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Bharat Electronics (BHE)
Industrials
Revenue traction on large projects positive; we seek better risk-reward, delivery.
Strong project-based orders may double the backlog to Rs200 bn (expects Rs80 bn in
4Q apart from Rs164 bn at Dec-end versus Rs113.5 bn at Mar-10-end) leading to
stronger revenues. However, lower contribution from the project may cramp EBITDA
margins despite operating leverage from employee costs. We retain our REDUCE rating,
holding out for better risk-reward and some delivery (disappointment possible in timing,
extent) on intent.
Strong order backlog to drive revenues in FY2012; company projects Rs100 bn revenue in FY2013
BEL reported strong backlog of Rs164 bn at end-Dec 2010 versus Rs114 bn at end-FY2010. It
expects another Rs80 bn in 4QFY11. This implies FY2011-end order backlog of about Rs210 bn,
(double of end-FY2010), driving revenues. Strong order inflows are driven by need to integrate
surveillance and communication systems (versus just firing systems). The mgmt is confident of
achieving its FY2013 revenue target of Rs100 bn (FY12 guidance of Rs75 bn) and sees visibility of
incremental Rs600 bn orders in 3-5 years.
Growing project share to contract margins; operating leverage short; expect flat margins near term
Current project: Product (20-80) mix may change in favor of projects to 60-40 in the long term. A
48% contribution margin for product business and 20% for project business (blending to current
42% margins) would reduce the contribution margin will reduce by 11% to 31%. Assuming
operating leverage of 6% from employee costs and 2% from other expenses still implies an
EBITDA margin contraction to 14-15% versus the current level of 17-18%. In the near term (till
FY2013E), we build flat EBITDA margins of about 17%, as 350 bps contribution margin fall is
buffered by operating leverage.
BEL affected less by competition, more by increasing customer bargaining; offset diluted a little
Despite DPP 2008 enabling the private sector to bid for defence orders, serious competition is still
not visible. Two key barriers for the private sector are (1) investment in infrastructure and
developing technologies and (2) bias of defence forces for PSUs (proven infrastructure, secrecy).
However, incrementally stronger customer push back is visible based on better customer education
by global and local competitors. While offset has not yet scaled up as an opportunity, the clause
has been partially diluted based on the inclusion of civilian aircraft components sourcing from India
towards meeting offset obligations versus only defense sourcing earlier (relevant for MMRCA).
Revise estimates and target price to Rs1,875; retain REDUCE for better risk-reward and delivery
We revise earnings to Rs101 (from Rs105), Rs125 (from Rs120), and Rs146 (from Rs137) from
FY2011E, FY2012E and FY2013E, respectively, based on (1) higher revenues – larger backlog,
(2) marginal changes in employee cost, (3) reduced other expenses, (4) lower other income -
adjusting for FY2010, Rs1 bn positive one-off in other income, (5) lower effective tax rate – sustained
R&D spend.
Strong order backlog to drive FY2012 revenues
BEL reported a strong backlog of Rs164 bn at end-Dec 2010 versus Rs114 bn at end-FY2010.
It further expects another Rs80 bn in 4QFY11. This implies an FY2011 order backlog of
about Rs210 bn, almost doubling end-FY2010 backlog. Such a strong backlog of
unexecuted orders would drive revenue growth in FY2012.
Modernization of defence systems giving fillip to industry demand
BEL management highlighted the increased focus of the defence forces towards
modernizing their systems. The defence forces are also looking more towards integrated
systems with their focus not limited to firing systems but also extending to reconditioning
and communication systems. BEL expects to get a significant share of such future orders.
Key orders in pipeline for which BEL will bid include (1) 26 bn Battle Surveillance System, (2)
Rs14 bn 3D radar order), (3) Rs10 bn night vision devices order, (4) Rs9 bn Sambhavagh
communication system, (5) Rs7.4 bn Shilco upgradation order for 48 tanks and (6) Rs7 bn
Indian Coast Guard for Coastal Surveillance System (50% bought out).
