Capital Goods. Defence: Emerging from the junkyard. August Analysts: Tanuj Mukhija, CFA Tel:

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1 Capital Goods August 2014 Defence: Analysts: Tanuj Mukhija, CFA Tel: Nitin Bhasin Tel: Emerging from the junkyard

2 Defence CONTENTS SECTOR Defence: Emerging from the junkyard.. 3 Overview of India s defence industrial base 4 Technology: The Achilles heel 7 Private sector defence manufacturing base: Insignificant and ignored..9 Key learnings from defence experts and Turkey 11 Recommendations for success of FDI hike. 15 The way forward: JVs between domestic companies and global majors. 17 US$106bn opportunity over FY Capacity constraint at defence PSU shipyards.. 22 Key defence component companies 26 Relative valuation.30 Appendix I: List of critical technologies 31 Appendix II: Acquisition plans of armed forces. 32 COMPANIES Bharat Electronics: Efficient leader in an evolving market (BUY).. 35 L&T: Beneficiary but gains not substantial (SELL).. 57 Tata Group: The diversified leader. 59 Pipavav Defence: Growth certain but profitability? (Not Rated)...61 August 12, 2014 Ambit Capital Pvt. Ltd. Page 2

3 Capital Goods POSITIVE THEMATIC DEFENCE August 12, 2014 Emerging from the junkyard India s large yet incompetent defence PSU (DPSU) manufacturing base is hobbled by poor technology and complex procurement processes. The new Government addressed a few issues by: (a) ending the DPSU monopoly (AVRO project); (b) hiking the FDI limit to 49%; and (c) streamlining the licensing process. Companies with technical capability, manufacturing base and financial strength are best placed to form JVs with global majors and capitalise on the US$106bn opportunity over FY We prefer Bharat Electronics (BUY), a relatively efficient DPSU with rising focus on technology and superior manufacturing base. L&T (SELL) will benefit from capacity constraints at DPSU shipyards, but defence forms only ~1% of its revenues. New Government s initiatives to promote efficient companies Whilst India has the ninth-largest defence budget in the world and a large DPSU industrial base, India is the world s largest importer of defence equipment. The current state of affairs of the armed forces emerges from low private sector participation due to the default preference for technologically inept defence PSUs. Taking cognizance of these issues, the new Government put an end to the monopoly of DPSUs, increased the FDI limit to 49% and streamlined the defence licensing process. The way forward: JVs between domestic companies and global majors The new Government s initiatives not only promote JVs between domestic companies and global majors but also promote transfer of technology (the 56 aircraft AVRO project tender). In order to build India s manufacturing base, the Government should modify the offset policy and simplify the procurement process. Clearance of US$20bn projects awaiting final approval is the key driver for 15% defence capital budget CAGR over FY Potential winners: BEL, Astra Microwave; defence too small for L&T Amongst component manufacturers, the key beneficiaries would be BEL and Astra Microwave, i.e. companies with technology capability, manufacturing base and financial strength. L&T Shipbuilding and Pipavav Defence would benefit from the capacity constraints of defence PSU shipyards. Defence accounts for less than 1% of L&T s revenues, may not be more than 5% of revenues by FY19. Initiate coverage on BEL with BUY stance, TP of `2,082/share Unlike other inefficient DPSUs, BEL increased its focus on technology through higher R&D expense (24% CAGR in FY07-13), a 33% cut in non-r&d employees in FY07-13, and technology collaborations. BEL will retain its leadership in the fast-growing defence electronic industry. Execution of the Akash missile project would lead to higher revenues and EBITDA margins in FY Competitive mapping of defence companies Companies BEL Astra Microwave L&T Pipavav Defence Dynamatic Technologies BEML Bharat Forge Share of defence revenues Source: Company, Ambit Capital research Manufacturing Capability Financial Strength Legal/Corruption allegations Note: - Strong; - Relatively Strong; - Average; - Relatively weak. Total Key Recommendations Bharat Electronics BUY Target Price: `2,082 Upside : 19% L&T SELL Target Price: `1,367 Downside : 7% Tata Group Target Price: N.A. Pipavav Defence Target Price: N.A. N.A. Upside: N.A. NOT RATED Upside: N.A. Defence plays BEL, Astra Microwave FY14 RoE BEL Dynamatic Source: Bloomberg, Ambit Capital research; Note: Size of the bubble denotes gross block in the defence sector Analyst Details Astra Microw ave BEML Tanuj Mukhija, CFA tanujmukhija@ambitcapital.com Nitin Bhasin nitinbhasin@ambitcapital.com L&T Pipavav FY16 P/E Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

4 Capital Goods Overview of India s defence industrial base India has the ninth-largest defence budget in the world, and it is the largest importer of defence equipment. India s defence manufacturing sector was dominated by the public sector and the private sector was ignored for decades. Further, the inefficient defence PSUs have limited manufacturing and technology capability, leading to project delays and outdated defence equipment. The NDA Government, during its brief two-month tenure, has asserted that it would strengthen India s defence preparedness by modernising the armed forces and addressing the shortage of manpower on priority. Mr Pranab Mukherjee, the President of India, addressed both the Houses of Parliament and laid out the agenda of the NDA Government in the defence sector. He said, We will introduce policies to strengthen technology transfer, through liberalised FDI in defence production. The NDA Government has promised to carry out reforms that will increase efficiency in defence procurement and encourage the domestic sector, especially the private sector. In this report, we have discussed: (a) the defence equipment opportunity size, (b) key policy issues that could be resolved by the Government, and (c) the key beneficiaries of the annual defence capital expenditure budget of `940bn. India: Ninth-largest defence budget yet the highest importer India s CY13 annual defence budget of US$47bn was the ninth largest in the world. The United States accounted for 36.6% of the world s defence spending in CY13 and India s neighbour, China, had the second-largest CY13 defence budget of US$188bn, 4x of India s budget. The Middle East countries such as Saudi Arabia and the UAE had the highest defence to GDP ratio of 9.3x and 4.7x respectively in CY13. Exhibit 1: Whilst India is ranked ninth on CY13 defence expenditure.. Country Spending (US$bn) YoY growth (%) % of GDP World share (%) United States % China % Russia % Saudi Arabia % France % United Kingdom % Germany % Japan % India % South Korea % Italy % Brazil % Australia % Turkey % United Arab Emirates % Source: Stockholm International Peace Research Institute, 2013; Note: Based on trend indicator value. YoY growth is based on local currency YoY growth India is the largest importer of defence equipment in the world, according to the Stockholm International Peace Research Institute (SIPRI). Whilst India accounted for 2.7% of total defence spending, India accounted for 22% of total global defence imports. India s share of imports has consistently increased over CY05-13, highlighting that India has weak capabilities in indigenous defence equipment manufacturing. The government would strengthen its defence preparedness by modernising our Armed Forces. Mr Pranab Mukherjee, President of India India accounted for 22% of total global defence imports in CY13 August 12, 2014 Ambit Capital Pvt. Ltd. Page 4

5 Capital Goods Exhibit 2: India is the world s largest importer of defence equipment Country Value of imports (US$ bn) World share of total imports (%) CY11 CY12 CY CY11 CY12 CY India 3,566 4,524 5,581 25, % 15.7% 21.8% 11.0% China 1,020 1,631 1,534 16, % 5.6% 6.0% 7.2% UAE 1,213 1,154 2,245 11, % 4.0% 8.8% 5.0% South Korea 1,469 1, , % 3.6% 0.7% 4.6% Pakistan 1, ,002 8, % 3.3% 3.9% 3.9% United States 1,014 1, , % 4.2% 3.0% 3.5% Australia 1, , % 3.1% 1.2% 3.2% Turkey 642 1, , % 5.3% 2.4% 3.0% Algeria 1, , % 3.0% 1.3% 2.9% Singapore , % 2.9% 0.6% 2.9% Source: Stockholm International Peace Research Institute, 2013 Note: Based on trend indicator value, constant 1991 prices Overview of India s defence sector India s total defence expenditure can be split into revenue expenditure and capital expenditure. The revenue expenditure includes pay and allowance, transportations, revenue stores and revenue works. Capital expenditure includes expenses on land, construction works, aircraft and aero engines, heavy and medium vehicles, naval fleet, and naval dockyards. The share of revenue expenditure has declined from 75% in FY01 to 57% in FY14. Capital expenditure reported 17.8% CAGR over FY India has one of the largest defence industrial complexes, consisting of 9 defence PSUs and 39 ordnance factories. Exhibit 3: Increasing importance of capital expenditure in India s defence budget India has one of the largest defence industrial complexes consisting of 9 defence PSUs and 39 ordnance factories 2,500 2,000 1, % 50% 1, % -50% FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 Capital Expenditure (Rs bn) Revenue Expenditure (Rs bn) Revenue Expenditure (YoY growth, RHS) Capital Expenditure (YoY growth, RHS) Source: Ambit Capital research, Defence series estimates Ordnance factories primarily service the army The Ordnance Factories Organisation is the largest defence production enterprise in India. It is under the administrative control of the Department of Defence Production, Ministry of Defence. The ordnance factories were set-up to produce and supply arms, ammunition, armoured vehicles, etc., to the Indian armed forces. India has 39 ordnance factories that can be divided into five categories: Ammunition and explosives 10 factories Weapons, vehicles and equipments 10 factories Materials and components 9 factories Armoured vehicles 5 factories Ordnance equipment group of factories 5 factories August 12, 2014 Ambit Capital Pvt. Ltd. Page 5

6 Capital Goods The Indian armed forces fix their annual requirement for arms and ammunitions. The requirement of the Indian armed forces forms the target production for the ordnance factories. A report by the Comptroller and Auditor General of India (CAG) highlighted that these ordnance factories do not have the capability to meet the demands of the Indian armed forces. Further, these ordnance factories did not meet the targets set in FY Exhibit 4: Ordnance factories have failed to meet targets (` bn) Year Number of items Number of items Number of items Number of items for which target for which for which target manufactured as was not demand existed was fixed per target achieved Percentage shortfall with reference to target fixed (%) Source: Comptroller and Auditor General of India s report on the army and ordnance factories The ordnance factories were designated to operate at a utilisation rate of more than 80%. However, their utilisation was ~73% in FY Thus, supply constraint is not the key issue for the underperformance of the ordnance factories; in our opinion, the key constraints are: (a) lack of technology capability, (b) slow decision-making process, and (c) low coordination between the armed forces and the ordnance factories. In addition, the ordnance factories mainly cater to the requirements of the Indian Army, as the Army accounts for 82% of the sales of ordnance factories. A report by the Comptroller and Auditor General of India (CAG) highlights that these ordnance factories do not have the capability to meet the demands of the Indian armed forces Exhibit 5: Ordnance factories mainly cater to the Army MES, R&D and other, 1% Air Force, 2% Navy, 1% Civil Trade & Export, 14% Army, 82% Source: CAG report on the Army and ordnance factories, 2012 Exhibit 6: Despite high demand, the utilisation rate of ordnance factories remains low Year Machine hours available Machine hours utilised Percentage of capacity utilisation ,472 1, ,351 1, ,696 1, ,839 1, ,830 1, Total 8,188 6, Source: CAG report on the Army and ordnance factories, 2012 August 12, 2014 Ambit Capital Pvt. Ltd. Page 6

7 Capital Goods Technology: The Achilles heel India identified the need to reduce defence imports and increase indigenous manufacturing in Hence, India formed a self-reliance review committee to formulate a ten-year self-reliance plan. Despite India s strong defence PSU industrial / manufacturing base, its dependency on imports consistently increased due to: (a) focus on co-production without technology transfer and (b) lack of focus on R&D. The Indian defence manufacturing policy aimed to increase self-reliance through indigenous production from 40% in FY04 to 70% in FY13. Hence, India increased procurement from domestic supplies (defence PSUs and ordnance factories) from 44.5% in FY01 to 67% as on FY11. The defence PSUs and ordnance factories did not have the capability to indigenously design and manufacture products to meet the high standard of qualification requirements. Hence, the import content increased to ~70%, as these domestic suppliers imported equipments from foreign manufacturers. The Indian Government owned domestic suppliers have not been able to keep pace with the global development in arms technology, as the R&D expense of Indian defence PSUs has historically been low as compared to the R&D expense of defence global majors. The private sector participation has been insignificant due to strong preference for defence PSUs and delays caused by complex procurement policies. Exhibit 7: R&D budget of defence PSUs Sales (US$mn) R&D (US$mn) R&D as % of sales Hindustan Aeronautics Ltd (HAL) 2, % Mishra Dhatu Nigam Ltd % BEML % Bharat Dynamics Ltd % Bharat Electronics Ltd 1, % Hindustan Shipyard Ltd Goa Shipyard Ltd Garden Reach Shipbuilders & Engineers Ltd % Mazagon Dock Ltd Ordnance Factories 2, % Source: Company, Ambit Capital research Exhibit 8: R&D expense of global defence companies (US$mn) Name of the company R&D Expense R&D Expense as % of sales CY04 CY08 CY13 CY04 CY08 CY13 Boeing Co/The 1,879 3,768 3, % 6.2% 3.5% Airbus Group NV 2,645 3,926 4, % 6.2% 5.3% Lockheed Martin Corp 962 1, % 2.9% 1.5% BAE Systems Plc 2,035 1,933 1, % 6.3% 6.2% Northrop Grumman Corp % 1.7% 2.1% Raytheon Company % 2.2% 2.0% Finmeccanica Spa 1,718 2,661 2, % 12.0% 11.4% Thales SA % 3.5% 4.7% Rockwell Collins Inc % 18.8% 16.8% B/E Aerospace Inc % 6.2% 6.3% Cobham Plc % 4.8% 4.9% Meggitt Plc % 3.1% 2.5% ITT Corp % 2.1% 2.7% Cae Inc % 5.5% 3.0% Ultra Electronics Hldgs Plc % 6.2% 5.0% Source: Bloomberg The import content increased to ~70%, as these domestic suppliers imported equipments from foreign manufacturers. August 12, 2014 Ambit Capital Pvt. Ltd. Page 7

