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Ready to take off
Peak valuations notwithstanding, state-owned Bharat Electronics is a good proxy play on India’s ambitious defence plans

Jitendra Kumar Gupta

The country’s armed forces have a potent weapon in their arsenal. In May, the army inducted India’s first homegrown surface-to-air missile system Akash. The missile can take on multiple targets up to a maximum range of 25 km and at an altitude of 20 km, aided by sophisticated radars and control systems. Last month, the Indian Air Force (IAF) formally inducted the 96% indigenously made state-of-the-art weapon system. The IAF has signed an initial contract for eight squadrons of the Akash defence system, with each squadron featuring two firing units and four launchers.

Each launcher has a capacity to fire three missiles in quick succession. The missile can not only target enemy aircraft up to 30 km away and at altitudes up to 18,000 m, but can also annihilate aerial targets such as fighter jets, cruise missiles and air-to-surface missiles. Not surprising, then, that SK Sharma is proud to be associated with the manufacturing process of the missile. The 59-year-old is the CMD of the state-owned Bharat Electronics (BEL), which, along with another state undertaking, Bharat Dynamics (BDL), bagged the ₹4,000 crore order for the missile system.

While Bharat Dynamics is the main integrator partner, Bharat Electronics is developing the electronic systems, comprising long-range capture surveillance and capture radar, fire control radar and control systems. In short, BEL’s share of the pie is around ₹3,000 crore-₹4,000 crore but, more importantly, the quantum of orders will only increase going ahead.

“As of now, the segments in which we are operating have a market size of about ₹10,000 crore-₹12,000 crore. But the next level of growth will come from the different types of ongoing programmes such as missile development, control systems, weapon management platforms, submarine programmes, shipbuilding and aircraft programme, where the electronic component requirements are in the region of 30% of the total cost,” says Sharma, a career BEL employee who took on the top job in 2014.

Bengaluru-based BEL, despite having 65% market share in the Indian defence sector, on which the government spends close to ₹2.5 lakh crore annually, is merely a ₹7,000-crore turnover company. And even getting there was a challenge, with the annual order inflows falling from ₹17,700 crore in FY11 to ₹4,200 crore in FY14. However, thanks to a revival and an improvement in situations on the ground, along with a supportive policy announcement, the prospects for companies like BEL have improved in the recent past.

Full steam ahead

Order flows will increase as India’s

defence programme gathers pace

In fact, between July 2014 and February 2015, the defence acquisition council has approved projects worth more than ₹1.7 lakh crore to kick-start the revival of the defence manufacturing sector. This is also reflected in order inflows. In Q4FY15, BEL saw a sudden spike in its order inflows by 83% to ₹3,100 crore. For FY15, the company recorded a 30% jump in inflows, with its order book now burgeoning at an all-time high of ₹21,053 crore, or more than 3X its sales turnover. “Of late, the speed of decision-making has improved and things have actually started moving faster, leading to a pick-up in business. We have orders worth ₹12,000 crore-₹15,000 crore lined up over the next eight to nine months,” says Sharma. 

A growing order book is a good sign for the revenue and earnings visibility of the company. Sanjeev Zarbade of Kotak Securities, feels the state-owned undertaking is best placed  to take advantage of this. “I think for BEL the next five years will certainly be better than the previous five years, given the size of the addressable market. Things like submarine, battle field management systems, aircraft, shipbuilding, missile once opened up will have a huge market for electronics which will be far bigger in size.

SK Sharma, Bharat ElectronicsBEL will be the direct beneficiary of this because of its ready infrastructure.” While the company’s prospects are improving on the one hand, its stock hit a lifetime high of around ₹4,140 per share in February 2015, more than doubling over the past year. After a strong operating performance in Q1FY16, when the company’s margins improved by around 140 basis points and net profit grew by 137% to ₹60.7 crore, its stock spiked to around ₹3,920 a share. It is currently trading at 20X its estimated FY17 earnings, which is its highest valuation in the recent past. Because of the stretched valuations, it is quite possible that investors will have to live with moderate return expectations in the near term. 

Fully loaded

Cash reserve and payouts have

been growing at a healthy clip

However, in the long run, growth in earnings will drive the share price and ensure higher return for investors. Apart from the impending growth, Bharat Electronics is one among the few companies that offer very little risk, be it balance sheet risk, promoter risk or business risk. It is a zero-debt company that is sitting on ₹4,800 crore of cash (20% of its market capitalisation), enjoys decent return ratios and offers a long-term growth opportunity for investors. 

In fact, if we remove the cash from the total capital employed in the business of ₹7,624 crore, the company is able to do close to ₹7,000 crore sales turnover, or almost 3X its remaining capital of ₹2,760 crore. This means that the company’s business is just marginally capital-intensive and is generating a lot of cash, a part of which is given back to the shareholders in the form of dividends. If this continues on a higher scale, BEL can be a good dividend stock as well. In fact, the dividend declared has grown 3X over the past ten years, which is considered to be an
average period in the life of defence companies. 

Looking ahead

However, more than the valuations, the Street is turning positive about the idea of the long-term prospects improving. A series of initiatives related to the defence sector have been undertaken by the government, among them increasing the FDI limit to 49% (from 26%), making defence one of the 25 identified sectors under the Make in India initiative. “Further, given the security challenges faced by India and the immediate need for modernisation of the armed forces, we believe that the Indian defence manufacturing sector is at an inflection point. Procurement of new equipment and technology over the coming years should lead to a huge market opportunity,” states Venkatesh Balasubramaniam, who tracks the sector at Citi Research, in a report. India has the third-largest armed force in the world, with an annual budget of about $38 billion, and 40% of this is used for capital acquisition.

