Bharat Forge rating: Reduce; Opportunity in defence business is a positive

We are admirers of Bharat Forge (BHFC) for its focus on quality and innovation, yet the truth is its key business segments (CV, PV, Oil & Gas) are cyclical, which are currently in differing demand rebound cycles. Management is trying to pivot and create a larger pie of revenues from stable segments like defence, aerospace, etc. Aerospace segment outlook remains uncertain due to Covid-19 pandemic; however, recent defence procurement policy shift has raised investor confidence in BHFC’s potential to win artillery guns’ orders.

We deep-dived into the artillery segment opportunity, analysed global peers (e.g. Rheinmetall) and our base case incremental DCF value is ~Rs 41/share. Key risk: If Kalyani group chooses to bid for defence orders via Kalyani Strategic Systems BHFC benefits drop by 50%. We roll forward earnings into Sep’20, upgrade our rating to Reduce from SELL.

Trying to decode defence opportunity: As per media reports, Indian army might procure ~2,700 artillery guns. Currently, the key systems being tested/procured are from: (i) Global suppliers – e.g. BAE M777, Hanwha K9-Vajra; (ii) domestic suppliers – e.g. ATAGS (BHFC, Tata Power), Dhanush (OFB). As per our estimates, the cumulative order value relevant for BHFC could be ~Rs 243 bn. Our base case assumes: ATAGS wins 60% of towed artillery guns’ requirement (~1600 guns), BHFC wins ~30% of orders (~500 guns) along with key input supplies. We estimate BHFC’s defence business to clock Ebit margins of >25%, factoring in significant labour cost advantage, higher asset efficiency.

Upgrade to REDUCE: The class-8 truck demand (exports) is likely to scale back >300k units by CY22; however, domestic truck market is unlikely to reach FY18 peak volumes before FY24/25. We cut our multiple to 25x (earlier:27x) Sep’22e EPS (roll forward), add `41/share fair value (DCF basis) to arrive at fair value of Rs 412.