Defence PSUs can deliver good returns to investors, shield portfolio

The debt-free status is positive; robust order book and execution will drive earnings

Government-owned defence equipment makers, such as Bharat Electronics (BEL), Bharat Dynamics (BDL), Hindustan Aeronautics (HAL) and Cochin Shipyard, have attracted investors, given the 53-142 per cent gains in their share price since March lows.

While the scarcity of growth across sectors and high market volatility are partly responsible for the odds tilting in their favour, investor sentiment has got a boost from their better-than-expected March quarter performance, which is led by order execution and, in turn, improved margins. The stocks, too, were trading at attractive valuations. And, there is more steam in the rally.

After the recent India-China standoff, the defence sector is getting priority in terms of government spending — which is not the case with many other sectors, looking at Covid-19-triggered economic challenges. Prospects of companies with strong order books, such as BEL and Cochin Shipyard, are improving with fresh orders and improving execution; others, such as HAL and BDL (relatively softer order book), too, are seeing gains.

As order inflows pick up, execution is seen gaining pace, with the requirement of armed forces being addressed on a priority basis. Analysts, such as Umesh Raut of YES Securities, see a continued increase in order inflows over the next two years.

Also, these companies are debt-free and new orders usually are received with advance payments (or based on the order completion method). Therefore, payments and working capital are not an issue. This, in turn, also allows them to sustain decent dividend payouts, increasing their attractiveness for investors.

Among these companies, BEL remains the top pick of most analysts, given its strong research and development (R&D) capabilities and order book. A better-than-expected March quarter (Q4) performance and the company being able to address concerns on soft margins (as seen during the first three quarters of FY20, which restricted its profit growth) has boosted the Street's confidence.

In Q4FY20, its revenue grew 49 per cent year-on-year (YoY), led by strong execution, while earnings before interest, tax, depreciation and amortisation (Ebitda) jumped 60 per cent, leading to a 160-basis point YoY expansion in the margin to 25.5 per cent. This was despite the lockdown impact in late March. BEL’s order book of Rs 52,000 crore already indicates revenue visibility of four years. Major orders acquired during FY20 by BEL includes the Akash missile system, the coastal surveillance system, and upgrade of the electronic warfare system (EWS) and software-defined radios. In FY21, orders for the EWS, avionics package for light combat aircraft, etc, are expected. The company has also diversified, albeit marginally, in non-defence equipment, such as ventilators amid the Covid-19 crisis. “With better systems integration capabilities, BEL is capable of delivering a much larger turnover, yielding better cash flows and returns over two-three years,” say analysts at Edelweiss.
 

With captive R&D, BEL scores over BDL, which depends on DRDO (Defence Research and Development Organisation)-designed and developed projects and has exposure to a single segment — missiles (anti-tank missiles, surface-to-air missile and torpedoes). Nevertheless, BDL, too, is well poised to grow. It had posted extraordinary performance for the March quarter, driven by the execution of deferred sales from the first nine months in the Akash missile project. Sales grew 64 per cent YoY, while a better sales mix and higher operating leverage led to a 236 per cent YoY jump in Ebitda. Its order book of Rs 7,400 crore can multiply with large orders worth Rs 20,000 crore; the order book at end of FY22 is estimated to grow to Rs 22,500 crore, say analysts at PhillipCapital. New orders that are expected in the coming months include those for Akash missiles (Rs 10,000 crore), Astra missiles (Rs 2,500 crore), and Milan anti-tank missiles (Rs 800 crore).

For shipbuilder Cochin Shipyard, there are expectations of large ship orders from the Indian Navy over the next two-three years. Even otherwise, in order to equip itself, the Navy regularly places orders for other (smaller) vessels. The company has also bid for next-generation missile vessels, new generation offshore patrol vessels, and multi-purpose vessels, totalling Rs 4,000-4,500 crore. Order wins from these could boost its order book of Rs 14,634 crore. Beyond shipbuilding, the company also undertakes ship repairing, which is 17 per cent of its revenue. The growing domestic ship repair market worth Rs 2,500 crore is also an opportunity for stable revenues.
 

HAL, which is into aircraft and helicopter manufacturing, had an order book of Rs 52,965 crore (2.5x FY20 revenue) as at end-March 2020. The same has improved by Rs 10,730 crore with this month's order to manufacture Sukhoi aircraft. Further orders for the upgrade of MIG aircraft and manufacture of light combat aircraft remain larger opportunities, which analysts at CIMB estimate to worth Rs 2.8 trillion over the next five-seven years.