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The Indian defence sector is currently experiencing a resurgence, capturing the attention of investors and analysts alike. After a period of relative calm following an initial surge, the Nifty India Defence Index has recently soared, reaching unprecedented heights. This renewed interest raises critical questions about the underlying drivers of this rally and whether the sector's fundamentals can sustain the current momentum. Several factors appear to be contributing to the renewed investor enthusiasm surrounding Indian defence stocks. One significant catalyst has been the increasing recognition of India's indigenous defence capabilities, exemplified by initiatives like Operation Sindoor. This operation not only showcased the strength of India's domestic manufacturing capabilities but also garnered international attention, leading to discussions with several countries regarding the potential acquisition of the BrahMos missile system. Furthermore, Russia's proposal to manufacture its advanced S-500 missile defense system in India further underscores the growing confidence in India's defence industrial base. The surge in India's defence exports provides further evidence of the sector's growing prominence. In FY25, defence exports reached a record ₹23,622 crore, nearly tripling the levels seen in FY21. Projections indicate a further doubling of exports to ₹50,000 crore by FY29. This export growth has been largely driven by defence public sector undertakings (PSUs), whose exports increased by 43% to ₹8,389 crore. This strong performance by PSUs demonstrates the increasing global acceptance of indigenously manufactured defence products. India is also actively pursuing major export markets in Southeast Asia, Europe, and Africa, which could provide further growth opportunities for the sector. The planned increase in defence spending by NATO members, totaling €800 billion over the next 3-4 years, could also benefit Indian companies, particularly private sector players. Globally, defence spending is expected to grow at a compounded annual growth rate (CAGR) of 5%, reaching $3.2 trillion by CY28. This projected growth suggests a long-term potential for export-driven growth, which could be a key driver of the ongoing rally in Indian defence stocks. Domestically, India's FY26 defence budget is expected to receive a significant boost with a potential ₹50,000 crore supplementary allocation. This additional funding could fuel defence research and weapons procurement, particularly benefiting indigenous manufacturers. However, the article cautions that valuations are now stretched, urging investors to carefully consider optimism against earnings visibility.
While the long-term outlook for the Indian defence sector appears promising, the article also highlights several concerns regarding current valuations and potential risks to sustained growth. The period between June 2023 and July 2024 saw a significant rerating of defence stocks, driven by low initial valuations, strong order inflows, improved earnings visibility, and supportive government policies. However, this led to inflated valuations by July 2024, resulting in a sharp correction. The recent rally has once again pushed valuations well above historical averages, setting a high bar for future earnings growth. For example, Bharat Electronics Limited (BEL) is currently trading at a P/E ratio of 53, suggesting that investors are paying a premium for its earnings. Recent earnings reports reveal mixed performance among defence companies. While Garden Reach Shipbuilders & Engineers Ltd (GRSE) reported a 46% profit growth and Mazagon Dock and BEL saw 64% and 46% profit growth respectively, Cochin Shipyard's profit increased by only 3.6%, and Bharat Dynamics' profit declined by 15% in 9MFY25. The article notes that, with the exception of Mazagon, these growth rates may not justify their high P/E multiples. Furthermore, achieving similar levels of earnings growth from the high base of FY25 will be challenging. Another concern is the limited free float in many defence PSUs, which can distort price movements. For example, the Government of India holds a significant stake in Mazagon Dock, limiting price discovery and allowing relatively small trading volumes to significantly impact the share price. More importantly, the earnings outlook is now heavily reliant on future order inflows. However, recent data indicates a potential slowdown in order inflows, which could pose a risk to sustaining current valuation levels, particularly since much of the existing order book may already be factored into stock prices.
The article analyzes order book trends, noting that while order book-to-revenue ratios appear healthy across most defence companies, the momentum in fresh orders has slowed over the past 12 months, partly due to election-related disruptions in FY25. Moreover, the Union Budget 2025 allocated a modest 4.6% increase for military modernization capital expenditure in FY26, suggesting potential constraints on near-term order inflows for defence companies. Company-level data supports this trend, with BEL, GRSE, Mazagon Dock Shipbuilders, and Cochin Shipyard all experiencing declines in their order books. While Bharat Dynamics saw its order book rise, its revenue declined, highlighting the importance of execution. The article also points out a divergence between stock price performance and financial performance. While Mazagon Dock Shipbuilders and GRSE saw strong revenue and profit CAGR, along with significant stock price appreciation, other companies, such as Cochin Shipyard, experienced stock returns that substantially exceeded their financial growth. This divergence suggests that valuations may be driven more by market sentiment than by underlying financial performance. Looking ahead, BEL management expects significant order inflows from the Army and Navy in FY26. Similarly, analysts project substantial order inflows for Bharat Dynamics. Shipbuilders, particularly Mazagon and GRSE, are also expected to see stronger order book growth. These inflows are crucial to justifying current valuations and providing long-term revenue visibility. However, execution remains key. The article concludes that while the long-term prospects for the defence sector remain promising, stretched valuations leave little room for error. To sustain the rally, order inflows and execution must accelerate.
Source: Defence stocks are soaring again, but can fundamentals support the rally?