Mgmt. maintains Rs100bn target for FY13E revenues
BEL strongly believes in accomplishing Rs57 bn revenues for FY2011 and has a FY2012
target of Rs75 bn. The management sees visibility of Rs600 bn orders from the defence
forces over the next 3-5 years. It believes that even if it gets half of these orders, it would be
on track for the Rs100 bn FY2013E revenue guidance. It also highlighted that its present
capacities are sufficient and that it doesn’t require additional capex and manpower for
achieving the FY2013 revenue target.
Increase in share of project business to reduce margins
The management highlighted BEL product-project mix would change from the current 80:20
to a 40:60 mix. We highlight that BEL has a contribution margin of about 42%. Assuming a
project contribution margin of 48% implies a product contribution margin of 20% (80:20
product project mix). If the project share increases to 40:60, the contribution margin falls to
about 31%. Of the decrease of 11% in contribution margin, about 8% would be taken up
by operating leverage (5-6% reduction in employee cost as a percentage of sales and
another 2-3% reduction in other expenses as a percentage of sales). The rest would flow
through to EBITDA, reducing margins to 14-15% from the present levels of 17-18%. In
order to prepare itself for the increase in the project business, it is focusing on its manpower.
It hired 50 from various IITs this year after a long gap. It is making 300 of its engineers take
a project management course for developing the required skills.
Limited impact of private sector competition on BEL
Though DPP 2008 signaled the entry of private players for bidding for defence orders, their
participation has been limited. A key barrier to the increase in private sector participation is
investment in infrastructure and in developing/acquiring technologies. A further requirement
of supply of the product before the actual award also reduces private sector interest in
bidding. The defence forces are also biased towards awarding contracts to defence PSUs for
reasons of secrecy, reliability and proven infrastructure. This lack of competition is reflected
in Tata mainly bidding for truck orders while L&T focuses on launchers though it has also
started bidding for radars.
BEL has the advantage of having acquired European and American technologies and of
strong experience in manufacturing and supplying defence equipment. It also has a strong
relationship with DRDO and therefore benefits from its design capabilities.
Availability of global pricing information increasing customer’s bargaining power
The management stressed on the end customer getting more aware of the costing of
defence products leading to strong negotiations on price. A lot of global information of
related orders is contributing to such an increase in awareness. Although the customer may
not go for a foreign bid (important to have expertise on technology used), nonetheless, it
acquires the pricing information. Moreover, increased integration in orders is also adding to
customer’s bargaining power.
Offset business still to pickup; offset business now to include civilian orders
Under the offset policies, the government keeps a minimum of 30% of the invoice value for
transactions in defense and aviation with foreign supplier until the supplier offshores an
equivalent amount of services equivalent to that offset. A recent revision of norms implies
the inclusion of civilian aviation investment as part of the offset business. This development
would reduce the scope of business for BEL.
The management mentioned a US$40 mn order by an Italian ship builder that it is working
on. They agree that the offset business has not yet picked up. Export vendors generally keep
running a current account, rather than maintain a 30% level from their domestic businesses.
Employee expense to stabilize from FY2012
The management believes the employee expense for FY2011 of Rs10.5 bn and expects it to
stabilize from FY2012. It gave the following reasons for the recent hike in employee cost:
�� Increase in gratuity to Rs1,000,000 from Rs350,000 with effect from FY2009.
�� Salary revision of non-executives was finalized in June 2010, leading to prior period
expenses apart from arrears increasing employee expense in FY2011.
�� Provision for pension of executives added Rs2-3 mn per year. No provision for nonexecutives
exists currently and may add another Rs2-3 mn per year if it were to
materialize.
Rising employee cost is the prime factor responsible to reducing EBITDA margins in FY2010
and YTD-FY2011.
