Defence Procurement Policy 2016 DPP 2016–Huge opportunity in offing but will not materialise immediately
DPP 2016–A major step towards indigenization: The defence minister recently cleared the Defence Procurement Policy of 2016 (DPP-2016) which is likely to govern all defence acquisitions after April 1, 2016. The aim here is to achieve the target of 60% indigenization by 2020. The policy is expected to incentivise indigenous design and development through indigenously designed, developed and manufactured (IDDM) category, higher government reimbursement, increasing roles of micro, small and medium enterprises (MSMEs), relaxation of offset clauses, fast track purchase clause etc.
Defence opportunity to the tune of $150 billion over a decade: India's aggregate defence expenditure (revenue plus capital) over FY2008-FY2017BE has risen by a compounded annual growth rate (CAGR) of 12.2% to Rs2.59 lakh crore. Whereas, the capital outlay for the same period has witnessed a 8.6% CAGR to Rs78,587 crore. Assuming the government's relentless and time bound focus on enhancing country's defence capabilities with a conservative 5% CAGR in capital outlay over the next decade, the opportunity in defence is of the size of $150 billion.
Large companies to be major participants and beneficiaries: DPP's unequivocal focus on "Make in India", institutionalising, streamlining and simplifying defence procurement procedure in a time-bound manner is expected to significantly increase the role of local defence industry companies. However, the industry players estimate the actual earnings to start flowing after three to five years due to long gestation and due diligence processes. The government has issued over 300 defence industrial licences since 2004 upto February 2016 which includes over 40 listed entities. The major players like Larsen & Toubro, Mahindra & Mahindra, ABG Shipyard, Bharat Electronics, BHEL, Bharat Forge, Anil Ambani Group and Tata Group are the key beneficiaries of the defence industrial licences.
Bharat Electronics is our preferred pick as it would be an early beneficiary and is a pure play in the defence space. On the other hand, it would take many years before defence business contributes materially to the financials of large conglomerates and industrial houses.
Defence Procurement Policy 2016
The defence minister recently cleared a long awaited Defence Procurement Policy of 2016 (DPP-2016) which will overtake DPP-2013 and govern all defence acquisitions initiated after April 1, 2016. The chapter 6 which deals with the appointment of "strategic partners" (priority partners in the manufacturing equipments like aircraft, warships, helicopters, submarines, tanks etc based on technology from foreign vendors) in the private sector would be finalised in another one to two months.
Increasing target market size with DPP-2016: In our special report on the defence sector dated March 29, 2016, on DPP-2016, we have highlighted the defence capital outlay opportunity for the industry to the tune of $150 billion over the next decade. Bharat Electronics Ltd (BEL) has already got a head start with four licences since 2004 in radar and wafers where the company enjoys a monopoly position. Further, the company has a market opportunity size of Rs70,000 crore over the next seven to eight years in its area of expertise.
Gearing up to compete with the private sector: BEL is planning to invest Rs1,500 crore over the next three years under its "Make In India" expansion and modernisation strategy. The company will also be increasing its R&D spends to 10% of turnover (currently at 8%). BEL will be increasing its procurement from MSMEs (thrust area in DPP-2016) from 8% in FY2015 (5% in FY2014) to focus on core areas and R&D. Additionally, BEL will be focusing on exports, offsets and buyer nominated equipment. The likely increased private sector participation has led BEL to diversify into areas of homeland security, smart cards, smart city elements and solar power plants which too have tremendous growth potential with better operating profit margins.
Maintain Buy with price target of Rs1,450: BEL remains our preferred pick in the defence sector on account of its strong manufacturing and R&D base. BEL has already started to reap benefits of indigenization of the defence procurement with 44% Y-o-Y jump in its order book which stood at Rs32,333 crore at the end of Q3FY2016 (order intake of Rs12,000 crore in Q3FY2016). BEL being a virtually debt-free company with cash of over Rs5,200 crore (Q2FY2016), return ratios (RoCE, RoE) at 15% (FY2015) and consistently paying dividend is suitably placed to capitalise on the upcoming defence procurement opportunities. Consequently, we reiterate our Buy rating on the stock with an unchanged price target of Rs1,450.
Sharekhan Limited, its analyst or dependant(s) of the analyst might be holding or having a position in the companies mentioned in the article.
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