Stellar rally in defence stocks not pricing potential risks, says KIE- QHN

The stellar rally in defence stocks belies the potential risks of delays in companies securing orders and their lower profitability, according to a note by Kotak Institutional Equities (KIE).

The note said the defence sector had seen a sharp rerating and delivered massive returns over the past three-six months on expectations of large spending by the government for an extended period and a steady increase in indigenisation.

Large deal wins by companies have boosted investor sentiment. However, while most stocks factor in the positives, they are oblivious to the potential risks, the note has cautioned.

“Our reverse valuation analysis, based on the current market capitalisation of a basket of major defence stocks, suggests that these companies will need to execute around ~1.4 trillion of defence orders annually to justify their current stock prices. For context, these companies combined revenues of ~62,500 crore in FY23,” said the note.

The note said there could be a market opportunity of ~1.6 trillion for domestic procurement by FY26 due to solid defence capex growth and low imports due to indigenisation.

“Defence stocks will need to capture a significantly larger share of India’s domestic defence budget compared with history even as more private companies are entering the sector,” the note said.

The note said there were uncertainties about the profitability of defence companies. Their current profitability seems to be higher, and the defence industry could become more competitive with the entry of private players.

“The government may tighten procurement terms as domestic production capabilities scale up over time.”