8 Capital Goods As a result of the low R&D expenditure, the Indian defence industry does not have significant patents. US private companies have high R&D expense, which has resulted in the highest number of patents for these companies. Thus, it is no surprise that the US is the largest defence equipment exporter in the world, accounting for 30% of global exports. Exhibit 9: Number of patents held by DPSU/OF as on CY13 Number of patents Hindustan Aeronautics Ltd (HAL) 6 Mishra Dhatu Nigam Ltd 5 BEML 3 Bharat Dynamics Ltd 2 Bharat Electronics Ltd 6 Hindustan Shipyard Ltd 0 Goa Shipyard Ltd 0 Garden Reach Shipbuilders & Engineers Ltd 0 Mazagon Dock Ltd 0 Ordnance Factories 1 Total 23 Source: Company, Ambit Capital research Exhibit 10: Patents held by global defence majors as on CY year average Boeing (US) Lockheed Martin (US) EADS (Europe) Raytheon (US) General Electric (US) United Technologies (US) Safran (France) Honeywell (US) Northrop Grumman (US) Rockwell Collins (US) Source: Company, Ambit Capital research August 12, 2014 Ambit Capital Pvt. Ltd. Page 8

9 Capital Goods Private sector defence manufacturing base: Insignificant and ignored Defence procurement was restricted to government-controlled entities postindependence until In 2001, the Government allowed 100% domestic private participation and 26% FDI for foreign companies. Since 2001, the Government has taken several steps to encourage private sector participation such as creation of the offset policy and consistent modifications in the procurement process. However, private sector contribution to defence capital expenditure is below 5% due to several bottlenecks. The low share of the private sector is not due to lack of interest of private players, which is supported by the 116 licences awarded to private companies for defence production. In our opinion, the key reasons for the lack of participation of private players in priority orders are: Default preference for defence PSUs especially for large orders: Before deciding the mode of procurement, the qualification requirements are sent to the Department of Defence Production (DDP) of the Ministry of Defence (MoD) for their views and comments. The defence PSUs and ordnance factories give suggestions to the DDP which favour the interest of defence PSUs. As a result, major orders are awarded to defence PSUs and very few orders are awarded to the private sector. Complex procurement process leading to delays in awarding the project: The procurement process for project sizes of more than `3bn has 11 stages, including three stages of review by multi-disciplinary committees such as the technical evaluation committee, technical oversight committee and contract negotiation committee. For example, the Indian armed forces had requested for a medium multi-role combat aircraft (MMRCA) in The Government began the tendering process for MMRCA in 2007 but the final order has not yet been awarded. The delay in awarding the project led to a 100% cost escalation from `900bn to `1,860bn. Foreign exchange rate variation (FERV) pass-through for defence PSUs but not for private companies: The average import content of India s defence procurement is ~70% and higher than 80% for large projects. Thus, the volatility in the INR/USD exchange rate can lead to significant volatility in profits. The defence PSUs are compensated for foreign exchange rate variations whereas private players have to bear the risk of INR/USD volatility. Lack of order intake visibility for private sector: The Government is the only buyer of defence equipment in India. The Ministry of Defence does not share its long-term procurement plans with the private sector. Thus, the private sector players do not have adequate time to form JVs with foreign players or build manufacturing facilities. Hence, the private sector has been hesitant in making large investments in defence manufacturing facilities. Expensive no cost no commitment trials : Private players have to conduct three trials in three different locations during the bidding of a large project on a no cost no commitment basis. The millions of US dollars required for these trial runs is a hindrance for several private sector players. Indirect tax anomaly results in higher taxes for private sector vs defence PSUs: The vendors of defence PSUs are exempted from customs and excise duty. Private sector integrators are uncompetitive, as their vendors have to pay both customs and excise duty. The private sector s contribution to defence capital expenditure is below 5% due to several bottlenecks The defence PSUs and ordnance factories give suggestions to the DDP which favour the interest of defence PSUs. Defence PSU are compensated for foreign exchange rate variation whereas the private players have to bear the risk of INR/USD volatility The Ministry of Defence does not share its long-term procurement plans with the private sector The millions of US dollars required for these trial runs is a hindrance for several private sector players August 12, 2014 Ambit Capital Pvt. Ltd. Page 9

10 Capital Goods Why have foreign OEMs not set-up manufacturing facilities in India? In addition to the problems for domestic manufacturing companies, foreign companies also have restrictions on FDI. The Indian Government allowed 26% FDI in defence in We believe that the FDI limit was not a constraint for foreign OEMs in their consideration to set-up manufacturing facilities in India; the erstwhile UPA-II Government had allowed FDI above 26% on a case-to-case basis to be approved by the Cabinet Committee of Security (CCS). However, there have been no applications for 100% FDI by foreign original equipment manufacturers (OEMs). The total FDI inflows into the defence sector have been a meagre US$5mn since 2001 (0.002% of total FDI since 2001). Foreign companies have little incentive to set-up manufacturing facilities in India as long as the Indian Government does not make domestic manufacturing mandatory. According to media articles and industry participants, several vested interests such as middlemen benefit from import of defence equipment. These vested interests have prevented the entry of foreign manufacturers, which would be willing to consider India as a low-cost manufacturing location. The FDI limit was not a constraint for foreign OEMs to set-up manufacturing facilities in India, as the erstwhile UPA-II Government had allowed FDI above 26% on a case-to-case basis Foreign companies have little incentive to set-up manufacturing facilities in India as long as the Indian Government does not make domestic manufacturing mandatory August 12, 2014 Ambit Capital Pvt. Ltd. Page 10

11 Capital Goods Key learnings from defence experts and Turkey In the previous section, we highlighted the key issues that have led to the limited indigenous manufacturing base and consistent rise in the share of imports in defence equipment procurement. We studied several international markets that have successfully reduced their share of imports and increased their share of exports such as Turkey and Israel. We also met several defence industry stakeholders such as defence experts with the Indian Government, independent consultants, private companies and foreign global majors. Based on our discussions with industry participants and Turkey s success, we recommend that an indigenous defence manufacturing base needs to be setup in India. What can we learn from Turkey? Four countries successfully reduced the percentage of defence imports and increased the share of exports South Korea, Israel, Turkey and South Africa. South Korea and Israel are developed countries with advanced industrial manufacturing capabilities. We believe that Turkey s industrial manufacturing base and defence budget until 2000 are comparable to India s. Whilst India s share of imports has increased, Turkey has successfully reduced its share of imports. Exhibit 11: Defence budget of Turkey and India 50,000 40,000 30,000 20,000 10, Turkey (US$mn) India (US$mn) Source: Stockholm Institute of Peace Research, Note: The defence budgets of India and Turkey are based on constant 2010 prices Prior to the 1980s, Turkey had not emphasised on indigenous production of defence equipment. It had an off-the-shelf procurement policy, leading to a high share of imports. However, the game-changer for the Turkish defence manufacturing industry was the formulation of a defence offset policy. The Government established the Undersecretariat for the Defence Industry (UDI) in 1985, an agency to make decisions about the defence tenders and manage offset implementations. The UDI was funded through Central tax revenues 10% of taxes on fuel, 5% of individual and corporate income taxes and 5% of taxes on alcohol and tobacco. The main functions of the UDI were: To manage and coordinate offset implementations for Turkish defence procurements To direct R&D activities for armoured vehicles, arms and ammunition To encourage investments in the defence industry by private, public and mixed investments To coordinate the subjects of the export of defence industry products and offset trade The game-changer for the Turkish defence manufacturing industry was the formulation of a defence offset policy August 12, 2014 Ambit Capital Pvt. Ltd. Page 11

12 Capital Goods The Turkish defence industry was developed through an effective offset policy in three phases from The offset policy in the first phase ( ) did not achieve the objective of reducing imports. The offset policy in the second phase ( ) encouraged defence equipment manufacturing in Turkey through mandatory direct defence offsets. The offset policy in the third phase (2007-current) was formulated to increase the competitive advantage of domestic manufacturing companies. Exhibit 12: Evolution of Turkish defence industry The offset policy in the second phase ( ) encouraged defence equipment manufacturing in Turkey through mandatory direct defence offsets Phase 1 offset policy: a tool of financing Phase 2 offset policy objective: to build manufacturing base Phase 3 offset policy: to promote domestic companies Imports (USDmn) Exports (USDmn, RHS) Source: Stockholm Industrial Peace Research Institute (SIPRI); *Note: The imports and exports of the Turkish defence industry are based on USD 1990 constant prices Phase : Tool of financing Turkey did not have an official offset policy until The country formulated an official offset policy in 1991 which allowed indirect offsets. Thus, most offsets were indirect offsets, as Turkey did not have a manufacturing base. Phase : To develop the national defence industry base The offset policy was modified in 2000 to increase the focus on direct offsets. In addition, the UDI introduced offset credits to strengthen the national defence industry base. The offset credit system was updated to include offset multipliers for high importance categories. The first priority of these new offset guidelines was to promote exports. Phase current: To increase the competitive advantage of Turkish domestic industry The offset multipliers and categorisation of industries were modified to increase the competitive advantages of Turkish manufacturing companies. For example, higher offset multipliers for export-focussed SMEs and foreign companies with an offset obligation in Turkey were allowed to exchange the offset obligation with a Turkish company that had an offset obligation in that foreign country. Learnings for India from Turkey We believe India can adopt the offset policies formulated by Turkey in phase two and three (to set-up a manufacturing base in Turkey). In our opinion, the first step for indigenous manufacturing is to promote foreign companies to set-up a manufacturing base in India through a partnership with domestic manufacturers. As highlighted above, the foreign vendor with the core technology should be allowed a majority stake in the domestic manufacturing facility. After India has developed a manufacturing base then the next step is to modify the offset policy to increase the competitive advantage of domestic manufacturing companies. The first step for indigenous manufacturing is to promote foreign companies to set-up a manufacturing base in India through a partnership August 12, 2014 Ambit Capital Pvt. Ltd. Page 12

13 Capital Goods Interview with Dr Deba Mohanty Mr Deba Mohanty is a former member of the FICCI Defence Committee. During his 20 years of experience, Mr Mohanty has written more than 40 research publications in the field of defence and strategic studies. The total size of the opportunity for private sector manufacturers could be US$2bn in the next 3-5 years. What are the key issues in the defence sector manufacturing? The key issues in India s defence sector are: (a) strong preference for defence PSUs, (b) complex procurement process, leading to time delays, and (c) lack of synergy between the stakeholders such as the armed forces, civil bureaucracy, government production agencies, private sector and the Defence Research & Development Organisation (DRDO). All projects that qualify for application of "Offsets Obligations" over tender value of `3bn would require a 'nominator', which goes to a relevant DPSU. Hence, most of the projects go to DPSUs as nominators / facilitators, leaving little for the private sector. The procurement process for project sizes of more than `3bn has 11 stages, including three stages of review by multi-disciplinary committees such as the technical evaluation committee, technical oversight committee and contract negotiation committee. What are the policy changes the government will do in the next 6 months? I expect the Government to simplify the procurement process, modify the offset policies, and significantly reduce the preference for defence PSUs in the next 6-12 months. Why do you think the current Government s attitude will change as compared to UPA II towards the private sector and why will it increase expenditure given that India has a high fiscal deficit? The NDA Government understands that the armed forces were neglected and national security is of utmost importance. The NDA Government in 2001 had liberalised the defence procurement policies by allowing FDI in defence and 100% private sector participation. Mr Arun Jaitley, the Defence Minister, approved the appointment of the Army Chief within 48 hours and made a promise more procurement, faster procurement. India is the highest importer and it can leverage its bargaining power for transfer of technology. What is your view on increase in the FDI limit to 49%? I was expecting that the Government will increase the FDI limit to 74% in nonstrategic and semi-strategic projects and 100% in strategic projects. Whilst 49% FDI is a disappointment, the Government may increase the FDI to 74% after a year if the 49% FDI hike does not yield results. The global defence majors will not share critical technology if they are minority shareholders. Do you think India can indigenously manufacture aircrafts and helicopters? The short answer is not in the next 10 years. The product development lifecycle of a fighter aircraft is years. Without technology transfer, it is very difficult for India to manufacture high-end fighter aircrafts. I think India should start with manufacturing low-technology products and then scale up through mandatory technology transfer. So, what is the opportunity for domestic private players in the next 3-5 years? The total annual capex defence budget is ~US$18bn, in which the share of the private sector is less than 2%. During the next 3-5 years, the total size of opportunities for the Indian private sector could be to the tune of US$3 billion in realistic terms. The domestic players have the capability to provide small components for defence projects. The most likely private sector beneficiaries could be L&T, Pipavav Defence, Tata Group, M&M, Godrej Industries, Dynamatic Technologies and Bharat Forge. Further, the competitive advantages of defence PSUs would be reduced if the projects were awarded based on a competitive bidding process. Mr Deba Mohanty, a former member of the FICCI Defence Committee, has more than 20 years of experience in the defence sector; Mr Mohanty has written more than 40 research publications in the field of defence and strategic studies August 12, 2014 Ambit Capital Pvt. Ltd. Page 13

14 Capital Goods Interview with Dr Laxman Behera, IDSA Dr Laxman Behera, a noted defence expert, working for a leading defence think-tank, highlighted that NDA government s revision of defence FDI policy would foster partnership between foreign OEMs and Indian companies. Lack of technology, a key issue for domestic companies, should be addressed by the new offset policy with a higher emphasis on transfer of technology. The new defence capital acquisition opportunity could be US$20bn over the next three years, leading to a US$6bn offset opportunity for domestic manufacturers. Do you think an increase in the FDI limit to 49% would help in setting up manufacturing capacities in India? The 49% FDI in defence could be successful, as the Government has made the Buy (Indian), Buy and Make (Indian) and Make category of procurement as the default choice for defence equipment procurement. As a result, foreign OEMs will have no option but to form JVs with Indian companies to participate in the fast-growing Indian defence industry. What is the key constraint for domestic defence equipment manufacturers? In terms of overall technology, India is way behind the advanced countries, particularly the USA, the UK, France, Russia and Israel. In contrast to these countries which spend over 10% of their defence budget on R&D India s total defence R&D spend amounts to only 6%. India s offset policy has also so far failed to attack technology, as the policy itself had no provision to compel the foreign OEMs to transfer technology to India. Although the first ever Defence Production Policy issued in January 2011 has declared its intentions to proactively engage the private sector, the statement is not backed by ground realities. What are the policy changes that the NDA Government will implement? The NDA government seems very much to be committed to indigenisation and selfreliance. I think the government will not hesitate to award a host of big ticket projects to Indian industry under the Make and Buy and Make (Indian) category. Soon, we may also see a simplified version of Make procedure to help facilitate Indian industry s participation in big projects. The offset policy, which was last revised in 2011, is also likely to be revised to focus on transfer of technology to the Indian industry. The capital acquisition budget is likely to increase at 15% YoY for the next 5-7 years. Do you believe the Government will give clearance to the MMRCA project? The Government should in all probability award the MMRCA contract in the next 6-12 months. India s air force combat squadron number has already decreased from the authorised level of 42 to 34 due to the phasing out of the MiGs. If the Government further delays procurement then the combat fleet could further reduce to an unacceptable level What is the offset opportunity for Indian manufacturers and who are the key beneficiaries? Projects worth US$20bn are awaiting final clearance from the Ministry of Defence. The project pipeline indicates that 75% of the capital expenditure would be incurred by the Indian Air Force. The key projects in the Air Force awaiting clearance are US$12bn MMRCA aircrafts, US$1.1bn Boeing Apache helicopters and US$1.2bn Airbus 330 tankers. India has signed offsets worth $4.8bn since the introduction of the offset policy, of which nearly half are to be discharged. The offset opportunity from the contracts in the pipeline could be ~Rs500bn over the next 3-5 years. Most of this offset opportunity would be in the aerospace components and avionics sector. Thus, the key beneficiaries would be companies with proven capability such as BEL, Tata Advanced Systems, Tata Power SED, Astra Microwave and Dynamatic Technologies. Dr Laxman Kumar Behera is a Research Fellow at the Institute for Defence Studies and Analyses (IDSA), a premier think-tank under India's Ministry of Defence; he has written a monograph, Indian Defence Industry: Issues in self-reliance August 12, 2014 Ambit Capital Pvt. Ltd. Page 14

