New policy pushes defence stocks

While companies like BEL, L&T, M&M and Tata Power stand to gain, execution holds the key

The clearance of the new defence procurement policy or DPP set on fire stocks of companies such as Astra Microwave, Walchandnagar Industries, Rolta, Bharat Electronics (BEL), BEML, Bharat Forge and L&T, which have registered smart gains of 3-10 per cent since Monday.

Even as the fine print is awaited, introduction of a new procurement category – Indian Designed, Developed and Manufactured (IDDM), where at least 40 per cent of products have to be manufactured in India – may be a game-changer for defence companies. Currently, around 90-95 per cent of raw materials/components are imported, particularly in the foundry and forging segment. Domestic companies scaling up their production capabilities along with quality assurance could significantly boost revenues from defence.

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Further, the DPP promises first preference to IDDM products. It also allows the acquisition council to fast-track procurement of weapons, which was until now opened only to the army. Therefore, delays in project awarding and time taken for clearances too will narrow. All these work in favour of India’s largest defence player BEL, while L&T, Mahindra and Mahindra, Bharat Forge and Walchandnagar Industries too stand to gain. However, the Street feels being a pure-play defence player, BEL may capture a large share of the pie, ensuring steady order flows and revenues for the company. Santosh Yellapu, analyst tracking the sector at Angel Broking, says the industry has a revenue potential of about Rs 1.50 lakh crore over the next two-three years, and with an order book of Rs 32,000 crore (representing over 20 per cent share in likely orders), BEL may deliver 16 per cent revenue growth in the FY15-18 period. Analysts also brushed aside concerns of BEL losing market share to private players.

Mahesh Bendre, an analyst at Way2Wealth, said of the total orders in the space, 20 per cent is directly executed by BEL, and players such as Astra Microwave, Walchandnagar Industries act as subcontractors of BEL. Thus, it continues to remain the delivery point for defence equipments, which makes it a forerunner. It is important to note that despite the sector ebbing opened up for private participants in 2007, BEL continues to hold its forte in the electronic equipment segment, particularly sonar and radars, though its market contribution has reduced from 51 per cent to 32 per cent. Market share dilution may be attributed to opening up of more products in the sector, say analysts. BEL’s transfer of technology agreements with global majors such as Lockheed Martin, Boeing, Airbus, Northrop Grumman, Elbit Systems, Honeywell and Thales laps up its leadership position. From an investor perspective, being a large-cap stock, BEL is shielded from the risk of variability in revenue, which smaller companies such as Astra Microwave, Walchandnagar Industries and Rolta India may not be able to stomach. Also, there will always be the inherent market risk attached to small-cap stocks. BEL is virtually debt-free with cash and bank balances in excess of Rs 5,000 crore as on September 30, 2015. On the whole, 16 of 20 analysts polled on Bloomberg recommend ‘buy’ for BEL.

While larger players such as L&T, M&M and Tata Power do have a presence in the space, the share of the segment in their revenues is still a fraction and, hence, any meaningful re-rating due to higher revenues from the sector appears far-fetched. Yellapu explains that even as L&T (which has expertise in battlefield equipment), has guided for Rs 5,000 crore of defence orders in the next three years, seen against its December’15 quarter order book of Rs 2.56 lakh crore, this is still paltry. Similarly, M&M and Tata Power may see the share of defence rise. Smaller companies with relatively higher exposure could see gains accruing faster.

There is a word of caution though. A chief investment officer of a large fund house says, this is just a policy initiative and orders will take a while to flow. Also, the Rs 85,894 crore of capital expenditure earmarked for defence forces for 2015-16 was revised to Rs 74,299 crore as Rs 11,595 crore or 13.4 per cent of funds for purchase of military equipment remained unspent in FY16. For 2016-17, the capital expenditure is pegged at Rs 78,586 crore. It is, however, yet to be seen how much of this materialises, and how soon. These timelines are crucial and will be key in determining the fortunes of companies relying on defence orders.