Despite formidable stock returns in the defence sector, analysts feel there is further steam left in it on the back of robust order books and improving earnings quality
uoyed by healthy order books, revenue expansions and the government’s major push for localisation, India’s defence sector has turned attractive for investors. However, analysts caution that steep valuations, execution hiccups, competition pressures and cash flow generation risks may poise threats to the bumper rally defence stocks have seen recently.
Sachin Trivedi, head of research and fund manager, Equity, UTI AMC, believes that the defence sector is still favourably placed, given the opportunity size (domestic and export) and potential growth over many years. Recent conflicts closer to India, Europe, and other parts of the world strengthened the urgency and need to increase capex and localise production, which made the sector attractive to investments.
In recent conflicts, we have seen the importance of new defence equipment such as drones, anti-drone systems, missiles, air-defence systems, etc. Countries at war have struggled to get reliable supplies during a tough time. Therefore, India can’t afford to rely on the external supply of equipment and critical components. Thus, pushing for localisation of production is essential, which will generate large and sustainable opportunities for domestic players,” Trivedi says.
India’s defence sector has undergone major reforms as the government is trying to strengthen the nation’s defence prowess by reducing dependence on imports. Measures such as simplification of procedure for procurement of defence products, provision for funding of up to 70 percent of development cost by the government, and a hike in foreign direct investment (FDI) to 74 percent through the automatic route are expected to further boost investments in the sector.
“In addition, the Ministry of Defence has banned the import of several components over a period of time, thus encouraging indigenisation. This clearly shows the favourable tilt of policy framework for defence companies,” says Gaurav Dua, head, Capital Market Strategy, Sharekhan by BNP Paribas. Indigenisation in the defence sector refers to increasing manufacturing capacity within the country, create research and development, and boost exports.
The government has introduced a series of booster schemes and measures that have resulted in a steady flow of capital and investment opportunities in the sector. The cumulative FDI inflow in the defence industry stands at $15.71 million, during the period April 2000 to September 2022, according to the Make In India website. Earlier in 2020, the government had increased the FDI limit to 74 percent from 49 percent, under the automatic route, and up to 100 percent through the government route in the defence sector.
According to government data, India has around 194 defence start-ups building innovative tech solutions. The government has set a target of Rs 1.75 lakh crore of defence production by 2025, which includes export of Rs 35,000 crore. The Budget outlay for FY23 has been fixed at Rs 5.3 trillion, a 10 percent increase over last year.
“The Indian private sector has grown since opening of the defence sector and evolved from producing components and sub-systems, to developing complete equipment and systems, system of systems and platform level solutions,” says Jayant D Patil, member of executive committee and advisor (Defence and Smart Technologies), to CEO and MD, L&T.
“This is clearly visible from the quantum [more than 90 percent] of defence exports by private defence companies. Going forward, the industry looks forward to stepping up and empowering itself with latest manufacturing practices including industry 4.0, for efficient serial production and additive manufacturing towards faster development and limited series production of high-tech parts agglomeration,” Patil adds.
Key defence stocks like Bharat Electronics, Hindustan Aeronautics, Bharat Dynamics, Solar Industries, Garden Reach Shipbuilders & Engineers, Cochin Shipyard and Data Patterns have jumped 30 to 145 percent in 2022 so far, outperforming benchmark indices Sensex and Nifty in this period. Despite formidable stock returns of over 70 percent on average over a year, Amit Dixit, analyst, ICICI Securities feels there is further steam left in the sector on the back of robust order books and improving earnings quality.
However, valuations in certain stocks seem to have run ahead of fundamental post the sharp rally in the past few quarters. So, investors need to have mid-to-long term investment horizons to make meaningful gains from investments in the defence sector, cautions Dua.
Edited by Ragul Senthil