sales mix is expected to improve with >125cc motorcycles and three wheelers accounting for 45% of export sales by FY13E. The company has not yet disclosed its strategy post DEPB withdrawal and we expect it to increase prices as expected in case of BAL. We take into account lower DDS rates post September and expect export volumes in 2HFY12 and to some extent in FY13E to be slightly impacted as a result of the pricing action. To support its domestic sales the company is planning to launch a scooter and a motorcycle in the current fiscal. Though the management did not divulge into further details, the motorcycle is rumored to have a 125cc powered engine to strengthen its position in the largest of the domestic motorcycle segment. As per news wires, it also has plans to re-launch the “electric scooter” which can be provide a new avenue of growth for the company. We expect TVS’s net revenue to grow at a CAGR of 19% and net profit to grow at a CAGR of 33% over the next two years in FY13E. We expect EBITDA margin to hover around similar levels over FY11-FY13P driven by higher realisations, softening raw material prices and stable other expenses. We value TVS’s standalone business at 11.6x FY13E core EPS at a 25% discount to HMC’s three year mean P/E. The applied discount (25%) is lower than the discount it has been trading to HMC’s multiple over past three years (39%) as TVS’s business model has undergone positive changes in our view (see table below). This gives us standalone value of ` 73/share (after net debt of ` 16/share and value in strategic investment of ` 2/share). At CMP of ` 63/share, it is trading at 12.1x and 8.7x FY12E and FY13E earnings respectively at a discount to HMC.

Transformation in strategy to compliment diversified business model

Scooters to record strong growth, motorcycle growth stable

Three wheeler business growing strong

Exports key earning driver, DEPB withdrawal to have minimal impact

Buy with TP of ` 73 - upside of 15%

New focused launches

MSFL Research

59

Table 1: Factors influencing valuation

FY 2006-11 FY 2011-13E#

HMC TVS HMC TVS

Volume growth 12% 9% 14% 15%

Exposure to exports Negligible Low Negligible Medium

Susceptibility to competition Low High High Medium

Margin performance 14.0% 5.2% 11.1% 7.2%

Adj. NPAT growth 15% 11% 11% 33%

Free cash flow growth 41% NA 5% 52%

Conclusion Strong Weak Moderate Moderate

Premium/Discount to Benchmark Premium High Discount Nil to Discount Less Discount

Source: Company data & MSFL Research, #-MSFL forecast and expectation Risk factors are failure of new launches, lower than expected demand in overseas markets, higher than expected competition or irrational price competition and low return on strategic investments. Key catalysts are higher than expected three wheeler sales and earlier than expected turnaround of Indonesian investments. Our forecasts for the company are higher than consensus on all the three accounts as we remain confident of company’s business model. Our forecast at EBITDA levels are ahead of consensus as we factor in better improvement in realisations. While lower depreciation charges and higher yield on investments increase our EPS forecasts. Table 2: MSFL Forecast v/s Consensus

FY12E FY13E

Particulars (` mln, except per share data)

MSFL forecasts

Consensus % chg MSFL

forecasts Consensus % chg

Revenues 76,451 73,710 4% 89,721 84,948 6%

EBITDA 5,277 4,905 8% 6,723 5,696 18%

EPS 5.3 5.2 2% 7.3 6.4 14%

Source: Bloomberg & MSFL Research

Key Risk & catalysts to valuation

How we differ from consensus

MSFL Research

60

Time to get aggressive TVS Motors (TVS) has a diversified business model with presence both in the domestic and export market offering multiple vehicles in each segments. We expect the company to earn nearly 75% of its revenues from the domestic two wheeler business, 3% from high margin domestic three wheeler business, 14% from exports and the rest from spares in FY12E. We have seen a transformation in company’s strategy in the past two years and we believe the new found aggression will lead to improvement in its market share/ overall profitability over the period.

Exhibit 1: Revenue Mix – FY12E Exhibit 2: Market share (Domestic & Exports)

Source: Company data, SIAM & MSFL Research, 2012-till date actual share

With increasing competition and slowdown of 2008-09, TVS Motors lost significant market share in both the motorcycle and the scooter segment however it re-gained some market share in FY11 as it launched two new products (one each in motorcycle and scooter segment). It plans to launch two new models in FY12 as well. TVS, in the current year, has lost nearly 50bps market share in the domestic markets, however it continues to grow exponentially in the exports market which in our view will aid margins.

Exhibit 3: Domestic sales and growth (% RHS) Exhibit 4: Exports sales and growth (% RHS)

Source: Company data & MSFL Research Growth in the scooter segment is likely to outpace that in motorcycles and mopeds over the forecasted period. We forecast TVS scooter segment to record a CAGR of 19% over FY2011-13E higher than the motorcycle growth of 13% and 15% for moped over the same period. We also expect the near term growth to be driven higher by the strong traction in the exports market. We expect the export market growth to moderate in second half of the fiscal as company is expected to increase prices in response to DEPB withdrawal. We therefore believe TVS to record decent growth in the domestic market in the second half of the fiscal as companies target the domestic markets aggressively.

38%

23%

14%

14%

8%

3%

Scooter - Domestic Motorcycle - DomesticMopeds - Domestic ExportsSpares Three wheeler - Domestic

12%

13%

14%

15%

16%

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19%

2006 2007 2008 2009 2010 2011 2012

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Total Exports Growth

MSFL Research

61

Domestic scooters – niche business segment TVS is one of the major players in the domestic scooter segment, with market share of 21%. It offers two products in the segment 1) Scooty targeting the female customers and 2) Wego – an unisex model in direct competition with Honda’s Activa and Suzuki’s Access. Both models have done well, with Scooty remaining the most preferable vehicle for the young female population. YTDFY12 it has increased its market share by 30bps, driven by the increased demand for the Wego model. Wego has, within a year, achieved a run rate of 16-17,000 per quarter. Higher demand for Wego also improves the overall product mix as it increases realization per vehicle (Wego is priced > 20% higher than the average selling price for the Scooty family). We remain positive on the outlook for the Scooter segment and expect TVS to register a CAGR of 19% over FY2011-13E. We expect the scooter segment to register grow at a faster rate than the domestic 2W industry driven by the conveience factor attached to the scooter and increase in female students and working population. We believe that the successful launch of Wego last year, coupled with sustained volumes for the Scooty family, will further help TVS increase its market share from the current levels. Table 3: Demographic advantage (mln)

2001A 2011E 2015E

Male Female Male Female Male Female

20 to 24 46 44 65 59 65 60

25 to 29 41 42 53 46 64 58

30 to 34 37 37 46 43 53 45

35 to 39 36 35 41 41 46 43

Target Youth 161 157 205 189 228 206

Scooty family TVS has been pioneer in the scooter market with launch of Scooty variants trageting the young women. With increasing target women population and low penetration levels we expect its Scooty brand to do well. Its nearest competitor in the segment is HMC’s Pleasure. It launched the Scooty Babelicious series in last fiscal to further consolidate its position in the domestic scooter segment. Wego – unisex model The introduction of Wego will also provide some competitive strength against Honda which is commanding top position due to its Activa brand and the fast growing Suzuki’s Access 125. TVS plans to launch another scooter in FY12 for the domestic market.

Exhibit 5: Domestic Scooters & growth (% RHS) Exhibit 6: Domestic market share (%)

Source: Company data, SIAM & MSFL Research

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FY06 FY07 FY08 FY09 FY10 FY11 FY12P FY13P

Domestic scooters Growth

18%

20%

22%

24%

26%

28%

2006 2007 2008 2009 2010 2011 YTD 2012

MSFL Research

62

Competition heating up We expect the scooter segment to outpace the domestic motorcycle segment. This has attracted various players who hitherto concentrated on the motorcycle segment. HMC recently launched an 110cc scooter Mastero which would directly compete with TVS’s Wego. Suzuki has been ramping up sales in the domestic scooter segment with a market share of c13% in three years of it entering this segment. Yamaha plans to launch entry level scooters in India by 2012. HMSI’s production constraints have led to market share gains for all the remaining players but with it commencing production at its new Rajasthan plant we expect it to gain market share over the next two years. We thus expect fast churning of vehicles in the segment as player’s launch new variants to outclass competition. Despite aggressive competition, TVS’s market share increased to 21.9% in FY11 as against 20.7% in FY10. With another launch this year, we expect TVS to register market share increase as demand for its scooter increases. Domestic motorcycles – stable growth, superior product mix TVS has evolved over the period from being a player in the entry and executive segment to the fast growing premium segment. It share of sub 125cc motorcycles have fallen from 89% in FY06 to nearly 76% in FY11. We further expect it to fall to 75% by FY13E. This has largely benefited the operating margins over the period as premium segment vehicles command higher margins. Moreover, the share in the sub 125cc segment has improved with higher share from newly launched 110cc “Jive”, which accounts for c60% of the category. In the entry level segment, it has “Star” and “Sport” brands. This segment is dominated by HMC and BAL. Increasing competition, smaller product portfolio and lower frequency of launches and rising competition, TVSL’s market share has declined from 14% in FY06 to c7% in YTD FY12. However to strengthen its position in this executive segment the company is launching a 125cc motorcycle in FY12. The new launch is expected to further consolidate its position in the domestic motorcycle industry. We expect the domestic motorcycle business to grow at a CAGR of 11% over FY11-13E with premium segment to grow at a CAGR of 13% over the same period.

