Bharat Electronics Rating – Buy: Re-rating of stock is in the works

Bharat Electronics (BEL) derated in FY19 after the Ministry reduced margins on nominated projects to 7.5% from 10-12.5%. Investor concerns on the uncertainty of the margin impact kept valuations subdued, despite the rising order flow. Management explicitly mentioned at its Nov. 2020 analyst meet, that FY20 has seen the impact of lower margins already and 20% is sustainable. We believe margin delivery, order flow and execution ramp-up will drive upside.

Visible Rs 565-bn order flow pipeline
QRSAM is a new missile system order, which has a Rs 300-bn 10-year opportunity for BEL. Rs 150-200 bn of this should come through in FY22e-23e. Rs 150-bn LRSAM missile system order should come in FY22e. The above pipeline does not include incremental orders that will open due to the import embargo initiated by the Ministry of Defence (MOD) in August 2020. Additionally, BEL is exploring growth in non-defence areas.

Rs 521-bn order book at 4x FY20 revenues gives comfort on revenue growth
FY21e-23e revenues are comfortably covered by the existing order book. Mgmt is confident of possibly doing double-digit revenue growth in FY21e. We have single-digit growth considering government spend could ramp-up gradually vs initial FY21e targets in the COVID-19 backdrop. MOD’s push for indigenisation will see BEL continue to gain share, which began in FY15, in India’s defence spend.

Defence policy could raise nominated projects’ margins, a potential surprise
Nearly 1/3rd of BEL’s projects are awarded on a nominated basis. Mgmt mentioned that a fair amount of FY20 revenues came from such projects under the revised lower margins. Given this and the order book, they are confident of maintaining 20% margins in medium term. If an upward revision in nominated project margins come through, it will add to these margin assumptions.

FY20-23e 16% EPS CAGR
BEL’s ROE should once again cross 20% in FY22e-23e, as execution ramps up and earnings growth picks up post a difficult FY20. Mgmt mentioned Rs 50-bn capex annually for the next 3-5 years is likely, vs. the average annual capex of Rs 2.6 bn in FY10-20. BEL should see some of the derating post the new margin policy reverse, given the clarity on the margin outlook. Additionally, net cash position, ROE upwards of 20% and systemic push for defence indigenisation leading to growth should support earnings and valuations. We retain Buy with a revised PT of Rs 145, valuing BEL at 14x PE (avg PE since Apr-08) Sept 22e vs 12x FY22e EPS earlier.