The management also highlighted that attrition level within the company has fallen to less
than 1%. BEL’s salary structure up until the level of deputy manager (5-6 years experience or
less) is competitive. These employees also have the comfort of working for a good company
with job security which is not there in the private sector. The disparity in salary of BEL
employees versus the private sector is more visible for employees with greater experience.
R&D expense to increase faster than sales going forward
BEL has been spending on R&D at a steady rate of 5-6% of sales. The management
highlighted that from FY2012-14, R&D expense would increase to about 8% of sales. Key
reasons leading to increase in spending include:
�� Demand for modernization of defence systems. BEL is increasing spending on
acquiring research tools and developing technologies to cater to demand arising from
modernization of defence equipment.
�� DRDO asking for its share. DRDO has now started asking BEL to contribute to the cost
of projects done with BEL. The structure being thought of includes 60% cost borne by
DRDO, 30% by BEL and 10% by the end customer.
Technology transfer procedure adding variation to margin
Technology providers have now changed their terms with BEL. Instead of paying for the
technology, the new terms mandate a certain share of business coming from the technology
providers. Taking an example of an order of 100 radars, the technology provider will supply
(1) 10 complete radars, (2) 15-20 radars at the semi knocked down level (3) and the rest of
the radars at the completely knocked down level. For some part of radars, in-depth
manufacturing would take place wherein the technology developer supplies all components
and BEL assembles them. Some critical components are still made by the technology
provider.
Such terms lead to variation in the margin recognition by BEL as the revenue realized for
each product is the same. At the early stages of the project, value addition by BEL is lesser
leading to lower revenue recognition.
The management cited that (1) 57% of its revenues come from technologies with BEL,
(2) 18% from technologies of DRDO and (3) 25% from foreign technology transfers. The
management also clarified that the limit on foreign purchases is on technology transfers and
that components purchased exceed 75% (about 80% presently).
Management confident of meeting FY11 revenue guidance
BEL is confident of meeting its guidance and our estimates of Rs57 bn of revenues in FY11.
Our estimates require 4Q revenues of Rs24.3 bn (yoy growth of 34%) and strong EBITDA
margin assumption of 27.2% versus 4QFY10 margin of 9.5%.
BHEL JV to start shortly; planning JVs with Thales and Rafael
The BEL-BHEL JV for manufacturing solar wafers, cells and modules will implement the 250
MW solar photovoltaic (PV) production facility in Hyderabad. The capex for the plant is
estimated at Rs20 bn with BHEL to take lead in setting up the facility.
BEL is in discussion with Thales of France for a JV in the area of civilian and select defence
radars. The company is also in discussion with Israel's Rafael for floating a joint venture in
the field of missile seekers and guidance electronics.
BEL revenues dependent on defence capital budget spending
We highlight that BEL has historically maintained a consistent 11-12% share of defence
capital spending. We therefore view the budget for spending as a leading indicator of fullyear
revenues.
Rs1 bn positive one-off in FY2010 PAT; strong cash position nullifies working capital
concerns
The management cited that FY2010 financials included Rs330 mn gain from the write back
of provisions and Rs660 mn of forex gains amounting to a PAT inflation of about Rs1 bn.
We have already included the same in our current estimates. The management also cited
that though forex gains would also happen this year, their quantum would be much less.
BEL does not hedge its exposure since it is protected by a foreign exchange escalation clause
in most of its contracts.
The management hinted at cash reserves of about Rs35 bn, out which some part would go
towards accounting for a higher working capital (BEL to pay greater advances).
Reiterate REDUCE, revise estimates to reflect strong FY11E order backlog
We revise our estimates to Rs98.9, Rs122.2 and Rs142.8 from Rs103.3, Rs117.4 and
Rs133.6 for FY2011E, FY2012E and FY2013E, respectively. The change reflects (1) increase
in FY2011E backlog driving revenues in FY2012 and FY2013.(2) marginal changes in
employee cost, (3) reduced other expenses, (4) lower other income - adjusting for FY2010,
Rs1 bn positive one-off in other income, (5) lower effective tax rate based on sustained R&D
spending.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Bharat Electronics (BHE)
Industrials
Revenue traction on large projects positive; we seek better risk-reward, delivery.