Exhibit 7: Product sales mix Exhibit 8: Domestic motorcycle market share (%)

Source: SIAM & MSFL Research

On the other hand, TVS competes in the premium segment with its Apache series and launched Apache ATR 180 in FY10 which revived the falling sales for the company in this segment. Sales in the >125cc motorcycles category grew at a CAGR of 22% over FY07‐FY11, outpacing the sub 125cc category (CAGR of ‐4%). TVS share in the domestic premium segment has fallen to 5.5% in YTD12 from 8% in FY06 mainly due to lower churning of its product portfolio. The company has also been growing strongly in the overseas market in last two years and the company may be facing some constraints to satisfy domestic demand.

0%

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100%

FY09 FY09 FY09 FY09 FY10 FY11 FY12P FY13P

<125cc >125cc

2%

4%

6%

8%

10%

12%

14%

2006 2007 2008 2009 2010 2011 YTD 2012

MSFL Research

63

Three-wheeler business ramping up

TVS entered the lucrative three wheeler passenger carrier segment in 2008 and has significantly increased its presence in the segment in a short span of time. We expect overall three-wheeler sales to grow 28% to 51,200 units in FY12E driven by strong traction in the export markets. TVS is also planning to expand its three wheeler capacity by 50% to 90,000 units by end FY12 on the back of domestic demand visibility with opening of permits in various states and robust export markets. Increasing substitution of old petrol/diesel three wheelers with CNG based engines is also a major driver for growth. We believe the company will be able to clock stable growth irrespective of additional permits coming from State government through higher replacement demand.

Exhibit 9: Robust 3W sales Exhibit 10: 3W market share (domestic & exports)

Source: Company data, SIAM & MSFL Research

Three wheeler exports have grown exponentially over the past five years (CAGR – 30%) as companies target countries with inadequate public transport systems. Countries in Middle East and South Asia (especially Sri Lanka) have been the major end markets. The contribution from exports has constantly increased and stand at 51% in FY11. We further expect it to increase to 60% in FY12E. We believe, the underlying potential of these markets is huge as the penetration levels are still low. We expect TVS three wheeler sales, in the medium term, to be driven by higher exports as it ramps ups it capacity. TVS has also quickly gained market share in the booming exports market. The company has successfully captured market share from players such as BJAUT (market share - 69%) and Piaggio Vehicles (15%) despite higher prices. Its overall market share has increased to 5% in three years of launching the product The contribution of three wheeler segment currently remains low (near 2%) in volume terms, however its contribution to margins/profitability will be higher than two wheeler business. We believe that the high-margin three-wheeler segment will start significantly contributing to profitability in the coming period as it ramps up its capacity to 90,000 units. We do not expect very high return in near term (as compared to BAL) as the three wheeler operations are still in the nascent stage but expect returns to improve as the company scales up its operations. Table 4: Return on 3W business segments

Average realization 110,000 Capex 20,833

EBIT margin 22% WC requirement (days) 7

EBIT / vehicle 24,200 WC per unit 2,110

Tax rate 28% Capital employed 22,943

NOPAT (EBIT - tax) 17,424

ROCE (%) 76%

Source: Company data & MSFL Research, assuming 100% utilisation

0

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FY 09 FY 10 FY 11 FY 12E FY 13E

3W - domestic 3W - export

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2009 2010 2011 2012

MSFL Research

64

On our calculation, the return ratio for three wheeler segment is as high as 80%. This increases the importance of three wheelers in the company’s portfolio from view of competition, especially when there is substantial pressure on margins in other segments.

Mopeds TVS, the pioneer in the manufacturing mopeds, is now the only player in the segment after exit of Kinetic and Majestic Auto. TVS’s moped segment has grown at a CAGR of 20% over FY06-11 higher than the industry rate of 16% over the same period. Moreover, the moped even recorded a 16% growth in 2008 when the overall industry declined by 8%. We believe that the buoyant moped growth was partly due to de-growth in entry-level motorcycles as some potential customers have downgraded to mopeds, given the lack of financing. We forecast the moped segment to grow at 16% in FY12E and growth to taper down in FY13E to 14%. We factor in lower volume growth compared to historical CAGR (19%) to factor in moderation expected in demand (due to shift towards motorcycles).

MSFL Research

65

Exports leading the growth Export volumes for TVS have been on an upward trend from FY06 and have witnessed a CAGR of 21% from FY06-FY10 led by growing acceptance of Indian vehicles in the overseas markets (value for money). The exports contribution as a percentage of overall sales volumes has also increased. It accounts for 13% in FY11 as against 6% in FY06. Overall, we expect export sales to grow at 31% for FY12E and 22% for FY13E and contribution of it to total sales to rise further to 14% by FY13E.

Exhibit 11: Export sales and growth (% RHS) Exhibit 12: Export sales mix

Source: Company data & MSFL Research

TVSL has a wider reach with its presence in 55 countries compared to BJAUT (36 countries) and HH (4 countries). The company has an assembly operation in Brazil where it assembles the Apache motorcycle, and it plans to use Brazil as a base to supply other countries in Latin America like Colombia. We estimate export growth to be moderate in the second half of the year as we believe there has been some stocking at the overseas distributor level in anticipation of DEPB being withdrawn. TVS primarily exported the sub 125cc bikes to the African markets and its contribution to overall motorcycle exports was 77% in FY06. However, in the past two years it has significantly ramped up exports of its premium motorcycle and its now accounts for nearly 45% of exports (as compared to 23% earlier). Indonesian subsidiary getting on track TVS made investment of ` 935mln and 595mln in FY10 and FY11 respectively in its Indonesian subsidiary PT TVS Motor Indonesia. The subsidiary continues to be loss making and the accumulated losses as of end FY11 were 3,000mln. From the inception in 2007, Indonesian subsidiary has sold 50,000 vehicles out of which nearly 20,000 two-wheelers were sold in FY11. The company has further sold 7,000 two wheelers in 1Q FY12. Going forward, the focus will be on brand building; increasing sales and distribution network from 160 to 500 and reaching a monthly sales of 10,000 two wheelers. To fund the activities, the company has further invested 574mln in FY12 and we expect further investment to be funded through internal accruals and prudent working capital management. We remain positive on the South East Asian two wheeler industry and recent data flows have been encouraging for both TVS’s Apache brand and BAL’s Pulsar brand. Though the subsidiary has not been EBITDA positive, the loss has fallen considerably and we expect the company to breakeven FY12-13.

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<125cc >125cc 3W

MSFL Research

66

New launches TVS lags its peers in new launches and frequent upgrade of its vehicle portfolio to keep with the customer needs and a step ahead of competition. This has been a key reason for falling market share over last three – four years. As can be seen in the chart below, TVS consistently lost market in FY 2007-09 as there were no exciting launches (no launch in slowdown of 2008). However launch of TVS Wego, Jive and Apache 180 in FY10 stimulated sales and it gained 190bps share in the domestic industry. We thus believe it is imperative for the company to continuously strengthen its product lineup to sustain its market share. Exhibit 13: Domestic two wheeler market share

Source: SIAM & MSFL Research

The company is planning to launch a scooter and a motorcycle in the current fiscal. Though the management did not divulge into further details, the motorcycle is rumored to have a 125cc powered engine to strengthen its position in the largest of the domestic motorcycle segment. As per news wires, it also has plans to re-launch the “electric scooter” which can be a new growth driver for the company. The electric vehicles launched first in 2007 (by Electrotherm (India) Ltd) and by TVS in 2009 failed due to unreliable vehicles and the perception of this unproven technology. Further, it fares poorly as compared to high power and stylish fuel powered two wheelers. As the new age vehicle is still in nascent stage, we believe active marketing and public awareness by both government and OEM’s will be necessary for its success.

Factors supporting sales of electric vehicles • Potential environmental benefit with lower green house emissions • Subsidy of ` 4,000/vehicle till the end of the XIth Five‐Year Plan • No requirement of license • Potential substitute for bi-cycles • High acceptability in China (20mln bikes yearly)

Factors hampering sales of electric vehicle • Lack of public awareness • Negative public perception due to poor performance • Efficient battery requirements

13%

14%

15%

16%

17%

18%

19%

2006 2007 2008 2009 2010 2011

MSFL Research

67

Financial Outlook Net sales forecast to increase by a 19% CAGR from FY11-13 We expect TVS’s net revenue to grow at a CAGR of 19% more than the overall volume CAGR of 15% over the next two years to 89,721 mln in FY13E. We believe the ASP gains seen over the past two years on account of a superior product mix to continue and expect a 4% CAGR from FY11-13E with superior product mix (high three wheelers and scooters). We expect exports (gross) to grow at a CAGR of 26% to 16,085 mln in FY13E and account for 14% of sales.

