Defence Stocks Are Vulnerable To Potential Lower Profitability: Kotak Institutional
Defence companies will need to execute around Rs 1.4 lakh crore of defense orders annually to justify their current stock prices.
Indian defence stocks rallied in the past few months on expectations of increased indigenisation and government spending, according to Kotak Institutional Equities. However, the brokerage has reservations about implied profitability of these stocks.
An unconventional valuation analysis of prominent major listed defence companies suggests they may secure the majority of future defence capital expenditures, contrary to historical patterns, the brokerage said.
This has resulted in a sharp re-rating of the defence sector, which delivered average returns of 80% in the past six months.
The large deals won by these companies also boosted investor sentiment. However, in Kotak's view, the stocks have only favoured the positives without the potential risks of delays in ordering and lower profitability.
Defence companies will need to execute around Rs 1.4 lakh crore of defence orders annually to justify their current stock prices, the brokerage's reverse valuation analysis based on the current market capitalisation of a basket of major defence stocks showed.
From FY17–23, India witnessed a consistent 9% CAGR in its total defence capital expenditure. However, this resulted in a gradual reduction in the portion of the government's overall capital expenditure allocated to defence. In FY20, India's defence imports amounted to approximately Rs 40,000 crore.
Kotak Institution's analysis predicts a substantial market opportunity of Rs 1.6 lakh crore for domestic procurement by FY26. This projection is based on the brokerage's assumption of robust growth in overall defence capital expenditure and a relatively slower pace of import growth, driven by the push for indigenisation.
Consequently, defence stocks will be required to secure a notably larger portion of India's domestic defence budget compared to historical allocations, particularly with the increasing participation of private companies in the sector.
The brokerage is uncertain about the future profitability of the defence companies, as their current profitability seems to be on the higher side, private sector entry could intensify competition in the defence industry, and the government may tighten procurement terms as domestic production capabilities scale up over time.
Kotak notes that lower profitability assumptions will imply much higher implied revenues, which may not be feasible in the context of the market opportunity.