15 Capital Goods Recommendations for success of FDI hike The Indian Government allowed 26% FDI in defence in 2001 but total FDI inflows into the defence sector have been a meagre US$5mn since 2001 (0.002% of total FDI since 2001). We believe that the increase in the FDI limit to 49% would be successful, as the Government has mandated foreign JVs to set-up manufacturing facilities in India and transfer technology to the JV partner (as demonstrated in the tender of 56 AVRO aircrafts). FDI limit of 49% in defence: Protection for domestic companies The Government announced an increase in the FDI limit in defence from 26% to 49%, as suggested by the Department of Industrial Production and Policy (DIPP). We believe that the 49% limit on FDI is positive for large domestic private manufacturers, which would retain a majority share in the JV. Need for FDI in defence: A liberalised FDI policy would bring external finance and more importantly technology. The manufacturing of defence items in-house would lead to a technology spin-off besides generating additional employment. We believe FDI in defence is not detrimental to national security. An argument was put forth by trade unions associated with government-owned enterprises that higher FDI would impinge on national security. National security is better protected through domestic manufacturing than through imports for the complete system. Contrasting opinions of domestic and global defence manufacturers on FDI hike Domestic companies such as L&T and Tata Power prefer FDI in defence to be limited to 49% so that domestic manufacturers have a majority stake. So yes 26% to 49% maybe required if genuine technology transfer takes place. But beyond 49%, I do not think it is in national interest. Even in other advanced countries, beyond 49% in the defence sector perhaps is not allowed. stated Mr A.M. Naik, Managing Director, L&T. However, global defence technology leaders have suggested at least 50% FDI in defence as a mandate to make investments for setting up manufacturing capacity in India. "For higher-tech intellectual property we would want to go over 50% to be in a position to share technology that we have significant investments in. Uplift from 26% to 49% maintains the status quo and may not be sufficient incentive to make an investment here." according to Phil Shaw, Chief Executive of Lockheed Martin India. Pro-active policy changes required to encourage defence manufacturing in India A simple hike in FDI would not incentivise foreign manufacturers to form manufacturing JVs or set-up manufacturing plants in India. The Government needs to address administrative and bureaucratic policy changes to increase the ease of doing business for private companies in defence manufacturing. We have categorised the required changes as easy-to-implement changes and structural changes: Easy-to-implement changes Modify offset policy: The offset policy has not achieved its objectives to promote transfer of technology and manufacturing in India. The defence procurement policy of 2013 has mandated that 50% of the value of the project should be sourced from India in the Buy & Make (Indian) category. The number of projects awarded under the Buy & Make (Indian) category is very few, as Indian domestic players do not have the capability. The Government should reduce the 50% offset requirement. Streamline procurement process: As highlighted earlier, the procurement process has several multi-disciplinary committees with no accountability. The number of multi-disciplinary committees in the procurement process should be reduced and the projects should be awarded on-time. 49% FDI limit in defence: Protection for foreign companies So yes 26% to 49% maybe required, if genuine technology transfer takes place. But beyond 49%, I do not think it is in national interest. Mr A.M. Naik Managing Director, L&T August 12, 2014 Ambit Capital Pvt. Ltd. Page 15

16 Capital Goods Structural changes Our discussions with industry experts and the private sector highlighted that the biggest hurdle for private sector participation is the default preference for defence PSUs for large orders. The Kelkar Committee was formed in 2005 to suggest measures to facilitate the participation of the Indian industry in the defence procurement process. We believe that the Government should implement two key suggestions of the Kelkar Committee to create a level playing field for private manufacturing companies: Identify Raksha Udyog Ratna (RuR) from the private sector: The Government formed a committee under Prabir Sengupta to identify the Raksha Udyog Ratnas. In 2007, this committee submitted a list of 13 RU`: Tata Motors, Larsen and Toubro, Tata Power Company, Mahindra and Mahindra, Ashok Leyland, Tata Advance Materials, Kirloskar, HCL, Godrej and Boyce, Bharat Forge, Infosys Technologies, Wipro Technologies, and Tata Consultancy Services. However, the Government has delayed the identification of Ru` due to pressure from state-owned associates. We suggest the Government should identify Ru` and nurture them through industry support programmes. These RU` should be treated on par with the defence PSUs. Provide order intake visibility to these Ru`: Even if the defence PSUs do not have the technological capability to execute the project, they are given time to acquire capability. On the other hand, the private sector has to showcase execution capability at the time of bidding for the project. The private sector has not made significant investments in setting-up defence manufacturing capabilities. The Ministry of Defence should prepare a 15-year technology acquisition plan of the armed forces and share this plan with the private sector for order inflow visibility. Increase private participation in designing the qualitative requirement for projects: The private defence manufacturing industry is not considered during the designing of qualitative requirements. As a result, the qualitative requirements prepared by the service headquarters have unrealistic requirements vis-à-vis the capability of the domestic manufacturing companies (Source: CAG). Promote R&D in both public and private enterprises: As discussed earlier, one of the main reasons for India s high import dependency was the lack of focus on R&D. The Rama Rao Committee recommended the creation of a Board of Research for Advanced Defence Sciences (BRADS), similar to the highly acclaimed Defence Advanced Research Projects Agency (DARPA). BRADS was designed to meet the following objectives: promote post-doctoral scholarships, fund R&D institutes of higher excellence, promote innovation in SMEs and promote an intellectual property culture. It is difficult to mandate the private sector companies to increase their R&D expense. We suggest the Government can fund research through industry support programmes. For example, the Australian Government provided US$8.2mn to New Air Combat Capability, an industry support programme. The programme was launched to enable Australian companies and research organisations to support the development of the Joint Strike Fighter programme. The Ministry of Defence should prepare a 15-year technology acquisition plan of the armed forces and share this plan with the private sector for order inflow visibility August 12, 2014 Ambit Capital Pvt. Ltd. Page 16

17 Capital Goods The way forward: JVs between domestic companies and global majors We believe that the Government will continue to reduce the monopoly of inefficient DPSUs and promote efficient private sector companies with a proven track record. The NDA Government appears to have taken several positive steps to encourage the domestic private sector by: (a) putting an end to DPSU monopoly in aircraft production, (b) increasing the FDI limit to 49%, and (c) relaxing the licensing norms for defence equipment production. As a result of the procurement policy changes, we expect that foreign OEMs would form JVs with domestic manufacturers. The key beneficiaries would be L&T, Tata Group entities, Bharat Forge, Astra Microwave, Pipavav Defence, and Dynamatic Technologies, which have a proven track record. Key initiatives taken by the new Government to increase private participation One of the key issues highlighted by private sector participants was the delay in obtaining defence industrial licences due to approvals required from the Ministry of Commerce and Ministry of Defence. The Government announced measures on 26 June 2014 to streamline the defence licensing process. A defence licence is not required to manufacture items that are not used on the battleground. Further, a defence licence is not required for dual use items with military as well as civilian applications. An industrial licence would be required to manufacture tanks and other armoured fighting vehicles; defence aircraft, space aircraft and parts; warships of all kinds; and arms and ammunition and allied items of defence equipment, parts and accessories. The Government increased the FDI limit for automatic approval from 26% to 49%. Dr Laxman Behera, a defence expert, believes that 49% FDI in defence could be successful, as the Government has made the Buy (India) and Buy and Make (India) category of procurement as the default choice for defence equipment procurement. As a result, foreign OEMs will have to form JVs with Indian companies to participate in the fast-growing Indian defence industry. The Government barred HAL from participating in the manufacturing of 56 AVRO aircrafts, as HAL had failed to meet the delivery schedule of several projects. The tender for this `130bn contract mandates a foreign manufacturer to form a JV with an Indian manufacturer and establish a production facility in India. Eight global manufacturers have expressed interest in this tender including Russia's Illusion, Ukraine's Antonov, European Consortium EADS CASA (Airbus Industry Associate), Italian Alenia Aermachhi, and the Unites States' Boeing and Lockheed Martin. The Defence Acquisition Council plans to tender and purchase military equipment for projects worth `343bn in the next 12 months. In addition, the defence minister has asked for a detailed review of the defence PSUs to understand the reasons for their delays, pending projects and the tangible benefits of their dealings with foreign OEMs. The tender for the `130bn AVRO contract mandates a foreign manufacturer to form a JV with an Indian manufacturer and establish a production facility in India Technology collaborations The new Government s policies incentivise domestic companies to form JVs with foreign OEMs to build a manufacturing base in India. Thus, we expect JVs between domestic companies with investment ability and global defence manufacturing majors would be best placed to win defence projects. Several Indian companies have already formed several technology collaborations through Memorandum of Understanding (MoU) with leading domestic manufacturers. We expect domestic companies with existing relationships to have a first-mover advantage to form manufacturing JVs with domestic players. August 12, 2014 Ambit Capital Pvt. Ltd. Page 17

18 Capital Goods Exhibit 13: Defence technology collaborations between Indian and foreign companies Indian Company Foreign OEM Work Domain for technology collaboration Tata Group L&T Wipro Sirkorsky Aircraft Corporation Israel Aerospace Industries EADS Thales Boeing Lockheed Martin Boeing EADS Raytheon Pratt & Whitney Fincanteri Thales Cassidian BAE Systems Panhard General Defence Saab S-92 Helicopter Cabins Manufacture and defence products Advanced tactical communication systems Optronics solutions for multi-role combat aircraft, aerospace component work Aerospace components Aero-structures for Hercules helicopters P-8I reconnaissance planes, naval systems Manufacture high-end defence electronics Upgrade of T-72 tanks Aircraft engine components Fleet refueling tankers, naval systems High-end avionics software Electronic warfare, radars, avionics and mobile systems Commercial aerospace projects Mine protected vehicles, armored wheeled vehicles recovery vehicles, artillery and combat systems, bridge Mahindra Group Dynamatic Technologies BAE Systems Lockheed Martin UK Information System Telephonic Corporation Boeing Up-armored light vehicles, specialist military vehicles, mine protected vehicles, artillery systems Simulators Radars and Electronics Manufacturing Cabinets for housing critical equipment on Boeing's P-8I Aircraft Pipavav Defence Saab Naval combat system design and architecture Babcock Warships Bharat Forge Elbit Artillery and mortars systems solutions Reliance Industries Dassault Aviation Bharat Electronics Thales Defence and homeland security Sextant Avionics LCD systems for MiG 21 Multitone Electronics Sagem Systems Textron Systems Elbit Systems General Electric Company Oldelft Israel Aerospace Industries Source: Industry, Companies, Ambit Capital research Design, development, marketing, supply and support of civilian and select defence radars for Indian and Global markets To set up Integrated circuit design center Production and supply of navigational sensors, inertial navigation system MicroObserver Unattended Ground Sensor System Joint production of Compact Multi-Purpose Advance Stabilization System for naval helicopter applications Manufacture and supply of X-ray tubes Image intensifiers Long range Surface to Air Missile ship-defence systems August 12, 2014 Ambit Capital Pvt. Ltd. Page 18

19 US$106bn opportunity over FY14-19 India s defence capital expenditure reported 16% CAGR over FY The defence capital expenditure was led by 21% FY09-14 CAGR in the Indian Navy s capital expenditure and 19% FY09-14 CAGR in the Indian Air Force s capital expenditure. The Indian Army s capital expenditure reported 12% CAGR over FY09-14 and hence the share of the Indian Army declined over FY According to media reports, projects worth US$20bn are awaiting final clearance from the Ministry of Defence. We estimate that the total defence expenditure would be US$27bn in FY19. The project pipeline indicates that 75% of the capital expenditure would be incurred by the Indian Air Force. The key projects in the Air Force awaiting clearance are the US$12bn MMRCA aircraft, US$1.1bn Boeing Apache helicopters and US$1.2bn Airbus 330 tankers. Exhibit 14: India s defence capital expenditure to increase at 14% CAGR over FY14-19 (` bn) Capital Goods FY09 FY10 FY11 FY12 FY13 FY14 FY15E FY16E FY17E FY18E FY19E India's defence capital outlay ,088 1,245 1,427 1,637 YoY growth (%) 9% 25% 21% 9% 2% 25% 11% 13% 14% 15% 15% Of which Indian Army YoY growth (%) 51% 1% -7% 6% 15% 9% 9% 9% 9% 9% Indian Navy YoY growth (%) 43% 28% 13% -5% 33% 13% 13% 13% 14% 14% Indian Air-force YoY growth (%) 11% 27% 22% 5% 30% 10% 15% 17% 17% 17% Source: Ambit Capital research, Defence series estimates Exhibit 15: Major defence projects awaiting final clearance List of projects Air Force Medium Multi-role Combat Aircraft (MMRCA) 15 Boeing Chinook heavy-lift helicopters 22 Boeing Apache attack helicopters Value of the project (US$ mn) Value of projects (` bn) Identified foreign OEM 12, Dassault, France Boeing 1, Boeing Six Airbus A330 tankers 1, Airbus Total Air Force 15, Indian Navy Eight mine countermeasures ships 1, Kangnam, South Korea 98 Black Shark torpedoes Italy's WASS Total Indian Navy 1, Indian Army 197 light utility helicopters 1, Light Howitzer guns BAE Systems 1,418 thermal imaging sights for T-72 tanks Israel 262 Barak missiles 250 Israel Aerospace 15 Industries Total Indian Army 2, Total armed forces 19,033 1,148 Source: According to the acquisition plan of the Indian Army (for details, please see Appendix 2), the Army s spending would be focussed on artilleries, missiles and other equipments. The Army does not have a significant aircraft procurement plant except for the 197 light utility helicopter project which was delayed due to corruption allegations. August 12, 2014 Ambit Capital Pvt. Ltd. Page 19