Exhibit 14: Sales Volume and growth (% RHS) Exhibit 15: Net Revenue (mln) and growth (% RHS)

Source: Company data & MSFL Research

Input costs lead by conversion costs to stabilize margins As discussed in earlier section, we expect commodity prices to soften in second half but still remain at elevated levels and fall marginally in FY13E. The raw material cost as a percentage of total income is expected to remain at similar levels as seen in FY11 (c73%). TVS raw material cost was quite higher as compared to the other listed peers and we expect it to converge to the industry average. Since there is no widespread difference in input costs the key reason for lower margins as compared to peers have been exceptionally high advertisement & publicity expenses. TVS on an average incurs 7.3% of net revenues as advertisement expenses as compared to BAL (1-1.5%) and HMC (2.5-3%). The higher other expense has put pressure on EBITDA margin for TVS and it enjoys lowest EBITDA margin across the automobile industry.

Exhibit 16: Cost and EBITDA break up Exhibit 17: EBITDA (mln) and EBITDA margin (% RHS)

Source: Company data & MSFL Research

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MSFL Research

68

EBITDA and EBITDA margin TVS has felt margin pressures during FY07-08 due to higher input and other cost per vehicle sold resulting in operating margins as low as 1%. However, its margin improved as new launches in the scooter and motorcycle segment increased realisations. Its three-wheelers operations gained market and improved margins. Going ahead, we expect EBITDA margins to hover around similar levels over FY11-FY13P driven by higher realisations, softening raw material prices and stable other expenses

Exhibit 18: EBITDA and NPAT margin (%) Exhibit 19: Adj NPAT (mln) and growth (% RHS)

Source: Company data & MSFL Research Profitability PAT margin for TVS has hovered around 1-2% over FY08-10 before increasing to 3% in FY11. With improving EBITDA margins, stable fixed costs, we expect net profit to grow at a CAGR of 33% over FY11-13E and profit margin to improve by 80 bps over the same period.

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MSFL Research

69

Valuation methodology and Recommendation TVS Motors – Initiate with Buy; target price of ` 73 (upside of 15%) We have a positive view on the two wheeler industry and expect industry to grow at healthy CAGR of 15% over next two years (with an upward bias). The new found aggression in the company’s business strategy and higher contribution from high margin businesses offer favorable return on our forecasts. We expect TVS’s net revenue to grow at a CAGR of 19% higher than the volume CAGR of 15% over the next two years. We forecast company to post a robust 33% CAGR in its Adjusted NPAT. Given strong cash flow and return profile and lower capex requirements in near term we forecast to be net cash by FY14. We expect TVS to trade at relatively lower discounts (25%) than it has been trading over past three years (39%). Table 5: Factors influencing valuation

FY 2006-11 FY 2011-13E#

HMC TVS HMC TVS

Volume growth 12% 9% 14% 15%

Exposure to exports Negligible Low Negligible Medium

Susceptibility to competition Low High High Medium

Margin performance 14.0% 5.2% 11.1% 7.2%

Adj. NPAT growth 15% 11% 11% 33%

Free cash flow growth 41% NA 5% 52%

Conclusion Strong Weak Moderate Moderate

Premium/Discount to Benchmark Premium High Discount Nil to Discount Less Discount

Source: Company data & MSFL Research, #-MSFL forecast and expectation We Initiate coverage on the stock with a Buy rating with our SOTP based one year target price at ` 73 which provides a potential upside 15%. Risk factors are failure of new launches, lower than expected demand in overseas markets, higher than expected competition or irrational price competition and low return on strategic investments. Key catalysts are higher than expected three wheeler sales and earlier than expected turnaround of Indonesian investments. Exhibit 20: Price band chart (1 year forward adjusted earnings)

Source: Bloomberg, Company data & MSFL Research We value TVS’s standalone business at 11.6x FY13E core earnings (before interest on debt) at a 25% discount to HMC’s three year mean P/E (based on core earnings). The applied discount is lower than the discount it has been trading to HMC’s multiple over past three years as TVS’s business model has undergone positive changes in our view. This gives us standalone value of ` 71/share (after net debt of ` 16/share as of last reporting date).

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Key Risk & catalysts to valuation

MSFL Research

70

Table 6: Standalone valuation

Particulars FY13P

Core EPS 7.5

P/E multiple 11.6

Standalone Operating value 87

Net debt (incl liquid invs) 7,643

Net debt per share 16

Fair value 71

Source: Company data & MSFL Research We value the company’s strategic investments in the Indonesian subsidiary at BV (after accumulated losses) at ` 2/share. We thus arrive at our TP woth SOTP valuation of ` 73/share. At CMP of ` 63/share, it is trading at 12.1x and 8.7x FY12E and FY13E earnings respectively at a discount to HMC. At our target price, the company is expected to trade at 13.9x and 10.0x FY12E and FY13E reported earnings respectively.

MSFL Research

71

Financial Summary

Profit & Loss Particulars (` in mln) 2008 2009 2010 2011 2012P 2013P Sales 32,195 37,367 44,301 62,913 76,451 89,721

Total Expenditure 31,782 35,522 40,803 58,254 71,173 82,998

EBIDTA 413 1,845 3,499 4,659 5,277 6,723

EBIDTA Margin (%) 1.3 4.9 7.9 7.4 6.9 7.5

Depreciation 946 1,029 1,643 1,704 1,618 1,764

EBIT -533 816 1,856 2,955 3,660 4,959

Interest cost 22 550 632 465 324 227

Operating Profit -555 266 1,224 2,491 3,335 4,732

Other Income 909 0 0 0 0 0

Extraordinary Item 0 0 0 0 0 0

PBT 354 266 1,224 2,491 3,335 4,732

Tax 36 0 -118 535 834 1,278

PAT 318 266 1,343 1,956 2,502 3,454

PAT Margin (%) 1.0% 0.7% 3.0% 3.1% 3.3% 3.9%

EPS 0.7 0.6 1.9 4.1 5.3 7.3

Sales Growth (%) -16% 16% 19% 42% 22% 17%

EBITDA Growth (%) -70% 347% 90% 33% 13% 27%

PAT Growth (%) -52% -16% 405% 46% 28% 38%

Source: Company data & MSFL Research

Balance Sheet Particulars (` in mln) 2008 2009 2010 2011 2012P 2013P Sources of Funds

Share Capital 238 238 238 475 475 475

Reserves & Surplus 7,978 7,819 8,415 9,519 11,314 13,900

Networth 8,215 8,056 8,652 9,994 11,789 14,375

Secured Loans 4,527 6,224 8,300 5,659 4,359 3,109

Unsecured Loans 2,137 2,836 1,733 2,195 2,195 1,695

Total Loans 6,663 9,060 10,033 7,854 6,554 4,804

Deferred Tax Liability 0 0 0 0 0 0

Deferred Liability 1,550 1,511 1,146 957 957 957

Foreign Curry Monetary Items 0 30 1 0 0 0

TOTAL 16,429 18,657 19,832 18,805 19,300 20,136

Application of Funds

Net Fixed Assets 10,431 10,364 9,828 9,950 9,560 9,014

Investment 3,390 4,777 7,393 6,611 7,211 7,611

Current Assets 7,748 8,937 9,652 12,016 12,563 15,086

Current Liabilities 5,668 6,158 7,341 9,772 10,034 11,575

Net Current Assets 2,080 2,778 2,311 2,244 2,530 3,511

Miscellaneous Exp. 528 738 300 0 0 0

TOTAL 16,429 18,657 19,832 18,805 19,301 20,136

Source: Company data & MSFL Research

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Cash Flow Particulars (` in mln) 2008 2009 2010 2011 2012P 2013P

Internal accruals 1,264 1,295 2,522 3,659 4,119 5,218

(Inc)/Dec in Net Current Assets 124 701 -489 883 -181 -262

Cash flow from Operations 1,140 594 3,011 2,777 4,300 5,481

Inc/(Dec) in Debt 328 2,396 973 -2,179 -1,300 -1,750

Inc/(Dec) in Equity 0 0 0 0 0 0

Cash flow from Financing 328 2,396 973 -2,179 -1,300 -1,750

Fixed Asset formation 1,287 882 304 935 1,227 1,219

Dividend Payment 166 166 313 562 706 869

Inc/(Dec) in Investment -57 1,387 2,616 -781 600 400

Cash flow from Investment 1,396 2,436 3,233 715 2,533 2,487

Net Change in Cash 71 554 751 -118 467 1,243

Source: Company data & MSFL Research

Ratios Valuation Ratio 2008 2009 2010 2011 2012P 2013P P/E 94.2 112.6 24.7 15.3 12.0 8.7

P/BV 1.8 1.9 1.7 3.0 2.5 2.1

EV/EBIDTA 47.8 11.0 5.1 6.9 5.7 4.2

EV/Sales 0.6 0.5 0.4 0.5 0.4 0.3

Dividend Yield (%) 1.1% 1.1% 1.9% 1.7% 2.1% 2.5%

EPS adjusted 0.7 0.6 2.5 4.1 5.3 7.3

DPS 0.7 0.7 1.2 1.1 1.3 1.6

Book Value 34.6 33.9 36.4 21.0 24.8 30.3

Adj. ROE (%) 3.9 3.3 15.5 19.6 21.2 24.0

Adj. ROCE (%) 2.3% 4.4% 9.4% 15.3% 19.2% 25.2%

Solvency Ratio (x)

