Private defence stocks over public ones? Here’s what the market thinks

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The government’s focus on Atmanirbhar Bharat has encouraged investors to look at defence stocks. With a lot of hype around the defence pack, a deep dive into the sector surfaced an interesting question: should one invest in a private or a state-owned defence company?

A section of the market believes public defence companies could be a risky bet.

Sachin Shah, Fund Manager at Emkay Investment Managers, pointed out that most of the large defence companies are PSUs, and in general, his experience of investing in PSU companies has not been very encouraging.

He explained: “There is a fear of long-pending receivables as most of the clients of these PSU defence companies are the central government and state-owned agencies.” But there are quite a few private sector listings in the sector that are on his radar, he added.

Even Rohan Mehta, CEO & Portfolio Manager, Turtle Wealth, cautioned that there was a lot of fear regarding stuck payments and corporate governance issues in case of state-run defence companies.

“A public company can suddenly announce an offer for sale (OFS) lower than the market price, which can kill the confidence in the stock. Also, with respect to  corporate governance, companies that can grow manifold are burdened with extraordinary dividend payouts-companies like PFC, REC, Coal India etc.,” Mehta said, adding: “I am not confident of the growth story and cannot envisage three-five years of growth for a PSU company.”

Rather, Mehta finds a private defence player like Bharat Forge interesting.

On the other hand, Ashwini Shami, smallcase Manager, EVP & Portfolio Manager OmniScience Capital, is of the view that investors should look beyond the public or private company tag and focus on the fundamentals in terms of execution track record, profitability, and growth prospects.

He noted that defence had emerged as an investable, comprehensive, and strong growth vector only after the listing of key defence PSUs such as Hindustan Aeronautics, Cochin Shipyard, Bharat Dynamics, Mazagon Dock Shipbuilders, Garden Reach Shipbuilders & Engineering, among others, over the last few years.

“While the large private defence players are typically diversified conglomerates, the public sector companies offer pure-play exposure to the defence theme, making it easier to estimate long-term growth projections and fundamentals at the company level,” Shami pointed out.

Some attractive private and public sector defence firms:

Data Patterns

Data Patterns is a vertically-integrated defence and aerospace electronics solutions provider.

The company’s revenue increased 39 percent year-on-year (YoY) to Rs 311 crore during FY21-22. Profit after tax (PAT) jumped 69 percent YoY to Rs 94 crore. In that period, the operating margin surged to 45.4 percent from 41.1 percent in FY20-21 and 27.7 percent in FY19-20.

In the first nine months of FY22-23, the company’s order inflows stood at Rs 680 crore, and the order book stood at Rs 888 crore as on Q3 FY22-23. Analysts said that strong order inflows along with a healthy order pipeline of Rs 2,000-3,000 crore to be implemented over the next two to three years provides good visibility.

Defence electronics presents a huge opportunity of about Rs 1.5 lakh crore in the next four to five years led by the armed forces’ need for advanced systems, said ICICI Securities.

While a large chunk of electronic components used in Indian defence are supplied by foreign OEMs (original equipment manufacturers), as indigenisation efforts continue, future procurement will see a large portion of defence electronics being sourced locally, highlighted the brokerage firm.

In FY21-22, the return on equity (RoE) for the company stood at 16.4 percent compared to  26.7 percent in FY20-21, and 13.7 percent in FY19-20.

Paras Defence

Paras Defence is one of the leading players in India’s defence and space industry, and one of the very few Indian companies with specialised technology competencies like defence and space optics and EMP protection (blocks radio signals).

Its consolidated revenue from operations came in at Rs 182.6 crore in FY21-22 compared to Rs 143.33 crore a year ago, while net profit rose to Rs 27.08 crore from Rs 15.79 crore in the year-ago period.

The company manufactures products and services for five key verticals – defence and space optics (51 percent of FY21-22 revenues), defence electronics and EMP solutions (26 percent of revenues), heavy engineering (23 percent), and drones and anti-drone systems (negligible revenues), Edelweiss Wealth Research noted.

The company’s order inflow over the past four fiscals have remained adequate, with orders worth Rs 268 crore added in FY21-22. The order book as on December 31, 2022, provides revenue visibility in the medium term, said ICRA, a ratings firm.

The ratings agency says that Paras Defence’s long presence in the sector has helped it establish strong relationships with customers and suppliers. It has also developed a strong management and execution team comprising several ex-employees of Bharat Electronics Limited (BEL) and the Defence Research and Development Organisation (DRDO), among others.

Nuvama Wealth Research believes the company’s diversified mix of businesses with leadership in niche areas like optics, EMP solutions, and defence electronics, as well as exposure to high-growth opportunities such as drones and anti-drones, will help sustain industry-leading growth.

Bharat Forge

Bharat Forge is India’s leading auto components exporter with strong engineering and technological competencies in forging and metallurgy. With a global forging capacity of 7 lakh tonnes per annum, its products find application in the domestic and exports markets across sectors like passenger vehicles (PV), commercial vehicles (CV), oil & gas, construction & mining, power, and defence, among others.

Kotak Securities feels Bharat Forge has a significant competitive advantage in the artillery segment, as their products are 30-40 percent cheaper than the competition.

In FY21-22, its consolidated revenue rose 65 percent YoY to Rs 10,461.1 crore, while net profit surged over five times from the year-ago figure to hit Rs 1,017.7 crore. The company’s EBITDA, or operating margin, expanded to 19.3 percent of revenues in FY21-22, from 13.6 percent in FY20-21.

