We recently interacted with defence industry experts and ex-management of Bharat Electronics (BEL). Demonetisation impact should be relatively limited given defence is government budgetary allocations based on medium-term plans. R110-130 billion annual order flow visibility for the next 3 years, rising R&D focus, capex and shareholder-friendly measures of buybacks are positives. Factoring in completed buyback, maintain Buy; PT R1,650 (vs R1,600), 24xPE FY18E.
Visible R110-130 billion annual pipeline for 3 years
BEL’s competitive advantage of working with Defence Research Development Organisation on new technology for more than three decades should see it flush with orders for at least 3-5 years. The government focus on domestic manufacturing should see defence PSUs which have focussed on R&D benefit from this. Ongoing government projects suggest BEL should have at least a three-year pipeline of R400 billion, excluding larger Tactical Communication Systems (TCS) and Battlefield Management System (BMS) projects totalling another R1,300 billion. Order book mix – 60% products and 40% systems should not see a major change in the next three years.
Execution ramp-up surprise possible with government push on end-client
In its September analyst meet, management exhibited confidence in revenue growth ramp-up from 10-12% y-o-y to 12-15% y-o-y. Given BEL’s 4.4x order book to revenue coverage, we interacted with industry experts to get a sense on constraints for faster execution growth. Readiness of army-navy-air force to take deliveries and BEL’s conservative accounting policy of not accounting for revenues till bills are accepted came out as a key reason for management’s conservative stance.
16-17% NPM – our expected range
BEL’s material savings led to a sharp 330 bps EBITDA margin improvement to 20% in FY16. As R&D expenditure continues to ramp up and the Seventh Pay Commission is factored in, our FY17E-18E margin assumptions are 18-19%. For FY19E, we have factored leverage linked improvement to 19.5%. If BEL manages to contain material costs, this could potentially be higher.
Maintain Buy with a revised PT of R1,650 vs R1,600, valuing the stock at 24x PE FY18E, at 10% premium to previous peak levels. Risks: defence spend plateaus; indigenisation push slows down.
Bharat Electronics Limited (BEL) is an Indian government owned defence company with about nine factories. It is a market leader in India in advanced electronic products for the Indian Armed Forces. BEL is one of the eight PSUs under Ministry of Defence, and has Navratna status.