Honda Motor Company (NYSE: Hmc)

Honda Motor Company (NYSE: HMC) is a worldwide producer of motorcycles, automobiles and power products. They are the #6 automobile manufacturer in the world, the #1 motorcycle manufacturer and the #1 engine maker. Based out of Tokyo, Honda trades on the Tokyo Stock Exchange, and as an ADR on the New York Stock Exchange. The firm employs approximately 185,000 workers. In addition to the physical products that Honda produces, the firm also earns income from Honda Financial Services, which provides financing for consumers with which to purchase Honda products. Despite a long history of strong growth, Honda has recently struggled, as have almost all automotive manufacturers.

In 2008, the company's profits showed deterioration. Finally, in Q3, which ended 12/31/08, Honda lost money, almost 4 trillion. This paper will analyze Honda, and attempt to determine whether or not Honda remains a good investment. The company's history, financials and future outlook will all be analyzed. At the end of the paper, a recommendation will be made with respect to Honda's stock.

History

Honda was founded by Soichiro Honda in 1946 and the next year introduced its first product, which was the a-type bicycle engine. The company was reorganized in 1948 as Honda Motor Company. The company continued to focus on motorcycles throughout the 1950s, and in 1959 opened their first outlet in the United States, a small storefront in Los Angeles. By 1963 Honda had begun manufacturing automobiles, beginning with the S500 sports car. In 1966, the company introduced its first compact car, the product that would eventually bring it tremendous success in North America.

That success was spurred by the introduction of the Honda Civic, which debuted in 1972. The company opened its first overseas manufacturing facility in the United States in 1979, making it the first Japanese automaker to do so. The company continued to build on its success in the American automobile market throughout the 1980s. They launched the Acura division in 1986 and by 1989 had the best-selling car on the market in the Accord. The company by this point had also expanded into a wide range of other products, including power tools, lawnmowers, generators, boat engines and other engine-drive products.

Throughout its history, Honda has been one of the technological leaders in the automotive industry. This has long proved to be a substantial source of competitive advantage. The company is now a leader in robotics and has moved into aircraft manufacturing. Honda is also at the head of the curve with respect to developing vehicles powered by alternative sources of energy.

Financial Data

In the past five years, Honda has enjoyed steady growth, hampered only recently by the global economic downturn. Honda is profitable, liquid and in generally sound financial position.

The company has grown revenues steadily over the past five years. Revenues have increased 47% in the past five years, a strong number for a firm that derives the bulk of its sales from markets that are both mature and intensely competitive. In the past year, however, revenues have declined. Q3 revenues for fiscal 2009 declined 16.7% compared with those of Q3 of 2008. This came after the company's revenues had essentially flatlined over the calendar year of 2008.

In terms of profits, Honda has remained profitable throughout the past five years. Profit growth, however, has been slower than revenue growth. Over the past five years profit growth has been 30.5%, and there was little to no profit growth from 2006-2008.

This past year has seen significant deterioration in profitability, from 200 billion profit in 2008 Q3 down to just 20 billion profit in 2009 Q3.

Some of the declines can be attributed to declines in sales. The company had modest increases on a few products in a few geographic regions but for the most part there was significant weakness in key markets. Unit sales of motorcycles were higher, driven by success in Brazil and Asia, where the economic crisis did not hit as hard. However, yen sales of motorcycles declined. Unit sales of automobiles and power products declined. Financial services sales showed a modest increase.

Another contributing factor to the declines has been declines in Honda's margins. Net margin has declined from 5.6% five years ago to 4.2% in fiscal 2008, and lower still in 2009. Gross margins have also declined, from 31.2% five years ago to 28.8% in 2008. This decline in margins indicates that the company is facing more intense competition and has had difficulty in containing key factor costs as a result.

Honda has healthy liquidity ratios. Their current ratio has improved over the past five years, from 1.09 in fiscal 2004 to 1.11 in fiscal 2008. The cash ratio has also improved over that same span, from 0.217 to 0.224. Despite the economic slowdown, liquidity continued to improve over 2008. The current and cash ratios at the end of 2009 Q3 were 1.12 and 0.17 respectively. The decline in the cash ratio reflects a slowing down in the company's inventory turn.

Honda has maintained a healthy capital structure. The debt ratio at the end of fiscal 2004 was 65.5% and at the end of fiscal 2008 it was 63.97%. Though it had climbed back up to 64.6% in the first three quarters of fiscal 2009, the company has demonstrated the ability to maintain its debt ratio despite the difficult financial times and revenue declines.

Honda's financial performance relative to its industry peers has been good. The company has consistently outperformed the industry over the past five years on several key measures, including gross and net margins, debt-to-equity ratio and ROE, ROI and ROA. The major area where the company has struggled, as indicated above, is inventory turn, where Honda not only trails the industry but has slipped in the recent quarters. However, this can be attributed to overproduction as a result of overestimating sales in Q3 2009, and the company may reduce production in the coming quarters in order to reduce existing inventory.