20 Capital Goods Exhibit 16: Capital acquisition of the Army to report 9% CAGR over FY14-19 (` bn) Year FY09 FY10 FY11 FY12 FY13 (RE) FY14 (BE) FY15E FY16E FY17E FY18E FY19E Aircrafts and Aero Engines YoY growth (%) -77% -55% 2493% 48% -35% 8% 8% 8% 8% 8% Heavy and medium vehicles YoY growth (%) 14% 50% 19% -14% 3% 5% 5% 5% 5% 5% Other Equipments YoY growth (%) 71% -5% -28% 4% 35% 10% 10% 10% 10% 10% Total YoY growth (%) 51% 1% -7% 6% 15% 9% 9% 9% 9% 9% Source: Survey of Defence Estimates, Ambit Capital research. Note: RE = Revised Estimate and BE=Base Estimate As mentioned earlier, the Indian Air Force has planned to procure several multimedium aircrafts, helicopters and air tankers. Whilst these projects have been delayed since the last five years, industry experts believe that the projects would be awarded in the next three years. Exhibit 17: Capital acquisition of the Air Force to report 15% CAGR over FY14-19 (` bn) Year FY09 FY10 FY11 FY12 FY13 (RE) FY14 (BE) FY15E FY16E FY17E FY18E FY19E Aircraft & Aero Engines YoY growth (%) 7% 33% 26% 11% 13% 10% 15% 17% 17% 17% Heavy and medium vehicles YoY growth (%) -74% 13% 179% 3% -96% 10% 15% 17% 17% 17% Other Equip YoY growth (%) 24% 14% 12% -12% 94% 10% 15% 17% 17% 17% Total YoY growth (%) 11% 27% 22% 5% 30% 10% 15% 17% 17% 17% Source: Survey of Defence Estimates, Ambit Capital Research. Note: RE = Revised Estimate and BE=Base Estimate The Indian Navy s capital expenditure reported 21% CAGR over FY04-09, higher than the total defence capital expenditure. We estimate that the Indian Navy s capital expenditure would be broadly in line with the India s defence capital outlay. The key drivers of growth in the Navy s capital expenditure would be increase in naval fleet. Exhibit 18: Capital acquisition of the Indian Navy to report 13% CAGR over FY14-19 (` bn) Year FY09 FY10 FY11 FY12 FY13 (RE) FY14 (BE) FY15E FY16E FY17E FY18E FY19E Naval Fleet YoY growth (%) 38% 42% -3% 7% 7% 18% 18% 18% 18% 18% Naval Dockyards/Projects YoY growth (%) -38% 0% -10% 19% 161% 10% 10% 10% 10% 10% AC & AE YoY growth (%) 570% -12% 36% -51% 216% 8% 8% 8% 8% 8% H & MV YoY growth (%) 108% -79% 348% -59% 974% 5% 5% 5% 5% 5% Others YoY growth (%) -41% 72% 71% 11% -22% 5% 5% 5% 5% 5% Total YoY growth (%) 43% 28% 13% -5% 33% 13% 13% 13% 14% 14% Source: Survey of Defence Estimates, Ambit Capital Research. Note: RE = Revised Estimate and BE=Base Estimate India has built a reasonable manufacturing base for land systems. However, India does not have the technology to manufacture complex and large aircrafts and navy warships. Hence, most large defence projects are imported from global foreign OEMs. August 12, 2014 Ambit Capital Pvt. Ltd. Page 20

21 Capital Goods Exhibit 19: Detailed share of imports segment-wise Service Procurement Head DPSU/OF (%) Trade (%) Army Aircrafts and Aero Engines Heavy & Medium Vehicles Other Equipment Sub-Total (Army) Navy Aircraft & Aero Engines 4 96 Heavy & Medium Vehicles Other Equipment Naval Fleet Sub-Total (Navy) Air Force Aircraft & Aero Engines Source: Ambit Capital research Heavy & Medium Vehicles Other Equipment Sub-total (Air Force) The average development lifecycle of a complex aircraft and a warship vessel is years. We believe that India is unlikely to be able to indigenously manufacture these large projects. Thus, the scope of work for India s private sector would be limited to components and spares which are low-technology products. Exhibit 20: Scope of work for private sector Armed Force Equipment Key beneficiaries Army Towed Artillery Licensed Production Self-propelled Artillery Licensed Production Self-propelled air defense guns and missile systems Tactical communication Systems Bridges Licensed production Mine-laying Licensed production L&T, Tata, Bharat Forge, BDL L&T, Tata BEL, L&T, TCS, HCL Tech, Tata Power SED Navy Patrol vessels building Pipavav Defence, L&T Frigates and submarines hull construction L&T Air Force Tugs/yard craft building Command and control and IT systems Airframe structures Major electro-magnetic (EM) systems Avionics, electronics and displays Design analysis Dynamatic Technologies, Tata Advanced Systems, HAL BEL, Astra Microwave, Tata Power SED General Engineering support, GSE/GHE, Role Equipment Licensed production under OEM s supervision for: UAV, SAGW, Ground Radars, Light a/c and helicopters, moving up the ladder Source: Ambit Capital research HAL, Tata Advanced Systems, Dynamatic Technologies August 12, 2014 Ambit Capital Pvt. Ltd. Page 21

22 Capital Goods Capacity constraint at defence PSU shipyards: An opportunity for the private sector India has four defence public sector undertakings (DPSU) shipyards: Mazagon Dock Limited (MDL), Garden Reach Shipbuilders and Engineers Limited (GRSE), Goa Shipyard Limited (GSL) and Hindustan Shipyard limited (HSL). In addition, Cochin Shipyard Limited (CSL), owned by the Ministry of Shipping, has the capability to build aircraft carriers. Mazagon Dock Limited (MDL): MDL is the largest defence PSU shipyard in India with capacity of 6,500 deadweight tonnes (DWT). More importantly, MDL is the only defence PSU shipyard that has the capability to construct large warships such as destroyers, frigates, corvettes and submarines. The company s order book includes frigate ship-p17, three destroyer ships P15A, and six scorpene class submarines. Garden Reach Shipbuilders and Engineers Limited (GRSE): GRSE was acquired by the Ministry of Defence in The shipyard has the capability to manufacture submarine corvettes, fleet tankers, fast attack crafts and patrol ships. Whilst the primary objective of GRSE was to build frigates, GRSE has limited experience in building frigates. It has built 3 frigates until date. Goa Shipyard Limited (GSL): GSL is the smallest defence PSU shipyard with the capacity to build ships up to 105 metres long, 3,000 deadweight tonnes and 4.5 metres draught. GSL has the capability to manufacture fast patrol vessels, survey vessels, sail training ships, missile crafts and offshore patrol vessels. Hindustan Shipyard Limited (HSL): HSL has the capability to build offshore patrol vessels and inshore patrol vessels. HSL has built 163 ships and repaired 1,850 ships. Whilst HSL is one of the largest shipyards, it has continuously incurred financial losses. Cochin Shipyard Limited (CSL): CSL is the largest public sector shipyard in India, with a capacity of 110,000 deadweight tonnes and repair capacity of 125,000 deadweight tonnes. It is the first shipyard in India that is indigenously building an aircraft carrier of 40,000 DWT. The Department of Defence Production (DDP) of the Ministry of Defence nominates yards for major shipbuilding projects. The DDP has ensured that the orders are awarded to the defence PSUs irrespective of their cost competitiveness and capacity to deliver the project on time. This has led to capacity constraints at all the defence PSU shipyards, as shown below. Exhibit 21: Capacity constraint of defence PSU shipyards FY12 sales (US$bn) FY12 Order book (US$ bn) FY12 Order book to bill (years) MDL GRSE HSL GSL Source: Aviotech, Summary of performance of Unlisted Defence PSUs The Government identified the need to increase the capacity of these shipyards and chalked out a modernisation plan for each shipyard. However, we believe that the modernisation budget would not be sufficient to resolve the capacity constraint. In addition, several structural issues need to be addressed to meet the Indian Navy s requirements. August 12, 2014 Ambit Capital Pvt. Ltd. Page 22

23 Capital Goods Exhibit 22: Modernisation plan not sufficient to resolve the capacity constraint Shipy ard Modernisation budget (` bn) MDL 15.0 Comments Modular construction technology, construction of a new wet basin and additional cradle for submarine production GRSE 6.1 Upgrade infrastructure to double its shipbuilding capacity GSL 7.9 Enhance shipbuilding capacity by 2x HSL 11.9 Financial restructuring plan Source: Ministry of Defence Key structural issues for the defence PSU shipyard industry The present capacity of the three defence PSU shipyards MDL, GRSE and GSL is four ships a year. However, the requirement of the Indian Navy is eight ships a year to achieve the desired target of 160 ships. Whilst these defence PSU shipyards win most of the orders, the defence PSU shipyards have limited decision-making independence. For example, these PSUs require government approval for procurement above `5bn. The Navy provides the design for the ship, the key equipment and the source of equipment. The design parameters are not finalised before giving the order to the shipyards. Further, the Navy changes the design parameters during the construction process, leading to delays and cost overruns. In addition, the Navy decides the equipment and sources of equipment, which are expensive and the equipment procurement is delayed due to the slow decision-making process. August 12, 2014 Ambit Capital Pvt. Ltd. Page 23

24 Capital Goods Competitive mapping: Shipyards In addition to the four defence PSU shipyards, India has four private sector shipyard companies: L&T Shipbuilding, Pipavav Defence, Bharati Shipyard and ABG Shipyard. The key parameters for a superior shipyard are: (a) location and design of the shipyard, (b) land available adjoining the shipyard for assembling the ammunition and components of warship, (c) connecting infrastructure, and (d) depth of the sea. According to shipbuilding industry experts and defence experts, Bharati Shipyard and ABG Shipyard do not have prior experience and the capability to build navy patrol vessels. Hence, we have not evaluated Bharati Shipyard and ABG Shipyard in our competitive framework. L&T Shipbuilding is ranked 1 in our competitive framework, ahead of the more experienced MDL, as MDL has a capacity constraint. L&T Shipbuilding is ranked 1 in our competitive framework, ahead of the more experienced MDL, as MDL has a capacity constraint Exhibit 23: Competitive mapping framework of Indian defence shipyards Shipbuilding companies Relationship with armed forces Manufacturing capabilities Legal/ Corruption cases Gross block and revenue Size Financial strength of the parent Total L&T Shipbuilding Pipavav Defence Mazagon Dock (MDL) Goa Shipyard (GSL) Garden Reach Shipyard (GRSE) Hindustan Shipyard (HSL) Source: Ambit Capital research Note: - Strong; - Relatively Strong; - Average; - Relatively weak. Exhibit 24: The numbers behind our shipyard scorecard Shipbuilding companies Revenues (` mn) EBIT margin RoCE Debt: Equity Gross Gross block Block turnover (` mn) L&T Shipbuilding 1, % -4.1% , Pipavav Defence 25, % 4.3% , Mazagon Dock (MDL) 24, % 36.5% , Goa Shipyard (GSL) 8, % -0.7% , Garden Reach Shipyard (GRSE) 19, % 23.2% , Hindustan Shipyard (HSL) 4, % 14.1% (0.62) 2, Source: Company, Ambit Capital research. Note: We have used FY13 financial statements for L&T Shipbuilding, MDL, GSL, GRSE and HSL and FY14 financials for Pipavav Defence (a) Key promoter/senior management for the orders: Private sector shipyards hired employees from the armed forces to build technical expertise and to understand the nuances of bureaucratic defence equipment procurement procedures. L&T Shipbuilding: L&T Shipbuilding hired former naval employees at various levels to build technical expertise. Pipavav Defence and Offshoring: The independent directors on the board of Pipavav Defence had an illustrious career in the armed forces Mr. Ajai Vikram Singh (former Defence Secretary, Government of India), Mr. Samar Ballav Mohapatra (former Commerce Secretary Government of India), and Mr. R. M. Premkumar (former Chief Secretary Maharashtra State of India). August 12, 2014 Ambit Capital Pvt. Ltd. Page 24

