The best form of defence is offence, but then a good military doctrine more importantly involves an ideal structure and combination of offence, defence and deterrence. In recent months while Indian defence stocks which have been on a rampage in the markets, have likened to the former, they seem to have completely ignored the latter. With their offence in the markets stretching way past what fundamentals can support, the stocks lack sufficient defence/deterrence to avert a painful retreat when market cycle attacks with a vengeance.
Why so?
There is strong policy support from the government for the sector, the push for indigenisation has never been better, and order books for Indian defence companies are so strong. So what is the case for a retreat, when the Indian defence story is so good? A comparison with global defence stocks lays bare the facts.
While we have made strides in defence technology, the fact that we still have a heavy import bill in our annual defence capex indicates that there is a lot more technology gap to be filled. While HAL’s LCA Tejas is making waves and is set to become the second largest fleet in Indian Air Force in few years, we still covet the Rafale manufactured by French defence company Dassault Aviation for strategic purposes.
In recently concluded FY, Dassault Aviation posted revenue of $5.19 billion and net profit of $974 million, while HAL posted revenue of $3.67 billion and net profit of $921 million. However, HAL trades at enterprise value (EV) of a staggering $41 billion, while Dassault Aviation is valued at a mere $6.7 billion.
A bull would argue the growth opportunity that favours Indian defence stocks. But, here are some interesting facts – over the next two years Dassault Aviation revenue/earnings is expected to grow at a CAGR of around 24/12 per cent, while that of HAL at around 13/8 per cent, respectively. Even when you compare the order backlog, Dassault Aviation exited its recent FY (CY23) with a backlog of $41 billion, while HAL backlog is at around $11 billion.
If you come to future opportunities, it would be worth noting that not just India, but many other countries also are on a significant re-armament cycle given the current geopolitical dynamics. For example, in a recent report on European defence stocks, global brokerage house JP Morgan refers to a ‘Europe’s Rearmament Cycle’ that could last at least a decade. This has been triggered by Russia-Ukraine war which brought to the spotlight the underinvestment of NATO countries of Europe in defence capabilities. According to a report by the German ifo institute, Europe had extracted a peace dividend of $1.8 trillion between 1991 and 2023, by spending less than their NATO mandated target spending on defence. It is now catch-up time and could present a bonanza for defence companies there, more in impact in terms of future opportunities than that for Indian defence companies. But investors there are not even remotely reflecting euphoria as witnessed here (see table).
Another example is when you compare shipbuilders like Mazagon Dock with the largest shipbuilders in the US and major defence company there – Huntington Ingals. Mazagon Dock has an EV of $12.03 billion that values it almost as much as Huntington Ingals, although its revenue at present is less than 10 per cent of that of Huntington Ingals!
What’s amiss?
Stocks are worth the net present value of their future cash flows, which are not perfectly forecastable. So the debate on fair valuation will always be never ending. But then when stocks continue to move on no significant news, outpace their business growth and trade at valuations totally incomparable with global peers, some of them with advanced technology, long execution track record and equally good prospects, investors need to take stock.
As Warren Buffet once said – ‘Unfortunately, however, stocks can’t outperform businesses indefinitely’ A painful retreat in defence stocks is quite a plausible scenario, and it’s better that fundamental investors take cover.