Our interaction with various business heads of Bharat Electronics (BEL) at its analyst meet reinforces our cautious view on the company. Key takeaways: (i) Order inflows in defence electronics are lumpy and strong order inflow of FY16 may not repeat in FY17/18, (ii) Steep rise in FY16 order book (up 48% y-o-y) would be realised slowly in FY17-21 revenue as execution depends upon approvals, delivery schedules and execution of main product, (iii) RM costs are expected to stabilise at 55-60% of sales (vs. 55% in FY16 and 65% in FY13).
(i) Order inflow to decline to R100-120 bn in FY17 and sustain at this level in medium term, (ii) FY17 revenue growth at 10-12% and five-year revenue CAGR at 8-10%, (iii) Ebitda margin to decline up to 100 bps in FY17 and get further impacted in FY18.
BEL gearing up to defend its leadership from pvt sector
Competition will intensify in defence electronics with Tata, L&T, and M&M entering into strategic tie-ups with international majors. However, we believe BEL will be able to maintain its leadership in the medium term given the strong pipeline of products it has developed with DRDO. Also, BEL is stepping up its investment in capacity expansion and R&D to fight competition.
Best is behind it
We believe FY16 was a peak year for BEL in terms of order inflow and Ebitda margin. Management has guided for sustainable level of orders at R100-120 bn p.a. vs. R170 bn in FY16. Except two large orders (Akash Missile, LR-SAM) worth R60-70 bn each expected in FY17 and FY18, other big-ticket projects are 3-8 years away. We believe Ebitda margin has peaked in FY16 driven by better product mix and would face headwinds over FY17/18 from wage revision and rising share of low-margin systems business.
Maintain estimates,TP and hold rating
Our target price stands at R1,290 (18x FY18e). We have a hold rating on the stock, given 2% upside from CMP of R1,262.
Highlights from analyst meet
After a new government at the centre, decision-making has become faster and rate of order finalisation has improved significantly. This was reflected in BEL’s order inflow of R170 bn in FY16 (vs. R51 bn y-o-y). As most of the orders received in FY16 were originally expected next year, order inflow in FY17 would be corresponding lower at R100-120 bn. Orders to rebound in FY18 at R150 bn based on large order for missile and then sustain at R100-120 billion p.a. in the medium term.
Strong order pipeline in long term: BEL has a strong pipeline of R1 trillion beyond FY18 based on the products it is developing with DRDO. These include:
Battlefield management systems worth R500 bn, Quick Reaction SAM worth R200-500 bn,Short and medium range SAM worth over R50 bn, and Tactical Communication Systems worth R100-200 bn.
Management expects revenue growth of 10-12% in FY17 and that of 8-10% p.a. over the medium term: While order book is significantly large at R320 bn in FY16 end (or 4x revenue), execution timelines are much longer at 4-5 years. Further, BEL’s product deliveries are also dependent on execution schedule of the main product such as naval ships, missile systems, etc which are beyond the control of the management.
Ebitda margin improved 220 bps in FY16 largely driven by improvement in gross margin: Gross margin increased by 10 ppt to 45% over FY13-16 driven by better product mix, increased indigenisation, and higher outsourcing of non-critical manufacturing.
Management expects gross margin to remain stable or decline marginally on rising share of systems business. Ebitda margin has peaked and the management expects it to decline by up to 100 bps in FY17. Further downside is expected in FY18 on wage revision.
Competition is unlikely to dent in near term due to high entry barriers: Competition will intensify in the defence electronics sector with Tata, L&T, and M&M entering into strategic tie-ups after the sector was opened up to private players. However, BEL has maintained 65-70% market share in new order wins in the past 4-5 years and is expected to maintain its leadership considering high entry barriers in the defence electronics space.