Strong project-based orders may double the backlog to Rs200 bn (expects Rs80 bn in
4Q apart from Rs164 bn at Dec-end versus Rs113.5 bn at Mar-10-end) leading to
stronger revenues. However, lower contribution from the project may cramp EBITDA
margins despite operating leverage from employee costs. We retain our REDUCE rating,
holding out for better risk-reward and some delivery (disappointment possible in timing,
extent) on intent.
Strong order backlog to drive revenues in FY2012; company projects Rs100 bn revenue in FY2013
BEL reported strong backlog of Rs164 bn at end-Dec 2010 versus Rs114 bn at end-FY2010. It
expects another Rs80 bn in 4QFY11. This implies FY2011-end order backlog of about Rs210 bn,
(double of end-FY2010), driving revenues. Strong order inflows are driven by need to integrate
surveillance and communication systems (versus just firing systems). The mgmt is confident of
achieving its FY2013 revenue target of Rs100 bn (FY12 guidance of Rs75 bn) and sees visibility of
incremental Rs600 bn orders in 3-5 years.
Growing project share to contract margins; operating leverage short; expect flat margins near term
Current project: Product (20-80) mix may change in favor of projects to 60-40 in the long term. A
48% contribution margin for product business and 20% for project business (blending to current
42% margins) would reduce the contribution margin will reduce by 11% to 31%. Assuming
operating leverage of 6% from employee costs and 2% from other expenses still implies an
EBITDA margin contraction to 14-15% versus the current level of 17-18%. In the near term (till
FY2013E), we build flat EBITDA margins of about 17%, as 350 bps contribution margin fall is
buffered by operating leverage.
BEL affected less by competition, more by increasing customer bargaining; offset diluted a little
Despite DPP 2008 enabling the private sector to bid for defence orders, serious competition is still
not visible. Two key barriers for the private sector are (1) investment in infrastructure and
developing technologies and (2) bias of defence forces for PSUs (proven infrastructure, secrecy).
However, incrementally stronger customer push back is visible based on better customer education
by global and local competitors. While offset has not yet scaled up as an opportunity, the clause
has been partially diluted based on the inclusion of civilian aircraft components sourcing from India
towards meeting offset obligations versus only defense sourcing earlier (relevant for MMRCA).
Revise estimates and target price to Rs1,875; retain REDUCE for better risk-reward and delivery
We revise earnings to Rs101 (from Rs105), Rs125 (from Rs120), and Rs146 (from Rs137) from
FY2011E, FY2012E and FY2013E, respectively, based on (1) higher revenues – larger backlog,
(2) marginal changes in employee cost, (3) reduced other expenses, (4) lower other income -
adjusting for FY2010, Rs1 bn positive one-off in other income, (5) lower effective tax rate – sustained
R&D spend.
Strong order backlog to drive FY2012 revenues
BEL reported a strong backlog of Rs164 bn at end-Dec 2010 versus Rs114 bn at end-FY2010.
It further expects another Rs80 bn in 4QFY11. This implies an FY2011 order backlog of
about Rs210 bn, almost doubling end-FY2010 backlog. Such a strong backlog of
unexecuted orders would drive revenue growth in FY2012.
Modernization of defence systems giving fillip to industry demand
BEL management highlighted the increased focus of the defence forces towards
modernizing their systems. The defence forces are also looking more towards integrated
systems with their focus not limited to firing systems but also extending to reconditioning
and communication systems. BEL expects to get a significant share of such future orders.
Key orders in pipeline for which BEL will bid include (1) 26 bn Battle Surveillance System, (2)
Rs14 bn 3D radar order), (3) Rs10 bn night vision devices order, (4) Rs9 bn Sambhavagh
communication system, (5) Rs7.4 bn Shilco upgradation order for 48 tanks and (6) Rs7 bn
Indian Coast Guard for Coastal Surveillance System (50% bought out).
