Does Honda’s Increased Capital Expenditure Make Sense?

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Honda Motors (NYSE:HMC) has increased its capital spending in the past three years and this figure is now the highest among its peers relative to revenues. The company is allocating its capex partly towards improving the production facilities, in terms of additional quality checks, which is not surprising given the recent recall of Honda vehicles due to quality issues. Some of the capital spending will be directed towards capacity addition which will ensure that shortage similar to that faced by Honda during the Japanese earthquake and Thailand floods will not occur. We expect Honda’s international market share to increase gradually and additional production capacity will help it capitalize demand for its vehicles. However, the additional capital spending appears to be a step towards correcting past issues and not a long-term production enhancement strategy aimed at improving profitability.

Honda Has Been More Aggressive Than Competitors In Capital Investments Recently

Honda’s capital expenditure has seen a jump since 2011 and the figure, as a percentage of revenues, is the highest among its peers now, as seen in our diagram below. Overall capital expenditure has been applied to the introduction of new models as well a the improvement, streamlining and modernization of production facilities, so as to foster higher sales and more effective R&D.

Honda 1

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For GM and Ford numbers are of the automotive division only in the diagram above. Capital expenditure excludes purchase of operating lease assets. Years in the above chart refer to fiscal years for each of the companies, and thus do no align precise with calendar -year results. (Fiscal 2014ended Dec 2014 for GM and Ford and Mar 2015 for Honda and Toyota

While Toyota’s capex has hovered around 4% of revenues since 2010, Honda spent 7% of its revenues on capex in fiscal year 2014 which represents a significant jump since 2010.

Honda 2

Honda’s capital expenditure as a percentage of its depreciation increased to nearly 200% for the fiscal year 2013, as is seen in the figure above. This shows that the company is spending on the purchase of additional assets over and above replacing fully depreciated assets. Toyota’s capex spending on the other hand is less than 100% of its depreciation, indicating primarily maintenance.  Also, Honda is ploughing back nearly 70% of its cash generated from operations into capital spending, as opposed to only 30% by Toyota.

However, The Increase In Capital Expenditure Does Not Appear To A Be Part Of Long Term Strategy

In 2014, Honda had to recall 60 million vehicles due to flawed air bags provided by Takata Corporation and faulty hybrid system in the redesigned “Fit”.  On the back of these quality issues, the company’s new CEO now plans to cut the model variants by 20% in the next two years and add a number of quality checks to the production process.  Part of the capex increase is towards improving and modernizing the production facilities to ensure that the quality is not compromised. Honda’s new models expected to be launched next year are being designed with increased focus on customer safety and product quality. The new CEO has a very strong focus on R&D and quality and this is reflected in the capital spend on research.

For the capital expenditure to lead to an increase in profitability in the car manufacturing industry, we believe that focus should be to bring about a significant change in the production process which would reduce fixed costs. Also, the luxury car segment tends to contribute the most to the bottom line and carving out a space in this segment can boost profits significantly.  Honda’s “Acura” is popular but has stiff competition from Tesla, BMW, Mercedes-Benz, Lexus and high end Audis and Porches.

Honda’s increased capital spending appears to be towards addressing quality issues and avoiding shortages and not towards a long term production improvement plan.  We do not expect this increased capex to have any significant impact on the company’s profitability or valuation.

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