Honda Motor: Key Challenges To Come For Both Motorcycles And Automobiles
Summary
- Honda's motorcycle business is the company's core earnings driver. We believe it will face headwinds in the form of maturing ASEAN markets, and EV product introduction.
- The automobile business continues to face challenges to execute cost reductions, although the key will be to raise sales volume primarily in the US.
- The shares are trading on PER FY3/2022 8.8x with a prospective dividend yield of 3.4%. These are not expensive but we are neutral on the shares.
Investment thesis
We expect to see Honda (NYSE:HMC) see a muted return to growth in its motorcycle business as ASEAN markets mature and EV products deteriorate the sales mix. The automobile business has scope for cost reduction but sales volume challenges and execution risks remain. We are neutral on the shares.
Our objectives
In this piece we want to assess the following:
- Outlook for the motorcycle business including EV adoption which is Honda's core earnings driver.
- Potential for cost reductions in order to raise overall profitability.
We will take each point in turn.
Motorcycle outlook limited
Honda Motor has one key characteristic which differentiates it from both its domestic and global peers. Despite the majority of its sales volume is generated by the automobile segment, the majority of earnings stems from its motorcycles.
Sales split FY3/2020
Source: Company, created by author
Operating profit by business segment
Source: Company, created by author
We can see that motorcycle operating margins have been steadily improving over the last 10 years, whilst the automobile business continued to struggle. Motorcycles have enjoyed a vintage decade, growing volumes significantly in Asian markets such as Indonesia, Vietnam and Thailand where Honda now has market share of 75% or more.
Operating margins - motorcycle versus automobile over the last 10 years
Source: Company, created by author
Asia sales have effectively doubled since FY3/2011 driven by motorcycle demand, but Honda remains hugely exposed to the North American market with automobiles. North America made up 47% of total FY3/2020 sales.
Regional sales trend over the last 10 years
Source: Company, created by author
The outlook for the motorcycle segment is key to Honda. There is always potential to improve margins in automotive, but the track record would denote making material progress here is highly challenging. We see opportunities as well as challenges for Honda - in ASEAN markets, new market growth and electrified vehicles.
Management has stated that ASEAN markets are beginning to mature for Honda, and that they do not expect to see major demand worldwide through to 2025. The company has its focus on the emerging India and is dominant in scooters, but it has limited presence in light (LBC) and medium size motorcycles ((Mid MC)) which is an area for improvement. All told, it would appear that the company is toning down volume expansion prospects at this current juncture and focusing on improving the sales mix with LMCs and MCs (apart from markets such as Bangladesh). It is positive to see Honda tailoring its approach to local markets, but it would appear growth will be less straightforward that driving share with volume in local markets.
New markets targeted are Latin America and parts of Africa. Honda has a strong foothold in Brazil and hence expansion could follow in neighboring markets such as Argentina and Colombia. Africa is more of a question mark given the dominant positions of Indian manufacturers Baja and TVR, and the multiple Chinese brands that operate there such as Apsonic and Jialing. Honda has a notable presence in the continent, but from a pricing perspective will have to compete at very low ASPs to make a major market offensive here difficult to justify.
Then we come to EVs. Rules for banning motorcycles with internal combustion engines is not as stringent as other vehicles, but the trend is set for their introduction. Honda will roll out models using standardized replaceable batteries for its small and mid-sized motorcycles with three other domestic OEMs, KTM and Piaggio. For larger motorcycles, rapid-charge batteries are expected to be used. The issue here is that electrified vehicles are expected to be negative for the sales mix. Although management are confident that margins can improve over time, the fact is EVs will be upon introduction dilutive to margins at Honda's core business segment.
From this standpoint we believe that the outlook for Honda's motorcycle business is neutral to negative. The outlook for volume growth look limited in saturated markets, and EVs will be disruptive for profitability.
Now we look at the scope for cost reductions.
Continuing cost reductions
Honda's efforts in continued cost reductions and general spending cuts in SG&A and R&D resulted in an operating margin of 7.4% versus 4.4% YoY in Q3 FY3/2021 results. Full year guidance for FY3/2021 was also raised, with FY operating profit being raised by ¥100 billion (from ¥420 billion to ¥520 billion). Although some costs will normalize YoY into FY3/2022, Honda has responded relatively positively to the challenges of the pandemic.
