Large domestic order book, exports growth key drivers for defence stocks

India is world's second-largest importer of defence equipment with 9% of global arms imports

Defence exports grew 33 per cent in the calendar year 2023 (CY23) to around Rs 21,083 crore while domestic defence orders serviced by listed companies were Rs 48,000 crore. The sector is poised for steady growth. Budgeted domestic capex is likely to hit Rs 3 trillion per annum, and exports could reach $6 billion by FY29.

There are listed high-end players in areas like electronics, aerospace, IT-enabling and material sciences. The Nifty Defence Index (NDI) of 14 listed companies has far outperformed the benchmark Nifty. The NDI has beaten the Nifty by 31 per cent and 96 per cent in the last 6 months and 12 months respectively. The best price performers over 12 months are Cochin Shipyard which is up 290 per cent, Zen Technologies (183 per cent) and Mazgaon Dock (173 per cent). MTAR Technologies (down 21 per cent in 12 months) is the only loser in the NDI.

The average operating profit margin for listed constituents was up 280 basis points at 21.8 per cent and operating profit grew 23.5 per cent year on year (Y-o-Y) to Rs 10,400 crore and net profit was up 27 per cent at Rs 8,900 crore. There are six NDI constituents with over $2 billion market capitalisation, and for them, 9MFY24 profit growth was led by Cochin Shipyard (PAT up 91 per cent), Bharat Dynamics (62 per cent), Mazagon Dock (58 per cent) and Bharat Electronics or BEL (36 per cent) and dragged down by Hindustan Aeronautics or HAL (10.5 per cent) and Solar Industries (9 per cent).

By December 2023 end, the cumulative order book for NDI companies at Rs 2.8 trillion was up 7 per cent above the end-March 23 levels. The 9MFY24 new order inflow was Rs 67,000 crore, which was around 76 per cent of full-year FY23 inflows. Among NDI companies with a $2 billion market cap, order book growth was led by Solar Industries (+63 per cent vs. FY23) and BEL (+26 per cent vs FY23). Bloomberg consensus forecasts for 10 NDI constituents imply Q4FY24 will see a pick-up in revenue growth to 23 per cent Y-o-Y, with an operating profit margin dip of 190 basis points Y-o-Y, and a profit decline of 5 per cent Y-o-Y.

HAL and BEL together account for 62 per cent of the total market cap of NDI constituents. They have consensus forecasts of Q4FY24 revenue growth of 8 per cent and 34 per cent Y-o-Y respectively and net profit fall of -23 per cent and growth of 1 per cent respectively. Over the FY24-26 period, 7 NDI firms have consensus earnings growth forecasts ranging above 25 per cent.

The total FY25 budgeted defence spending is of Rs 6.22 trillion (down 0.4 per cent Y-o-Y) which is 1.86 per cent of GDP. The FY24 revised defence capex expenditure was Rs 1.57 trillion (up 10 per cent Y-o-Y), which was 3.3 per cent lower than Budget estimates. The FY25 Budget estimate capex is Rs 1.72 trillion, implying growth of 10 per cent Y-o-Y. The policy push for import substitution and exports can drive 15 per cent annual growth in defence production turnover for the next five financial years, which is somewhat priced in by the market rally.

India is the world’s number-two importer of defence equipment, with 9 per cent of global arms imports. The indigenisation eases the trade balance and drives double-digit growth. But defence spends are lumpy, with long payment delays and orders sometimes drying up.

In terms of revenue visibility, HAL has a service income of over 55 per cent of revenue. BEL has a zero-debt balance sheet which is also worth noting given capital intensity. Many analysts have buy/add recommendations ranging across the whole sector.