The Defence Portfolio – grab the Rs 15 lakh crore opportunity

A visitor is seen at India's Brahmos' booth at the Maritime Air Systems and Technologies Asia (MAST) show in Chiba, Japan June 12, 2017. REUTERS/Toru Hanai - RTS16N97

In 2016, India surpassed Saudi Arabia and Russia to become the country with the fourth highest defence budget globally. With defence spending expected to accelerate in the next couple of years, the ranking could rise to number three by 2018.

Source: IHS Markit 

India has the third largest military in the world and is one of the largest importer of conventional defence equipment. It spends around 30 percent of its Rs 2.75 trillion defence budget on capital acquisition. At present, 60 percent of the defence requirements are met through imports. But this mix could change dramatically as the government looks to step up indigenous sourcing to 70 percent over the next decade.

Convinced that indigenous weapons production can provide jobs, result in savings and transfer of technological know-how, defence is at the core of “Make in India”.

As per government’s own projections, contractual offset obligations—the orders required to be sourced locally--worth approximately USD 4.53 billion, are likely to come up in the next 5-6 years. The offset policy in capital purchase contracts with foreign defence OEMs, stipulates a mandatory offset requirement of a minimum of 30 percent for defence contracts. The minimum contract value for which offsets are mandatory stands at Rs 2,000 crore.

India’s defence spending has increased at a compounded annual growth rate (CAGR) of 12 percent in the last 15 years. In budget 2017-18, the allocation for defence capital outlay stood at Rs 86,488 crore out of the Rs 2,74,114 crore allotted to defence expenditure. The preferential treatment given to defence PSUs in excise/customs duty has been discontinued to create a level-playing field and customs duty exemption on import of defence equipment has been removed to incentivize domestic manufacturing.

According to industry sources, the capital acquisition of defence hardware in the next 15 years is expected to be Rs 1.5 lakh crore (USD 225 billion), divided under- i) Land systems (Rs 6 lakh crore) - focused on small arms, ammunition, artillery and air defence guns, combat vehicles and anti-tank missiles., ii) Aerospace – Rs 5.2 lakh crore, iii) Naval – Rs 3.5 lakh crore, and iv) Security (Rs 0.3 lakh crore) – catering to all segments with Radars, electro-optics, C4I system, underwater systems, missiles and guided weapons, avionics, and communications and electronic warfare.

The Cabinet has also recently cleared a new strategic policy (SP) for private sector participation in equipment manufacturing in India. A pool of top six Indian companies will be made based upon three main criteria- Financial (Rs 40 billion turnover for 3-years and Crisil A rating), technical capability and existing infrastructure, and could bid for approximately USD 20 billion worth of projects.

While this opportunity size is significant and will run for the next eight to ten years, we suggest investors adopt a portfolio approach to ride on this theme. Moneycontrol Research has created a portfolio for the long-term ‘buy & hold’ investors to capitalise on the opportunity that “Make in India in Defence” is likely to offer.

The portfolio with 15 stocks has an eclectic mix of stocks from the large and mid-cap universe. We have judiciously created a cash cushion of 20 percent to capture the opportunities, should markets turn a tad jittery post GST implementation in the near term.

The defence portfolio is unique in many ways because the companies in the fray need not just have the requisite financial muscle, but should possess the right technical capabilities and pre-qualification to capture this opportunity. Thus, investors got to be selective as this is a high ‘entry barrier’ business and companies that manage to get qualified stands to enjoy the ‘exclusivity’ premium for a while.

We envisage this portfolio to deliver decent outperformance over the medium term as India pushes the pedal on “Make in India” through defence indigenisation.