Debt/Equity 0.8 1.1 1.2 0.8 0.6 0.3

Debt/EBIDTA 16.1 4.9 2.9 1.7 1.2 0.7

Turnover Ratio (x)

Asset Turnover 2.0 2.1 2.3 3.3 4.0 4.6

Fixed Asset Turnover 3.1 3.6 4.4 6.4 7.8 9.7

Current Ratio 1.4 1.5 1.3 1.2 1.3 1.3

Inventory (days) 47 33 26 33 25 26

Debtors (days) 10 18 18 16 16 16

Source: Company data & MSFL Research

[Type text]

MSFL Research

Institutional Business Group, MSFL @p-sec, 306, Gresham Assurance House, 132, Mint Road, Fort, Mumbai – 400 001 India

Tel + 91 22 22690474 / 75 www.marwadionline.com

Turning of the tide, valuations expensive

Summary Financials ` in Mln FY10 FY11 FY12E FY13E

Net Sales 158,605 194,012 224,333 255,554

EBITDA 27,670 24,349 24,068 29,181

Net Profit 22,318 19,279 20,951 24,764

Reported EPS 111.8 99.7 104.9 124.0

Networth 34,650 29,561 40,264 53,642

Debt 660 14,912 13,420 12,078

Fixed Assets 17,069 17,261 24,608 25,738

Net Current Assets -19,488 -46,402 -44,381 -34,486

SELL CMP ` 2,206 Target Price ` 1,920 Downside Potential 13%

Price Performance 52 wk Hi/Lo 2237/1376 All time Hi/Lo 2237/17 6 month Average Vol 478992 Stock Beta 0.44

Valuation FY11 FY12E FY13E

P/E (x) 22.1 21.0 17.8 P/BV (x) 14.9 10.9 8.2 RONW (%) 62 60 53 ROCE (%) 59 49 48

Peer Valuation - FY12E Bajaj Auto TVS Mot PE 15.0 12.1 P/BV 7.4 2.6

Equity Data Market Cap. (` bln) 440.5 Face value (`) 2 No of shares o/s (mln) 200

Jun’10 Jun’11 ∆% Promoters 52.21 52.21 0.00 DFI's 6.00 4.57 -23.83 FII's 31.16 33.67 8.06 Public 10.63 9.55 -10.16

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Hero MotoCorp BSE Auto

The split between the Hero group and Honda Motors presents short term challenges. We expect competition to be highest in both the executive motorcycle and the scooter segment in medium term. At CMP, HMC is trading at premium of over 30% to its three year mean P/E, valuations look expensive considering higher competition and continuing margin pressure. We do not expect high dividend payout ratio in medium term due to higher in house cash requirements. Our target price stands at ` 1,920/share (downside of 13%). We initiate coverage with a Sell rating.

Motrcycle gowth stable, competition to intensify We expects HMC domestic business to register 15% and 12% growth in FY12F and FY13F respectively with sales mix however skewed towards the sub 125cc segment. HMSI has announced plans to launch a motorcycle in the executive segment challenging HMC’s dominance in the segment. BAL has also launched Boxer 150cc in the segment which has received good initial response.

Dealer network key advantage, other catching up HMC dominance in the Indian markets, in our view, is largely due to vast customer touch point network across the country. It has the most excellent dealership network as compared to its peers in terms of reach and its ability to increase reach in new geographies. However BAL, HMSI and Yamaha are aggressively increasing their presence across the country thus negating the company’s key advantage.

Margins to remain under pressure The company plans to focus on the re-branding of the earlier “Hero Honda” brand with the new “Hero” brand both in domestic and global markets. HMC plans to spend ` 1750 mln on an image makeover in FY12E which would negatively impact margins. The company will also spend 1.0% to 1.2% of revenues on R&D over FY12-14E. HMC has guided R&D expenditure of ` 2,500 mln in FY12, majority of which will be capitalized in early years. The company till FY14 will be paying both royalty and the R&D expenses which will impact cash flows and profitability (to the extent it is expensed in P&L). We forecast margins to fall 190bps to 10.7% in FY12E

Initiate with Sell, TP of ` 1,920 (potential downside of 13%) We value HMC’s standalone business at 15.4x core FY13E core earnings, at nil premium to its three year historical mean P/E (based on core earnings). Our TP for HMC stands at ` 1,920 (including cash per share ` 257/share) with a downside potential of 13%. We initiate coverage with a Sell rating. At CMP of ` 2,206/share, it is trading at 21.0x and 17.8x FY 12E and FY 13E earnings.

Initiating Coverage

Ronak Sarda ronak.sarda@msflibg.in (+ 91 22 3094 7135)

Shyamal Dhruve shyamal.dhruve@msflibg.in September 21, 2011

Hero MotoCorp Ltd.

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Executive Summary We believe HMC to grow in line with industry both in motorcycle & scooter segment in FY12E however the product mix is expected to deteriorate. We expect competition to be highest in both the executive motorcycle and the scooter segment in medium term. At CMP, it is trading at premium of over 30% to its three year mean P/E, valuations look expensive considering higher competition in its key business segments and continuing margin pressure. We do not expect high dividend payout ratio in medium term due to increased in house cash requirements. With downside potential of 13% to our target price, we initiate with a Sell rating. The split between the Hero group and Honda Motors, in our view, will not only have an impact on the dynamics of the domestic two wheeler industry but will also alter the course of Hero MotoCorp Ltd. We expect increased competition from the erstwhile partner Honda Motors in medium term as it ramps up its production capacity and enhances the dealership network. The key challenges for the company will be to 1) set up a proper back end support or the efficient R&D facilities, superior quality, production efficiency and timely throughput to support the front end. 2) Successfully replace the established brand of “Hero Honda” with “Hero”. We expect company domestic motorcycle segment to register 15% and 12% growth in FY12F and FY13F respectively with sales mix however skewed towards the sub 125cc segment. We forecast more than 125cc segment to grow at much slower rate of 11% in FY12 mainly due to increasing competition from BAL and HMSI and also because of capacity constraints faced by the company. We expect the scooter segment to grow at higher rate than the two wheeler industry in FY12E driven by suitability and convenience factor attached to scooters. HMC until now has just one brand ‘Pleasure’ in the scooters segment targeting female consumers. The company has recently launched a 110cc scooter ‘Mastero’, a unisex model, targeting the urban markets. We expect HMC scooter segment to grow at a healthy CAGR of 17% over FY 2012-13E. HMC is dependent on its key models Splendor and Passion which contribute to over 70% of the vehicle sales. Motorcycle sales have crossed the 5lac per month mark in CY 2012 but it is largely skewed towards the entry and executive segment (low pricing power and low margin segment). Further, we expect HMC’s key segment to be the most competitive with host of new launches and upgrades from other players. HMSI has also announced its plan to launch a motorcycle in this segment while BAL has launched Boxer 150cc in the segment which has received good initial response. HMC dominance in the Indian markets, in our view, is largely due to vast dealership network across the country. It has the most excellent dealership network as compared to its peers in terms of reach. Its ability to increase reach in new geographies and growth markets which gives it an edge. BAL, HMSI and Yamaha are also aggressively increasing their presence across the country to challenge HMC dominance. BAL added 159 more dealers in FY11 and HMSI plans to increase its customer network by 200 annually in regional cities and rural districts. Yamaha also announced its plans of increasing its network strength in tier-2 and tier-3 cities and increasing the number of sub-dealers in rural areas. This is expected to challenge HMC’s key hold over domestic markets over the medium term. Export markets also offer a strong growth opportunity to Indian companies, given India’s low-cost manufacturing capabilities and superior quality. Hero Honda has been a laggard in the export market bound by the former licensing agreement with its JV partner Honda. We believe exports can prove to be a key earning driver over medium term as it invests in new manufacturing facility & ramps up its distribution network to carter to export markets. The company will also need to build its brand in the exports market which will be a dificult task. We therefore do not expect any meaningful contribution till FY14.