Mgmt. maintains Rs100bn target for FY13E revenues
BEL strongly believes in accomplishing Rs57 bn revenues for FY2011 and has a FY2012
target of Rs75 bn. The management sees visibility of Rs600 bn orders from the defence
forces over the next 3-5 years. It believes that even if it gets half of these orders, it would be
on track for the Rs100 bn FY2013E revenue guidance. It also highlighted that its present
capacities are sufficient and that it doesn’t require additional capex and manpower for
achieving the FY2013 revenue target.
Increase in share of project business to reduce margins
The management highlighted BEL product-project mix would change from the current 80:20
to a 40:60 mix. We highlight that BEL has a contribution margin of about 42%. Assuming a
project contribution margin of 48% implies a product contribution margin of 20% (80:20
product project mix). If the project share increases to 40:60, the contribution margin falls to
about 31%. Of the decrease of 11% in contribution margin, about 8% would be taken up
by operating leverage (5-6% reduction in employee cost as a percentage of sales and
another 2-3% reduction in other expenses as a percentage of sales). The rest would flow
through to EBITDA, reducing margins to 14-15% from the present levels of 17-18%. In
order to prepare itself for the increase in the project business, it is focusing on its manpower.
It hired 50 from various IITs this year after a long gap. It is making 300 of its engineers take
a project management course for developing the required skills.
Limited impact of private sector competition on BEL
Though DPP 2008 signaled the entry of private players for bidding for defence orders, their
participation has been limited. A key barrier to the increase in private sector participation is
investment in infrastructure and in developing/acquiring technologies. A further requirement
of supply of the product before the actual award also reduces private sector interest in
bidding. The defence forces are also biased towards awarding contracts to defence PSUs for
reasons of secrecy, reliability and proven infrastructure. This lack of competition is reflected
in Tata mainly bidding for truck orders while L&T focuses on launchers though it has also
started bidding for radars.
BEL has the advantage of having acquired European and American technologies and of
strong experience in manufacturing and supplying defence equipment. It also has a strong
relationship with DRDO and therefore benefits from its design capabilities.
Availability of global pricing information increasing customer’s bargaining power
The management stressed on the end customer getting more aware of the costing of
defence products leading to strong negotiations on price. A lot of global information of
related orders is contributing to such an increase in awareness. Although the customer may
not go for a foreign bid (important to have expertise on technology used), nonetheless, it
acquires the pricing information. Moreover, increased integration in orders is also adding to
customer’s bargaining power.
Offset business still to pickup; offset business now to include civilian orders
Under the offset policies, the government keeps a minimum of 30% of the invoice value for
transactions in defense and aviation with foreign supplier until the supplier offshores an
equivalent amount of services equivalent to that offset. A recent revision of norms implies
the inclusion of civilian aviation investment as part of the offset business. This development
would reduce the scope of business for BEL.
The management mentioned a US$40 mn order by an Italian ship builder that it is working
on. They agree that the offset business has not yet picked up. Export vendors generally keep
running a current account, rather than maintain a 30% level from their domestic businesses.
Employee expense to stabilize from FY2012
The management believes the employee expense for FY2011 of Rs10.5 bn and expects it to
stabilize from FY2012. It gave the following reasons for the recent hike in employee cost:
�� Increase in gratuity to Rs1,000,000 from Rs350,000 with effect from FY2009.
�� Salary revision of non-executives was finalized in June 2010, leading to prior period
expenses apart from arrears increasing employee expense in FY2011.
�� Provision for pension of executives added Rs2-3 mn per year. No provision for nonexecutives
exists currently and may add another Rs2-3 mn per year if it were to
materialize.
Rising employee cost is the prime factor responsible to reducing EBITDA margins in FY2010
and YTD-FY2011.
