India’s defence public sector units have moved from the sidelines of the equity market to the centre of many portfolios. Mutual funds have launched thematic schemes, retail participation has surged, and brokerages now publish dedicated sector reports. Investors who track the BDL share price often notice that it responds strongly to missile contracts, export news and policy announcements. Those who follow the Bharat Electronics share price see a somewhat different pattern, shaped by radar, communication and electronic warfare orders. Understanding what lies behind these movements is the first step towards making sensible decisions.
Strategic Importance and Government Ownership
Defence PSUs are a special segment of the Indian economy. Most have majority ownership by the government and have historically been the go-to suppliers for the army, navy and air force. They therefore benefit from a loyal customer base, high levels of technical expertise and decades of experience.
However, this ownership structure also has some negative points. While they provide consistency of work and the assurance of less competition in public sectors, the government can manipulate dividend policy, pricing and strategy decisions. Minority shareholders are not given much say. The valuation will reflect this.
Order Book and Revenue
One number that always dominates discussions around Defence PSUs is the order book. Having a large booked order book and delivering over multiple years means investors know how much revenue they are going to get. Often Defence PSUs have an order book that is multiple times bigger than their sales, and this is why the market often gives them a premium over many cyclical manufacturers.
However, we need to look at how quickly they are delivering. If they take longer (say 5 years vs 3 years), then they won’t be growing revenue as fast and will be tying up working capital. Investors should look at how much of an order book they are receiving and if they are delivering. How much of the order book are they near delivery on? Management guidance for the next year should be consistent to build investor confidence, and this will show in the valuation.
Margins, Returns & Cost Control
Margins within defence manufacturing are determined by the product mix, how much indigenous content they have and the type of contracts they have. Cost plus contracts provide consistency but low upside potential. Fixed price contracts expose the company to input cost inflation. Companies that manufacture a lot of components in house and have less items to outsource will often maintain margins.
Returns on equity and capital employed should also be considered. Many PSUs will have large amounts of cash due to customers paying in advance. This will inflate the balance sheet but reduce returns. If management can utilise this cash to increase capacity, create new products or buy new technology, this will result in increased returns. The market will usually respond positively.
Dividend, Cash & Multiples
Defence PSUs are known for having consistent dividend payouts. Income investors will like this. However, the dividend payout ratios are set in discussion with the government. Sometimes the government will prefer companies to pay higher dividends. Investors should look at the dividend yield and growth.
Multiples such as P/E and EV/EBITDA are often looked at. After a good run, these multiples can look expensive relative to historic averages and other manufacturers. If they have sustainable earnings growth, they may be justified. If the growth starts to slow, multiples can fall quite quickly. Comparing the multiples to the 5 year range for that company will give a more realistic view.
Flows
Flows can play a big part. Institutional investors buying, additions to indices and new thematic funds can cause the price to rise much higher than earnings justify. However, large holders booking profits, offers for sale of government holdings and global risk appetite can cause the stock to fall.
Long term investors should try to ignore the noise. If the stock falls due to a one off sale of government holdings, this doesn’t affect the order book. If the stock rises due to hype on social media, this will not improve their margins.
Overall
Valuing defence PSUs will require understanding of policy, order book, delivery, profitability and sentiment. There isn’t one factor to consider. Investors that develop the habit of looking at the annual reports, listening to the earnings calls and following the exchange filings will be in a much better position than those taking tips.
The push for India to be more self-sufficient will likely be a theme over the coming years; however, not all companies will have the same returns.