Earnings Review: Renewed Quality Focus Boosts Honda’s Profits

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Earlier this year, Honda Motors (NYSE:HMC) decided to move in a different direction. The company removed Takanobu Ito from the CEO position and decided to replace him with Takahiro Hachigo. Under Ito, the company had undergone significant change in identity. While previously only known as a Japanese manufacturer of high-quality and high-performing cars, Honda decided to make each of its geographic divisions autonomous and accountable. This was with the view of allowing each division to localize production, development and purchasing in order to pursue an individual approach to each market. Unfortunately, the North America division faultered under the weight of this increased burden. 2014 was a disappointing year and sales in the U.S. had fallen by 5% over the first two months of the year as Honda’s cars began to be reported from quality. Two separate incidents — one related to Takata Corporation’s flawed air bags, the other related to the faulty redesigned Fit — hurt profits badly and Honda decided to rethink its position in the market.

The new direction that the company decided to take under Hachigo was a return to Honda’s original identity. The Japanese auto maker decided to go back to its roots as a Japanese car maker known for its quality rather than its ubiquity and cut the total model count by 20%, with an increased expenditure on ensuring that the slim model line-up had superior quality to ensure higher sales. This strategy to starting pay off and, as the results of the first quarter of fiscal 2016 show, may be beginning to sow unexpected rewards.

We have a $34 price estimate for Honda Motors, which is about 10% above the current market price.

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Renewed Quality Focus Propels Sales

Global car sales rose by 4.9% for Honda in the first quarter of fiscal 2016. [1] This happened despite a 27% decline in Japan and a 16% decline in Europe. [2] An increase of 11% in North America and 19% in Asia more than cancelled the decline in the former pair. [2] Interestingly, the North America and Asia sales both rose on the back of higher margin vehicles — the HR-V compact SUV sales in North America and the refreshed Vezel SUV in China. This meant that Honda’s net profit jumped by 20% in the first quarter. [2] Given the weakness of the yen, the higher profits meant even more in translated terms in Yen and boosted the numbers. The currency effect would have been even more pronounced if Honda did not have to also take in the additional expenses related to the recall of cars equipped with faulty Takata airbags. Although Honda does not break out numbers for specific expenses, it had earlier this year restated its earnings to reflect additional costs for the expanded recalls earlier this year.

What Next For Honda

The 19 percent increase in Asian sales was mostly caused by a 30% increase in deliveries in China. [3] The car maker introduced new and crossover models in China and, as China’s stock market increased by more than 100% in the first half of the year, sales for Honda also grew. But now the Chinese economy has experienced a major setback. Growth was already slowing but the stock market crash has started a reverse capital flight from China and this could impact the market in the months to come. Given this backdrop, we should not expect Honda sales to continue increasing in the coming quarters.

However, Honda’s performance in North America should continue to be as strong. Earlier this year, the 2016 ILX, Acura’s entry level sedan, went on the market in the first half of 2015 and has been doing well. Entry level luxury cars are some of the hottest selling cars in the segment and new car launches are known to be sales drivers. In 2015, the U.S. luxury car market is expected to grow by around 10%. Gas prices are low, interest rates are low, and consumer confidence is at a seven year high. All these factors should contribute to increasing sales of luxury vehicles and Acura is in a good position to cash in on these trends.

Additionally, the Acura NSX super-sportscar is set to enter the market later this year. Honda’s 2016 Accord also became the first car on the market featuring both Android Auto and Apple CarPlay functionality. [4] This will allow Honda to target a larger market as in car entertainment features are a major influencing factor in car purchases. Now people with both iOS and Android phones will be able to consider the Accord as a potential purchase and Honda’s superior quality could result in even higher sales numbers in the rest of the year.

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Notes:
  1. FY 16 First Quarter Financial Results, Honda Investor Relations []
  2. Ref: 1 [] [] []
  3. Honda Profit Beats Estimates as China Offsets Recalls, Bloomberg, July 2015 []
  4. Honda Touts Silicon Valley Chops, Debuts 2016 Accord With CarPlay and Android Auto, re/code, July 2015 []