The management also highlighted that attrition level within the company has fallen to less
than 1%. BEL’s salary structure up until the level of deputy manager (5-6 years experience or
less) is competitive. These employees also have the comfort of working for a good company
with job security which is not there in the private sector. The disparity in salary of BEL
employees versus the private sector is more visible for employees with greater experience.
R&D expense to increase faster than sales going forward
BEL has been spending on R&D at a steady rate of 5-6% of sales. The management
highlighted that from FY2012-14, R&D expense would increase to about 8% of sales. Key
reasons leading to increase in spending include:
�� Demand for modernization of defence systems. BEL is increasing spending on
acquiring research tools and developing technologies to cater to demand arising from
modernization of defence equipment.
�� DRDO asking for its share. DRDO has now started asking BEL to contribute to the cost
of projects done with BEL. The structure being thought of includes 60% cost borne by
DRDO, 30% by BEL and 10% by the end customer.
Technology transfer procedure adding variation to margin
Technology providers have now changed their terms with BEL. Instead of paying for the
technology, the new terms mandate a certain share of business coming from the technology
providers. Taking an example of an order of 100 radars, the technology provider will supply
(1) 10 complete radars, (2) 15-20 radars at the semi knocked down level (3) and the rest of
the radars at the completely knocked down level. For some part of radars, in-depth
manufacturing would take place wherein the technology developer supplies all components
and BEL assembles them. Some critical components are still made by the technology
provider.
Such terms lead to variation in the margin recognition by BEL as the revenue realized for
each product is the same. At the early stages of the project, value addition by BEL is lesser
leading to lower revenue recognition.
The management cited that (1) 57% of its revenues come from technologies with BEL,
(2) 18% from technologies of DRDO and (3) 25% from foreign technology transfers. The
management also clarified that the limit on foreign purchases is on technology transfers and
that components purchased exceed 75% (about 80% presently).
Management confident of meeting FY11 revenue guidance
BEL is confident of meeting its guidance and our estimates of Rs57 bn of revenues in FY11.
Our estimates require 4Q revenues of Rs24.3 bn (yoy growth of 34%) and strong EBITDA
margin assumption of 27.2% versus 4QFY10 margin of 9.5%.
BHEL JV to start shortly; planning JVs with Thales and Rafael
The BEL-BHEL JV for manufacturing solar wafers, cells and modules will implement the 250
MW solar photovoltaic (PV) production facility in Hyderabad. The capex for the plant is
estimated at Rs20 bn with BHEL to take lead in setting up the facility.
BEL is in discussion with Thales of France for a JV in the area of civilian and select defence
radars. The company is also in discussion with Israel's Rafael for floating a joint venture in
the field of missile seekers and guidance electronics.
BEL revenues dependent on defence capital budget spending
We highlight that BEL has historically maintained a consistent 11-12% share of defence
capital spending. We therefore view the budget for spending as a leading indicator of fullyear
revenues.
Rs1 bn positive one-off in FY2010 PAT; strong cash position nullifies working capital
concerns
The management cited that FY2010 financials included Rs330 mn gain from the write back
of provisions and Rs660 mn of forex gains amounting to a PAT inflation of about Rs1 bn.
We have already included the same in our current estimates. The management also cited
that though forex gains would also happen this year, their quantum would be much less.
BEL does not hedge its exposure since it is protected by a foreign exchange escalation clause
in most of its contracts.
The management hinted at cash reserves of about Rs35 bn, out which some part would go
towards accounting for a higher working capital (BEL to pay greater advances).
Reiterate REDUCE, revise estimates to reflect strong FY11E order backlog
We revise our estimates to Rs98.9, Rs122.2 and Rs142.8 from Rs103.3, Rs117.4 and
Rs133.6 for FY2011E, FY2012E and FY2013E, respectively. The change reflects (1) increase
in FY2011E backlog driving revenues in FY2012 and FY2013.(2) marginal changes in
employee cost, (3) reduced other expenses, (4) lower other income - adjusting for FY2010,
Rs1 bn positive one-off in other income, (5) lower effective tax rate based on sustained R&D
spending.
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