Hero MotoCorp Ltd

Economic Scenario

The year 2010-11 turned out to be a year of moderation, with growing trepidationacross the domains of economics, environment and geopolitics.

If recovery was the underlying theme for the previous year, 2010-11’s summativetheme was surely uncertainty, with the massive earthquake in Japan and turmoil in theMiddle East and North Africa (MENA) creating insecurity, along with volatility in crudeand commodity prices.

In the US, a slew of factors – double-dipping home prices; a slow recovery inlabour markets and weak wage growth; the fiscal contraction of state and localgovernments; and underlying weakness in final demand – suggested that the subpar,anaemic recovery for the U.S. economy might endure for a while.

Barring Germany, European recovery has almost ground to a halt. The reasons are nothard to seek: fiscal tightening in UK (a leading economy), political uncertainty in Italy,recession in some Scandinavian countries and solvency problems in peripheral EU nations(Greece and Turkey) contributed to the mess. Japan, which had just begun to limp back on apath of recovery, plunged back into defiation as the impact of its natural disaster fullysank in.

To make matters worse, the growth potential in emerging markets like China, Brazil andIndia, which had demonstrated so much promise in recent years, showed signs of gettingimpacted by monetary tightening and high interest rates.

In 2010-11, India followed a deviant growth trajectory as opposed to last year: thefastest growth was notched in the first quarter, and the slowest was reserved for thelast. In the previous year, India began growing at a comparatively slow pace, but endedwith a strong kick. This sparked off hope that the economy would enter the nine percentgrowth orbit. In fact, economic performance was strong throughout the first half of thefiscal, with the manufacturing sector growing in double digits, and the service sectorgrowing almost as fast. Yet towards the completion of the year, the growth rate dwindledto 7.8%; in the last quarter of 2010-11 it was the slowest in six quarters.

Even though the manufacturing sector notched a double-digit growth during the first twoquarters of the year, monetary tightening eventually took its toll in the remainingquarters: it slowed down the pace of capital formation and kept growth in the index ofindustrial production in single digits.

Nevertheless, India eventually ended the year with 8.5% growth; this was largely on theback of a strong export demand, a resurgent agriculture sector and sustained growth inindustries like hotels, real estate, retail and banking as well as core industries, suchas cement and steel.

Of course, the performance of the service and agriculture sector was important fordifferent reasons: the former now makes up more than 57% of national output, while 2/3 ofIndia depends on the farm sector for its livelihood.

Services and agriculture growth in turn, ensured strong demand for both consumerdurables and automobiles. However, there is little doubt that if high interest ratespersist, they will start eating into demand and private consumption expenditure in thecoming fiscal. In fact, as the year progressed, there was some early evidence of this inMarch 2011, with consumer durable growth shrinking to 12% from 23% in the previous month.

In the previous annual report, fears were expressed that inflation could stifle some ofIndia’s growth impetus in 2010-11. That is exactly what happened during the year inreview. 2010-11 began with double digit food inflation. By the time it ended,manufacturing inflation became the source of concern: it accounted for 30% of theinflation pie in the March-July period, but in the November-March period,manufacturing’s share of the inflation pie was up more than 55%.

This forced RBI to tighten monetary policy aggressively throughout 2010-11. The processcontinues, even at the time of writing as headline inflation remains way above the apexbank’s comfort level.

While the near-term outlook for the Indian economy looks uncertain, India’slong-term growth prospects are stable, given the favourable demographics and increasingconnectivity between India and Bharat. At one level, there is visible evidence ofsustainable demand emanating from traditional rural areas. At the other, growth polesopportunities are sprouting in newly urbanised centres across the country.

Even in the short term, there is a growing perception that India may soon be on top ofits rate hike and inflation curves; in other words, as food inflation moderates on theback of another good monsoon and as crude prices stabilise, the RBI may loosen itstightening policy towards the end of 2011. This would have a stabilising influence ongrowth towards the end of 2011-12.

Industry and Segment Insight

A growing number of jobs in the service sector, favourable demographics, increasingurbanisation across towns and bountiful rains ensured strong demand for two wheelers inIndia during the year in review. In combination, these factors offset continuously risingconsumer finance rates.

