Defence Stocks may Not Yet be a Formidable Bet

ET Intelligence Group

Technological complexities, lack of strong private sector presence plague the sector; building a self-reliant defence ecosystem with export capabilities is an uphill task

Stocks of companies that cater to the domestic defence sector have rallied notwithstanding the volatility in the broader market. Investors have been chasing a rather simple story: New Delhi’s plan to increase indigenization in defence procurement. While a thrust on developing domestic defence capabilities is a welcome move, investors must make a mental note that such a story could take a long time to play out. Stocks like Astra Microwave Products, Bharat Electronics, Dynamatic Technologies, BEML, Precision Electronics, Rolta India, Walchandnagar Industries, and Zen Technologies have gained between 30% and 200% in the past six months as against 9% increase in the S&P BSE Sensex.Each of these companies has defence as a focus area. Industry ex perts ET spoke to said building a self-reliant defence ecosystem with export capabilities would be an uphill task. There are multiple hurdles: increasing technological complexities due to fast-evolving combat strategies, a lack of strong private sector presence in defence R&D, limited scope to expand defence budget, absence of a clearer strategy on ownership and control of defence companies, and an inverted duty structure that makes defence imports cheaper than local procurement.

The government’s latest decision to purchase 36 completely built Rafale fighter planes from France reflects the predicament.

The earlier tender that was floated in 2007 for 126 planes required the successful vendor to produce 108 aircraft in India with the help of Hindustan Aeronautics. On Friday, the government struck a new deal to buy planes that are ready to fly. This may appear as a step that downplays the `Make in India’ push.

IMPORT DEPENDENCE

India imports over two-third of its defence requirements, thanks to the absence of a well-developed local manufacturing base. “Traditionally, we have been dependent on defence imports largely from Russia. Therefore, we didn’t have a major defence manufacturing base other than the defence PSUs (public sector undertakings). Also, the volume of orders other than bilateral orders in most categories was not feasible for multinational players to set up plants in India,“ said Kumar Kandaswamy, senior director, Deloitte Touche Tohmastu (India).

Thus, there is a lack of defence manufacturing infrastructure in terms of broad-based R&D, skilled high-end component makers, and large systems integrators -which form the backbone of the defence ecosystem. The data from the department of industrial policy & promotion shows that while the proportion of value of investment intentions in the defence sector improved over the past five years -from 0.3% of total intended investment of `. 17.4 lakh crore across sectors in CY 2010 -it was still under 1% of the total intended investment of . 75,509 crore in Feb` ruary 2015. Compare this with the share of other sectors: chemicals (2.8%), textiles (3.5%), metallurgy (4.1%), and electrical equipment (17.4%).

“The defence sector is technologically complex and India doesn’t have the re quired ecosystem in terms of wellbuilt supply chains comprising OEMs and suppliers,“ said Dhiraj Mathur, partner and leader, national aerospace and defence practice, PWC.

LOW ON CAPEX

A paltry capital expenditure on defence is another factor that has limited India’s ability to develop a locally viable manufacturing base.India’s current defence budget is at $40 billion or 1.8% of its total annual economic output measured in terms of GDP. Of this, nearly 60% is spent on covering expenses of the armed forces and the balance of just over $15 billion is spent on buying and maintaining equipment and technology.

“The 14th Finance Commission has significantly enhanced the share of states in the net proceeds of the shareable central taxes from 32% to 42%. This limits the fiscal width that the central government has for defence expenditure,“ said Amber Dubey, partner and India head of aerospace and defence at global consultancy KPMG.

This underscores the need to achieve and pre achieve and preserve a higher economic growth rate. “Indian economy needs to grow at 8-10% per annum to be able to put more money for defence equipment. The defence budget needs to be gradually scaled gradually scaled up to 2.5% of GDP,“ said Dubey. According to Dubey, while China, too, spends an estimated 2% of the GDP on defence, the absolute defence outgo works out to be an estimated $130-190 billion, given its four times larger economy.

NEED FOR INTEGRATED EFFORTS

At present, India sources its requirement from multinational vendors from Russia, Switzerland, France, Israel, and the US. “These big weapon merchants who are used to selling to India over so many years would not like to lose their pie of business. Given the strong lobby, we will take any where between five to 15 years to increase indigenisation,“ said Maroof Raza, a leading defence consultant. Raza pointed out that in order to establish local manufacturing base, the armed forces need to plan for the future. “Armed services do not buy for the long-term.There is no joint planning; and there is a lot of overlap. Also, except for navy, air force and army do not have an integrated design and concepts team,“ he said. China, however, has a sharp focus on gradually developing the defence ecosystem. “Since mid `90s, China has consciously reduced its number of personnel by a whopping 1.7 million and reallocated the savings to strengthen its aerial, naval, cyber and satellite warfare capabilities,“ said KPMG’s Dubey.

PUSH FOR R&D

Lack of broad-based indigenous R&D is another area of concern.“At present onus of R&D is primarily on the government-run Defence Research and Development Organisation (DRDO) with limited inputs coming from the private sector. Small-cap domestic companies are primarily into component manufacturing, yielding muted margins. They need to move up the value chain which can also be achieved through tie-ups with international players,“ said Sandeep Upadhyay, senior VP, infrastructure solutions group, Centrum Capital.

 Source: The Economic Times