Defence stocks pricing in all positives and offer limited upside: Analysts

However, the rally, which has been accompanied by high valuations, could stagnate in near term as companies may not meet investors' expectations of sustained performance every quarter, analysts say

Stocks of defence-related companies have been firing on all cylinders at the bourses in calendar year 2023 (CY23). Shares of Hindustan Aeronautics (HAL), Bharat Electronics (BEL), Bharat Dynamics (BDL), Data Patterns, MTAR Tech, Cochin Shipyard and GRSE have rallied 21-96 per cent so far this year. 
 

The gains have been sustained on the back of robust export opportunities, a healthy project pipeline and the government’s continued push for local manufacturing and indigenisation of defence equipment.

However, the rally, which has been accompanied by high valuations, could stagnate in the near term as companies may not meet investors’ expectations of sustained performance every quarter, analysts said.
 

“The order book cannot be evaluated on a quarterly basis as it plays out over long periods of 5-10 years. Since companies have got milestone payments, a lot of good news is already priced in, which has been seen in some PSU (public sector undertaking) stocks.

Fresh buying looks difficult and stocks will consolidate in the near term as the market wants similar results every quarter, which will not happen. The order book can also be lumpy, so one should remain selective,” said Amit Kumar Gupta, founder, Fintrekk Capital.
 

In the June quarter (Q1FY24), which is generally seasonally weak for the defence pocket, the net profit of companies such as HAL, MTAR Tech, BEL, BDL, and Data Patterns declined 35-72 per cent on a sequential basis. Moreover, revenue fall was in the range of 22-69 per cent quarter-on-quarter (Q-o-Q).
 

On a yearly basis, the net profit grew between 25 and 85 per cent and revenue rose 8-68 per cent.

From this, BDL was the top underperformer and reported a 5 per cent year-on-year (Y-o-Y) profit growth and a 57 per cent Y-o-Y slump in revenue.  

The subdued results seem to indicate that the companies’ valuations have run up beyond justification, but the stocks are broadly fully valued, notes Deepak Jasani, head of retail research, HDFC Securities.
 

“Limited floating stock and chase for revenue visibility have led to high valuations. But temporarily, the stocks are fully valued and can gain even more if companies deliver better-than-expected results on better execution. Early investors can partly book profits, while those looking to add could take the SIP route in select stocks,” Jasani said.

Long-term story intact

While the strong up move for defence stocks could face hiccups in the near term, analysts believe the sector’s growth prospects remain firm on the back of robust demand, both domestically and in the international markets.

As domestic demand is primarily driven by government orders, this huge dependence also implies vulnerability to political and economic risks. But the growing export front could partially offset these concerns, according to a recent note by Fisdom Research.  
 

Notably, the government has aimed to drive defence exports to Rs. 350 billion by 2024-25 (FY25) from Rs. 116 billion in 2021-22 (FY22).
 

India is also being increasingly seen as an appealing base for global original equipment manufacturers (OEMs) due to the cost advantage to make and export defence products.

This was recently evident with the pact GE Aerospace signed with Hindustan Aeronautics (HAL) to produce the crucial F-414 engines.
 

“Companies are increasing their focus on the ability to execute and are early in the delivery cycle, ramping up execution capabilities. Valuations are relatively high but largely justified, given the growth expectations,” said the Fisdom Research note.

Looking at a favourable risk-reward ratio, analysts at PhillipCapital prefer BEL, BDL, Solar Industries and MTAR in the defence pack.