The domestic two-wheeler market grew a rollicking 26%, with sales of 11.8 millionunits, compared to 9.4 million in the previous year.

Two wheeler exports grew 35%, and crossed the 1.5 million mark for the first time.Overall, two wheelers sales grew at 27% in 2010-11, with 13.4 million units of sales ascompared to 10.5 million units of sales in the previous year.

Each of the three two wheeler segments clocked strong growth. Motorcycle sales expandedby 24% from 8.4 million units to 10.5 million units. Domestic sales made up the bulk ofmotorcycle sales. The domestic motorcycle market witnessed a growth of 23% in 2010-11,sales of 90,18,945 units as compared to sales of 73,41,090 units in 2009-10.

Continuing with a recent trend, scooter sales grew the fastest (42%) from 1.5 to 2.2million units. In the domestic market, scooters now make up close to 18.5% of the twowheeler market. The revival in the mopeds segment continued as well; sales were up 23%from 5.7 lakh to over 7 lakh units.

India’s motorcycle market comprises three categories: entry, executive andpremium. During the year, the entry segment grew at close to 14%. Nevertheless, the entrysegment’s overall share in the two wheeler pie declined from 18.7% to 17.3%. Thedeluxe segment sustained its steady performance, notching volumes of 4.8 million units,and a growth in excess of 15%. This segment accounted for over 62% of overall motorcyclesales.

The show-stealer in the motorcycle category was the premium segment. More than 1.85million units were sold during the year, a growth of 66%. The strong showing ensured thatthe premium share in the overall motorcycle pie went up from 15.3% to 20.6%.

In fact in the domestic industry the premium segment outsold the entry segment for thefirst time ever.

New Product Launches

The Company has consistently relied on innovation, technology and design to sustainexcitement amongst customers.

This year saw the introduction of several new product launches and refreshes. The newproducts launches and refreshes were supported throughout the year by impactful,clutter-breaking and engaging communication. The products which were launched are Glamour,Glamour FI, New Hunk, Super Splendor, Splendor Pro, New Karizma

Accelerated Performance

Despite its significantly higher base vis-a-vis competitors, Company’s two-wheelersales improved by 17%; from 4.6 to 5.4 million units during the year to garner over 40%two wheeler market share. In the domestic two wheeler market, it had a share of 44.5%,with sales of 5.2 million.

In the motorcycle segment, the Company sold over five million units. In the domesticmarket, the Company sold over 4.9 million motorcycles at a growth of 15%, therebycapturing 54.6% domestic motorcycle market share.

In the scooter segment Pleasure, grew a whopping 65% during the year, with sales of3.42 lakh units. This single scooter brand now accounts for over 16% market share.

Across various motorcycle segments, the Company bested industry growth in the entrysegment by growing in excess of 17%, and selling more than 1.5 million units.

In the deluxe segment, the Company captured 68.9% share. With sales of 3.8 millionunits, the Company registered growth in excess of 12%.

Financial Scorecard

Sales

The Company’s sales grew by 17.44%. It ended the year with a domestic market shareof around 45%. The Company clocked a sales volume of 5,402,444 units in 2010-11, comparedto 4,600,130 units in 2009-10. In value terms total sales (net of excise duty) increasedby 22.1% to Rs. 19,245 crores from Rs. 15,758 crores in 2009-10.

Profitability

The Company’s earnings before interest depreciation and taxes (EBITDA) marginsdecreased from 17.45% in 2009-10 to 13.49% in 2010-11 and the Operating Profit (PBT beforeother income) decreased from Rs. 2,575.48 crores in 2009-10 to Rs. 2,214.61 crores in2010-11. The margin fell despite healthy growth in the sales volume on account of higherprices of raw materials and components and additional cost of meeting emission norms

Other Income, including non-operating income

Other income increased by 24.7% from Rs. 341 crores in 2009-10 to Rs. 425 crores in2010-11.

Cash flows

The free cash flow from operations during the year stood at Rs. 2,288.11 crores(previous year 2,686.64 crores). The same have been deployed in capital assets,investments and paid out as dividends during the year.

Capital expenditure

During the year, the Company incurred a capital expenditure of Rs. 364.12 crores. Thefunds went into capacity expansion and replacements.