Operational challenges ahead

Motorcycle to grow in line with industry, product mix deteriorates New launch in scooters to grow

Product mix worst of the lot Competition to increase in medium term

Strong dealer network works best for Hero... but others catching up quickly

Exports to grow gradually

MSFL Research

75

The company plans to focus on the re-branding of the “Hero Honda” brand with the new “Hero” brand both in domestic and global markets. HMC will spend ` 1750 mln on an image makeover in FY12E (over and above the advertisement expenses) which would negatively impact margins. The company will spend 1.0% to 1.2% of revenues on R&D over FY12-14E. The company, till FY14, will be paying both royalty and the R&D expenses which will impact cash flows and profitability (to the extent it is expensed in P&L). We see that the stock has weakened over the factors discussed in table (except strong growth) as compared to BAL and we do not envisage higher payout ratio as seen in past two years due to higher cash requirement for HMC in the medium term (two new manufacturing facilities, R&D set-up and higher expenditure on branding and promotion). We expect HMC’s high growth in domestic markets to end as competition intensifies. Further, the product mix has deteriorated than last year due to falling volumes in high margin premium motorcycle segment thus continuing the margin pressure. We expect margin to fall 190bps in FY12E to 10.7%. We value HMC’s standalone business at 15.4x FY13E core EPS, at nil premium/discount to HMC’s three year mean P/E (based on core earnings), due to factors considered in table below. This gives us standalone value of ` 1,920/share (including cash per share of ` 257/share). At CMP of ` 2,206/share, it is trading at 21.0x and 17.8x FY 12E and FY 13E earnings. Table 1: Factors influencing valuation

FY 2006-11 FY 2011-13E#

HMC BAL TVS HMC BAL TVS

Volume growth 12% 10% 9% 14% 16% 15%

Exposure to exports Negligible High Low Negligible High Medium

Susceptibility to competition Low Medium High High Medium Medium

Margin performance 14.0% 16.8% 5.2% 11.1% 19.2% 7.2%

Adj. NPAT growth 15% 20% 11% 11% 13% 33%

Free cash flow growth 41% 25% NA 5% 24% 52%

Conclusion Strong Moderate Weak Weak Strong Moderate

Premium/Discount to Benchmark

Premium Discount High

Discount Nil

Premium Premium

Less Discount

Source: Company data & MSFL Research, # - MSFL forecasts and expectation Risk factors are failure of new launches, lower than expected demand in domestic markets, higher than expected competition, HMSI launching a motorcycle segment in executive segment, irrational price competition and failure to set up itself in overseas markets. Key catalysts to our target price is lower than expected expenditure on branding and R&D (improving margins), higher than expected demand scenario for HMC’s product and payout ratio. Our forecasts for HMC are below consensus expectation on all counts due to negative view on the operating leverage of the company. Our forecast at revenue and EBITDA levels are below consensus as we factor in lower vehicle realisation and higher other expenditure (branding and promotion). Table 2: MSFL forecasts v/s consensus

FY12E FY13E

Particulars (` mln, except per share data)

MSFL forecasts

Consensus % chg MSFL

forecasts Consensus % chg

Revenues 224,333 226,399 -1% 255,554 257,324 -1%

EBIT 21,697 24,472 -11% 26,036 28,990 -10%

EPS 104.9 112.8 -7% 124.0 130.4 -5%

Source: Bloomberg & MSFL Research

Key Risk & catalysts to

valuation

Re-branding exp to weigh

on margins while R&D set

up to lower cash flows

How we differ from

consensus

Valuations expensive, risk to

reward ratio increases

Sell with TP of ` 1,920-downside of 13% Prefer BAL and TVS to HMC

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76

Business model – challenges ahead… The split between the Hero group and Honda Motors, we believe, shall not only have an impact on the dynamics of the domestic two wheeler industry but will also alter the course of Hero MotoCorp Ltd. As noted in our earlier section, we expect increased competition from the erstwhile partner Honda Motors in medium term as it ramps up its production capacity and enhances the dealership network. The key challenges for the company will be to 1) set up a proper back end support or the efficient R&D facilities, superior quality, production efficiency and timely throughput to support the front end. 2) Successfully replace the established brand of “Hero Honda” with “Hero”. HMC is the largest two wheeler manufacturer in India and has established a strong brand over the period, we therefore see the Hero Group acquisition of Honda’s stake a step forward in establishing the Hero MotoCorp brand in the booming overseas markets and developing its own R&D capabilities to drive future growth. We however also foresee various challenges in the near – medium term which needs to be addressed successfully for HMC’s continuous growth and sustained competitiveness. The licensing agreement signed with Honda over the transient period looks favorable for the company as it provides 1) technological support until 2014 2) unchanged royalty structure 3) new product/upgrades at one time licensing fees and 4) Use of Hero Honda brand until the 2014 (if no modification is made to products). This to some extent reduces near term threat however the key challenges will be to 1) set up a proper back end support or the R&D facilities, superior quality, production efficiency and timely throughput to support the front end and 2) Successfully replace the established brand of “Hero Honda” with “Hero”. As seen in cases of both BAL and TVS, it takes several years to effectively develop a product which not only suits the customer needs and market conditions but also creates a market for itself. As can be seen with BAL for example it launched Pulsar and Discover back in 2001 and 2004 which finally established as major products after 2007-08. It also made failed attempts with Caliber and Avenger (many variants). Moreover, HMC will have to upgrade its engines to comply with the Bharat IV emission norms which are scheduled to be implemented by 2015. The company has started investing in human resource and setting up the required infrastructure but it would be difficult to gauge the timeframe required for HMC to successful develop an in-house R&D facility. We believe market concerns about company’s capabilities of successfully developing R&D to be justifiable as it fears the technology gap could play the spoiler even after having the best in class marketing and distribution network. We believe this to be a tough task in hand and needs immediate attention. Exhibit 1: R&D costs for BAL and TVS vis-à-vis royalty cost for HMC

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

TVSM BAL HMC

FY06 FY07 FY08 FY09 FY10 FY11

Source: Company data & MSFL Research

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HMC being the largest two wheeler player and with exposure to one of the fastest growing economies can also opt for a new technological alliances with another partner to replace Honda Motors. We however believe that it will set up its own R&D facility as it is more cost efficient alternative in longer term (reduces as a % of sales with increasing revenues as compared to royalty which remains stable in % terms). We compare the royalty cost HMC has paid over the period to Honda with R&D expense in BAL and TVS and note that once successfully established it not only results in lower costs but also eliminates dependence and thus brings in flexibility. Historically, R&D expense for BAL and TVS has been ranged from 1%-2.5% however we see a general downward trend as the revenue increases over a period. The company plans to spend 1.0% to 1.2% of revenues on R&D over FY12E to FY14E. HMC has guided to R&D expenditure of ` 2,500 mln in FY12, majority of which will be capitalized. The company till FY14 will be paying royalty and simultaneously incurring R&D expenses which will impact cash flows and profitability (to the extent R&D is expensed in P&L). Sales growth to be in line with industry Motorcycle – Splendor and Passion still drive strong We forecast HMC to register sales growth in line with the industry driven by robust rural demand and urban replacement demand. We expect company motorcycle segment to register 15% and 12% growth in FY12F and FY13F respectively with sales mix however skewed towards the sub 125cc segment. We forecast more than 125cc segment to grow at much slower rate of 11% in FY12 mainly due to increasing competition from BAL and HMSI and also because of capacity constraints in the premium segment.

Exhibit 2: Domestic motorcycle sales and growth (% RHS) Exhibit 3: Domestic motorcycle sales mix

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75cc to 125cc motorcycles 125cc to 250cc motorcycles

Source: Company data & MSFL Research We believe market concerns regarding customer loyalty after the split with Honda to be overdone as the products will continue to be serviced by Honda till 2014 under the new licensing agreement. As per the management, the contribution from the rural areas to overall sales has increased from 38% in FY 2009 to 45% in current fiscal year. This substantiates that its brand has more than just a name to it. The company is witnessing robust demand growth across India and is thus not dependant on particular geography. However declining contribution from the premium segments will lead to margin pressure. Further, its bread and butter executive segment is the one which we expect to be most competitive and thus reudcing pricing power for HMC.

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Exhibit 4: Domestic Market share

30%

35%

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45%

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2006 2007 2008 2009 2010 2011 YTD 2012

Motorcycle mkt share Overall mkt share

Source: SIAM & MSFL Research In the FY11, Hero’s share of the domestic motorcycle segment has declined by c400bps, mainly going to Bajaj and HMSI. We attribute this to the success of Bajaj’s Discover range and lack of focused launches by HMC during this period. However, with the recent launch of the Splendor Pro and other refurbished models, it partially gained back most of the market it lost. With new model support from Honda over the next two years, we forecast Hero’s share of the domestic motorcycle market to stabilize at about 52% for FY12-13 with downward bias. Scooters sales remain buoyant We expect the scooter segment to grow at higher rate than the two wheeler industry in FY 12 driven by more suitability and convenience factor attached to scooters. HMC until now has just one brand ‘Pleasure’ in the scooters segment targeting female consumers. The company has recently launched an 110cc scooter ‘Mastero’, a unisex model, targeting the urban markets and in direct competition to TVS’s Wego. With Increasing female working population, college goers and the convenience factor attached to scooters, we expect HMC scooter segment to grow at a healthy CAGR of 17% over FY 2012-13E.

Exhibit 5: Domestic scooter sales and growth (% RHS) Exhibit 6: Domestic scooter market share

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2006 2007 2008 2009 2010 2011 YTD 2012

Source: Company data, SIAM & MSFL Research Since its entry into the scooter market, it has garnered a good slice of market in short period of time. Its market share at end 1Q FY12 was more than 18%. Its nearest rival in the segment is TVS Motors with its trademark ‘Scooty’ model which has increased its share. However with HMSI ramping up production at its Rajasthan plant and higher competition, we expect HMC’s share to peak out and remain near 17-18% over FY12-13.

