Honda Motors: A Buy on Further Weakness

Sep.24.09 | About: Honda Motor (HMC)

Honda Motors (NYSE:HMC) has grown earnings at negative 5.41% annualized between 1999 and 2008. By the end of 2009 the annualized rate is expected be negative 10.91%.

When you compare two points in time ignoring the period in between, you get a good handle on annualized rates, but you do not get the trend. For example, the average year on year change in EPS for HMC during the 1999 to 2009 period was 5.22%; the damage to earnings was inflicted on HMC during 2008 and 2009; it is pretty clear that the stock as suffered as a consequence of the crushed consumer following the popping of the property bubble and debt bubble.

What is encouraging is how well they have held up in very poor industry wide conditions. HMC has grown dividends at an annualized rate of over 13% between 1999 and 2009. This is good, but the payout has risen to over 87.50% even after the 2009 dividend cut.

Because operating cash flows have remained strong running at over $2 over the rolling 12 months, I believe the reduced dividend is safe, provided that 2009 is a trough year with a fairly robust recovery during 2010.

HMC uses a mix of dividends and buybacks to return shareholder value; the payout ratio including buybacks has run at a median of 20%. Unlike the vast majority of buyback programs, HMC’s program is not disappointing; they have reduced share count by 7% 1999 and 2009 and they have purchased shares during 2003 and 2004 – years when the shares were trading cheap.

Buybacks are good; they boost earnings growth and it offer a tax effective method through which continuing shareholders in effect reinvest dividends with no tax consequences. But they are also bad, because they remove choice; personally I would not re-invest dividends in a stock which was trading at a premium to fair value; I would prefer to pay the tax and invest net proceeds elsewhere.

Buybacks only work well when shares are trading at a discount to fair values and I will never understand why companies buyback when shares trade at premium levels.

HMC has a reasonable balance sheet with a net debt to net debt plus equity ratio of 48.39%. This is well over my “normal” debt acceptance level of 30%, but frankly, for the industry, investment in financial services is essential to drive growth and maintain market-share.

I am glad the balance sheet is not leveraged to over 80% as is the case in several US Industrials, because HMC’s exposure is to lower quality consumer debt. Over-all I would consider HMC’s balance sheet sound in the context of its industry.

The stock is yielding over 1%; which is not great. It is also trading at a premium on value relative to SP500 on a 2009 basis and the 6 year basis is in line; so HMC is not cheap; but its not terribly expensive given upcoming replacement cycle growth triggers.

HMC is a global leader in its space; I expect it to consolidate and increase share over the coming years. HMC’s presence in emerging and lesser developed economies is a major plus because it provides access to growth markets.

In developed economies, HMC can look forward to acceleration in earnings growth, 2008 and 2009 have been hard years; but eventually cars must be replaced – some recovery in 2010 is likely as consumers recover from the recession – 2011 can be expected to be even stronger.

As a discretionary stock, HMC can expect to mark time during the first six months of an economic expansion and then outperform during the subsequent six months.

In my view the stock is a buy on weakness play; I would buy half of my intended allocation at $29, a further half if the stock falls to $28. The dividend yield together with capital gain potential to 2014 is attractive; I believe the scope for dividend growth from $0.35 presently is considerable and am looking for dividend to double by 2014. I estimate a bullish price objective of $58 for 2014 with a higher confidence lower target of $48.

Please refer to HMC on the Quant Report for insight into numbers referred to above.

Disclosure: No holdings.