Brokerage house Phillip Capital maintained its bullish outlook on defence stocks as it sees an opportunity pipeline of $110 billion spread over 6-8 years. Looking at a favourable risk-reward ratio, the brokerage prefers Bharat Electronics (BHE), Bharat Dynamics (BDL), Solar Industries India (SOIL), and MTAR, among defence stocks.
"We believe defence stocks are placed favourably because they offer the following: (1) long-term execution growth visibility, backed by robust order book and a healthy pipeline, (2) timely execution due to localization, integrated modular construction, and subcontracting, (3) domain expertise/moat of government preference, (4) cash-rich balance sheets that avoid major working capital issues because of stage payments, (5) in‐house R&D investments and appropriate tech support from DRDO, (6) favourable policies with the highest priority for local manufacturing, Agnipath Scheme, strategic partnerships, and the import embargo, and (7) dividend pay-outs of 30‐60 percent," explained PC.
It also believes that margins from core defence products could rise due to efficiencies developed over the years and the indigenization mandate.
Investment Rationale
$110 bn opportunities: The brokerage forecasts a bottom-up derived opportunity pipeline of $110 billion spread over 6-8 years for its coverage, against their cumulative FY23 revenues of just $8 billion. The tangibility for these orders is high because projects in the pipeline are for products already developed or transfer-of-technology (TOT) from foreign OEMs. At $44 bn, defence aerospace accounts for a bulk of the opportunities, followed by defence shipbuilding at US$ 40 bn, and missiles/ artillery guns systems at $26 bn, it estimates.
Favourable policies: As per the brokerage, the Indian defence sector has experienced significant reforms, leading to improved efficiency, self-reliance, and capabilities. The Make in India initiative has contributed to a rise in domestic defence capital procurement to 68 percent of total in FY23 from 38 percent in FY13, it informed. Meanwhile, the streamlining of defence procurement procedures (DPP) and relaxation of the offset clause have attracted foreign investment, it added. Further, the newly corporatized Ordnance Factory Board (OFB) has successfully turned profitable, exemplifying how accountability drives performance. Also, the Agnipath scheme, targeting the reduction of hefty allocations towards personnel and pensions (51 percent of the defence budget), is expected to free up substantial funds for crucial defence capital procurement, noted the brokerage.
Potential for global OEMs: Foreign OEMs have a distinct technological advantage and expertise over their Indian counterparts, which is why the Indian market holds vast potential for them. India's “offset” or countertrade requirements have been relaxed, allowing foreign investors greater flexibility. Given India's strategic significance in the Indo-Pacific region, defence OEMs can now strengthen their relations with the Indian military by sharing technology via strategic collaborations, which not only helps secure future contracts but also opens doors to new markets, stated PC.
Stocks
Among the 6 defence stocks under coverage by Phillip Capital, it is bullish on Bharat Electronics (BHE), Bharat Dynamics (BDL), Solar Industries India (SOIL), and MTAR. Let's see why.
Bharat Electronics: The brokerage has a ‘buy’ call on the stock with a target price of ₹159, indicating an upside of 25 percent. BHE has a strong moat in the highly specialized defence electronics segment, with a market share of 60 percent, backed by its ability to execute large defence contracts, said PC. It believes BHE’s virtuous cycle of growth will be based on two factors – order visibility and swift execution. BHE has shown secular growth over a decade with revenue/PAT growth of 11%/13% over FY13-23. It has an order backlog of ₹60,700 crore providing revenue visibility over the next three years, backed by a strong pipeline of ₹70,000-80,000 crore. It expects revenue/EBITDA/PAT CAGR at 15%/16%/18% over FY23-26.
Bharat Dynamics: The brokerage initiated coverage on the stock with a ‘BUY’ rating and a target of ₹1,428, indicating an upside of 22 percent. BDL has been the sole supplier of Surface-to-Air Missiles (SAMs), Anti-Tank Guided Missiles (ATGMs), and torpedoes to the Indian armed forces. With its recent offering of Astra (air-to-air missile), it has increased its addressable market to 61% of India’s US$ 24.5bn missile demand until FY26. BDL’s declining order backlog, a key concern, received a major boost of ₹13,000 crore in FY23; its order pipeline should be robust at over ₹30,000 crore over the next 3-5 years, it said. PC expects a revenue CAGR of 32% over FY23-26, EBITDA CAGR of 47%, margin of 21-23%, and subsequent PAT CAGR of 44%.
Solar Industries: The brokerage initiated coverage with a /BUY' rating and a target of ₹4,318, indicating an upside of almost 17 percent. SOIL is a dominant player in industrial explosives, controlling a significant one-fourth of this market in India. It is well poised to sustain its dominance in domestic explosives volumes over FY23-26. SOIL’s overseas manufacturing base is likely to help growth with a 15% revenue CAGR over FY23-26. Given the optimistic outlook for the sector, it expects SOIL’s revenue/EBITDA/PAT CAGR at 10%/15%/17% over FY23-26. PC believes premium valuations will sustain, as SOIL has displayed traits of being a winner with the least cyclicity, despite catering to a cyclical sector, and expects its moat to sustain, as no near competitor can match its scale and capabilities.
MTAR Tech: The brokerage has a ‘buy’ call on the stock with a target of ₹2,637, indicating an upside of 25 percent. MTAR is a leading-precision engineering solutions company that caters to prestigious clients such as ISRO, NPCI, DRDO, and Bloom. It has a strong presence in the emerging ‘clean energy’ segment and in nuclear, space, and defence sectors. Despite a stringent qualification environment acting as a robust entry barrier, MTAR has consolidated its market position. Its revenue CAGR was 30% over FY18-23, and PC expects it to accelerate to 41% over FY23-26, driven by a significant 59% growth in its order backlog.
Meanwhile, among defence stocks, the brokerage also has ‘neutral’ calls on Hindustan Aeronautics and Data Patterns. It has a target price of ₹3,975 for HAL, implying an upside of 3 percent and a target of ₹1,858 for Data Patterns, which indicates an over 9 percent downside.