In Q3 of FY22-23, the company along with its defence subsidiary Kalyani Strategic Systems, secured contracts worth Rs 600 crore (including Rs 265 crore for India operations), taking the order book to Rs 1,950 crore. This will start reflecting from FY23-24 and is to be completed in 24-30 months. The fulfilment of these orders along with export of artillery gun systems will commence from beginning of FY23-24 and expects Rs 1,000 crore revenue in FY23-24.

Jefferies sees a large domestic order for artillery guns as a key potential upside to the earnings of Bharat Forge. But it also added that the stock is trading at 17 times FY23-24 EV/EBITDA (Enterprise Value to its Earnings Before Interest, Taxes, Depreciation & Amortisation) and five times FY24 Price to Book, versus its 10-year average of 12 and 3.8, respectively. The foreign brokerage firm finds these valuations expensive, notwithstanding the order for artillery guns.

ICICI Securities sees the 18 percent RoE (return on equity) in FY21-22 rising to 22.9 percent in FY24-25.

Hindustan Aeronautics Ltd (HAL)

HAL, the largest defence PSU in India, is engaged in the design, development, manufacture, repair, overhaul, upgrade, and servicing of a wide range of products, including aircraft, helicopters, aero-engines, avionics, accessories, and aerospace structures.

To boost growth, HAL is focusing on the international market, civil aviation, civil maintenance, repair and overhaul (MRO), unmanned aerial vehicles (UAVs, or drones), and other business opportunities through indigenous efforts and business collaborations.

In the financial year 21-22, HAL recorded its highest-ever turnover of Rs 24,361.66 crore, up 8 percent YoY, while PAT jumped 57 percent to Rs 5,086.5 crore.

Its order book stands at Rs 84,000 crore, flat quarter-on-quarter (QoQ), as on December 2022.

Sharekhan by BNP Paribas is bullish on HAL’s growth trajectory as it is one of the key beneficiaries of structural reforms in the defence sector. The company has a healthy order book with a revenue visibility of more than three years, and a strong likelihood of margin improvement in the long term, it highlighted.

Once the execution of large orders picks up pace, the company could post double-digit revenue growth FY25 onwards. Sharekhan also likes the fact that HAL is debt-free, has strong cash and equivalents, and healthy return ratios. The stock is currently trading at around 15 times its September FY23-24 EPS, which is lower than its listed peers in the defence pack.

Elara Securities says ‘Buy’ HAL shares, on the back of a surge in inflows, stable margins, and sustained double-digit earnings growth. The brokerage firm believes rising indigenisation along with exports in the aircraft and helicopter industry warrants a valuation rerating this recommendation.

The brokerage firm expects a compounded annual growth rate of 16 percent in earnings over FY21-22 to FY24-25 with a ROE of 21 percent over FY22-25. Its RoE in FY21-22 is at 20.8 percent.

Bharat Electronics Ltd (BEL)

BEL is a leading aerospace and defence electronics company that primarily manufactures advanced electronics products, including radars, missile systems, avionics, and equipment used in electronic warfare, anti-submarine warfare, electro-optics, etc.

BEL has also diversified into areas like homeland security solutions, smart cities, e-governance solutions, space electronics, etc.

The company’s strategy is to diversify into non-defence areas, and focus on increasing exports and services, which would aid long-term growth and help de-risk its business, ICICI Securities said. The company is focussed on increasing its share of non-defence revenues to around 20-25 percent over two to three years.

Despite an order inflow of just Rs 3,736 crore in the first nine months of FY22-23, the company’s management has reiterated its order inflow guidance of Rs 20,000 crore for the year.

Major orders expected are Rs 3,300 crore for the Himshakti programme (electronic warfare systems for mountainous regions), Rs 2,000-3,000 crore for Atulya radars, and orders worth about Rs 10,000 crore for radars and sonar systems for the Indian Navy. Other large orders expected include contracts for the Quick Reaction Surface-to-Air Missile, and Akash missile systems. These orders are expected in FY23-24, the brokerage firm noted.

In FY21-22, the company’s revenue from operations rose to Rs 15,368.18 crore from Rs 14,108.69 crore in the year-ago period, while net profit came in at Rs 2,398.87 crore, up from Rs 2,098.94 crore.

Prabhudas Lilladher, a brokerage, has estimated that BEL’s RoE of 20.6 percent in FY21-22 will increase to 24.4 percent in FY24-25.

The domestic brokerage firm is confident about BEL’s long-term growth story given its strong order pipeline, and diversification in newer business verticals like medical equipment, hydrogen fuel cell, EV batteries, focus on exports, and the government focus on indigenisation.

Bharat Dynamics Ltd (BDL)

BDL is another leading Indian defence PSU engaged in the manufacture of surface-to-air missiles, guided anti-tank missiles, air-to-air missiles, underwater weaponry, launchers, countermeasures, and test equipment.

During FY21-22, BDL reported a revenue of Rs 2,817 crore, which increased 47.2 percent YoY, while EBITDA and net profit jumped 110.6 percent and 94 percent to Rs 726 crore and Rs 500 crore, respectively.

According to ICICI Securities, BDL’s order book stands at Rs 11,906 crore, or 3.8 times its trailing twelve month revenues, which gives us strong revenue visibility.

However, BDL’s RoE has fallen to 17 percent in FY21-22 from 20.5 percent in FY19-20. The brokerage firm has estimated that the company’s RoE will bounce back to 20.5 percent by FY24-25.

Elara Securities is optimistic about the defence indigenisation story, supported by the unexplored exports market in the missiles segment, which has prompted the brokerage to give a ‘Buy’ call on the stock.