Revenue visibility on strong order books and increasing emphasis on execution in the light of the country's geopolitical uncertainties make defence companies good investment bets.
Execution of defence orders is visibly picking up with companies in the space reporting an aggregate 12 percent year-on-year (YoY) sales growth during the quarter ended December 2018.
The trend looks favourable with signs of growth in the coming quarters as well, backed by strong order book providing revenue visibility and increasing emphasis on execution in the light of geopolitical uncertainty in the country.
Defence projects typically have a longer cycle and lumpy growth. During the December quarter, most companies delivered well ahead of expectations led by improved execution; Cochin Shipyard was a case in point.
The government has also started taking deliveries of large projects, which was absent earlier and had been a key issue with some companies. As the government starts to take deliveries and provide clearance, companies start to book revenue.
To put this into perspective, Garden Reach Shipyards (GRSE) reported 116 percent revenue growth clearly due to the approval of its finished inventory that allowed the company to book more revenue. About 10 of its high-value ships faced delivery delays because of the changes in specifications. But, it is now ready to book revenues, part of which would reflect in the coming quarters. This development makes the stock one of our top investment ideas in the sector.
Similarly, Bharat Dynamics, that manufactures missile systems and launchers, reported a 25.8 percent YoY sales growth. Recent capacity expansions, the increasing size of projects and investment in value-added products is now helping the company scale up faster.
Among the downstream players though, vendors such as Bharat Electronics, Astra Microwave, Mishra Dhatu and few others reported a muted growth. This is largely a cascading effect of the last few quarters of payment delays in the extended delivery schedules.
Strong order book
If the larger manufacturers witness traction in deliveries then the benefits would trickle down to the suppliers in the coming quarters. Importantly, most companies are sitting on a strong order book of about 3-5 times their annual revenues.
GRSE, for example, has an order book of close to 15 times its revenue. Cochin Shipyard, which is also our preferred investment pick, has an order book of close to Rs 10,800 crore or 5.5 times its shipbuilding segment revenues.
Most companies have expanded capacities in the recent past in the hope of increasing project size and opportunities. While they received the orders, the capacities were lagging behind.
These capacities are now finally coming on stream and operating leverage is kicking in. During the December quarter, companies covered by us reported a 38 percent increase in depreciation on an aggregate basis. This is precisely the reason that EBITDA grew 49 percent YoY and net profits grew 32 percent YoY. This will continue over the next few quarters resulting in higher earnings growth. This could ease the Street’s apprehensions about growth and lead to valuation re-rating.Moneycontrol Research Page.