Raw material costs

Hardening of metal prices particularly steel, copper, aluminium and nickel during theyear results in escalation in material costs. Raw material costs as a proportion of totalcost increased 68.1% to 73.3% and adversely impacted EBITDA margins.

Current asset turnover

This ratio, which shows sales as a proportion of average current assets, decreased from17.2 to 15.5 times, on account of higher average inventory and loans and advances.

Debt structure

Hero Honda has been a debt free company for the last 10 years. The unsecured loan ofRs. 32.71 crores from the state government of Haryana on account of sales tax deferment,is interest free and has no holding costs. Net interest payment by the Company has beennegative during the last few years.

Dividend policy

Over the years, the Company has consistently followed a policy of paying highdividends, keeping in mind the cash-generating capacities, the expected capital needs ofthe business and strategic considerations. For 2010-11, the Board has recommended adividend of 1750% higher than 1500% declared in previous year, and has maintained a payoutratio of 42.1% vis-a-vis 31.3% in the previous year. Further, it has also declared 3500%interim dividend (previous year 4000%).

Working capital management

The Company has always sought to efficiently use the various components of workingcapital cycle. It has been able to effectively control the receivable and inventories,enabling it to continue to operate on negative working capital.

WORKING CAPITAL MANAGEMENT AND LIQUIDITY RATIOS

Notes on Working Capital:

The average of inventory, receivables and payables has been taken for the abovecalculations of inventory period, operating and cash cycle.

KEY INDICATORS OF PROFITABILITY (%)

Network Expansion

Over the last five years, more than 2000 customer touch points have been added to theCompany’s network.

Manufacturing Excellence

India’s two wheeler industry continues to benefit from an expanding economy. Arevival in agriculture, growing job opportunities in the service sector and expandingurbanisation ensured a healthy demand for two wheelers

These factors continued to create a significant demand for the Company’s twowheelers.

Meeting this demand was a key concern during the year gone by. The challenge wassurmounted by optimising plant capacities and installing balancing equipment not onlyinternally but across the supply chain. The team work was exceptional in overcoming thischallenge.

High speed and flexible machines were introduced to debottleneck the critical shops andlines. This was done to meet not just demand surges, but also variability in the productmix, which decelerates the throughput. Concurrently, production of less value-added partswas outsourced. This created space, allowed machines to be used for critical operations,and also accommodated new models and variants that were introduced by the Company.

These initiatives helped in different ways. By the end of the year, overall productioncapacity went up and the Company was able to ramp up from 4.6 million units to 5.4 millionunits. Over the last three years, production capacity has been augmented by over 2 millionunits.

As a part of the journey towards operational excellence, shopfloor managementprogrammes like Kanban and Kaizen were strengthened to improve efficiency, throughputtimes and debottlenecking critical operations. At the same time, TPM (Total ProductiveMaintenance) initiatives were beefed up across each of the three plants. Thissignificantly improved the reliability of delivery by increasing equipment uptime.

A significant enhancement in production, innovation and quality control represented thekey focus areas during the year. The result is appreciable reduction in customercomplaints.

Over time, the Company has learnt the valuable lesson that productivity improvements atthe shopfloor would lose much of their impact if concurrent ramp-ups were not made at thevendor’s end.

During the year, therefore, extensive attention was paid to production planning. Thereis a growing realisation about the importance of accurate and robust long-term forecastingmodels, so that vendors are in a position to plan capacity well in advance.

At the same time, the Supply Chain team impressed upon vendors the need to build incertain flexibilities into their component supply operations, so that they could scale ineither direction during business cycles.

The Company also invested considerable time and effort in making the direct onlinesystem (an ERP system which manages production and supply of components across theproduction chain) more effective.

The control of in-plant manufacturing costs was another focus area. Various steps wereadopted in this direction. Gas-based generators and heat recovery units were introduced tocut emissions and reduce electricity generation costs.

Research and Development Expertise

For 25 years, the Company’s research and development functioned and evolvedunobtrusively, but efficiently and effectively.

Over the years, the department has developed requisite infrastructure and expertise todevelop, test and approve products in-house in line with international standards. Thedomain knowledge, acquired through the interaction with Honda R&D, made it possible toincrease the level of customisation at the design stage itself. In turn, this has helpedin launching multi-models in short interval with high levels of localisation.