25 Capital Goods (b) Manufacturing capabilities L&T Shipbuilding operates two shipyards Hazira in Gujarat and Kattupalli in Tamil Nadu. The Hazira port, located within the L&T Hazira manufacturing complex, has the capability to build ships of 20,000 DWT and 160 metres in length. The hull of INS Arihant, a nuclear submarine was built at L&T s Hazira shipbuilding facility. The total project cost of the submarine was US$2.9 billion, out of which the cost of the hull built by L&T was ~US$333mn. The Kattupalli shipyard has a shipbuilding facility along with a port complex. The port has the capability to handle 1.2million TEUs. Pipavav Defence and Offshoring: It has the second-largest drydock shipbuilding facility in the world, with a capacity to build up to 400,000 DWT. The dry dock is 662 metres long and 65 metres wide. Adjoining the dry dock, the company has an offshore yard for fabrication of offshore structure and floating units. According to shipbuilding industry experts, Pipavav Defence has good infrastructure connectivity and a favourable location. The Pipavav shipyard was designed by Korea Maritime Consultants (KOMAC), a leading global shipbuilding consultant. However, Pipavav made modifications to the design submitted by KOMAC, leading to an inefficiently designed linear shipyard. Defence PSU shipyards: Amongst the defence PSU shipyards, Mazagon Dock Limited is the largest shipyard which has the capability to construct large warships such as destroyers, frigates, corvettes and submarines. Goa Shipyard has the capability to construct smaller-sized fast navy patrol vessels up to 105 metres long and 3,000 DWT. Pipavav made modifications to the design submitted by KOMAC, leading to an inefficiently designed linear shipyard (c) Legal/corruption cases L&T Shipbuilding: We did not find any malpractice allegations by government authorities and competitors in the public information domain. Pipavav Defence: SKIL Infrastructure held a 36.3% stake in Pipavav Defence as on March The main promoter of both Pipavav Defence and SKIL Infrastructure is Mr Nikhil Gandhi. SKIL Infrastructure s offices were raided in FY12 due to tax evasion allegations. (Source: ) Defence shipyards: The CAG report on naval shipyards highlighted that the defence PSU shipyards have won contracts to construct naval ships without the capacity and capability to build the vessels. For example, Mazagon Dock Limited was awarded the P15A project despite inadequate infrastructure. (d) Gross block and revenue size: Mazagon Dock Limited has the highest revenues, as it is awarded projects on a nomination basis. As a result, the private sector shipyards of L&T and Pipavav with manufacturing capabilities are operating at very low utilisation rates. The gross block turnover of L&T Shipbuilding was 0.03x in FY13 and that of Pipavav Defence was 0.38x in FY14. (e) Financial strength: Amongst private sector players, L&T has a strong balance sheet (debt:equity of 0.3x as on FY14) to invest in its subsidiary, L&T Shipbuilding. Pipavav Defence has a relatively high gross debt:equity of 2x. Whilst defence PSU shipyards MDL, GSL, and GRSE have strong balance sheets, they do not have the financial autonomy to incur capital expenditure for increasing capacity. Hindustan Shipyard Limited is under a financial restructuring programme due to huge losses. August 12, 2014 Ambit Capital Pvt. Ltd. Page 25

26 Capital Goods Key defence component companies We have done competitive mapping of key defence component manufacturers for the armed forces. We have compared the competitive advantages of: (a) defence electronic equipment companies such as BEL and Astra Microwave, (b) unlisted subsidiaries of conglomerates in diverse defence applications such as L&T, Tata and M&M, and (c) component manufacturers such as Dynamatic Technologies and Bharat Forge. Exhibit 25: Competitive mapping framework of Indian defence shipyards Shipbuilding companies Bharat Electronics Tata Group subsidiaries L&T subsidiaries Astra Microwave Mahindra & Mahindra subsidiaries Dynamatic Technologies BEML Bharat Forge Source: Ambit Capital research Relationship with armed forces Manufacturing capabilities Note: - Strong; - Relatively Strong; - Average; - Relatively weak. Legal/ Corruption cases Gross Block and revenue size Financial strength of the parent Total Exhibit 26: The numbers behind our scorecard for key defence component companies (` mn, unless mentioned) Companies Revenues EBIT margin Pre-tax RoCE Debt: Equity Defence Gross Block size Gross block turnover Bharat Electronics 65, % 11.6% , Key Tata Group Entities Tata Advanced materials % -18.7% , Tata Advanced systems % 0.2% , Tata Power SED 2, % 30.7% , Bharat Forge N.A. N.A. N.A. N.A. 1,000 N.A. L&T subsidiaries L&T Cassidian L&T special steel & forgings % -7.1% , Astra microwave 5, % 23.5% , Mahindra & Mahindra subsidiaries % -50.5% Mahindra Defence Naval systems % 0.6% Mahindra Defence Systems % 10.4% 0 0 N.A. Defence Land Systems % -67.9% Dynamatic Technologies (aerospace segment) 1, % 30% , BEML 3, % N.A N.A. N.A. Source: Company, Ambit Capital research Note: We have used FY13 financial details for Tata Advanced Systems, Tata Power SED, BEML, L&T Cassidian, L&T Special steel and forgings, M&M subsidiaries August 12, 2014 Ambit Capital Pvt. Ltd. Page 26

27 Capital Goods Bharat Electronics (BEL, BUY, TP `2,082, upside 19%) Key relationships: Bharat Electronics is a public sector undertaking under the Ministry of Defence. Manufacturing ability: It is a leading manufacturer of defence electronic equipment with an order book of `232bn. Its order book comprises Akash weapon systems, passive night vision devices, advanced communication systems and civilian orders such as the national population register. The defence segment accounts for 82% of total FY14 revenues. BEL has built an indigenous manufacturing capability on the back of its strong focus on R&D. BEL s R&D expense was `5,099mn, 8.1% of consolidated FY13 sales. As a result, 85% of BEL s revenues were driven by indigenous products. In addition, the company has an export order book of US$191mn as on FY14, 103% higher than FY13. Legal and bribery allegations: We did not find any allegations and bribery charges against Bharat Electronics. However, BEL had a JV with Rheinmettal Air Defence, which was blacklisted by the MoD. Financial strength: Whilst BEL had surplus cash of `46bn as on March 2014 (37% of market cap), it has not used the surplus cash to increase manufacturing capacity. BEL s R&D expense was `5,099mn, 8.1% of consolidated FY13 sales; as a result, 85% of BEL s revenues were driven by indigenous products L&T (SELL, TP `1,367/share, 8% downside) Key relationships: The Head of the International Defence and Aerospace business at L&T Heavy Engineering is Commadore Mukesh Bhargava. Mr Bhargava has more than 30 years of experience in the Indian Navy. He was the head of submarine design for strategic forces, communication and C4I systems. Manufacturing ability: L&T Special Steel and Forgings has the capability to manufacture forgings for three types of gun systems self-propelled howitzer, towed gun and truck mounted gun. In addition, the company designed parts of the weapon delivery system for the Pinaka missile, a multiple rocket launcher developed by the DRDO and mounted on the Tatra truck. L&T s order size for the Pinaka missile is `1,720mn. L&T had formed a JV with Cassidian in 2011 to manufacture electronic equipments in India for electronic warfare, radars and avionics for military application. L&T has a 74% share and Cassidian has a 26% share in the JV. The JV had planned to make investments of US$20mn to set-up a manufacturing plant in Talegaon, Maharashtra. However, the JV has no manufacturing base and it did not win any projects. This JV had nil gross block and nil revenues as on March Legal and bribery allegations: We did not find any allegations and bribery charges against L&T and its subsidiaries. Financial strength: L&T has the financial strength to set-up large manufacturing plants in India with transfer of technology from foreign players. Tata Group defence entities (Not Listed) Key relationships: The CFO of Tata Advanced Systems is Lieutenant General Davinder Kumar who served the Indian Army for almost 40 years. Lt. Gen. Kumar is a specialist in Network Design Implementation and has conceived, designed and fielded a large variety of communication and computer networks for the Indian Army. Manufacturing ability: The key subsidiaries of the Tata Group involved in manufacturing of components and spares for the defence sector are the Tata Power Strategic Engineering division, Tata Advanced Systems and Tata Motors. The Tata Power SED can design missiles and rocket launchers, communication systems and electronic warfare. The order book of Tata Power SED was August 12, 2014 Ambit Capital Pvt. Ltd. Page 27

28 Capital Goods `27,700mn as on March 2013 and it reported `2,930mn revenues in FY13, implying a book-to-bill ratio of 9.4x. Tata Power has the highest R&D expense to sales ratio in the private sector at 8.9%. Its R&D expense was `261mn in FY13. Tata Advanced Systems has built niche capabilities in the aerospace segment. The company can build aerospace aero-structures, radar systems and missile systems. Tata Motors has supplied over 100,000 vehicles to the Indian military and paramilitary forces. Legal and bribery allegations: We did not find any allegations and bribery charges against Tata and its subsidiaries. Financial strength: Tata has the financial strength to set-up large manufacturing plants in India with transfer of technology from foreign players. In fact, the Tata Group claims that it is well positioned to enter into virtually any area where the Ministry of Defence wishes to build private sector capabilities. Mahindra and Mahindra subsidiaries Key relationships: The Chief Executive of Mahindra Land Defence System, Mr Khutub Hai was a Brigadier with the Indian Army. Manufacturing ability: In 2009, Mahindra and Mahindra through its Mahindra Aerospace subsidiary acquired two Australia-based aerospace companies for a consideration of `1,750mn. Mahindra Aerospace acquired Aerostaff Australia, a component manufacturer, and Gippsland Aeronautics, a general aircraft manufacturer. In addition, the company formed a JV with BAE Systems in 2009 but this JV was mutually cancelled in 2013 due to lack of orders and change in the customer procurement framework. Thus, the total revenues of M&M s defence entities were a paltry `320mn in FY14 with a negative EBIT margin. Legal and bribery allegations: We did not find any allegations and bribery charges against M&M and its subsidiaries. However, Mahindra Defence Systems had a JV with Rheinmettal Air Defence which was blacklisted by the MoD. Financial strength: M&M has the financial strength to set-up large manufacturing plants in India with transfer of technology from foreign players. Bharat Forge (Not Rated) Key relationships: Mr Baba Kalyani, the promoter of Bharat Forge, was the former chairman of the Confederation of Indian Industry Defence Council. Manufacturing capability: Bharat Forge has formed a JV with Elbit Systems to manufacture towed guns, mounted guns and upgrade of 130mm artillery guns. According to media reports, Bharat Forge has invested `1bn to develop an artillery gun manufacturing facility. At the 2014 Defence Expo, Bharat Forge unveiled ultralight self-propelled guns such as Bharat 52 and Garuda Industry experts highlighted that Bharat Forge has a unique capability of forging ultralight materials such as titanium. Legal and bribery allegations: We did not find any allegations and bribery charges against Bharat Forge. Financial strength: Bharat Forge has a strong balance sheet with net debt to equity of 0.6x. August 12, 2014 Ambit Capital Pvt. Ltd. Page 28

29 Capital Goods Astra Microwave (Not Rated) Key relationships: The core founders of Astra Microwave were researchers with government agencies. Mr Malla Reddy, Managing Director, worked for more than two decades in research agencies such as ISRO and DRDO. Mr Chitrakar, Director and COO, was a scientist with the Defence Electronics Laboratory for 20 years. Further, L&T has 9.7% stake in Astra Microwave. Manufacturing capability: Astra Microwave manufactures radars and telemetry and ground-based surveillance. The company had an order book of `9,716mn, out of which the export order book accounts for `4,814mn. The revenues of the company increased from `2,383mn in FY13 to `5,442mn, 127% YoY. Further, exports accounted for 63% of FY14 revenues (i.e. `5,442mn). The export order book is driven by the offset clause which mandates a minimum 30% procurement from India for defence equipment categorised as Buy (Global) and Buy and Make (Global). Astra Microwave incurred an R&D expense of `154mn, 2.9% of sales in FY14. Legal and bribery allegations: We did not find any allegations and bribery charges against Astra Microwave. Financial strength: Amongst the component manufacturers, Astra Microwave has a strong balance sheet with 0.2x debt-to-equity as on March Dynamatic Technologies (Not Rated) Key relationships: The board of Dynamatic Technologies has several retired armed personnel such as (1) Air Chief Marshal S Krishnaswamy, Chief of Air Staff, Indian Air Force and (2) Mr Nalini Ranjan Mohanty, former Chairman of HAL. Manufacturing capability: Dynamatic Technologies manufactures components for aircrafts such as wing flaps and aero structures. The key clients of the company are Boeing, Airbus and Spirit. The aerospace and defence segment accounted for 14% of FY14 revenues and the EBITDA margin of this segment was 25.5% in FY14. The R&D expense was 1.5% of sales in FY14. The company received a major order from Airbus to supply flap track beam for aircraft A330 as a tier-1 supplier. The aerospace order book of the firm consists of a US$100mn order from Boeing, US$250mn from Bell Helicopters and US$300mn from Airbus. Legal and bribery allegations: We did not find any allegations and bribery charges against Dynamatic Technologies. Financial strength: Dynamatics Technologies is highly levered with debt-toequity of 6.6x. Bharat Earth Movers Limited (BEML, Not Rated) Key relationships: Bharat Earth Movers Limited is a public sector undertaking under the Ministry of Defence. Manufacturing capability: BEML supplies variants of Tatra vehicles and vehicles for aircraft weapon landing trolleys. In addition, BEML launched its aerospace division in The revenues of BEML from the defence segment were `3,445mn, 12% of revenue. According to our industry checks, BEML has not developed significant indigenous manufacturing capability which is corroborated by the company s defence segment EBIT margins of -1.6% in FY13 and low R&D expense to sales ratio of 3.1%. Legal and bribery allegations: The former Army Chief General Mr V. K. Singh alleged that he was offered `140mn to clear the purchase of expensive Tatra Trucks supplied to BEML. The cost of Tatra truck to the army was ~`8mn as compared to the trucks of Tata Motors and Ashok Leyland which cost ~`2mn. Financial strength: BEML has a strong balance sheet with a net debt to equity of 0.4x. August 12, 2014 Ambit Capital Pvt. Ltd. Page 29

30 Capital Goods Relative valuation We have compared the valuation multiples of companies with defence manufacturing facilities in India. However, the relative valuation of conglomerates with small exposure to the defence sector such as L&T, M&M, Bharat Forge, Lakshmi Machine Works are comparable to defence component manufacturing companies such as BEL, Pipavav Defence, and Astra Microwave. BEL is trading at 13.5x, a marginal discount to Astra Microwave (14.0x FY16E EPS), given Astra Microwave s higher RoEs and YoY EBITDA growth. Exhibit 27: Relative valuation of potential manufacturing defence sector plays Companies Mcap 6m ADV EV/EBITDA P/B P/E CAGR (FY11-14) CAGR (FY14-16) RoE (%) RoCE (%) US$ mn US$mn FY15 FY16 FY15 FY15 FY16 Revenue EBITDA Revenue EBITDA FY14 FY15 FY14 FY15 Industry average % 22% 14% 22% L&T* 22, % 9% 17% 14% Mahindra & Mahindra 13, % 29% 17% 16% Bharat Forge 2, % 14% 14% 26% Bharat Electronics 2, % -5% 12% 9% Lakshmi Machine Works* % -1% 14% 21% Solar Industries* % 36% 21% 17% Pipavav Defence % 87% 6% 9% BEML* % -11% 15% 67% 0 5 N.A. 2 Astra Microwave % 31% 8% 25% Dynamatic Technologies % 42% 11% 17% Walchandnagar N.A. N.A. N.A. N.A. N.A. -13% N.A. N.A. N.A. -7 N.A. N.A. N.A. Source: Company, Bloomberg. Note * These companies' numbers are on a standalone basis and the rest are on a consolidated basis The major listed players in the defence sectors are L&T, Pipavav Defence and BEL. We prefer BEL, as it is an efficient DPSU with a strong focus on technology (8.1% of FY13 sales) with a superior manufacturing base. Whilst Pipavav has the second-largest drydock in the world, leading to gross block of `65bn, the company s five-year average RoE is only 0.5%, thereby raising questions about its profitability. Further, our industry participants highlight that Pipavav had aggressively bid for the orders from navy worth `30bn. Defence accounts for less than 1% of L&T s FY14 revenues. Exhibit 28: Identifying winners in the defence sector FY14 RoE M&M Astra Microwave Bharat Forge BEL Solar L&T Dynamatic Pipavav BEML FY16 P/E Source: Ambit Capital research, Company. Note: Size of the bubble denotes gross block invested in the defence sector August 12, 2014 Ambit Capital Pvt. Ltd. Page 30

