Vijay Kumar Gaba: HAL

Friday, September 16, 2022

In the name of country’s defence

Self-reliance in the defence sector has been one of the major investment themes in the past one year in particular. Besides dedicated public sector defence manufacturers, the stocks of a large number of equipment and service providers to the Indian defence establishments have seen a sharp up move. In the melee to own “defence stocks” many investors have ignored the basic principles of investment and buying stocks of these companies at any price. It seems a little has been learned from the recent unwinding in pharma API manufacturers and internet stocks which witnessed similar traders’ interest in 2019-2021.

An informal discussion with some randomly selected market participants indicated that many individual investors and traders may not have a clear idea about the opportunity in the Indian defence sector. The way people tried to associate companies with the defence sector opportunity, it appeared that almost every company listed in India may be a potential beneficiary of the growth in the defence sector.

Companies manufacturing FMCG, alcoholic beverage, automobiles, white goods textiles, steel, cement etc could all be associated with the defence sector in some manner or the other. But, that is not the idea behind ‘defence self-reliance’ as an investment theme. This theme should focus on the indigenization of defence technology; material increase in local manufacturing of defence equipment and consumables; and export opportunities for defence equipment and arms.

For the existing dedicated defence suppliers (like defence PSUs) the opportunity may not be transformative as higher defence budget may result only in incremental growth for these companies. However, for some of the private sector service providers and manufacturers which have also been supplying to the defence establishments, the opportunity could be transformative.

To further elaborate my point, I would like to highlight a few points from the FY22 annual reports of some private sector “defence companies” that have been popular with the traders’.

NELCO Limited

No mention of the word ‘defence’ in the annual report. The management however emphasized on the new opportunities for the Satcom industry in the Indian space sector. The report reads, “Indian Space sector has been identified as an important sector for growth by the Indian Govt. Many new business models and collaborations are emerging, which are likely to provide new opportunities for the Satcom industry. Some of the next-gen technologies are also likely to move into the mainstream.”

(For a Sales CAGR of 7% over the past 10yrs, an RoE of 19%, and 10yr PAT CAGR of 11% the stock of the company trades at 132x PE for TTM earnings.)

Astra Microwave Products Limited

Performance: The Company has been able to create a solid diversified order book on the back of our deep domain expertise. With our proven track record, we are well placed to capture a bigger pie of the Indian defence sector market which is growing at a fast pace on the back of various government initiatives like IDDM, MAKE-II. Our order book as on 31st March, 2022 stood at Rs. 1,551 crores which is executable in the next 12 to 30 months period. Our current order book is 2 times of our FY22 revenue, which gives considerable visibility for next few years revenues. During FY22, we have received orders worth Rs. 760 Crores.

Opportunity: We see opportunities coming in from various programs planned by the Government through Defense Research labs (DRDO) and from the Make-II opportunities from the Ministry of Defence (MoD). Many of these are, especially in radar and electronic warfare systems where we have proven expertise. We believe going forward, our revenue mix will increase in the domestic area as compared to the last three previous years which should give an improved bottom line. We have clear opportunities of about Rs. 3,000 crores for next three years out of a market potential of about Rs. 14,500 crores upto year 2028.

(For a Sales CAGR of 14% over the past 10yrs, an RoE of 7%, and 10yr PAT CAGR of 2% the stock of the company trades at 70x PE for TTM earnings.)

Data Patterns (India) Limited

The latest annual report of the company discusses the recent developments in Indian defence sector, including policy changes and targets, in detail.

The report also presents a SWOT analysis of the company in defence related production. The Company inter alia, listed (i) Robust domain capability in Radars, Electronic Warfare, Communication systems, Avionics & Satellite Systems; (ii) All product development competencies under one roof; (iii) 100% in-house design and manufacturing capability; and (iv) Scalable business; potential to build complete systems as its core strengths. It also mentioned the growing size of defence sector opportunity for the private sector and improving export potential.

(For a Sales CAGR of 44% over the past 5yrs, an RoE of 24%, and 5yr PAT CAGR of 163% the stock of the company trades at 64x PE for TTM earnings.)

Paras Defence and Space Technologies Limited

Performance: The Company is engaged in designing, developing, manufacturing and testing of broad categories of defence and space engineering products and solutions. It is the sole Indian supplier of critical imaging components such as large size optics and diffractive gratings for space applications in India. Our revenue from operations increased by 27.37% to Rs182.56cr for Fiscal Year 2022 compared to Rs. 143.33cr for Fiscal Year 2021.

Opportunity: The Ministry of Defence has implemented a major reform for export promotion. Defence exports from India have expanded to more than 75 countries in the world. Due to the shifting geopolitical landscape, small nations are concerned about their safety and security and are considering India as a strategic partner for procuring affordable and high-quality defence equipment. The market for defence equipment is, therefore, anticipated to grow further. The government is also continually laying emphasis on the indigenisation of the defence sector.

(For a Sales CAGR of 30% over the past 5yrs, an RoE of 13%, and 5yr PAT CAGR of 68% the stock of the company trades at 89x PE for TTM earnings.)

