We interacted with defence industry experts and ex-management of Bharat Electronics (BEL). Q3FY17 results have surprised with 37% y-o-y revenue growth and 470 bps y-o-y margin improvement. We believe a visible R110-130 bn annual pipeline for the next 3 years (R82 bn last 5 years average run rate) makes it a good portfolio holding, despite the 7th Pay Commission hike leading to muted FY18e EPS growth. Maintain Buy— R1,750 target price (v/s R1,650), in line with EPS revision.

R1,300 bn TCS and BMS orders are 3.2x of existing pipeline : Tactical Communication Systems (TCS) and Battlefield Management Systems (BMS) are a R800 bn and R500 bn order opportunity, respectively. Both these contracts have 2 shortlisted companies, one of which is BEL, and are expected to be awarded in the next 3 years. BEL’s competitive advantage of working with DRDO on new technology for more than 3 decades will see it flush with orders for at least 3-5 years. 60% of visible 3-year pipeline of R405 bn (ex TCS and BMS) are product orders, which augurs well for the company as it is higher margin v/s systems and indicates a similar order book composition as the current one.

Execution ramp-up—good trend: Management in its September 2016 analyst meet exhibited confidence in revenue growth ramp-up from 10-12% y-o-y to 12-15% y-o-y. 9MFY17 BEL has reported 15% y-o-y revenue growth reinforcing management’s view, driven by 37% y-o-y growth in Q3FY17. Given BEL’s 4.4x order book to revenue coverage, we believe FY19E onwards this could be further pushed to 15-20% y-o-y range. The readiness of armed forces to take deliveries and BEL’s conservative accounting policy of not accounting for revenues till bills are accepted are key constraints. Government push on endclient could lead to earlier ramp-up surprise.

17-19% NPM—our expected range : BEL’s 68% y-o-y Ebitda growth in 9MFY17 has been driven by 500 bps margin improvement. Indigenisation in material cost has been a key support area. We have raised our FY17e-19e EPS by 6-11% to account for the same. FY18E earnings growth is muted at 6% y-o-y given the 7th Pay Commission hike. However, it picks up to 20% y-o-y in FY19e.

Valuation/Risks

Maintain Buy with a revised TP of R1,750 v/s R1,650, valuing the stock at 24x PE FY18E, ~10% premium to previous peak levels. Target Investment Thesis: Visible R110-130 bn annual pipeline for the next 3 years. Rise in capital defence spend in India over the next few years. FY18e EPS: R73, Target PE multiple: 24x, Target Price 1,750.

Upside scenario: Defence orders move at a faster pace with more proposals being cleared and tenders being floated. Make in India gains pace with thrust on higher proportion of domestic orders being placed. FY18E EPS: R80, Target PE multiple: 25x, Target Price 2,000.

Downside scenario: Defence spend faces regulatory roadblocks and ordering process slows down.Indigenisation push fails to materialise. FY18E EPS: R62, Target PE multiple: 20x, Target Price 1,240