31 Capital Goods Appendix I: List of critical technologies Exhibit 29: Critical technology classification Sr. No Name of Technology Sr. No Name of Technology 1 MEMs based sensors, actuators, RF devices, Focal Plane arrays. 14 Pulse Power network technologies 2 Nanotechnology based sensors & displays. 15 THZ technologies 3 Miniature SAR & ISAR technologies 16 Surface Coated Double Base (SCDB) Propellant 4 Fiber Lasers Technology 17 FSAPDS Technologies 5 EM Rail Gun technology 18 HESH Ammunition technologies 6 Shared and Conformal Apertures 19 Muzzle Reference System 7 High efficiency flexible Solar Cells technology 20 Composite Sabot manufacturing technology 8 Super Cavitation technology 21 MET projectiles 9 Molecularly Imprinted Polymers 22 Titanium casting, forging, fabrication and machining 10 Technologies for Hypersonic flights (Propulsion, Aerodynamics and Structures) 23 Precision Guided munitions 11 Low Observable technologies 24 Shock Hardened Sensors 12 Technologies for generating High Power Lasers 25 Gun Barrel Technologies High Strength, High Modulus, Carbon Fibers, Mesophase pitch-based 13 fiber, Carbon Fiber Production Facility Source: DRDO 26 Advanced Recoil System August 12, 2014 Ambit Capital Pvt. Ltd. Page 31

32 Appendix II: Acquisition plans of armed forces Indian Air Force s acquisition plan Exhibit 30: Indian air force acquisition plan Fighter aircraft Status Induction into service MMRCA PMF (FGFA) 5th Generation Fighter Sukhoi Su-30 MKI Mirage 2000 Upgrade MiG 29 Upgrade Jaguar Upgrade Specifications, contractual setup and workshare has been finalised with HAL by Dassault Aviation. Initial 18 to be procured as fly-away and remaining 108 to be licensed-produced by HAL in Bengaluru. PMF preliminary design phase (PDP) completed in June Series production likely to commence in Su-30 MKI would have ended by then. Total of 272 ordered till date. HAL will complete delivery of 222 aircraft it has on order by Two aircrafts being upgraded at present in France. Remaining 47 aircrafts to be upgraded by HAL in Bengaluru. First of upgraded aircraft to enter service this year. Contract signed with HAL. Capital Goods If a contract is signed this year, then the first batch of aircraft would be delivered by To take place in HAL to commence flight testing of IAF variant in More than 150 Su-30 MKIs are in IAF service. Upgrade of all aircrafts scheduled to be completed by Upgrade of more than 60 aircrafts will be completed by middle of 13 th Plan. Upgrade of all aircrafts will be completed by end of 13 th Plan. LCA Tejas Mk1 FOC to be obtained by end of Two squadrons to be inducted by end of 12 th Plan. Trainers Status Entry into service Pilatus PC-7 Mk II Basic Trainer RFI for additional 106 trainers to be acquired through buy & make (Indian) has been released. HJT 36 Sitara Intermediate Jet IOC yet to be obtained. Trainer (IJT) Hawk Mk-132 Advanced Jet Orders for 20 more Hawks for Surya Kiran display likely to be Trainer (AJT) placed by next year. Helicopters Status Entry into service Light Utility Helicopter (LUH) Reconnaissance & Surveillance Helicopter Advanced Light Helicopter First prototype likely to be ready this year. Winner yet to be declared. Dhruv Mk4 deliveries currently underway. Already in service with 37 trainers delivered as of May this year. Entry into service likely to be delayed by a few years. All 66 from first order have been delivered. Deliveries underway as part of additional contract for 40. Induction into service likely to take place by end of 12 th Plan. NA All Dhruv helicopter deliveries to be completed by end of 12 th Plan. Light Combat Helicopter (LCH) 65 on order for IAF. IOC likely to be obtained by Medium Lift Helicopter All 71 Mi-17V-5 helicopters to be delivered by next year. 80 helicopters from previous order are already in service. Heavy Lift Helicopter Boeing Ch-47 D Chinook declared winner. Order for 15 helicopters has been delayed. Attack Helicopter Boeing AH-64 D Apache block 3 selected. Order for 22 helicopters has been delayed. VVIP Helicopters Source: Force India magazine Order for 12 VVIP AW 101 helicopters terminated in January this year. Three helicopters delivered to the IAF before the order was terminated. August 12, 2014 Ambit Capital Pvt. Ltd. Page 32

33 Capital Goods Indian Navy s acquisition plan Exhibit 31: Indian Navy s acquisition plan Indigenous warships Status Entry into service Project 15A Kolkata class Destroyer Project 15B Destroyer Project 17 Shivalik class Frigate Project 17 A Frigate Project 28 Kamorta class ASW Corvette All three 6,800 tonne destroyers are significantly behind schedule. Follow on class to Project 15A. Contract for four P- 15B ships has been signed in January INS Sahyadri, the third and last of the Shivalikclass was delivered this year. Will consist of seven frigates. Total of four in class. Keel of the third ASW corvette Kiltan was laid in August Fourth and last of class named Kavaratti. Aircraft carrier Status Entry into service INS VIKRAMADITYA Indigenous Aircraft Carrier 1 (IAC-1) Commissioned into the Indian Navy in November last year. Now named INS Vikrant. Phase-I completed. First of class INS Kolkata to be delivered to Navy this year. Sister ships INS Kochi and INS are likely to both be in service by Delivery schedule for four ships projected to be July 2018, July 2020, July 2022 and July First two ships, INS Shivalik and INS Satpura, already on active duty with Indian Navy. First of class likely to be delivered to the Indian Navy post INS Kamorta to be delivered to the Indian Navy this year and INS Kadmatt in In service. Submarines Status Entry into service Project 75 Scorpene Sindhugosh-class Type 877 EKM (Kilo Class) Shishumar-class HDW Type 209/1500 Nuclear Submarine (foreign) Nuclear Submarine (indigenous) Total of six on order, has experienced substantial delays, but project is now said to be back on track. INS Sindhurakshak sunk at berth after a major fire last year and sister submarine INS Sindhuratna suffered a serious accident this year. Upgrades planned to refit newer INS Shalki and Shankul with Harpoon missiles. Akula II class Nerpa called INS Chakra in the Indian Navy. First of class named INS Arihant. Total of three submarines to be built. Trials to begin in 2016 with induction into Navy being planned for First Scorpene submarine will join the Indian Navy only in Deliveries of remaining 5 submarines will be completed by Fleet remains operational. Naval air arm Status Entry into service Boeing P-8I Long Range Maritime Reconnaissance (LRMR) Medium Range Maritime Reconnaissance (MRMR) MiG-29K Light Combat Aircraft (LCA) Navy Mk1 Source: Force India magazine Eight aircraft on order, options for more likely NA Request For Information (RFI) has been sent out for NA eight aircrafts. All 16 fighters from initial order have been delivered. Additional orders for 29 more placed in 2010 and deliveries are now underway. Behind Schedule. Target date for Initial Operational Clearance (IOC) by 2014 will not be met. Operational with the Indian Navy since Sea trials are likely to commence this year. Fourth P-8I delivered on schedule last month. Two additional aircrafts to be delivered this year. First MiG 29K squadron was commissioned last year at INS Hansa. IOC likely to be achieved by with entry into service towards August 12, 2014 Ambit Capital Pvt. Ltd. Page 33

34 Capital Goods Indian Army s acquisition plan Exhibit 32: Indian Army s acquisition plan Rockets and artillery Status Induction into service BRAHMOS Supersonic Cruise Missile M777 Ultra-Light Howitzers Ordinance Factory Board 155/45mm calibre Dhanush artillery gun Towed Gun Systems (TGS) and Mounted Gun System (MGS) Source: Force India magazine The Army has placed order for three regiments of Brahmos. Sanction for 4 th regiment awaited. Upgraded Block III Brahmos has undergone successful series of trials. MoD delay has pushed back purchase of 145 M mm / 39 calibre Ultra-Light Howitzer s, pending since Cost has now increased from US$647 million to US$885 million. Ordinance Factory Board displayed 155/45mm calibre Dhanush based on original Bofors drawings at Defexpo OFB has received indent for 114 units of 155mm x 45 calibre Artillery guns. Has been declared a Make and Buy for 1800 systems. Winner yet to be declared. Two regiments with Brahmos are fully operational. Third regiment of Brahmos to be deployed in Arunachal Pradesh. If an order is placed by , then the first guns would be delivered by , with deliveries being completed by 2020 for five regiments. Trials ongoing, likely to be completed by All 114 guns are to be delivered to the Army within a maximum of 36 months from accord of Bulk Production Clearance Armour Status Induction into service 59 armoured regiments to be equipped with around 1600 tanks (1000 to be manufactured in T-90 S Bhishma Main Battle Tank (MBT) India). DAC has cleared manufacture of 235 T-90 tanks at HVF Avadi. The fleet of T-72 tanks is being upgraded with Thermal Imager Stand Alone System, improved T-72 M1 Ajeya MBT engines and Auto Land Navigation System for Command and Control Tanks. All 124 tanks have been delivered to the Indian Arjun MBT Mk-1 Army. Orders for 118 Arjun Mk-2 likely to be obtained Arjun MBT Mk-2 next year. Trials likely to be completed this year. Make India project has requirement for 2,600 FICV s. Project approved in Future Infantry Combat Vehicle (FICV) Contenders are Mahindra, L&T, Tata Motors and OFB. Indian Army looking to upgrade BMP-2/2K to BMP-2/2K Sarath BMP-2M standard without replacement of existing turret. Small arms, anti-tank and air defence Indian Small Arms System (INSAS) Rifle replacement Status To be replaced through global route. Request for Proposal issued in November 2011 for 60,000 assault rifles. Field trials underway. Close Quarter Battle Carbines Requirement for 43,000 carbines. NA Israeli Rafael Spike & Raytheon/Lockheed Martin 3rd generation Anti-Tank Guided Missile Javelin in contention for order of up to 2,000 (ATGM) launchers with 24,000 missiles. Very short-range air-defence system (VSHORADS) Tender underway since Competitors are MBDA Mistral, Saab RBS 70 NG and KBM Igla S for an order of close to 1,000 launchers with 6,000 missiles initially. Raytheon s Stinger also on offer. Already in operation. Substantial numbers of T-90s to be upgraded with improved sighting, navigation and fire control systems Upgraded T-72 tanks are entering service and with life extension to remain operational beyond The 43 rd armoured regiment at Jaisalmer and 75 th armoured regiment are fully operational with 45 tanks each. If orders placed next year, deliveries will begin in Production rate of 30 tanks annually being targeted. An indigenous FICV will require at least 3 years to enter production. The large numbers mean that obsolete BMP2/2K will be replaced only by Large numbers and delays in the upgrade mean that the entire fleet upgrade for approximately 1,400 BMPs would be complete only by Entry into service Induction likely to begin 2016 onwards. Transfer of Technology, will enable Indian ordnance factories to manufacture 140,000 rifles. NA NA August 12, 2014 Ambit Capital Pvt. Ltd. Page 34

35 Bharat Electronics BUY INITIATING COVERAGE BHE IN EQUITY August 12, 2014 Efficient leader in an evolving market Bharat Electronics (BEL) will retain its leadership position in the defence electronic industry (which will become more technology-intensive) and report 17% revenue CAGR over FY Unlike other inefficient defence PSUs, BEL increased its focus on technology through a threepronged strategy: (1) higher R&D expense (24% CAGR over FY07-13), (2) 33% cut in non-r&d employees over FY07-13, and (3) technology collaborations with global majors. BEL has a superior manufacturing base and technical ability, leading to 82% of FY14 sales from indigenized products. The execution of the Akash missile project would lead to a pick-up in revenues and EBITDA margin (up 50bps to 14.6% over FY14-16). We initiate coverage with BUY (TP of `2,082). Competitive position: STRONG Changes to this position: STABLE Higher Air Force capex and project clearance to drive industry growth The defence electronics industry s revenue CAGR of 17% over FY14-19E would be driven by: (a) 14% CAGR in the defence capital acquisition budget led by clearance of defence projects worth `1,148bn, and (b) higher capex by the Air Force, which is more electronics-intensive. BEL would lose market share of 3% by FY18 owing to higher competition from the private sector. However, BEL will retain its market leadership owing to its unmatched competitive advantages. Efficient DPSU, R&D-focused and unmatched manufacturing base Amongst defence electronics firms, BEL is ranked 1, due to: (a) higher focus on R&D, (b) superior manufacturing base, and (c) strong execution track record. Post the management change in FY09, BEL increased its focus on technology through higher R&D expense, cut in non-r&d employees, and technology collaborations with global majors such as Thales and Elbit Systems. This led to 82% indigenisation of sales in FY14. Pick-up in revenues led by execution of the Akash missile project BEL s revenues would increase, as supply constraints at BDL for the Akash missile project (30% of FY14 order book) are resolved, leading to 13% revenue CAGR over FY We expect an EBITDA margin increase of 50bps in FY14-16 to 14.6%, 77bps above consensus, due to a marginal increase in the share of defence revenues, higher utilisation rate and lower employee to sales ratio. Valuations linked to scale up in technology and order intake Our estimates do not account for the complete defence electronics orders worth `314bn, 3x the industry revenues in FY14. If BEL can keep pace with technology upgrades then its order intake could record 20% CAGR for the next 10 years vs our estimate of 17% CAGR. Key risk: Entry of large global players would increase competitive intensity. Capital Goods - Defence Recommendation Mcap (bn): `141/US$2.3 6M ADV (mn): `1311/US$5.1 CMP: `1,757 TP (12 mths): `2,082 Upside (%): 19 Flags Accounting: Predictability: Earnings Momentum: Catalysts GREEN AMBER GREEN Award of delayed defence projects in the Indian Air Force and Navy Technology collaborations with foreign global majors Execution of Akash missile; indigenous manufacturing of new missile projects Performance 27,000 25,000 23,000 21,000 19,000 17,000 15,000 Aug-13 Oct-13 Sensex Dec-13 Feb-14 Apr-14 Jun-14 Source: Bloomberg, Ambit Capital research Aug Bharat Electronics (RHS) Key financials Year to March FY13 FY14 FY15E FY16E FY17E Net Revenues (` mn) 62,730 65,179 71,696 83,240 97,540 EBITDA (` mn) 6,282 9,222 10,177 12,122 14,794 Net Profits (` mn) 9,112 9,517 10,227 11,659 13,446 Diluted EPS (`) RoE (%) 15.1% 14.3% 13.9% 14.2% 14.6% P/E (x) EV/EBITDA (x) Source: Company, Ambit Capital research Analyst Details Tanuj Mukhija, CFA tanujmukhija@ambitcapital.com Nitin Bhasin nitinbhasin@ambitcapital.com Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

