Joseph D. Dean
In Indian defence manufacturing, the government is both the largest customer and the most important regulator. This relationship explains why the Apollo Micro Systems share price can jump after the announcement of a fresh supply contract, and why Paras Defence share price tends to react whenever a new procurement category is opened to domestic firms. To understand valuations in this field, one must first understand how the state buys equipment, how long that process takes and what signals investors should read from each stage.
From Requirement to Contract
Procurement begins with the armed forces identifying a need. Thereafter, this proposal will go through several approval processes, whereby the cost, technical specs and source of procurement are identified. Once approved, a Request for Proposal goes out to the sector; the trial process then begins, price negotiations and finally a signed contract.
This process can take a long time to get off the ground and can be delayed at any point. This means that if news comes out early on about a procurement plan being approved by the ministry, there will not be immediate revenue. Often there will be a rally in the stock price; however, the earnings will come much later, causing disappointment.
Indigenisation Policies
Policies which push domestic manufacturing have had a big impact on the competitive landscape. By limiting imports of certain items, this gives an advantage to local manufacturers. Categories that promote indigenous design mean that companies that have invested in research will gain an advantage. Defence corridors have been set up in Uttar Pradesh and Tamil Nadu, and innovation policies are in place for startups and smaller companies.
These signals will have an impact on valuation. If their main product falls under an import-limited category, the market will give a higher chance of re-orders. However, if they fall under a category where they will face competition from imports which are allowed, then this premium will be lower.
Union Budget
Every year the amount of money available for defence modernisation will be outlined in the Union Budget. The area that is most relevant to manufacturers is the capital outlay. This is the money used to purchase new kit rather than pay wages and pensions. It is also useful to look at how much of this has been allocated to domestic procurement. This shows how much of the business will be coming from local suppliers.
However this does not always equate to how much the company will actually spend. Sometimes the armed forces are unable to spend the full amount of capital they have been given due to delays in approvals and deliveries. We would recommend looking at the utilisation throughout the year. If there is a good budget but delays in spending it can cause the sentiment to be ahead of the fundamentals.
Order Announcements
All listed companies must report on major orders. These announcements are one of the most important parts of the stock price. However the size of the order, whether it is a repeat or new order, the delivery time and any terms can affect the impact.
Sometimes a small order from a new customer could be more valuable in terms of strategy. This opens up a new avenue for them. However if the headline mentions options over multiple years or optional amounts it could be misleading. We would recommend reading the small print of the announcement and if possible listening to the management talk about the order on the earnings call for a more accurate picture.
Payment Cycles
Even once orders are won this can cause issues. Often government contracts have milestone payments, inspections and acceptance certificates. If any of these are delayed this can cause cash flow issues. If a company is growing quickly but has slow receivables, they may need to borrow more which will reduce profitability.
Often free cash flow can be more important than profit. If a company has high conversion rates from earnings to cash, they will have better multiples over time. This is because they can use internal funding to grow and give a more reliable return to shareholders.
Why Valuations Can Be Volatile
As there are a few major decisions to make, defence stocks can be very volatile. If there is good news on a policy, the stock can gain a lot of value in a short space of time. However if there are any delays to contracts or any concerns from regulation, this value can quickly be lost. This is increased by retail excitement and momentum trading.
Experienced investors will see this as part of the nature of the sector. They will look at the long-term trend of orders, margins and return ratios.
Balanced View
Whilst there is a great tailwind from government support, there is still risk involved. Companies must still produce quality products on time, control costs and continue to invest in technology. If they do this, they are likely to see their valuations supported by earnings growth.
