India Defense Sector is at the cusp of strong growth upcycle: Edelweiss

Ministry of defense (MoD) organized defense expo 2022 in Gandhinagar, Gujarat with a theme “Path to Pride”. The aim was to showcase the might of the domestic defense industry. Following is our key takeaways from our recent visit to the DefExpo 2022:

1. Concerted push towards indigenization/”aatmanirbhar” defence: Inline with the current policy of boosting domestic defence industry, Govt. unveiled 4th positive indigenization list of 101 items. So, now total 411 items are placed in positive indigenization list. General buzz was that many things are surely changing positively, policy support is there, and many industry players – mainly smaller ones – indicated that we are at the cusp of strong growth cycle.

2. But, many kinks still need to be ironed out: Though large part of the industry participants was optimistic. But feedback also suggest many niggling issues are persisting, for example –

• Consistent order flow for the private industry is still elusive: Many private companies has done large investments (e.g. L&T defence has done ~INR 8000 cr investments) but assembly line is lying idle/underutilised (Vajra K9 SPH plan Hazira, or Katupalli dockyard)

• Insistence on “make in India” for low volume orders without roadmap for followon orders – there was feedback from one industry player that GoI wants “make in India” for 4 units only (without any Govt commitment for regular follow-on orders). Depreciation expense of new plant & machinery on 4 units will make the item exorbitantly expensive, but Govt wants L1 price as well.

• Few foreign OEM’s cited they already an established supply chain, and it is unattractive to creating parallel supply chain in India for limited sized orders. Also, foreign OEM’s have to comply with local regulations in the home country (like UK, USA, etc) which prohibits export/transfer of sensitive IP/technology.

• Another sticking point is IP ownership during commercial/production phase: Govt is willing to fund development projects, but wants to retain IP without committing to production orders later to same development partner. Govt idea is to develop IP separately and then use L1 route for production via transfer of technology/IP.

• Multiple players indicated trouble with L1 bidding route. Many times requirements are diluted to avoid single-vendor situation and/or increase bidders. This creates a piquant situation for player(s) who has invested based on earlier/original requirements.

We believe, Govt is aware is some of these challenges and hence indigenization list of more focused of mostly on “low to medium tech” items spread over 7-8 years period moving gradually from low tech items to higher tech items.

3. Mindset change: Our interaction with industry participants showed signs of change in Armed forces mindset towards accepting homegrown technologies and made in India products. Additionally focus is beginning to shift to dealing with only large PSUs to smaller private sector players.

4. Identifying Winners: Companies which can be part of value chain of large domestic platforms, participate in offset programs of global vendors and become part of the Global vendors value chains are likely to emerge as winners.

5. Focus on “Win” Ratios-to identify the winners: one should focus on the Tender win ratios of the companies. “Win” ratio among private platform player suggest that L&T defense, TASL (Tata advanced systems ltd) has cracked the code of Govt. defense procurement process compared to other large domestic peers. Now, Adani defense is catching up fast

6. INR 8 Lakh crore worth of orders for domestic procurement: On the sidelines of the DefExpo, Army chief said that domestic defense contracts worth INR 8 lakh crore is likely over next 7-8 years. This is ~3x of current domestic defense industry order book (We estimate current domestic order book of ~INR 2.7-2.8 lakh). We believe, given the trend growth in defense capital budget outlay with increasing share for indigenous products, total domestic orders are likely to exceed INR 8 crore by a wide margin.

7. 25-30 domestic projects will enter production phase: Our interaction with DRDO and range of companies suggest that around 25-30 projects (like Pinaka ER/guided, VSHORAD, VL-SRSAM, QRSAM, Brahmos-NG, guided munitions, HTT-40 trainer, LUH etc.) have completed development. Hence, within next 1-3 years we may see “explosion” of contracts for production & procurements these items.

8. Exports very likely to exceed target of US$5bn by 2025: General feedback was that Pinaka and Brahmos systems are emerging as a much sought after in the exports markets. Also, Govt of India (GoI) invited ~75 countries to showcase India domestic capabilities. Defense minister hosted IoR+ conclave with 40 countries and urged them to “leverage India’s R&D ecosystem for mutual benefit”.

EWM View:

Overall, based on the industry player’s feedback, we believe that optimism is based not on hope but is coming from policy steps from GoI, competency building and maturity of domestic R&D, greater interaction & handholding by defense services, large of projects crossing over into production phase after completion of development phase, and acceptability of Indian products in Exports markets (most notably Brahmos and Pinaka systems).

We believe, companies like BDL (CMP INR 988, Mcap INR 18,105 cr) , HAL (CMP INR 2501, Mcap 83,640 cr) and BEL ( CMP INR 108, Mcap INR 78,836 cr) among PSU’s and PTC Industries (CMP INR 2859, Mcap INR 3,745 cr), Paras Defense (CMP INR 639, Mcap INR 2,490 cr), Data Patterns (CMP INR 1335, Mcap INR 6,930 cr) and SOLAR industries (CMP INR 3935, Mcap INR 35,611 cr) among private companies are better placed to exploit the upcoming opportunity.

We believe, Industry likely to growth at ~15% CAGR over next 5 years with resilient margins Using combination of 3 factors) – 1st – Base/trend growth rate (8-9% = annual capital budget increase), 2nd – Incremental growth from Indigenization/Aatmanirbhar push (4-5% = annual shift towards domestic procurement), and 3rd – Incremental growth from Exports/Offset (~2% = Line of Credit + Offset + clear targets/dedicated policy support to drive exports).

• Above three factors will translate into ~14-15% long-term (5yrs+) sector/industry growth rate.

• Value migration will lead to differing individual sub-sectors growth trend – “Structural” players will be slower, while “Electronics/Sensors” will be faster. Margins to be resilient going ahead as

• Since, revenue growth is accelerating so the operating leverage effect will support margins.

• Bulk of headwinds (chip shortage, Pandemic disruption, supply chain issues) is already behind and likely to moderate over FY23. These disruptions have impacted revenues (and margins), and since orders are still standing so deferred delivery will increase growth rate in FY23/24.

• Also in some companies (especially long/medium cycle product companies), refurbishment/repair & Overhaul segment is gradually becoming meaningful