It should also be noted that Honda despite a weak calendar 2008, the company has built up its interest coverage substantially over the past decade. Because of this, Honda's has the financial strength to withstand further economic distress. They company has liquidity reserves and is operating within what management considers its ideal capital structure. We have even seen that strong sales in some developing markets overseas have helped to offset economy-based weakness in the U.S. And Europe.

There is some cause of concern, however, with respect to the recent burn rate. After years of capital accumulation, Honda has begun to see significant reductions in cash from operating activities. In the last quarter, this was specifically related to the company's working capital issues (the slowdown in inventory turn). If the burn rate of the last quarter continues, the company will be forced into a debt issue by fall in order to avoid a cash crunch.

Mergers & Acquisitions

Honda operates its business on the basis of three-year plans. Presently, they are in the middle of the 10th of these plans. Each of these plans has placed stronger emphasis on research and development as the key driver for success at Honda. Therefore, when Honda does engage in M&a activity, it is generally strategic, to acquire key technologies to assist in its research and development goals.

To that end, Honda has made a handful of minor acquisitions in recent years. They have acquired a motorcycle manufacturing plant in Malaysia, a Japanese parts manufacturer, a Japanese retailer, a Brazilian electronics manufacturer, a Japanese trucking company. One of the juicier rumors in recent years was talk of Honda acquiring Harley Davidson. Such an acquisition, however, does not fit with Honda's M&a strategy. No offer was ever tendered.

Honda is not afraid to divest itself of properties for which it no longer has value. For example, in 2005 it acquired British American Racing. Three years later, it moved to sell the Formula One team. Honda has also made other small divestitures in recent years, mostly from its stable of parts manufacturers. In total, Honda has made just 11 acquisitions in the past 20 years, and 13 divestitures.

Competition

Honda competes in a wide range of sectors, each providing a unique competitive environment. Their main businesses are automobiles, motorcycles, financing and power products. Honda also competes around the world. For most products, their key markets are North America, Japan and Europe. For motorcycles, they earn significant revenues in Asia and South America as well.

Automobiles represent nearly 78% of revenues. This industry is highly competitive in all of Honda's main markets. Honda is the #6 automaker worldwide and the #2 automaker in Japan (behind Toyota). They face intense competition both in terms of product and price. Honda has adopted a mass market strategy, with a competitive focus on differentiation. Honda attempts to use its technological superiority, particularly with respect to engine technology, to attain competitive advantage.

The automobile market is growing worldwide, but in Honda's key markets has begun to show signs of stagnation, a result of high fuel costs through the first half of 2008 and deepening global recession in the second half of 2008. Major markets are saturated with products. Because of high fixed costs in the industry, exit barriers are high. Competition has kept margins relatively low, so Honda must move volume since they do not have sufficient differentiation to leave the mass market category. Overall, the outlook for the automotive industry is weak for the coming years.

One environmental consideration however is with respect to higher fuel costs. While this represents a threat to most industry players, Honda has been at the front of the curve in terms of developing automobiles that utilize alternative fuels. They also have a core competency in developing automobiles with excellent mileage. Indeed, Honda's initial success in the North American automobile market was in marketing its fuel-efficient compact cars in the wake of the oil crisis in the early 1970s.

By the end of that decade, Honda has won enough market share to open a manufacturing operation in the U.S. Thus, higher fuel costs represent an opportunity for Honda to make market share gains at the expense of its competitors, particularly the U.S. automakers.

In the motorcycle market, Honda has dealt with the maturation of its key markets in North America, Japan and Europe by expanding its presence in developing nations. Motorcycles account for 13.5% of sales. At the core of Honda's 10th 3-year plan is leveraging the growth in the Asian and South American markets, where motorcycles play more of an integral role in day-to-day transportation than they do in North America. Despite the economic downturn, these markets are expected to continue to growth, and this growth is expected to at least partially offset declines in Western market automobile sales. As in its automobile division, Honda expects that R&D will play a major role in the development of motorcycle markets. Competition in the developing markets can be difficult, but because these markets are not mature, the degree of competition is not as intense. Furthermore, Honda has established a strong market presence, including distribution networks, in key developing markets. This gives Honda a competitive advantage. Therefore, the competitive environment for Honda in motorcycles in favorable.

Power products represent 2.9% of Honda's business. Competition is intense in this industry and in many products Honda is a minor player. There are few products in which Honda enjoys a competitive advantage. This has resulted in decreases in market share in both Europe and North America. Honda has, however, found new market share in the Middle East and in Asia. However, the competitive environment for power products remains difficult for Honda.

Financing represents 5.6% of Honda's revenues, this up from 4.4% a year ago. The reason for this increase is an improvement in the competitive environment. Honda generally finances the purchase of Honda products. Its main competitors in this market are banks and other financial institutions. The economic crisis has resulted in a credit crunch, particularly in the United States. As a result, Honda has been able to gain market share for its financing arm, as other financial institutions are less willing to lend. As they refuse customers, Honda Finance can win those customers. The longer the credit crunch continues, the better the competitive environment gets for Honda Finance. If the credit crunch extends deep into Europe and Japan, Honda Finance will continue to contribute ever-greater revenues to the company.