Honda still lags its peers in terms of operating a relatively cost-heavy business. It is making progress in making its supply chain more efficient by integrating its affiliated firms (the latest being Showa, Keihin and Nissin Kohgyo) with Hitachi Automotive Systems. Other efforts include introducing more common parts under the 'Honda Architecture' platform from 2021 (quite late in the day one must add), reducing the number of trim variations for global models to one third versus in 2018, and enhancing the global production network.
Despite these efforts (which are relatively well known), consensus forecasts show that there are still limited expectations for major profitability improvements for the short to medium term. In fact, consensus does not even expect margins to exceed the recent 10-year historic peak of 6.6% in FY3/2014, although it is not an exact apple-to-apple comparison (FY3/2014 reported Japanese GAAP versus current IFRS reporting).
Total operating margin trend and consensus forecasts
Source: Company, Refinitiv, created by author
The key issue appear to be sales volume expectations. Currently, consensus is either being conservative or there are concerns over volumes for both automobile and motorcycles.
Consensus sales forecasts
Source: Company, Refinitiv, created by author
From this we surmise that Honda is not currently expected to emerge from the pandemic to sustained high demand for its products to reach recent peak earnings. This comes from a combination of relatively subdued demand in ASEAN for motorcycles, and a slow recovery in automobile sales driven by Honda's light truck products. For most recent trading, the company has telegraphed production issues affecting sales as a result of the semiconductor supply shortage but this is an industry-wide issue.
Balance sheet
Honda is known for its well-capitalized underlying balance sheet (excluding the financial business). In FY3/2020, Honda had a net cash position of ¥2,093 billion (net cash excluding retirement benefit). This is a relatively unusual situation for an auto OEM, most of which are heavily indebted. Underlying free cash flow generation has been consistently positive for the last 5 years, and the net cash balance has continued to mount. Despite the pandemic conditions, Honda has begun to push up its quarterly dividend payments to reflect improving conditions as well as its strong cash position.
Quarterly dividend trend
Source: Company, created by author
Classed under financial assets, Honda has a stake in the autonomous technology venture GM Cruise Holdings LLC. The stake was worth ¥85 billion in FY3/2020 - if this technology sees mainstream product adoption, its value will increase significantly.
Valuation
On current consensus forecasts, the shares are trading on PER FY3/2022 8.8x with a prospective dividend yield of 3.4%. These are not demanding multiples but not necessarily out of place for the sector. Free cash flow yield for FY3/2022 is 7.5% which is high, but again more or less in line with recent historical trends. Whilst it may be argued that the cash rich balance sheet (making up 33% of current market capitalization) is not being reflected in the valuation, there does not seem to be major changes to the dividend payout target of 30%; there has been limited episodes of share buybacks in the last 5 years.
On this basis we believe that valuations are pointing to fair valuation as opposed to major undervaluation.
Risks
Upside risk comes from an accelerated recovery in automobile demand in the US, with motorcycle demand reigniting in the ASEAN region. These key volume drivers would allow Honda to see material improvements in profitability.
Downside risk in the short term would be limited manufacturing capacity as the semiconductor shortage continues. Any major investment costs required to spearhead EV development may act as a drag on earnings. Honda will appoint new CEO Toshihiro Mibe from April 2021 - he used to be the president of Honda R&D (the division responsible for all of Honda's new technologies and products), and may make more investments here in order to address carbon neutrality, autonomous driving as well as new business areas such as aerospace.
Conclusion
From the above we conclude that despite Honda having a motorcycle business which generates high returns for the company, the medium term outlook is one of slowing growth in key ASEAN markets. On top of this, any major introduction of EVs will result in a deteriorating sales mix. As motorcycles remain the company's key earnings driver, the outlook is not that positive.
The outlook for automobile demand looks relatively more neutral. A major spike in demand from the core US market could drive margin expansion through volume growth, but at present this is not expected by the market or by us. Cost reduction efforts should pay off from FY3/2022, but with limited volume growth the end result is not a major revamp in profitability once business conditions normalize.
Valuations are low but not notably cheap for a challenger auto OEM although it is a cash-rich one. With the shares are trading on PER FY3/2022 8.8x, we are neutral on the shares.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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Comments (6)
Due to lack of time to do proper analysis on this, I may just have to put this idea in the "too hard" pile. If anyone's done some work and is willing to share insights on HMC's non-automotive growth prospects, I'd love to hear.