At another level, the Company’s R&D actively participates in thecountry’s environmental ecosystem. R&D members involve themselves in theregulatory process at the outset. This ensures that all new regulation notifications arecomplied well on time (Hero’s R&D had successfully complied with BS-III normswithin the specified time). In fact, in some cases, for example, in the case of reductionof hazardous waste, the R&D is well ahead of the regulatory curve.

In December 2010, when the Company’s Board approved a New Licensing Arrangementbetween the two joint venture partners, it was a watershed event. A single pen strokechanged the Company’s future and its R&D function. With Hero Honda nowre-emerging in a new avatar, Hero MotoCorp Ltd., the organisation’s R&D is alsobeing revamped.

The facilities are being upgraded ahead of time for adoption of new technologies. Toensure that Hero MotoCorp is able to face a new world without the presence of Honda,capabilities are being enhanced across levels. Skilled manpower is being augmentedsignificantly, and design and validation infrastructure is being beefed up significantly.

The Company has implemented PLM (Product Lifecycle Management) and is in process ofupgrading it. At a strategic level, Hero MotoCorp’s R&D is also exploring the newtechnical alliances to cater to the latest requirements of new products, segments andgeographies.

Information Systems

Hero MotoCorp’s robust technology heritage was strengthened further during theyear under review. IT initiatives were embarked upon at multiple levels. There was astrong focus on supply chain integration, process efficiency and accurate and promptdecision-making.

Besides, since the time the Company had commenced its journey towards becoming a localenterprise, there was considerable emphasis in the areas of governance and compliance.

Hero MotoCorp Connect (a Dealer Management System) aimed at automating our supplychain, enhancing information availability as well as transparency. It has completed asuccessful year.

By the end of the financial year, the Company had successfully deployed the system atmore than 530 dealers outlets. Crossing this milestone was no mean achievement,considering the scope and magnitude of the project. As part of the project, importantenhancements were made in the dealers’ portal, which helped boost their integrationwith the organisation’s supply chain.

The Company also used IT infrastructure to accelerate its decision-making. Keyinitiatives included developing customised reports, using Business Intelligence (BI). Anapplication for Cost Modelling and Analysis (CMA) was also developed during the year.

Information security and risk management was another focus area. To protect theCompany’s drawings data and prevent leakage in any form to any unauthorised entity,its R&D processes were migrated from a mostly manual working system to a softwareapplication called Product Lifecycle Management. The PLM software will help provide accesscontrol of critical information.

At a larger level, in order to reduce risks associated with unauthorised system access,a solution for Governance, Risk and Compliance was implemented. At the same time, to helpthe Company keep track of all necessary statutory requirements and legal compliances, HeroMotoCorp became one of the first companies to implement an E-compliance application tool.

During the year, the Company also accredited itself with ISO 27001 certification forInformation Security. In order to establish the credibility of its robust securityprocesses and procedures.

Business sustainability is gaining significant importance in recent years. To de-riskbusiness operations the Company has commenced Disaster Recovery (DR) for all criticalapplications. So far, disaster recovery has been set up for R&D, GoodLife and thedealer management applications. Work on the SAP module and e-mail is in progress.

Meanwhile, to keep pace with changing technologies globally, the Company has alsointroduced solutions like mobile-based applications as well as web-based interfaces forenterprise applications. For example, workflows and approvals are now possible on mobilephones.

People Approach

The emphasis has always been on building a talent pipeline taking into account amedium-to-long-term perspective. The Company has tried to attract the right talent, buildcapabilities and facilitate career development to drive organisational objectives.

During the year, the SAP-ELS Module for Talent Development was initiated. The modulewill go live next year, and will give the new Company a contemporary and cutting-edgetalent development system.

The Company augmented its young talent by inducting a fresh batch of managementtrainees and GETs like every year. The ET programme has been re-engineered. Our five-monthlong induction is based on a ‘Job Function Criteria’ that recognise strengthsand facilitate appropriate job alignment. Besides, to widen the incumbent’s learninghorizon, On-the-Job Project (OTJP) and Job Simulation were introduced for the first time.