Foreign Interests

Honda is an international company and as such is heavily invested in foreign markets. The company first went overseas in 1959 when it entered the U.S. market and twenty years later opened its first overseas production facility there. Honda now has facilities and corporate offices in Japan, the United States, Canada, Brazil, Thailand, the United Kingdom and Germany. Most of these facilities are involved in the manufacture of either automobiles or motorcycles.

In terms of sales, overseas markets are crucial to Honda. Asia, for example, is worth 31% of the company's motorcycle revenues, followed by Other (which includes the burgeoning South American market) which was also a shade over 31%. Asia and Europe contributed 23.5% of automobile revenues, while North America contributed 54.8%. Power products was the only segment in which Japan was the leading region for revenues.

Some of the key emerging markets for Honda at present are India, Brazil and Vietnam in motorcycles; Russia and China in cars; and Russia, Eastern Europe and the Middle East in power products. As a global company, Honda's future is directly tied to its ability to drive new sales in the world's developing economies. These economies provide Honda with not only opportunities for rapid growth, but they also provide environments characterized by less intense competition than can be found in the company's three main mature markets of North America, Japan and Europe.

Future Expectations

Honda is now almost one year into its 10th three-year business plan. This plan is based around the premise that Japan will take the world lead on developing the next wave of technological initiatives, in particular with regards to green technology. At the core of the business plan, therefore, is to ensure that Honda is a major player in these initiatives. To that end, the company has two main objectives: "To create and launch innovative Honda products with world-leading environmental technologies and offer them to a wider range of customers" and "To develop advanced manufacturing systems for the future that will enable Honda to produce such advanced products."

Honda plans to leverage its traditional strength in research & development, both with respect to automobile manufacturing and to motorcycle product development. Honda is introducing a new hybrid in 2009 in its major markets, with an eye towards full-scale market penetration.

These future strategies address primarily medium- and long-term issues. This strategy reflects the long lead times for technological development in the industry and Honda's traditional approach to business. In the long-term, these are sound strategies for growth. Fuel efficiency is going to drive the transportation business in the coming decades, and Honda is taking proactive steps to be at the front of those technologies. The development of such technologies will give Honda a competitive advantage over their competitors, especially those in the United States, such as the Big Three automakers and Harley Davidson.

Honda's medium term strategy is also sound. The company recognizes the lead times for the development of alternative fuel technologies and is therefore not relying on those technologies for medium term growth. Instead, the company is continuing to focus on hybrid technology, motorcycles and other technology that represents more fuel efficient modes of transportation. As a result, they are well-positioned to gain market share during the upcoming "bridge" period between traditional gasoline-oriented technologies and alternative fuel technologies.

In the short-term, Honda is going to have to weather the economic storm. The company has derived growth from some of its smaller markets, but these have no offset sluggish automobile sales in Western markets. For its many products, Honda is still heavily dependent on one main product category and the three developed, mature markets. As a result, Honda's near-term future is expected to be relatively weak.

Judging by their finances, Honda is still well-positioned to weather the economic storm but there is cause for concern about the cash burn rate in the last quarter. Honda needs to find ways to cut costs in the short-term because cash flows from operations have been negative for three quarters now, even though the firm has maintained an accounting profit. Thus, while Honda is well-positioned beyond the next couple of years, there is some concern about the damage the global economic downturn might do to the company's financial strength. If the damage is substantial, Honda's research and development efforts could be stymied, which would reduce its medium and long-term prospects as well.

Honda is also a stock with significant upside potential, pertaining to its ability to develop new markets. When the company was still primarily in the motorcycle business, it entered the U.S. market with a compact car. Such vehicles represented only a tiny portion of the market, but Honda had successfully predicted a spike in fuel prices and subsequent demand for more fuel-efficient vehicles. They had essentially solved a problem that did not yet exist. But by being established in this segment before anybody else took it seriously, Honda was able to capture significant market share in the lucrative U.S. market, a position from which it has never looked back.

With respect to their long-term future, we can see other new product developments taking a similar trajectory. Honda is a leader in robotics, and has begun to dabble in medical supplies. They even purchase a medical supplies company a few years ago to help spearhead the venture.

Thus, we can see that Honda is actively looking to develop new markets for itself, rather than sitting content with its successes in automobiles and motorcycles. The company's relative youth compared with other industrial conglomerates gives them the optimism to look for such growth at a time when other such conglomerates are looking to scale back their ambitious plans.

Therefore, part of Honda's future potential is tied to these products, such as robotics, aircraft and medical supplies. The upside for these ventures is unknown, but each fits with Honda's core competencies of technology-driven market share growth and strength in engine manufacturing.