Pumping it up

The PSU has increased its spend

on developing in-house technology

Over the next seven to eight years, India would invest more than $130 billion in the modernisation of its armed forces. Besides, under offset needs, more than ₹25,000 crore obligations are to be discharged over the next seven to eight years.

The Indian defence sector is in dire need of not just future capex but modernisation and replacement of its existing equipment as well. Estimates provided by Ernst & Young suggest that close to 50% of defence equipment are obsolete and another 35% are maturing, indicating a huge opportunity in the pipeline. BEL, which was established in the year 1954 as part of the ministry of defence with the aim of providing specialised electronics products and services for defence requirements, has a big role to play and a sizeable opportunity to address. 

A focus on indigenous weaponry in line with the aim of Make In India has already begun. In the March quarter, BEL and Rolta were selected by the defence development agency for the first indigenous project for battle management systems worth ₹50,000 crore. A long-pending tender for the purchase of 197 light utility helicopters was scrapped in August 2014 and reissued to be manufactured in India. That apart, other aircraft tenders such as Avero, capable of short-distance transport of resources, were reserved to be manufactured in India.

Changing hues

Contribution of non-defence business

is also a top priority for BEL

The list is long and includes artillery guns, submarines as well as naval vessels, which are now supposed to be manufactured in India under the Make In India programme. However, one critical issue here is that most Indian companies do not have the requisite skills, resources and technology for production, which is where FDI and policy initiatives such as foreign celebrations are encouraged for domestic manufacturing. “Initially, we might see some of the low-tech manufacturing being shifted to India. Even if that happens, it will be a huge advantage for the companies, which already have the know-how and capacities. For others, regulatory approval itself will prove to be a big hurdle,” says Kumar Kandaswami, senior director, infrastructure, at Deloitte.

Because of its ready set-up, BEL has the option of attracting foreign technology partners looking for long-term opportunities in India. In fact, the biggest challenge now would be to scale the business and move up in the value chain, while at the same time remaining competitive in the face of increasing competition. “Considering our strengths in technology, we have the upper hand. We are continuously focusing on enhancing our advantages with investments in R&D to create cutting-edge products,” says Sharma. 

Kumar Kandaswami, DeloitteIn fact, R&D expenditure now accounts for 8.2% of BEL’s annual turnover, as against 5.9% about five years back. In fact, the company applied for nine product patents in FY15 alone. “We have also entered into many strategic alliances with defence laboratories, ordinance factory boards and other reputed global OEMs to address the emerging opportunities in these areas,” adds Sharma. The alliances include surface-to-air systems, air defence radars, battlefield management systems, sonar systems, next-generation night vision devices, gun programmes, inertial navigation systems, medium-altitude and long-endurance unmanned aerial vehicles, aerostat surveillance and communication systems. The company is also looking for more indigenous manufacturing for its own requirements, which moved up to 80% of its total turnover in FY15, against 60% in FY05.  

Sharing the wealth

Both in terms of offset obligations and selling to some neighbouring countries, exports could be a big growth area. BEL has an export order book of about ₹1,220 crore as on April 1, 2015. Importantly, offset only accounts for about 20%, or close to ₹280 crore, indicating the company’s capability to export to other countries. “BEL has signed MoUs with many foreign companies and is working with major aerospace and defence companies to establish long-term supply chain relationships,” says Sharma. He explains that the company is also pursuing the possibility of exporting products and systems to friendly countries with the approval of the ministry of defence.

Currently, coastal surveillance system and electronic voting machines are being promoted in southeast Asia, West Asia and African countries. Exports have been growing consistently from a mere 2% of its revenue in FY10 to 5% of revenue currently, and are expected to go up further. “Exports has remained a focus area for the company and it has set up dedicated business unit and marketing group to become key supply chain partners of global players such as Boeing, Pilatus, GE, Siemens, and Philips among others,” mentions Satyam Agarwal, who tracks the company at Motilal Oswal.

Besides, the company is also making efforts to diversify its revenue streams to capture some of the non-defence areas. “Over the past five years, the company has completed non-defence business of about 17% of the overall business and has plans to increase its non-defence share of the overall business over the coming years,” says Sharma. In the non-defence domain, opportunities related to critical infrastructure protection, air traffic management radars, intelligent traffic management systems, solar power plants and smart city elements are currently in focus. 

Because of the development of indigenous technologies and export orders and the move towards high-value orders, the company has been able to grow its Ebitda margins from 10.7% in FY10 to 16.7% in FY15. Apart from high export margins, high-value orders like those from Akash Missiles help bring in operating leverage, leading to higher operating margins. “Capacity utilisation is a concern today, and many of our facilities are running at 50% capacity, but if some of the big programmes come through, we should be able to load all our units. Some of the missile programmes are huge and if we become the systems integrator or lead integrator for them, the size of those projects could be as high as ₹5,000 crore-10,000 crore. We hope to improve capacity utilisation to about 90% over the next two years,” says Kumar. 

For now, the stock seems to have factored in the upside but analysts believe that BEL is the only proxy play for India’s growing defence story. Zarbade of Kotak Securities says, “This is the beginning of a high-PE era for BEL, one that may sustain for the next three or four years, given the growth expectations. And remember, for those institutional investors who want to participate in India’s defence story, there is no pure defence play available except Bharat Electronics.” While the PE expansion has already happened, earnings growth will take time to play out. “At these prices, investors should have reasonable expectations of around 15% annual return. However, the stock can double over the next four years,” says Zarbade. Looks like investors can go on the offensive with arguably the best stock in India’s gripping defence story. 

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