Religare: Bharat Electronics Ltd Structural play on Indian defence capex – BUY

Bharat Electronics Ltd
Structural play on Indian defence capex – BUY
We initiate coverage on Bharat Electronics (BEL) with a Buy rating and a
December ’11 price target of Rs 2,200. BEL is a state-owned company in the field
of defence electronics which supplies products to the Indian army, navy and
air force. In our view, BEL is attractively placed to benefit from the increase in
electronic defence spending in India. The company’s order book currently stands
at Rs 125bn (book-to-bill ratio of 2x), which we expect to grow to Rs 170bn by
FY13. Revenues are forecast to grow at a 17% CAGR over FY10-FY13 to Rs 89bn.
In our view, BEL is a safe defensive bet for investors looking for consistent returns
over the next 2–3 years. While order inflows are lumpy in nature, we believe the
downside risk would be cushioned by the stable nature of defence spends, BEL’s
high cash balance (~Rs 450/sh), strong cash generation and growing order book.
Beneficiary of rising electronic defence spending: India has a planned budget of
~US$ 33bn on defence expenditure for FY11, which is ~3% of GDP. We believe
that BEL is an attractive play on defence expenditure, which we expect to grow in
line with GDP at least. In our view, the spend on electronics in the defence budget
will increase as defence modernisation picks up. This would benefit BEL as it has
the strongest expertise in radar systems (~23% of its revenues) and communication
systems (~37%). The company also has a healthy R&D culture and a headstart over
new players, having already absorbed several technologies from foreign players.
Margins to come under pressure: BEL recently received an order for supplying
two squadrons of the Akash missile system to the air force for a total of Rs 15bn.
While the order size is quite significant, a substantial portion of it (~40%)
comprises low-margin hardware that the company buys from other suppliers. We
believe that there will be an increasing trend towards such integrated systems,
leading to fast topline growth, but pressure on margins. Besides this, increasing
competition from private players could also lead to some margin pressures. We
estimate that EBITDA margins will drop from 19% in FY10 to 16.5% by FY12.
Strong balance sheet to enable growth: In our view, the company has a healthy
balance sheet (cash balance of ~Rs 36bn, cash generation of Rs 4bn–5bn and
low debt), which should provide adequate scope for expansion in the form of JVs
with international players, technology transfers and funding of any R&D. We
note that debtor days are high at 162 days due to the long gestation period for
projects, but the risk of default is low as the government is the major customer.
Initiate with Buy: BEL is currently trading at 18x/15x FY11E/12E EPS. While there
may be margin pressure, higher order inflows (as defence modernisation picks up)
should lead to a 14% EPS CAGR over the next three years. We value BEL at 16x
12m forward earnings, giving us a December ’11 target of Rs 2200.