What to expect for Defence Stocks from Union Budget 2025
Defence Minister Rajnath Singh has declared 2025 as the Year of Reforms for India’s defence stocks(defense sector). Singh aims to modernize India’s defence capabilities and increase local production.
The government has acknowledged that India’s defence processes are outdated. However, implementing reforms has been challenging due to delays in updating command structures, internal resistance to change, and limited budgets.
Despite these obstacles, there has been significant progress. India’s defense exports have increased by 30 times in the past decade, largely due to the growing involvement of the private sector.
This transformation comes at a crucial time as the world is becoming increasingly volatile, with conflicts such as the Israel-Hamas dispute, the Ukraine-Russia war, and tensions between China and Taiwan. The recent election of a US President who has expressed interest in annexing Canada and Greenland further underscores the need for India to bolster its defense capabilities.
Investors in defense stocks may view this as a promising opportunity, as the market for defence-related products remains robust. Motilal Oswal’s Defense Fund advertisement, which poses the question “India is investing in defense, are you?” reflects the changing landscape of India’s defence sector over the past decade.
India’s defence strategy has also shifted towards the West, moving away from its longstanding reliance on Russia. The French Rafale deal, which garnered significant attention a few years ago, marked a turning point in India’s defense procurement. While Russia has historically been India’s primary arms supplier, accounting for 76% of imports between 2009 and 2013, this dependence has decreased significantly. Currently, Russia supplies 36% of India’s defence imports, while Western countries like France (33%) and the US (13%) are gaining a larger share. This diversification strategy aims to reduce India’s reliance on any single nation for its defense needs.
India, the world’s largest arms importer, currently accounts for 9.8% of global arms imports. However, the country is now shifting its focus towards manufacturing defense products domestically to reduce its reliance on foreign suppliers.
India’s defence transformation has been fueled by the ‘Make in India’ initiative launched in 2014. The government identified over 36,000 defense items that could be produced locally, including complex systems, sensors, weapons, and ammunition. Since then, public sector companies have placed orders worth over Rs. 7,500 crore with domestic defense vendors.
Indian diplomats have also taken on the role of promoting Indian-made defense products globally. India’s defense exports reached Rs. 21,000 crore in FY24, showing a 40% compound annual growth rate over the past decade. Defence production has also seen significant growth, with an 8% compound annual growth rate, increasing from around Rs. 74,000 crores in FY17 to Rs. 1.3 trillion in FY24. The government aims to achieve Rs. 3 trillion in production and Rs. 50,000 crore in exports by 2030.
While the public sector has traditionally dominated India’s defence production, the private sector’s role has been steadily increasing in recent years, accounting for 20% of production and 60% of exports. This rise in private sector participation has attracted interest from various investors, including retail investors, mutual funds, and foreign institutions.
In 2022, the NSE introduced the Nifty India Defence Index, which has experienced a remarkable 4.5-fold increase since its inception, further driving investor interest in the sector. Consequently, fund houses such as HDFC, Motilal Oswal, Aditya Birla Sun Life, and Groww have launched defence-specific schemes, with three of them being introduced in 2024.
A Balasubramanian, the CEO of Aditya Birla Sun Life, emphasized the substantial order books of top defense companies as an attractive opportunity for investors. However, he pointed out that state-owned firms continue to dominate the sector, with the government holding majority stakes in many companies. The limited free float of these stocks also leaves them vulnerable to price swings.
One concerning factor is the high valuations in the sector. For instance, the HDFC scheme had to halt accepting fresh investments due to concerns about peak valuations. Nevertheless, in the past six months, the defense sector index has corrected by 20%, driven by slower order inflows, supply chain disruptions, and other execution challenges.
The issue of high valuations in defense stocks remains a challenge despite the sector’s promise. Surjitt Singh Arora of PGIM India AMC warns that “valuations have outpaced fundamentals.” Shiv Chanani of Baroda BNP Paribas Mutual Fund agrees, highlighting that while order books offer revenue visibility, execution hurdles and high pricing are concerns.
However, Binod Modi of Mirae Asset Sharekhan remains optimistic, arguing that the sector’s growth potential justifies its current valuations. He believes the sector will continue to command premium valuations for the next 3-5 years. Brokerages like Antique and Elara Securities share this bullish outlook and view the recent correction as a favorable entry point for long-term investors.
Focusing on strong fundamentals amidst high valuations, key players in the industry such as Solar Industries, Astra Microwave, Hindustan Aeronautics (HAL), and Bharat Electronics (BEL) have shown steady growth in revenue, net profit, order books, and return ratios.
ICICI Securities anticipates Solar Industries to expand its share of defense revenue over the next five years, especially with the global ammunition shortage creating new opportunities.
Astra Microwave’s strong order book and robust pipeline have contributed to maintaining its revenue and profitability, particularly through a focus on higher-margin domestic contracts.
ICICI Direct predicts that HAL’s revenue growth will experience a significant increase starting from FY26, attributed to improved execution. Additionally, Mirae Asset Sharekhan anticipates that BEL will benefit the most from recent proposals by the Defence Acquisition Council, which include maritime surveillance and other capability upgrades.
Despite potential challenges such as high valuations or FII sell-offs impacting sentiment in the short term, analysts remain optimistic about the long-term prospects of the sector.
Since FY23, the government has approved Rs. 8.3 trillion worth of Acceptance of Necessities (AoNs) for defense projects, marking a 53% increase from the previous decade. This signals a substantial pipeline of upcoming projects for defense companies, driven by the government’s emphasis on indigenization and exports.
The government is also aiming to enhance the involvement of startups, SMEs, and large corporations in areas like research and AI. Antique Research is particularly enthusiastic about the potential of various defense companies with unique technologies that are not yet publicly listed, including Tata Advanced Systems, Reliance Naval and Engineering, Mahindra Aerospace, Kalyani Strategic Systems, DRDO, Munitions India, and BrahMos Aerospace. The sector, which has a long history, is experiencing renewed interest with the emergence of new players alongside established companies.
As we await the Q3 results, we are focusing on defense stocks with the highest Forecaster estimates for revenue YoY growth and strong durability scores. Companies with high durability scores are those with excellent management, consistent growth and cash flow, stable revenues and profits, and low debt.
Some of the most notable stocks in the defense sector include Bharat Dynamics, Data Patterns (India), ideaForge Technology, Hindustan Aeronautics, Mazagon Dock Shipbuilders, and Garden Reach Shipbuilders & Engineers.
Bharat Dynamics stands out in the screener with a Durability score of 70 and Forecaster estimates projecting revenue growth of 102.8% YoY in Q3FY25. This debt-free defense stock has seen its net profit increase YoY in five out of the past eight quarters, contributing to its high score. Analysts at Phillip Capital and Elara Capital anticipate the company’s revenue growth due to a strong order backlog and participation in defense modernization programs.
Bharat Electronics is another standout in the screener, boasting the highest Durability score of 85 among defense stocks. Its impressive durability is attributed to consistent revenue growth YoY for the past nine consecutive quarters and net profit increasing YoY for the past eight quarters. The company also maintains low interest expenses and a strong return on equity (RoE) of 16.8% in FY24. While its trailing twelve-month (TTM) PE ratio is 45.4, higher than its three-year and five-year averages, Trendlyne’s Forecaster predicts a 28.6% YoY revenue growth in Q3FY25. Sharekhan analysts expect revenue growth driven by increased defense spending in India, the trend of indigenization, and export opportunities.
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Disclaimer: This blog post is for informational purposes only and should not be considered financial advice. Investors should conduct thorough research and consult with a qualified financial advisor before making any investment decisions.