BEML, BEL, HAL: Defence stocks factor in most positives but not potential risks, says Kotak

Kotak Institutional Equities said listed defence manufacturers require execution of Rs 1.4 lakh crore worth of defence orders annually to jusfify their current stock prices. In a strategy note, the brokerage said the stocks largely factor in the aforementioned positives, but not potential risks of delays in ordering and lower profitability.

Defense stocks have climbed up an average of 80 per cent in the past six months. The prevailing market capitalisation of nine defense stocks including BEML Ltd, Hindustan Aeronautics Ltd, Bharat Electronics Ltd and MTAR Technologies Ltd, implies Rs 1.3 lakh crore of annual revenues, up from Rs 62,500 crore in FY23.

"Indian defense stocks have witnessed an explosive rally in their stock prices over the past few months on expectations of strong spending by the government and indigenization. We concur with the growth part, but are less sure about the implied profitability assumptions," the domestic brokerage said.

Kotak said that the sharp rerating and massive returns on the defence counters over the past 3-6 months were seen amid expectations of large spending by the government for an extended period of time and steady increase in indigenisation. Large deal wins of companies boosted investor sentiment, it said.

India’s total defense capex, Kotak said, increased at a CAGR of 9 per cent over FY2017-23, resulting in a steady decline in its share of overall government capex.

"We note that India’s defense imports were around Rs 40,000 crore in FY19-20. We estimate a market opportunity of Rs 1.6 lakh crore for domestic procurement by FY2026 based on our assumptions of strong growth in overall defense capex and low growth in imports due to indigenisation. As such, the basket of defense stocks will need to capture a significantly larger share of India’s domestic defense budget compared with history, even as more private companies are entering the sector.

Kotak said it is not sure about the future profitability of the defense companies, as their current profitability seems to be on the higher side, the defense industry could become more competitive with the entry of private sector players and government may tighten procurement terms (monopsony buyer), as domestic production capabilities scale up over time.

"We would note that lower profitability assumptions will imply much higher implied revenues, which may not be feasible in the context of the market opportunity," it said.

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