3Q PAT was hit by a prior-period provision for disputed central taxes. With an EBITDA margin near the historical low, price hikes could be a short-term trigger. With the amicable JV split, we believe the sharp stock price correction offers a good entry point at which to ride rural volume growth and cost rationalisation.

December quarter results: margins slip sharply
Hero Honda's 3Q results involved a large (Rs1.08bn) previous-period provision for tax claims pertaining to its new Haridwar plant. Adjusting for the provision, normalised PAT recorded 6.2% qoq growth to Rs5.37bn on 13% net sales growth. The EBITDA margin slipped 164bp qoq to 11.7%, 13% below our forecast. Higher raw material costs (up 119bp qoq) and manufacturing expenses affected margins, which was marginally offset by a lower tax provision of 12.8%. EPS was Rs26.9 for 3QFY11 and Rs72.8m for 9M.

Our EPS forecasts revised for weak 3Q and extraordinary items impact
The sharp erosion in 3Q EBITDA margin to near the historical low of 10.2% in 4QFY07, despite historical peak volume and market share gains in the quarter, surprised us.

Management views steel and rubber costs as a key concern, and we feel a product price hike is essential to reverse the margin trend. Building in the impact of the results and a delay in the product price hike, we trim our FY11-12F EPS 6-7%. We feel the potential benefits of cost rationalisation in the medium term as a result of the recent JV split are immense and could help retrace historical average margins of 14-15%.

Outlook for cost savings benefit and rural play
The numbers prompted a sharp correction in the stock price (back to pre-JV split levels), which we feel is a good entry point for medium-term investors as Hero announces expansion plans at existing plants to extend volume growth in the short term until its new fourth plant comes on stream in FY13 to provide medium-term growth. A sharp correction in the EBITDA margin from 17.4% at FY10 to 11.7% within three quarters seems overdone to us, considering peers' flat trends and Hero Honda's strong franchise profitability (dealers and components vendors). From PAT contraction in FY11F, we feel cost restructuring offers scope for a 22.6% EPS CAGR for FY11-13F, for which valuations are attractive at a 12.2x FY12F PE. Buy, with a revised three-stage DCF-based TP of Rs2,107.