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Product mix – worst of the lot HMC continues to be dependent on its key models Splendor and Passion which contribute to over 70% of the vehicle sales. Motorcycle sales have crossed the 5lac mark per month in CY 2012, an impressive feat in our view, but it is largely skewed towards the entry and executive motorcycles. The proportion of sub 125cc bikes (marked with low pricing power and lower margins) of the total domestic motorcycle sales have increased to more than 93% in 1Q FY12. We expect the bread and butter segment of HMC to be the most competitive with all players planning to launch a model in this segment. Though HMC has been able to maintain its leadership in the domestic 2W industry low pricing power and elevated input prices (as per our forecasts) will put pressure on margins.

Exhibit 7: Overall sales mix Exhibit 8: Domestic & export break up

80%

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100%

FY06 FY07 FY08 FY09 FY10 FY11 FY12P FY13P

Motorcycles - < 125cc Motorcycles - > 125cc Scooters

95%

96%

96%

97%

97%

98%

98%

99%

99%

100%

100%

FY06 FY07 FY08 FY09 FY10 FY11 FY12P FY13P

Domestic Exports

Source: Company data & MSFL Research (LHS scale adjusted) Neither three wheelers nor high exports… HMC does not have exposure to three wheelers and its export growth was constricted due to agreement with its tech partner Honda. The three wheeler domestic segment which is largely dominated by BAL & Piaggio enjoy high margins of nearly 30%. Similarly exports enjoy high margins due to government support in form of export incentives (currently 5.5% of FOB value). However increasing scooters sales will marginally improve the product mix, we say marginally because we forecast scooters share to increase 40bps to 7.1% of overall sales in FY13E.

MSFL Research

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Competition intensifies.. HMC and BAL are the two largest players in the domestic motorcycle industry with market share swinging from BAL to HMC during the slowdown experienced in 2008-09 and BAL regaining most of the market share in 2010-11 (see chart). BAL has launched a 150cc Boxer bike in August at an attractively price of ` 40,000. It is a multipurpose vehicle with power and durability of high end model at price of commuter standard model, we believe it could take some market share from HMC. BAL will progressively launch the model across India. It is further planning to launch Pulsar in 4Q FY12 which will receive positive reaction.

Exhibit 9: Motorcycle Market share diff – domestic Exhibit 10: Motorcycle Market share diff – (Domestic+Export)

10%

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35%

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50%Difference Average

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Source: SIAM & MSFL Research Also, with termination of JV between the Hero group and Honda, we feel Honda will more aggressively enter the domestic two wheeler market. It has already invested in setting up new facility in Rajasthan and coming up with another in Tamil Nadu. It is also ramping up the dealer network to challenge HMC dominance in India. Moreover, other players like Yamaha and Suzuki are also planning to launch a model in the high growing executive model. Both the players are still facing capacity constraints but have gained market share in the motorcycle & scooter segment. Dealer network and wide coverage works best for Hero... HMC dominance in the Indian markets, in our view, is largely due to vast dealership network across the country. It has the most excellent dealership network as compared to its peers in terms of reach and its ability to increase reach in new geographies and growth markets which gives it an edge. To further strengthen its presence in the flourishing rural markets, HMC had launched a dedicated rural vertical in 2007-08, which took several new marketing initiatives including launch of a national-level programme to direct sales efforts in territories with a population of 5,000 and above. Setting up a dealer involves a huge investment from both company and dealer point of view and thus lower volumes in the initial periods may deter new dealer inclusions. This is one of the key challenges confronting the relatively smaller players. HMC’s Splendor and Passion models, on the other hand, are household names for the last decade and the confidence in the company has been the major driving factor in helping it establish its network in new regions with some ease. HMC's extensive sales and service network now spans close to 5,000 customer touch points in FY10 (compared to 2,000 in FY06). These comprise a mix of authorized dealerships (approx 800 dealers), service & spare parts outlets, and dealer-appointed outlets across the country. It further plans to add 500-600 customer touch points every year.

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Exhibit 11: Dealer network Exhibit 12: Customer touch points

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HMC BAL TVS HMSI

Dealer

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HMC BAL TVS HMSI

Touch points

Source: Company data, media & MSFL Research …Bajaj, HMSI and others catching up quickly While HMC maintains pole position in the dealership network, other players have started to increase their dealer network to challenge HMC dominance and have a meaningful impact in the domestic markets. BAL and HMSI are thus aggressively increasing their presence across the country with popular products in their kitty. BAL which had nearly 500 dealers in the country added 159 more in FY11 of which more than 50% of outlets are in areas where the company did not have any presence earlier. At present, BAL’s distribution network is well placed as far as the Pulsar, a premium brand with an urban focus, is concerned. This network expansion programme was directed mainly towards the smaller towns and villages where its mass commuter bike Discover and now Boxer (launched in August 2011) can get a boost. Similarly HMSI plans to increase its customer network by 200 annually in regional cities and rural districts and also plan to introduce new products suited for the mass market and targeted at rural consumers. Yamaha mainly caters to urban markets with rural sales accounting for just 15% of its sales which is well below the industry average. The company recently announced its plans of increasing its network strength in tier-2 and tier-3 cities and increasing the number of sub-dealers in rural areas. We agree that increasing the distribution network will requires OEM’s to make higher investments initially and also ensure sufficient inventory at dealer level for them to be profitable. Thus ramp up by HMSI and Yamaha will challenge HMC’s dominance in the medium term. New product launches The company plans to continuously churn its product portfolio (see table) to better suit the need of customers as it has been doing over the last two - three years. The company in FY 12 has already launched refurbished models of Glamour, Glamour Fi, Karizma and Karizma ZMR. Moreover, as per the new agreement with Honda, Honda will provide it with technological support for new and refurbished launches. Sourcing new products from Honda will attract one time license fees and royalty of up to 5% of the net realization price. The company targets nearly 7-8 new introductions every year which will include one new model, one or two variants and the balance to be refresh or remodeled.

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Table 3: Vehicle launches

Year Vehicle launches

2001 Passion, Joy

2002 Dawn, Ambition

2003 CD Dawn, Splendor Plus, Passion Plus, Karizma

2004 Ambition 135, CBZ

2005 Super Splendor, CD Deluxe, Glamour, Achiever, Pleasure

2006 CBZ X‐treme, Karizma, Glamour, Passion Plus

2007 New Splendor NXG, CD Deluxe, CD Dawn, Hunk, Passion

2008 Pleasure (scooter) , Splendor, Super Splendor, Passion Pro, CBZ Xtreme, CD Deluxe, Glamour, Glamour FI

2009 Hunk, Karizma ZMR FI

2010 Super Splendor, Hunk, Splendor Pro

2011 Launch of refreshed versions of Glamour, Glamour FI, CBZ Xtreme, Karizma

2012 Maestro (scooter), Impulse (sports), 125cc motorcycle (expected)

Source: Company data & MSFL Research HMC launched an 110cc scooter “Maestro” and a 150cc on-road-off-road motorcycle “Impulse” at the launch of its new brand identity in early August. This on-off road dual purpose motorcycle will have an 150cc engine and the first in the niche segment. It will be imported in CKD form from Honda Motors and will be assembled in Hero Honda’s Gurgaon factory. It is believed to be priced in range of ` 1.1 lacs and ` 1.3 lacs.

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Exports – a low hanging fruit? Export markets also offer a strong growth opportunity to Indian companies, given India’s low-cost manufacturing capabilities and superior quality. We believe with increasing competition in the domestic market and reducing pricing power, companies with stable/growing exports have an edge over other players as it not only results in revenue diversification but also relatively stable margins. Thus increasing export market share has been a key component of their growth plans. Hero Honda has been a laggard in the export market bound by the former licensing agreement with its JV partner Honda wherein HMC was to export to only countries where Honda did not have any presence (a no cannibalizing market share clause). This had particularly eliminated most of the rapidly growing Asian and African countries from the list of potential markets where Honda already had presence. Hero Honda, currently, has presence only in South Asian countries like Sri Lanka, Nepal and Bangladesh with exports sales contributing only 2% to both volumes and gross sales. This is in comparison to BAL where exports contribute to more than 30% and TVS Motors where exports are c15% of sales at the end of FY12E.

Exhibit 13: Export sales and growth (% RHS) Exhibit 14: 2W export market share

-20%

-10%

0%

10%

20%

30%

40%

0

50,000

100,000

150,000

200,000

250,000

FY07 FY08 FY09 FY10 FY11 FY12P FY13P

Export sales % Growth

0%

10%

20%

30%

40%

50%

60%

70%

80%

2006 2007 2008 2009 2010 2011 YTD 2012

Bajaj Auto Hero Honda TVS Motor

Source: Company data, SIAM & MSFL Research

Now with the termination of the JV, HMC has the freedom to target the booming export markets which in our view can be a key earning driver in medium term. We however believe the sales volume ramp-up will require a significant lead time to set up of new dealership network and compete with established players and products. This will be altogether a different ball game for the company and similar to what was seen in the case of Bajaj, which entered the export markets back in 2002-03. It will also need to adapt itself to the dynamics of local markets by coming up with new or modified products to create a brand positioning in those markets. We note that the most popular models are BAL’s Boxer in the African markets categorized by low cost durable commuter product and TVS Motor’s step-thru’s for the South East Asian markets. We therefore do not expect any meaningful contribution till FY14. Capacity expansion The current capacity at HMC’s manufacturing plants is near 6.1mln units (from 5.7mln units in FY11) and it expects to increase it to near 6.5mln units by end FY12 through debottlenecking at its existing facilities. The current capacity will be in our view being able to only suffice the growing domestic demand and to cater to the export market it will have to take up capacity expansions. HMC is planning to set up a new facility (location not finalized) in the southern belt of India with initial capacity of 0.75mn vehicles (which can be expanded to 1.5mn units). It will also set up a new plant to cater to the exports markets. The company has lined up a capex of ` 9000mln in FY12, of which ` 5000-5500mln is earmarked for setting up this new plant. At the exit capacity end FY12 & FY13 (including the new plant) and our volume forecasts, utilisation levels would be around 97% and 98% respectively. This is significantly higher than the historical average and makes it vulnerable to supply based issues.