For mid-and junior-level management, selective education courses were introduced tofoster leadership and teamwork. As in previous years, the Company’s mandate of’Achieving Excellence through teamwork’ was executed in various ways. Acrosslevels and locations, programmes focusing on Strategic Thinking, People Development,Interface Management, Business Etiquette and Positive Attitude were held. Several newprogrammes for grooming young talent were also organised.

Simultaneously, entry-level induction for workers at the plant level was strengthenedduring the year. Technical Training facilities in the Gurukul (Company’s dedicatedtraining facility) were upgraded; new machines were brought in and a mini assembly linewas set up to provide new inductees with hands-on experience in vehicle assembly.

At another level, a new programme was introduced for plant employees to fulfil theirspiritual needs. The programme (Sadbhavna) has been commenced at the ’Om ShantiRetreat Centre in association with Brahma Kumaris, a well-known spiritual organisation.Close to 900 operators were covered under the programme during the year.

During the year, the Code of Conduct was launched to embed and codify the ethicaltenets of the Company.

On its part, the Top Management team underwent the Harvard Business School Programme on"Building a Global Enterprise in India".

Employee and industrial relations scenario at all three plants remained smooth duringthe year under review. At Dharuhera, union elections were held peacefully, and a new Unioncame into force.

To track and manage the performance of the contractors (who provide manpower)efficiently, a Performance Matrix was introduced for the first time in the contractagreements. The matrix was directly linked to the service charges of the contractors.During the year, biometric cards for the Gurgaon region were issued by the ESIauthorities.

Risk Management

Inflation and input prices

India’s core inflation has gone up significantly over the past year, and isunlikely to moderate significantly in the coming months. This is an area of considerableconcern as the bulk of the Company’s production costs comprise material costs.However, the Company continues to proactively focus on cost optimisation to offset thespiralling rise in material prices.

Interest rates

Sustained inflation forced India’s apex bank to tighten monetary policy throughoutthe year in review, and this process continues into the current year. While the Companyhas not been significantly affected by higher interest because of its strong balance sheetand healthy cash flows, some of its smaller vendors of the Company could face expansionconstraints if the cost of finance continue to remain high. The Company is now pursuing anaggressive policy of multiple sourcing to counter this challenge.

Global uncertainty

Global uncertainty didn’t significantly affect past performance as theCompany’s operations were mostly concentrated in domestic markets. With wideningtranscontinental footprint, the susceptibility to geo-political events can escalatesignificantly. However, considering the Company’s product profile, and planned focuson emerging and nascent markets similar to India, the management believes the challenge ofuncertainty can be overcome.

Transition challenges

Undergoing major transformation following the change in ownership, the Company is inthe process of acquiring a new identity for itself and its products. Although the Companycan use the Hero Honda brand till 2014, it is aware that it has to eventually create a newbrand association among customers without Honda. Moreover, it will have to contend withstrong competition from its erstwhile joint venture partner across all major segments.Admittedly, there will be challenges in the near term, yet the Company believes it issuitably positioned to capitalise on the market reputation created over a period of 26years. To succeed in the new dispensation, the R&D function has witnessed a majoroverhaul with a focus on new product development. New alliances and technology tie-ups arealso being finalised. In addition, new export markets are being explored.

Green Management

The Company’s environmental consciousness – embedded in the credo "wecare’’ – continued to be a key area of focus.

Since inception, the Company has invested substantially in clean and greentechnologies: a fluidised bed (for paint hanger burning), an advanced incinerator (forpaint and sludge), solid landfill (for the disposal of solid, hazardous and non-hazardouswaste), effluent and sewage treatment plants, rain water harvesting sites (referencesites), Green Roof (at Hardwar plant) and others.

The Green Vendor Development Programme has struck deep roots since its commencement in2007. This collaborative programme calls for partner companies to demonstrate theircommitment towards improved environmental performance and striving for continualimprovement.

Six pillars have been assigned under the programme, covering various aspects, such asenergy management, water management, waste minimisation, pollution prevention,substitution of hazardous chemicals and environmental compliance management. Partnervendors are given specific training on all six pillars. Process mapping is conducted toidentify different non-compliances and projects are undertaken for implementation. Thisprogramme is gaining increasing acceptability among vendors. In the first year, projectswere undertaken with around 30 vendors; by the end of the financial year more than 90vendors were enrolled.