36 Bharat Electronics Snapshot of Company Financials Profit and Loss Year to Mar (` mn) FY14 FY15E FY16E Net revenues 65,179 71,696 83,240 EBITDA 9,222 10,177 12,122 Depreciation 1,499 1,654 1,818 Interest expense Adjusted PBT 12,061 12,946 14,758 Tax 2,544 2,719 3,099 Adjusted net profit 9,517 10,227 11,659 Reported net profit 9,513 10,224 11,655 Profit and Loss Ratios EBITDA Margin (%) 14.1% 14.2% 14.6% Net profit margin (%) 14.6% 14.3% 14.0% EV/ EBITDA (x) P/E on adjusted basis (x) EV/Sales (x) Bharat Electronics Timeline Year Key events 1954 Incorporated under the Ministry of Defence specialized electronic needs of the Indian defence services 1956 Manufactured communication equipment at Bangalore plant 1966 Set-up radar manufacturing facility to meet the 1970 Manufacturing of Black & White picture tube, X-ray tube 1974 Set-up second manufacturing unit at Ghaziabad for radars and communication equipment for air force 1979 Set-up second manufacturing unit at Pune for image converter 1983 BEL acquired ailing Andhra Specific Company 1985 Set-up fifth unit in Chennai for tank electronics and sixth unit at Panchkula for military communication equipment 1986 Set-up seventh unit at Kotdwara to manufacture switching equipment, eight unit at Taloja and ninth unit at Hyderabad 1987 Set-up separate Naval Equipment division 1990 Formed JV with Delft, Holland for optronics 1992 Set-up second research laboratory at Ghaziabad 1992 IPO, 20% divestment 2002 First defence PSU to get miniratna status 2007 BEL was conferred Navratna status 2012 Signed an MoU with Israel Aerospace Industries Balance Sheet Year to Mar (` mn) FY14 FY15E FY16E Application of Funds 71,433 79,655 89,025 Fixed Assets 11,530 12,316 13,138 Current Assets 135, , ,294 Investments Net current assets 59,904 67,339 75,887 Total networth 72,203 80,421 89,787 Total debt Current liabilities 69,258 67,891 66,356 Deferred tax liability (3,015) (3,015) (3,015) Balance Sheet ratios RoCE 9.2% 9.2% 9.9% RoE 14.3% 13.9% 14.2% Gross Debt/Equity (x) Net debt (cash)/ Eq (x) (0.6) (0.6) (0.55) P/B (x) Cash flow Year to March (` mn) FY14 FY15E FY16E PBT 12,061 12,942 14,750 Depreciation 1,499 1,654 1,818 Tax (2,544) (2,718) (3,097) Net Working Capital (12,316) (4,522) (8,252) CFO (5,638) 2, Capital Expenditure (3,746) (2,440) (2,640) Investment CFI 626 2,043 1,881 Issuance of Equity Inc/Dec in Borrowings Net Dividends (35) (65) (75) Interest paid 12,061 12,942 14,750 CFF (1,829) (1,938) (2,208) Net change in cash (4,705) 2, Closing cash balance 46,045 48,959 49,255 BEL- Efficient player with high focus on R&D RoIC to stabilize at 23% over FY FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 Non R&D employees (000') Number of employees in R&D (000') R&D as % of sales (RHS) 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 35% 30% 25% 20% 15% FY14 FY15E RoIC FY16E FY17E RoCE (RHS) FY18E 12% 10% 8% 6% 4% Source: Bloomberg, Ambit Capital research August 12, 2014 Ambit Capital Pvt. Ltd. Page 36

37 Bharat Electronics BEL: Leader in defence electronics Bharat Electronics (BEL) is a leading manufacturer of defence electronics in India with an order book of `232bn. It is a public sector undertaking under the Ministry of Defence. BEL was conferred with Navratna Status by the Government in Exhibit 1: Business description Segment Defence Non-defence Description It manufactures radars, electronic warfare, avionics, military communication systems, tank electronics for army, navy and air force BEL manufactures electronic voting machines for the election commission of India, solar products and systems for government and public undertakings Source: Companies, Industry, Ambit Capital research FY14 revenues (` bn) FY14 revenue share 53,446 82% 11,732 18% Focus on indigenisation through R&D, collaborations BEL has formed several technology collaborations with global majors such as Thales, Textron Systems, Elbit Systems, and Israel Aerospace Industries for defence electronics equipment. In addition, the company had a R&D budget of `5.1bn in FY13, 8.1% of consolidated FY13 sales. The key products developed by the company are: national command control communication and intelligence network (NC 3 I), mobile communication system, passive night vision devices, coastal surveillance system, battle surveillance radars, etc. Exhibit 2: List of technology collaborations between BEL and foreign OEMs Foreign OEM Thales Work Domain for technology collaboration Sextant Avionics LCD systems for MiG 21 Multitone Electronics Sagem Systems Textron Systems Elbit Systems General Electric Company Oldelft Israel Aerospace Industries Design, development, marketing, supply and support of civilian and select defence radars for Indian and Global markets To set up Integrated circuit design center Production and supply of navigational sensors, inertial navigation system MicroObserver Unattended Ground Sensor System Joint production of Compact Multi-Purpose Advance Stabilization System for naval helicopter applications Manufacture and supply of X-ray tubes Image intensifiers Source: Companies, Industry, Ambit Capital research Long range Surface to Air Missile ship-defence systems August 12, 2014 Ambit Capital Pvt. Ltd. Page 37

38 Bharat Electronics Clearance of delayed projects to drive industry growth The defence electronics industry reported a modest 8.3% CAGR over FY08-14, as several large planned defence projects, such as the US$12bn MMRCA flight project and the US$1bn light utility helicopter project, were delayed due to lack of political will, complex procurement process and the unfolding of several scams. Bharat Electronics reported 7.3% revenue CAGR over FY08-14, lower than the industry average, as the Defence Procurement Policy of 2008 increased competition from the private sector. As a result, BEL s market share declined from ~65% in FY08 to 61% in ~FY14. Post the relaxation of procurement norms from the private sector, Tata Power SED, L&T, Astra Microwave and Centum Electronics emerged as key players that have set-up manufacturing plants to gain market share from BEL. Exhibit 3: Clearance of delayed projects to drive defence electronics industry growth % % 60% 55% 0 50% FY20E FY19E FY18E FY17E FY16E FY15E FY14 FY13 FY12 FY11 FY10 FY09 FY08 Defence Expenditure (Rs bn) BEL revenues from defence sector (Rs bn) BEL's market share (RHS) Source: Company, Department of Information Technology Annual reports, Ambit Capital research; Note: We have estimated FY14 defence electronics industry growth According to media reports, projects worth `1,148bn are in the final stages of project clearance, out of which `913bn are for the Air Force. The key projects in the Air Force awaiting clearance are `724bn MMRCA aircraft, `66bn Boeing Apache helicopters and `72bn Airbus 330 tankers. In addition, projects worth `103bn in the Indian Navy and other projects worth `133bn could be awarded in the next 3-5 years. The use of strategic electronics is the highest in aircrafts at 30% of the total project value followed by helicopters and complex navy warships at 20% of the project value. Strategic electronics account for ~10-15% of the project value of tanks and guns. Based on the value of projects awaiting clearance and the share of defence electronics in these projects, we estimate that the cumulative opportunity size for the defence electronics industry in the next four years would be `314bn (3x FY14 revenues of defence electronic industry). Thus, we expect the defence electronic industry to report 17% CAGR over FY August 12, 2014 Ambit Capital Pvt. Ltd. Page 38

39 Bharat Electronics Exhibit 4: Major defence projects awaiting final clearance List of projects Air Force Medium Multi-role Combat Aircraft (MMRCA) Value of the project (US$ mn) Value of projects (` bn) Identified Foreign OEM Potential share of defence electronics (` bn) Share of defence electronics 12, Dassault, France % 15 Boeing Chinook heavy-lift helicopters Boeing 15 30% 22 Boeing Apache attack helicopters 1, Boeing 20 30% Six Airbus A330 tankers 1, Airbus 22 30% Total Air Force 15, % Indian Navy Eight mine countermeasures ships 1, Kangnam, South Korea 18 20% 98 Black Shark torpedoes Italy's WASS 2 17% Total Indian Navy 1, % Indian Army 197 light utility helicopters 1, % Light Howitzer guns BAE Systems 4 10% 1,418 thermal imaging sights for T-72 tanks 262 Barak missiles Israel 2 10% Israel Aerospace Industries % Total Indian Army 2, % Total armed forces 19,033 1, % Source: Note: Ambit estimates for share of defence electronics August 12, 2014 Ambit Capital Pvt. Ltd. Page 39

40 Bharat Electronics Porter s analysis of defence electronics industry Our Porter analysis suggests that the competition intensity may marginally increase due to the Government s initiatives to encourage private sector participation in the defence equipment procurement process. However, entry barriers such as technology and execution track record would limit the entry of new players without prior experience in the defence sector. Exhibit 5: Porter s analysis Bargaining Power of Supplier LOW BEL subcontracts component work such as antennas and receivers for communication systems BEL is the largest client for its vendors and the vendors are fragmented SMEs with limited bargaining power Bargaining Power of Buyer MEDIUM The MoD awards large complex projects such as aircrafts and warships to foreign OEMs, as Indian players do not have the capability Foreign OEMs meet the offset clause related to defence electronics through three Indian players: BEL, Tata Power SED, Astra Microwave Competition LOW The competition is low, as few companies have the manufacturing and technical capability However, the new Government has taken several steps to encourage the private sector, which could increase competition Barriers to Entry MEDIUM Difficult for a new player to develop technology for complex products Stringent pre-qualification criteria that requires proven track record Threat of Substitution LOW Radars, electronic warfare, weapon systems and communication systems are integral components of a fighter plane, warship, and artillery Improving Source: Ambit Capital research Unchanged Deteriorating August 12, 2014 Ambit Capital Pvt. Ltd. Page 40

41 Bharat Electronics BEL s ongoing transformation Our 10-year analysis of BEL suggests that the management has made concrete efforts to increase BEL s competitiveness through: (a) higher focus on indigenisation, (b) increase in efficiency by reducing non-r&d employee strength, and (c) technology collaborations with global defence manufacturing leaders. Exhibit 6: Restructuring the organisation from a lethargic PSU to an efficient market leader 50% 40% 30% 20% 10% Phase 1: Limited private participation Phase 2: Relaxation of DPP norms led to higher competition Phase 3: Maintain market leadership in high growth phase % - FY19E FY18E FY17E FY16E FY15E FY14 FY13 FY12 FY11 FY10 FY09 FY08 FY07 FY06 FY05 FY04 EBITDA margin (%) Revenue YoY growth (%) Book-to-bill (x, RHS) Source: Company, Ambit Capital research Exhibit 7: Higher focus on R&D from FY08 Exhibit 8: Highest share of indigenous products amongst DPSUs % 90% FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 8.0% 6.0% 4.0% 2.0% 0.0% 85% 80% 75% 70% 65% FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 Non R&D employees (000') Number of employees in R&D (000') R&D as % of sales (RHS) % revenue from indigenous products % revenues from defence Source: Company Source: Company Phase 1 (FY04-09): Opaque procurement policies led to monopoly for BEL Whilst the Government had allowed 26% FDI in defence and 100% private participation in defence equipment procurement in 2001, the private sector was not awarded any defence electronic projects. BEL had a near monopoly in defence electronics for the Indian Government. The positives from this monopoly were 10.5% revenue CAGR over FY04-09 and high average EBITDA margin of 22.4% over FY However, assured orders from the Ministry of Defence and lack of initiatives by BEL s management made BEL a highly inefficient organisation. BEL s R&D expense as a percentage of sales was ~4.2% over FY According to its competitors, BEL did not have indigenous manufacturing abilities and it was just an assembler. In 2009, Rahul Chowdhary, CEO, Tata Power's Strategic Electronics Division stated, BEL lacks in-house design capability, and mostly does assembly jobs with imported technology and components. This capability can be easily replicated in the private sector." BEL lacks in-house design capability, and mostly does assembly job with imported technology and components." Rahul Chowdhary, CEO, Tata Power's Strategic Electronics Division in 2009 August 12, 2014 Ambit Capital Pvt. Ltd. Page 41

