Story of valuations – Analysing disparity in defence stocks

“The defence sector is now at a PE (price-earnings multiple) of more than 30 and is at a premium to the market PE of 25 or so,” said Vikas Gupta, smallcase Manager, CEO and chief investment strategist, OmniScience Capital. However, he added that for a higher growth portfolio a higher PE might be justified.

“Forward PE is not as high due to the higher growth rates,” he explained.

Yet, he noted that things have changed significantly since he launched the strategy years ago. Back then, he was one of the few who saw potential in the defence sector. Now, with the market's focus on the sector, including a Defence Index and mutual fund scheme, the sector's value has been unlocked.

PE ratio (times)

Among defence stocks, Hindustan Aeronautics Ltd (HAL) predicts moderate revenue growth for FY24. Manufacturing revenue is set to gain momentum from FY25, especially with the increase in deliveries of the light combat aircraft Tejas MK I. Until then, revenue will be mostly from the repair and overhaul wing, resulting in a muted revenue growth of 9 percent for FY24.

With regard to Bharat Electronics Ltd (BEL), Kotak Institutional Equities said it is factoring in the prospect of exports from non-defence segments that may start showing on the books in two years. The stock valuation is 28 times one-year forward earnings or mid-teens compound annual growth in profit after tax over the next 15 years, it said.

Antique Stock Broking believes that once the supply chain issues are resolved, Bharat Dynamics could see a surge in execution in the second half of FY24 or FY25. The company is expected to see a sharp jump in orders as India places a significant thrust on its indigenous missile development programme. The brokerage sees compound annual growth of 39 percent in revenue and 63 percent in earnings over FY23-25.

As for Mazagon Dock Shipbuilders, while the order book potential remains significant, ordering or execution timelines remain unclear at this stage, said ICICI Securities. Currently, the stock captures a lot of exuberance that might not fructify as expected, it added.

And JM Financial Institutional Securities sees compounded annual growth of 32 percent in revenue over FY23-25 for Data Patterns led by robust growth prospects and sustained margins. The defence player’s development-led business model and robust growth prospects will support elevated valuations of 56 times and 42 times its FY25 and FY26 earnings per share.

Earnings trajectory

Huge growth runway

While the market recognised defence as an alpha-generating sector quite some time ago, it is worth noting that experts in the field have consistently emphasised the substantial growth potential that still lies untapped.

The Defence Production and Export Promotion Policy 2020 is the driving force behind this vast growth opportunity. This policy aims to achieve a domestic defence production value of Rs 1,75,000 crore and nearly $5 billion in defence exports by 2025. Additionally, the defence ministry has been consistently issuing notifications that make it mandatory to source numerous components from domestic companies.

“This has triggered lots of JVs (joint ventures) of foreign companies with Indian defence companies and also a lot of FDI (foreign direct investment),” according to Gupta.

Anirudh Garg, Partner and Head of Research at Invasset PMS, too said collaborative initiatives involving foreign partners for Make in India and technology transfer significantly contribute to the sector's potential for sustained expansion.

Strategic partnerships

Market participants think that many companies in the defence sector have order backlogs ranging from over three years to nearly seven years in some instances.

Even as companies reach fair values instead of trading at discounts, the sector's positive growth trajectory remains steadfast, Garg said. He added that valuations are driven by frenetic buying, justified by growth expectations and positive sector re-rating.

Robust growth is powered by large order books that are 4-10 times the company’s revenue, and reflects strength in macro conditions and strong demand.

Companies are looking forward to making big profits from opportunities worth $110 billion over six to eight years, which is a lot more than the combined revenue of $8 billion in FY23, he said.

Challenges

Yet this very surge in defence stocks has injected an element of caution. Additionally, while the order books of Indian defence companies showcase resilience, the profits and revenues of some players have failed to impress investors.

Defence companies confront a range of challenges despite the promising growth prospects, according to Garg.

While the Indian defence industry has significant growth possibilities, challenges arise from the delayed realisation of indigenisation advantages in domestic companies' revenues due to time lags in execution after orders are placed, he said.

“While the Make-in-India drive has elevated domestic capital procurement, reflecting 68 percent of the total in FY23 compared to 38 percent in FY13, a significant portion of these gains is yet to manifest in revenue figures. Furthermore, the dependence on imports for 60 percent of defence requirements highlights a significant hurdle,” Garg explained.

Steps towards creating defence ecosystem in India

What Gupta of Omniscience Capital highlighted was that these defence companies are highly project-dependent. So revenue can only be recorded when project stages are finished and clients like the Indian Navy, the Indian Air Force and the Indian Army inspect and certify. Multi-year projects follow technical approval and accounting rules, which can be confusing for investors. This can lead to disappointment when continuous growth in revenue and earnings is not reported, he believes.

The sector will have lumpy earnings, he said, adding that an investor in this sector should be prepared for an uneven but secular growth over about three years. Some quarters or years may disappoint, but the next year's growth usually includes carryover revenue and new targets. So one should not react too much to quarterly earnings or sometimes even yearly earrings in this sector, said Gupta.

Abhinav Sharma, fund manager at Tata AMC, believes that in the case of defence firms, while the opportunity size is large, valuations have seen a sharp run up and further rerating may be unlikely. Valuations are ignoring the risks which can arise from any possible government policy changes and/or from the long execution cycle of these businesses.

“Which is why you have got to be a little cautious and be more stock specific in the sector at current levels,” said Sharma.

What could be your strategy?

Gupta believes new investors should not consider investing in the sector.

Even as he pointed out that valuations are closer to fair valuations now since it is in the limelight, he thinks an astute investor can find companies that are not overvalued and can make a portfolio heavy on such undervalued companies and light on the overvalued ones. Or they could sell off or not buy the overvalued ones, Gupta added.

While Mazagon Dock Shipbuilders thrives, stocks like Cochin Shipyard hold untapped potential, said Garg.