Ashok Leyland Limited

Performance: In FY22, your Company supplied all time high 1,125 units of completely built-up units (CBUs) including bullet proof vehicles and 600 kits. Your Company is proud to complete the execution of 711 Ambulances in record time under emergency procurement of Indian Army. Further, your Company is expanding its portfolio in Light Vehicles, new applications on Super Stallion platform and products specific to export markets.

Opportunity: No mention

Tata Motors Limited

No separate mention of Defence business or growth opportunity in defence sector.

The company sold certain assets related to defence business to Tata Advanced Systems Limited (TASL) for sale consideration of Rs234.09cr.

Friday, June 19, 2020

Investors Beware - 4

In past few days there has been heightened activity in stocks of the companies which are perceived to be beneficiaries of the "war" (trade or military) with China. My fellow small investors are lapping stocks making defence equipments, telecom equipments and missiles, as if there is going to be an attack on China tonight. The stock prices of many such stocks have risen by 10-25% this week. The stock price of a public sector power equipment manufacturer gained on the assumption that the government might ban Chinese competitors and the order book of this company may swell. Some pharma, chemical and agro chemical companies also witnessed action based on assumption of trade restrictions with China. The businesses dependent on imports from China witnessed selling pressure, while the businesses considered to be the alternative to the Chinese impost saw extra buying interest.

I would like to request my fellow investors to exercise some extra caution and restraint while jumping in buy the "beneficiaries" of the "war" with China. They must at least take note of the following points, before making any investment decision based on this impulse.

(a) A war, small or prolonged, with China will have disastrous impact on both Indian and Chinese economy. By extension it will also impact the global economy. The war with China will not be limited to stones and iron rods, as the recent reported skirmishes have been. It will be fought on ground, in air, in the ocean and most importantly in the cyberspace. Pakistan for sure would like to engage Indian forces in the western and northern sectors to distract Indian forces in order to help its ally China. Moreover, given that China is finding itself cornered due the suspicions over its role in spread of COVID-19 across the world, and has been mustering allies who can support it on the global platforms, there are chances that the conflict may expand beyond Sino-India borders.

The point to note is that a war, even if it lasts less than a week, could have disastrous economic impact in terms of disruptions and costs (economic and human). Higher taxation, higher inflation and higher rates would be the most natural consequences. If the assumption is 'war" then the investors would be better off buying USD with all their money rather than buying mid and small cap companies which may or may not survive a 5 day war.

(b) Accept it or not, as of today China is an integral part of India's economy. Millions of small businesses, traders, retailers, and footpath vendors depend overwhelmingly on the Chinese imports for their livelihood. Without a credible rehabilitation scheme for millions of these people dependent on trade with China, the "Boycott China" campaign in not going to be successful in any measure. If you want to fully assimilate what I am saying, take a round of you local market and see for yourself.

(c) A large number of large businesses are dependent on the imports from China to carry out their manufacturing activities. They import critical raw materials, engineering products, plant & machinery and spare parts for their plant & machinery from China. Sourcing all these from alternative sources may either not be feasible or may be materially expensive.

(d) A large number of large businesses have a big market for their final products in China. Finding alternative markets may be difficult for these businesses.

(e) A significant number of global companies are looking to shift their operations from China. The governments of emerging markets like India are willing to go out of their way to attract these companies to their shores. Some of these companies may finally land up in India. This will be both threat and opportunity for Indian businesses. Some businesses may face enhanced competitive pressure from these global companies which relocate to India from China, while others may gain from becoming part of a larger global supply chain. Betting on who will gain and who will lose from this shift in global supply chain is a difficult task even for most of the sophisticated investors.

(f) Chinese investors have invested, directly or indirectly, in a large number of Indian businesses. Many startups rely heavily on Chinese funds or technical support for their businesses. Many plants and infrastructure projects have been or are being built by Chinese companies. Their completion and maintenance could be severely impacted if the trade relations with China worsen due to war. The Indian promoters may lose heavily if this were to happen.

I am certainly not against the goals of self reliance and import substitution. But these things cannot be achieved over night and without tremendous pain. A long term strategy and willingness to bear the pain is what is needed to attain these goals. Rhetorical nationalism and mindless jingoism may lead to devastating consequences. In my view it will take 10-15years of meticulous planning, diplomacy and execution for us to meaningfully reduce "Made in China" from our day to day life. Doing a BTST (Buy Today Sell Tomorrow) trade on this theme can only bring losses. So at best it is avoidable.

Also note that the transition from a agro economy to industrial economy is a slow and excruciating process. Expecting quick results may lead to avoidable disappointment. Remember:

(a) Most of the claimed "Demand" in India is still "Need". The "capacity to pay" that is quintessential to "Demand" is still low.

(b) The "Democracy" is both the strength and weakness of India in economic context. Unlike China, it is not an easy order here to override sustainability concerns and regional aspirations for faster economic growth. Socio-political consideration would continue to take precedence over pure economic concerns.

(c) The "Demography" is a still a raw strength. Without substantial investment in "gender equality" and "skill development" this resource cannot be exploited fully.