A solid play on defence sector

Updated: Feb 27 2012, 06:11am hrs
We initiate coverage of Bharat Electronics (BEL) with an Overweight rating, with Sept-12 price target of R2,000 based on 16x (time) Sept 13E P/E (price-earnings ratio).

BEL, a leading Indian manufacturer of defense electronics, is a play on rising government expenditure on modernisation of Indian defence forces. This is supported by a favourable policy framework that seeks a higher share of domestically-produced equipment. With its strong R&D capability, solid execution track record, and long-standing relationship with the Indian defence establishment, we think BEL is well positioned to benefit. It currently has an order book of R270 bn providing revenue visibility for 4-5 years. Valuations have de-rated over the past few quarters on account of margin pressure owing to one-off lower-margin non-defence orders. We expect a rebound in margins to drive 18% EPS CAGR (earnings per share, compound annual growth rate) over FY12-FY14e (estimates), which should drive valuations higher. We estimate BEL has R55 bn of cash (R685 per share, 45% of market cap) as at Q3FY12; with the government looking at sources of cash to fund its fiscal deficit, we see a case for higher/special dividend payout (the government has a 75.9% stake in Bharat).

Well positioned to benefit from rising defence expenditure: Indian government spending on defence equipment is expected to rise at a 10% CAGR to $19 billion by 2015 (source CII-Deloitte). While most defence equipment procurement is from foreign vendors, govt. wants to increase domestic share defence procurement policy mandates minimum 30% offset against any foreign capital acquisition over R3 bn. BEL is well positioned to benefit, given its strong R&D capabilities and longstanding relationships with Indian defence establishment. Its current order book of R270 bn is largely skewed towards defence related orders (80%+) providing steady revenue visibility over next 4-5 years.

Strong R&D capabilities aiding diversification into new segments: BEL has a long standing track record of execution and has increasingly invested in R&D. Besides its own R&D facilities, BEL undertakes joint development with DRDO (Defence Research and Development Organisation), which is the leading government agency responsible for undertaking redevelopment of technology for use by the military. Over the past 10 years, BEL has increased its expenditure on R&D at a

CAGR of 25% and currently spends about 7% of its revenues on development of new products

Margins set to recover, solid cash profile. We forecast EPS CAGR of 18% over FY12-FY14e, driven by 8% revenue CAGR and margin recovery. We estimate BEL has cash balance of R55 bn (R685 per share) on its books, which will increase to R63.6 bn (R795 per share) by FY14e.

High cash levels make case for a higher dividend payout: As per our estimates, BEL currently has R55 bn of cash on its books, which translates to about R687.5 per share. Netting off the advances received against orders (esp. given that FY11 had a significant jump in advances on account of some large ticket orders), we estimate that BEL would have core cash about R35 bn, which amounts to R400 per share or 26% of current market capitalisation. We estimate BELs cash position to continue to improve going forward. So far dividend pay out rates have been kept low at about 20% (we assume same rate going forward), however we see a case for higher dividend payment/ one off special dividend, especially as Indian government. looks at sources of cash to fund its fiscal deficit. A special dividend announcement could be a potential stock price trigger.

Price target, valuations and key risks. Our September 12 PT (price target) of R2,000 is based on 16x Sep13e P/E, towards the middle of BELs historical trading range. BEL is trading at 13xFY13e P/E, which we believe is attractive given its order-book, earnings growth and cash profile. We expect margin recovery to drive stock re-rating. Key Risks to our rating and price target include rising competitive intensity from private players leading to market share losses, delays in execution of orders, late payments from customers/ change in payment norms and lower than expected government defence expenditure

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