FY19/20e EPS down 2/5%; TP cut to `110 from `175; CMP factors in development.
We reckon margins/RoCE profile of Bharat Electronics (BHE) could dilute by 200–300bps in the wake of the Ministry of Defence (MOD) slashing the benchmark margin on prospective contracts awarded on a nomination basis to 7.5% for both value-added and bought-out components (versus 12.5% permitted for value-added earlier). Nomination contracts form 50–60% of BHE’s overall order intake. Our apprehension that any change in government policy/terms for DPSUs might hurt sustainable margins is manifesting. It is a structural negative for DPSUs in our view and puts a question mark over sustainability of their future margins.
This warrants a P/E de-rating. We are thus reducing the target P/E from 23x to 15x, which is the last 12 years’ average P/E and at a 10% discount to global peers. We are also cutting EPS estimates by 2% and 5% for FY19 and FY20, respectively, building in lower other income. Maintain ‘BUY/SP’ with a revised TP of Rs 110 (versus `175 earlier).
New pricing policy — margins to be impacted beyond FY21: We reckon this would erode margins on incremental orders by 200–300bps, whose full impact on the P&L will be evident only beyond FY21e . That said, this policy is applicable prospectively and therefore does not impact the recently bagged LR-SAM order worth `92 bn.
Outlook: Risk perception changing — Being a major integrator, BHE is likely to sustain its competitive edge. However, changes in government policy make it difficult to ascertain a sustainable margin profile for the company. That said, following the 20% correction over the last three days, we believe the CMP factors in structural deterioration of the margin and RoCE profiles.