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Exhibit 15: Capacity and Utilisation – update chart

60%

65%

70%

75%

80%

85%

90%

95%

100%

0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

7,000,000

8,000,000

FY09 FY10 FY11 FY12E FY13E

Exit Capacity Utilisation

Source: Company data & MSFL Research

Re-branding exercise to weigh on margins The company plans to focus on the re-branding of the earlier “Hero Honda” brand with the new “Hero” brand both in domestic and global markets. HMC plans to spend ` 1,750 mln on an image makeover in FY12E which would negatively impact margins and cash flows. This is expected to include re‐branding expenditure of 1,000mln in FY12, in addition to the marketing expenditure. HMC has appointed creative firm Law & Kenneth to develop communication strategy for launching and establishing its new brand identity. It had earlier in March appointed London-based Wolff Olins to design a new identity for the company. The re‐branding expenditure is likely to pull down the FY12E EBITDA margin by 60bps, as marketing expenditure as a percentage of sales is likely to increase from 2.2% in FY11E to 2.8% in FY12E.

Exhibit 16: Adv & branding expenditure (mln) and % of revenues Exhibit 17: royalty cost (mln) and % of revenues

1.0%

1.5%

2.0%

2.5%

3.0%

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12E

Advertising and Publicity % of Total Revenue

2.0%

2.2%

2.4%

2.6%

2.8%

3.0%

3.2%

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

FY06 FY07 FY08 FY09 FY10 FY11 FY12E FY13E

Royalty % of Net Sales

Source: Company data & MSFL Research

Royalty & R&D – cash flows to strain during the transitory period HMC has entered into a new licensing agreement with Honda, which allows the company to use Honda’s technology & Hero Honda brand till 2014. The royalty is agreed at ` 24.8bn, to be amortized over 14 quarters till 1QFY15. Further, the company will pay one time license fees for new models it launches in the transitory period. Royalty as a percentage of total income is likely to increase to 3.1% in FY12E and 2.8% in FY13E, higher than the historical average of 2.5% over FY05‐11. The company plans to spend 1.0% to 1.2% of revenues on R&D over FY12-14E. The company, till FY14, will be paying both royalty and the R&D expenses which will impact cash flows and profitability (to the extent it is expensed in P&L).

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Financial Analysis Net sales forecast to increase by a 15% CAGR from FY11-13 We expect HMC’s net revenue to grow at a CAGR of 15% over the next two years to 255,554mln in FY13E. We believe the muted rise in ASP over the past three years (5% over FY08-11) on account of increasing competition to continue and revenues to be driven by volumes. We expect exports (gross) to grow at a CAGR of 29% to 7,439mln in FY13E and account for more than 3% of toal sales.

Exhibit 18: Sales volume and growth (% RHS) Exhibit 19: Net sales (mln) and growth (% RHS)

-5%

0%

5%

10%

15%

20%

25%

0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

7,000,000

8,000,000

FY07 FY08 FY09 FY10 FY11 FY12P FY13P

Sales % growth

0%

5%

10%

15%

20%

25%

30%

0

50,000

100,000

150,000

200,000

250,000

300,000

FY06 FY07 FY08 FY09 FY10 FY11 FY12E FY13E

Net Sales y-o-y % change

Source: Company data & MSFL Research Input costs lead by conversion costs to stabilize margins at current levels As discussed in earlier section, we expect commodity prices to soften in second half but still remain at elevated levels and fall marginally in FY13E. The raw material cost as a percentage of total income is expected to increase from 72.9% in FY11 to 73.3% in FY13E driven by higher conversion costs (fuel and labor costs at vendor’s end). We build in relatively lower raw material expenditure (as compared to peers) as the company will have benefit of sourcing materials from other than pre specified vendors. As per the management, HMC currently buys material and components from Honda’s pre-approved vendors.

Exhibit 20: Cost and EBITDA break up Exhibit 21: EBITDA (mln) and EBITDA margin (% RHS)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

FY07 FY08 FY09 FY10 FY11 FY12P FY13P

Raw Material % Staff Cost % Other Expenditure % EBITDA Margin

5%

7%

9%

11%

13%

15%

17%

19%

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

FY06 FY07 FY08 FY09 FY10 FY11 FY12E FY13E

EBITDA (post-royalty) EBITDA (post-royalty) %

Source: Company data & MSFL Research We forecast adjusted EBITDA margins to fall to 10.7% in FY12 before increasing to 11.4% in FY13E mainly due to higher branding and marketing expenditure in current year. Further, royalty expenses are expected to stay at similar levels till FY14, thus we expect a meaningful recovery in margins only post FY14 once royalty payments to Honda end and HMC is able to successfully set up the R&D facility. The current

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margins are way below the margin it enjoyed in early 2000’s and we expect similar trend to continue. HMC’s Haridwar plant will lose its 100% tax-exempt status in FY14 and the fiscal incentive will be limited to 30% of net income which will offset savings in royalty to some extent. Net profit expands We estimate a favorable trend in other income (on back of rising cash in company books) and lower tax rate translating into significantly higher NPAT growth. We estimate adjusted NPAT to record a CAGR of 11% over FY11-13E to 24,764mln. We forecast adjusted EPS to be 121/share in FY13E from 99.7/share in FY11.

Exhibit 22: EBITDA and NPAT margin (%) Exhibit 23: Adj NPAT (mln) and growth (% RHS)

5%

7%

9%

11%

13%

15%

17%

19%

FY07 FY08 FY09 FY10 FY11 FY12P FY13P

EBITDA Margin NPAT Margin

-20%

0%

20%

40%

60%

80%

100%

0

5,000

10,000

15,000

20,000

25,000

30,000

FY06 FY07 FY08 FY09 FY10 FY11 FY12E FY13E

Profit after Tax % y-o-y

Source: Company data & MSFL Research We expect lower free cash flow growth over the next two years due to higher requirement of cash for in house set up of R&D, capacity expansion and higher branding expeniture. We therefore do not foresee high payout ratio as observed in last two years. On our forecasts, dividend yield at CMP is lower than the average yield of its two wheeler peers.

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Valuation methodology and Recommendation Hero Motocorp – Initiate with Sell; target price of ` 1,920 (downside of 13%) We expect two-wheelers to grow at 15% in FY12E and expect demand to moderate in FY13E. We expect the executive segment, bread and butter segment for HMC, to be most competitive segment as OEM’s launch new models and upgrades to retain buyer interest and thus expect margins to remain under pressure. HMC has outperformed both Index and peers in last one month and currently trades at more than 30% premium to its three year mean P/E multiple which in our view is not sustainable due to following factors: Table 4: Factors influencing valuation

FY 2006-11 FY 2011-13E#

HMC BAL TVS HMC BAL TVS

Volume growth 12% 10% 9% 14% 16% 15%

Exposure to exports Negligible High Low Negligible High Medium

Susceptibility to competition

Low Medium High High Medium Medium

Margin performance 14.0% 16.8% 5.2% 11.1% 19.2% 7.2%

Adj. NPAT growth 15% 20% 11% 11% 13% 33%

Free cash flow growth 41% 25% NA 5% 24% 52%

Conclusion Strong Moderate Weak Weak Strong Moderate

Premium/Discount to Benchmark

Premium Discount High

Discount Nil

Premium Premium

Less Discount

Source: Company data & MSFL Research, # - MSFL forecasts and expectation We see that the stock has weakened over all the factors (except strong growth) as compared to BAL and we do not envisage higher payout ratio as seen in past two years due to higher cash requirement for HMC in the medium term (two new manufacturing facilities, R&D set-up and higher expenditure on branding and promotion). We expect dividend yield to be lower than the average of the other two wheeler peers. HMC has been able to register strong volume growth in YTD FY12, against consensus expectation, and has been key reason for the outperformance. We believe exports growth to moderate in 2H FY12 and expect higher competition from BAL and TVS in the domestic markets (not to forget HMSI’s threat in medium threat). We thus expect HMC’s high growth period to end and record growth in line with industry. Further, the product mix has deteriorated than last year due to falling volumes in high margin premium motorcycle segment thus continuing the margin pressure. We expect margin to fall 190bps in FY12E to 10.7%. We Initiate coverage on the stock with a Sell rating with our SOTP based one year target price at ` 1,920 with a potential downside of 13%. Risk factors are failure of new launches, lower than expected demand in domestic markets, higher than expected competition or irrational price competition and failure to set up itself in overseas markets. Key catalysts to our target price is lower than expected expenditure on branding and R&D (improving margins), higher than expected demand scenario for HMC’s product and payout ratio.

