Street remain optimistic on increase in defence capex spend

Earlier this month, as per a PIB release, the Ministry of Defence had achieved "the highest-ever growth in indigenous defence production" to Rs 1.26 lakh crore during FY24, around 17 percent higher than the year before.

The defence sector continues to be an investor favourite, as stocks continue to rise on  expectations of increased allocation for defence capex in the upcoming budget and a continued thrust on domestic production of armaments.

Defence has over the last few budgets, been on high priority. India is the fourth largest military spender globally. As per latest data from Stockholm International Peace Institute, in 2023, at $83.6 billion, India’s military expenditure was 4.2 per cent higher than in 2022.

In the interim budget announced in February, the defence budget for the current financial year was increased to Rs 6.21 lakh crore, with around Rs 1.7 lakh crore of it towards capex. With government finances in a much better position than what they were in January, investors and industry experts are betting that the defence outlay could be bumped up in the July 23 budget as well.

Earlier this month, as per a PIB release, the Ministry of Defence achieved "the highest-ever growth in indigenous defence production" to Rs 1.26 lakh crore during FY24, around 17 percent higher than the year before.

Krishna Appala, Senior Research Analyst at Capitalmind Research, feels this number could rise to around Rs 1.7 lakh crore this year, including Rs 35,000 crore in exports.

"By 2027, India seeks to achieve 70 percent self-sufficiency in defence," Appala told Moneycontrol.

Prabhudas Lilladher’s Amit Anwani notes that over the past 7-8 years there have seen significant defence reforms aimed at reducing component imports, creating a robust domestic vendor base, and promoting exports. Some of the notable efforts include mandating foreign players to set up manufacturing in India, transferring technology, and developing homegrown technology through DRDO.

“Domestic companies, particularly small and micro private firms, are witnessing rapid growth as they collaborate with DRDO and manufacture import substitute products. Larger OEMs and private sector giants like Tata and Mahindra Defence are also experiencing growth, though at a slower pace than smaller firms,” Anwani added.

In the interim Budget, the Ministry of Defence (MoD) received the highest allocation among ministries, with 27.67 percent for capital expenditure, 14.82 percent for revenue expenditure, 30.68 percent for pay and allowances, 22.72 percent for pensions, and 4.11 percent for civil organizations under MoD.

Anil R, Senior Research Analyst at Geojit Financial Services, adds that the interim defense budget has already allocated Rs 1.72 lakh crore for capital expenditure. "There may be a slight increase, potentially up to Rs 1.9 lakh crore, or even Rs 2 lakh crore," he says.

Currently, defence spending, as a percentage of GDP, is around 1.9 to 2 percent. But the industry has long advocated for increasing the capital expenditure (CapEx) to 3-4 percent, or even 5 percent, to accelerate modernization. "Currently, 40-50 percent of inventory across the armed forces is obsolete, necessitating significant investment," Anil says.

Anwani concurs. “We could see higher allocation to Navy and Airforce in each budget going forward, with defence budgets anticipated to grow slightly higher than GDP at about 7.5-8% annually. This could shift the defence percentage of GDP from 2.4-2.5% to 2.7-2.8% in the next 5-7 years,” he says.

Also read: Defence stock valuations on the offensive: Indian stocks three times more expensive than US stocks

Appala notes that several public sector undertakings (PSUs) and private players are positioned for growth, driven by government initiatives. These companies have strong order books and visibility for the next three to five years.

"Valuations in the defence sector are high, trading at 50-60x P/E FY25, but the market anticipates long-term growth, driven by government support for key sectors like this," he says, adding that the market factors in the continuity of government policies, with an expectation of schemes like the Production Linked Incentive (PLI) for domestic players.

Anil says that valuations in the defence sector have historically been around 10-20 times earnings but have risen due to government policies, such as the import ban. This has significantly changed valuation multiples. "Major defence companies have robust order books, but the execution remains a critical factor. The industry's long-term outlook is positive, but near-term valuations are high. Companies like Cochin Shipyard, BEML, and Astra Microwave Products have strong order books, but there are concerns about execution timelines," he says, adding that valuations are expected to correct post-budget announcements.

Anwani also concurs that while valuations in the defence sector are high, substantial order books and strong growth potential provide a positive long-term outlook. Companies like HAL, Bharat Electronics, and BEML, which have significant defence portfolios, are poised to benefit from continued budget allocations and order inflows.