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Exhibit 24: Price band chart (1 year forward earnings)

5x

8x

12x

16x

20x

0

500

1000

1500

2000

2500

Mar

-00

No

v-00

Jul-

01

Mar

-02

No

v-02

Jul-

03

Mar

-04

No

v-04

Jul-

05

Mar

-06

No

v-06

Jul-

07

Mar

-08

No

v-08

Jul-

09

Mar

-10

No

v-10

Jul-

11

Source: Bloomberg, Company data & MSFL Research The stock traded close to 20x (peak) its one year forward earnings back in FY 2006-07 when it registered a five year volume & net profit CAGR of 18-19% (FY02-07). However with slump in two wheeler industry it traded at a trough of 8x one year forward earnings. With increasing competition, moderating growth and subdued margins over FY11-13E such high valuations, in our view, are not justifiable. We value HMC’s standalone business at 15.4x FY13E core EPS, at nil premium/discount to HMC’s three year mean P/E (based on core earnings), due to factors considered above. This gives us standalone value of ` 1,920/share (including cash per share of ` 257/share) Table 5: Target price calculation

NPAT 24,764

Int income (net of tax) 3,196

Core PAT 21,568

Core EPS 108.0

PER 15.4

Operating value 1,663

Cash in book (incl liquid invs) 51,288

Cash per share 257

Fair value 1,920

Source: MSFL Research At CMP of ` 2,206/share, it is trading at 21.0x and 17.8x FY 12E and FY 13E earnings. At our target price, the company is expected to trade at 18.3x and 15.5x FY12E and FY13E earnings respectively.

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Financial Summary Profit & Loss Particulars (` in mln) 2008 2009 2010 2011 2012P 2013P Sales 103,318 123,823 158,605 194,012 224,333 255,554 Total Expenditure 89,824 107,104 130,936 169,663 200,265 226,372 EBIDTA 13,494 16,718 27,670 24,349 24,068 29,181 EBIDTA Margin (%) 13.1% 13.5% 17.4% 12.6% 10.7% 11.4% Depreciation (incl Royalty) 1,603 1,807 1,915 2,203 2,521 3,381 EBIT 11,891 14,912 25,755 22,146 21,547 25,801 Interest cost -358 -317 -206 -19 -150 -235 Operating Profit 12,249 15,228 25,961 22,165 21,697 26,036 Other Income 1,854 1,809 2,356 2,681 3,545 3,800 Extraordinary Item 0 0 0 -798 0 0 PBT 14,103 17,038 28,317 24,048 25,242 29,836 Tax 4,380 4,947 5,999 4,769 4,291 5,072 PAT 9,723 12,090 22,318 19,279 20,951 24,764 PAT Margin (%) 9.4% 9.8% 14.1% 9.9% 9.3% 9.7% EPS 48.5 60.3 111.8 99.7 104.9 124.0 Sales Growth (%) 4% 20% 28% 22% 16% 14% EBITDA Growth (%) 15% 24% 66% -12% -1% 21% PAT Growth (%) 13% 24% 85% -14% 9% 18% Source: Company data & MSFL Research

Balance Sheet Particulars (` in mln) 2008 2009 2010 2011 2012P 2013P Sources of Funds Share Capital 399 399 399 399 399 399 Reserves & Surplus 29,463 37,608 34,251 29,161 39,865 53,243 Networth 29,862 38,008 34,650 29,561 40,264 53,642 Secured Loans 0 0 0 0 0 0 Unsecured Loans 1,320 785 660 14,912 13,420 12,078 Total Loans 1,320 785 660 14,912 13,420 12,078 Deferred Tax Liability 1,306 1,531 1,606 2,468 2,468 2,468 TOTAL 32,488 40,323 36,917 46,940 56,152 68,188 Application of Funds Net Fixed Assets 15,487 16,943 17,069 17,261 24,608 25,738 Investment 25,668 33,688 39,257 51,288 56,416 63,186 Current Assets 9,368 10,135 28,826 15,046 18,468 30,462 Current Liabilities 18,247 20,528 48,314 61,448 62,849 64,948 Net Current Assets -8,880 -10,393 -19,488 -46,402 -44,381 -34,486 Intangible assets (royalty) 161 0 0 24,793 19,509 13,750 Deferred Tax Assets 52 87 79 0 0 0 TOTAL 32,488 40,323 36,917 46,940 56,152 68,188

Source: Company data & MSFL Research

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Cash Flow Particulars (` in mln) 2008 2009 2010 2011 2012P 2013P

Internal accruals 11,338 14,088 24,233 23,303 30,756 35,403

(Inc)/Dec in Net Current Assets -4,174 -2,399 -25,971 -8,557 -802 -1,104

Cash flow from Operations 15,512 16,486 50,204 31,859 31,558 36,507

Inc/(Dec) in Debt -332 -535 -125 14,251 -1,491 -1,342

Inc/(Dec) in Equity 0 0 0 0 0 0

Cash flow from Financing -332 -535 -125 14,251 -1,491 -1,342

Fixed Asset formation 3,407 3,056 1,623 2,395 11,867 6,011

Dividend Payment 4,439 4,673 25,676 23,910 10,247 11,386

Inc/(Dec) in Investment 5,930 8,019 5,570 12,030 5,129 6,770

Cash flow from Investment 13,775 15,748 32,868 38,336 27,243 24,167

Net Change in Cash 1,405 203 17,212 7,775 2,823 10,998

Source: Company data & MSFL Research

Ratios Valuation Ratio 2008 2009 2010 2011 2012P 2013P P/E 45.7 36.7 19.8 22.2 21.1 17.9 P/BV 14.8 11.6 12.8 15.0 11.0 8.2 EV/EBIDTA 10.4 26.6 13.8 16.3 16.4 13.5 EV/Sales 1.4 3.6 2.4 2.0 1.8 1.5 Dividend Yield (%) 0.9% 0.9% 5.0% 4.7% 2.0% 2.3% EPS adjusted 48.5 60.3 111.8 99.7 104.9 124.0 DPS 19.0 20.0 110.0 105.0 45.0 50.0 Book Value 149.5 190.3 173.5 148.0 201.6 268.6 Adj. ROE (%) 36% 36% 61% 62% 60% 53%

Adj. ROCE (%) 46% 46% 73% 59% 49% 48%

Solvency Ratio (x)

Debt/Equity 0.51 0.49 0.60 0.24 0.29 0.47 Debt/EBIDTA 0.10 0.05 0.02 0.57 0.43 0.33

Turnover Ratio (x)

Asset Turnover 3.4 3.4 4.1 4.6 4.4 4.1 Fixed Asset Turnover 7.1 7.6 9.3 11.3 10.7 10.2 Current Ratio 7.1 7.6 9.3 11.3 10.7 10.2 Inventory (days) 13 11 12 11 11 11 Debtors (days) 11 7 3 2 2 2 Source: Company data & MSFL Research

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MSFL Disclaimer: All information/opinion contained/expressed herein above by MSFL has been based upon information available to the public and the sources, we believe, to be reliable, but we do not make any representation or warranty as to its accuracy, completeness or correctness. Neither MSFL nor any of its employees shall be in any way responsible for the contents. Opinions expressed are subject to change without notice. This document does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this document. This document is for the information of the addressees only and is not to be taken in substitution for the exercise of judgement by the addressees. All information contained herein above must be construed solely as statements of opinion of MSFL at a particular point of time based on the information as mentioned above and MSFL shall not be liable for any losses incurred by users from any use of this publication or its contents.

Analyst declaration We, Ronak Sarda & Shyamal Dhruve, hereby certify that the views expressed in this report are purely our views taken in an unbiased manner out of information available to the public and believing it to be reliable. No part of our compensation is or was or in future will be linked to specific view/s or recommendation(s) expressed by us in this research report. All the views expressed herewith are our personal views on all the aspects covered in this report.

MSFL Investment Rating The ratings below have been prescribed on a potential returns basis with a timeline of up to 12 months. At times, the same may fall out of the price range due to market price movements and/or volatility in the short term. The same shall be reviewed from time to time by MSFL. The addressee(s) decision to buy or sell a security should be based upon his/her personal investment objectives and should be made only after evaluating the stocks’ expected performance and associated risks.

Key ratings:

Rating Expected Return

Buy > 15% Accumulate 5 to 15% Hold -5 to 5% Sell < -5% Not Rated -

Marwadi Shares & Finance Limited Institutional Business Group, MSFL @p-sec, 306, Gresham Assurance House

Registered Office Marwadi Financial Plaza, Nava Mava Main Road,

132, Mint Road, Fort, Mumbai - 400 001 Off 150 FT. Ring Road, Rajkot - 360 005 Tel : + 91 22 2269 0474 / 75 Fax : +91 22 2269 0478 Tel : + 91 281 2481313 / 3011000