42 Phase 2 (FY09-FY14): New management restructured the business to retain leadership post increase in competition from private sector BEL s monopoly was reduced by the Defence Procurement Policy 2008 which increased transparency in the procurement process and encouraged private sector participation. The key challenges for BEL to survive in a high competition industry were: (a) laidback culture of the employees and (b) lack of ability to indigenously design products. According to Mr M.L. Shanmukh, the Director of Human Resource at BEL, "The biggest challenge is to get people to think like businessmen, and not just like national champions." Prior to 2009, BEL took 7-8 years to develop a product and it was awarded projects by the Government irrespective of capability. BEL appointed a new chairman and Managing Director, Ashwani Kumar Dutt, in June 2009 to restructure the business operations for a competitive defence electronics industry. His first step was to increase the R&D budget from `2.4bn in FY09 to `4bn in FY10. The company has two R&D centres at Bangalore and Ghaziabad. Further, BEL restructured its employee base, as the company increased the number of R&D employees and reduced its non-r&d employees. Whilst BEL s non-r&d employees declined from 8,784 in FY09 to 6,436 in FY13, its R&D employees increased from 3,177 in FY09 to 3,869 in FY13. Phase 3 (FY14-19): Despite higher competition, BEL will maintain market leadership in high growth phase We estimate the defence electronic industry to record 17% CAGR over FY14-19 driven by clearance of delayed projects that are awaiting final approval. We expect the Government to amend policies to encourage private sector such as (a) reduce the preference for defence PSUs, (b) streamline the procurement process, and (c) incorporate the private sector s suggestions in designing the qualitative requirements for the projects. As a result of the above policy changes, the competition intensity would increase for BEL due to an increase in private sector participation. Thus, BEL s revenue would record 15% CAGR over FY14-19, lower than the industry average. Whilst BEL s market share would decline from 61% in FY14 to ~56% in FY19, we expect BEL to maintain its market leadership on the back of indigenous products developed through investments in R&D (8.1% of consolidated sales), manufacturing capabilities and technology collaboration with foreign OEMs. Exhibit 9: SWOT analysis Strengths BEL has 9 manufacturing plants with a gross block of `26.2bn, materially higher than any other defence electronic peer BEL s R&D budget is `5,099mn, significantly higher than the R&D budget of Tata Power SED (`261mn) and Astra Microwave (`154mn) BEL has strong relationship with armed forces and a proven track record BEL has technology collaboration with global majors such as Thales, Elbit systems, Textron Opportunities We estimate that the cumulative opportunity size for the defence electronics industry in the next 4 years would be `314bn (3x FY14 defence electronic revenues) The new defence capital acquisition opportunity could be US$20bn over the next three years, leading to a US$6bn offset opportunity for domestic manufacturers Source: Company, Ambit Capital research Weaknesses Bharat Electronics Whilst BEL is the most-efficient DPSU, it still has bureaucratic decisionmaking processes as compared to private companies Whilst BEL is a technology leader amongst domestic players, it is a laggard as compared to global defence manufacturing majors Threats The NDA Government has taken several steps to encourage private sector participation; hence, BEL could lose market share due to higher competition intensity in the sector The new Government s policies encourage JVs between domestic and foreign majors; BEL would not be able to match the R&D budget of global majors and hence it might lose market share in defence electronics August 12, 2014 Ambit Capital Pvt. Ltd. Page 42

43 Bharat Electronics Competitive mapping: BEL is best placed As mentioned above, we estimate that the opportunity size for the defence electronics industry in the next four years would be `314bn (3x the size of defence electronic industry as on March 2014). Based on our competitive mapping framework, we believe that Bharat Electronics followed by Tata Electronics SED are best placed to capitalise on this large upcoming opportunity in defence electronics. We have ranked the domestic defence electronics companies on five key parameters: (a) relationship with the armed forces, (b) manufacturing and technology capability, (c) legal cases/allegations, (d) gross block and revenue size, and (e) financial ability to make large investments. Exhibit 10: Competitive mapping framework of Indian defence shipyards Relationship Manufacturing Legal/Corruption Shipbuilding companies with armed capabilities allegations forces Bharat Electronics Tata Power SED Astra Microwave L&T subsidiaries* Source: Ambit Capital research; Note: L&T subsidiaries L&T Cassidian and L&T Heavy Steel and Forgings Note: - Strong; - Relatively Strong; - Average; - Relatively weak. Gross Block and revenue Size Financial strength of the parent Total Exhibit 11: The numbers behind our scorecard for key defence electronics companies Revenues EBIT Pre-tax Debt: Gross Block Companies (` mn) margin RoCE Equity size (` mn) Gross block turnover R&D expense (` mn) R&D as % of sales Bharat Electronics 65, % 11.6% , , % Tata Power SED 2, % 30.7% 1.0 7, % Astra Microwave 5, % 23.5% 0.2 2, % L&T subsidiaries % -7.1% , N.A. N.A. Source: Company, Ambit Capital research. Note: L&T Subsidiaries L&T Cassidian and L&T Heavy Steel and Forgings (a) Key relationships with the Government: Bharat Electronics: It is a public sector undertaking under the Ministry of Defence. Astra Microwave: The core founders of Astra Microwave were researchers with government agencies. Mr Malla Reddy, Managing Director, worked for more than two decades in research agencies such as ISRO and DRDO. Mr Chitrakar, Director and COO, was a scientist with Defence Electronics Laboratory for 20 years. L&T Heavy Steel and Forgings: The Head of the International Defence and Aerospace business at L&T Heavy Engineering is Commadore Mukesh Bhargava. Mr Bhargava has more than 30 years of experience in the Indian Navy. He was the head of submarine design for strategic forces, communication and C4I systems. (b) Manufacturing capability: BEL and Tata Power SED are best placed Bharat Electronics (BEL): It is a leading manufacturer of defence electronic equipment with an order book of `232bn. Its order book comprises Akash weapon systems, passive night vision devices, advanced communication systems and civilian orders such as the national population register. The defence segment accounts for 82% of FY14 revenues (`53.4bn revenues from the defence segment). BEL has built an indigenous manufacturing capability on the back of its strong focus on R&D. BEL s R&D expense was `5,099mn, 8.1% of consolidated FY13 sales. As a result, 85% of BEL s revenues were driven by indigenous products. In addition, the company has an export order book of US$191mn as on FY14, 103% higher than FY13. August 12, 2014 Ambit Capital Pvt. Ltd. Page 43

44 Bharat Electronics Exhibit 12: Bharat Electronics has built superior manufacturing capability Manufacturing Location Ghaziabad Panchkula Kotdwara Navi Mumbai Pune Hyderabad Machalipatnam Bangalore Chennai Source: Company Products Network Centric systems, radars, antennas, satcom, microwave components Military communication equipment, encryption products Military communication system, tele-communication system Shelters, masts X-ray tubes, batteries, laser products Electronic warfare system Electro-optics Military communication, network centric systems, naval systems, electronic warfare, avionics, weapon systems, telecom & broadcast systems, components, coastal surveillance systems, electronic voting machines, solar products, traffic signals, security systems, microwave super components Tank Electronics, Gun upgrades Tata Power SED: Tata Power SED can design missile and rocket launchers, communication systems and electronic warfare. The order book of Tata Power SED was `27,700mn as on March 2013 and it reported revenues of `2,930mn in FY13, implying a book-to-bill ratio of 9.4x. L&T s JV with Cassidian and L&T Heavy Steel and Forging: L&T had formed a JV with Cassidian in 2011 to manufacture electronic equipments in India for electronic warfare, radars and avionics for military application. L&T has a 74% share and Cassidian has a 26% share in the JV. The JV had planned to make investments of US$20mn to set-up a manufacturing plant in Talegaon, Maharashtra. However, the JV has no manufacturing base and it did not win any projects. This JV had nil gross block and nil revenues as on March Astra Microwave: Astra Microwave manufactures radars, telemetry and groundbased surveillance. The company had an order book of `9,716mn, out of which the export order book accounts for `4,814mn. The company s revenues increased from `2,383mn in FY13 to `5,442mn in FY14 (up 127% YoY). Further, exports accounted for 63% of FY14 revenues (` 5,442mn). The export order book is driven by the offset clause which mandates a minimum 30% procurement from India for defence equipment categorised as Buy (Global), and Buy and Make (Global). Astra Microwave incurred an R&D expense of `154mn, 2.9% of sales in FY14. (c) Legal and corruption allegations: We did not find any legal and corruption allegations against BEL, L&T, Tata Power SED and Astra Microwave. (d) Gross block and revenue size: BEL has nine manufacturing plants, leading to a gross block of `26.2bn and revenue turnover of `65.2bn as on FY14, materially higher than its peers. Amongst the private sector companies, Tata Power SED has a reasonable defence electronics manufacturing ability. In addition, Astra Microwave has a small manufacturing base for defence electronic equipments through a gross block size of `2.3bn. Further, Astra Microwave reported revenues of `5.3bn from the defence sector, higher than any other private domestic peer. (e) Financial strength: Amongst the private sector players, L&T and Tata have the financial strength to set-up large manufacturing plants in India with transfer of technology from foreign players. Whilst BEL has a strong balance sheet, it has not used its surplus cash to increase manufacturing capacity. Amongst the component manufacturers, Astra Microwave has a strong balance sheet, with 0.2x debt-to-equity as on March (f) Technology collaborations and R&D budget: BEL has formed several technology collaborations with several reputed foreign defence manufacturers, as mentioned below, for high-technology radars and communication systems. In addition, BEL has the highest R&D budget of `5.1bn in FY14 as compared to Astra Microwave s `154mn and Tata Power SED s `261mn. August 12, 2014 Ambit Capital Pvt. Ltd. Page 44

45 Bharat Electronics Pick-up in execution of the Akash missile project Bharat Electronics won the contract as the lead integrator for Akash missile systems ordered by the Indian Air Force. BEL is responsible for supplying missile launchers, radars and substations for these contracts. In addition, BEL also won the contract to supply radars and other electronic equipment for Akash missiles for the Army. The total order intake of BEL from the Akash missile systems ordered by the Army and Air Force was `67bn in FY According to industry participants, the execution of the Akash missile system was delayed due to the capacity constraints at Bharat Dynamics Limited (BDL). As a result, BEL s revenues were sluggish over FY We estimate that the execution of Akash missile would pick-up post the capacity addition at BDL. As a result, BEL s order book execution (book-to-bill of 3.8x) would pick-up, leading to 14% revenue CAGR over FY Exhibit 13: Execution of Akash missile would lead to pickup in YoY revenue growth Exhibit 14: Pick-up in revenue growth, with 90bps increase in EBITDA margin over FY % % 80 15% % % 5% % 5% - FY11 FY12 FY13 FY14 FY15E FY16E 0% - FY17E FY18E FY19E FY20E FY21E FY22E 0% Revenues (Rs bn) Revenue YoY growth (%) EBITDA margin (%) Revenues (Rs bn) Revenue YoY growth (%) EBITDA margin (%) Source: Company, Ambit Capital research Source: Company, Ambit Capital research 13% revenue CAGR over FY17-22 We estimate the defence electronic industry to record 16% CAGR over FY17-22 driven by clearance of delayed projects awaiting final approval. The NDA Government has taken several positive steps to encourage the domestic private sector, such as: (a) putting an end to DPSU monopoly in aircraft production, (b) increasing the FDI limit to 49%, and (c) relaxing the licensing norms for defence equipment production. As a result of the above policy changes that encourage private sector participation, the competition intensity would increase for BEL. Thus, BEL would report 13% revenue CAGR over FY17-22, lower than the industry average. Whilst BEL s market share would decline from 61% in FY14 to ~54% in FY22, we expect BEL to retain its market leadership on the back of indigenous products developed through investments in R&D (8.1% of sales), manufacturing capabilities and technology collaboration with foreign OEMs. Higher EBITDA margin driven by higher share of defence revenues and employee productivity We expect EBITDA margin to increase from 14.1% in FY14 to 15.2% in FY16 owing to increase in the share of the defence segment through execution of higher-margin Akash missile orders and continued increase in employee productivity. Bharat Electronics restructured its employee base over FY04-14, as it reduced the number of employees from 13,038 in FY04 to 9,306 in FY14. Further, it increased the number of R&D employees from 2,393 in FY04 to 3,869 in FY14. As a result, employee productivity increased sharply over FY Despite the 38% wage hike in FY10, the employee cost to sales ratio of 16% in FY14 is similar to the FY09 levels. We expect BEL will add 315 employees over the next two years, as the company has given a job advertisement to add 200 engineers. Thus, the employee to sales ratio would increase to 16.3% in FY15 and then decline to 15.5% in FY16. August 12, 2014 Ambit Capital Pvt. Ltd. Page 45

46 Bharat Electronics Exhibit 15: Employee restructuring led to higher productivity Exhibit 16: Moderate 8% annual wage hike, as there are no pending wage revisions at BEL % 40% 30% 20% 10% 0% -10% FY17E FY16E FY15E FY14 FY13 FY12 FY11 FY10 FY09 FY08 FY07 FY06 FY05 FY17E FY16E FY15E FY14 FY13 FY12 FY11 FY10 FY09 FY08 FY07 FY06 FY05 FY04 Number of employees (000') Source: Company, Ambit Capital research Revenue per employee (Rs mn, RHS) Employee cost (Rs mn/employee) YoY change (RHS) Source: Company, Ambit Capital research RoCE understated due to cash surplus from advances BEL received a hefty advance from the Government for the Akash missile project to set-up manufacturing facilities for the integration of the missile. Hence, its advances from clients increased by `34.2bn to `64.4bn in FY11, leading to a corresponding `29.5bn increase in cash equivalents to `65.4bn. Thus, Bharat Electronics had a negative working capital turnover in FY11. Cash equivalent of accounted for 55% of the FY14 capital employed. Thus, BEL s RoCE of 9.2% is not a true reflection of its operating return on capital employed. In our opinion, RoIC is the right metric to evaluate return on capital employed in the business. We estimate RoIC would normalise to ~23% over FY16-18, marginally lower than the average RoCE of 26.3% over FY We believe that high advances from the Government are one-off and we expect advances from clients to continue to decline for BEL. Hence, BEL s working capital will continue to deteriorate over FY We estimate gross block turnover would improve from 2.7x as on FY14 to 2.9x in FY17 due to increase in capacity utilisation. BEL is operating at 60% utilisation rate as on FY14. Overall, we expect capital employed turnover to remain flat at ~1x over FY Stable capital employed turnover as higher gross block turnover offset by lower working capital turnover Exhibit 17: Advances from Government to decline Exhibit 18: RoIC to stabilise at 23% over FY FY09 FY10 FY11 FY12 FY13 FY14 FY15E FY16E FY17E FY18E 35% 30% 25% 20% 15% 10% 5% 0% 35% 30% 25% 20% 15% FY14 FY15E FY16E FY17E FY18E 12% 10% 8% 6% 4% Advances from clients (Rs bn) % of order book (RHS) Source: Company, Ambit Capital research RoIC Source: Company, Ambit Capital research RoCE (RHS) August 12, 2014 Ambit Capital Pvt. Ltd. Page 46

47 Bharat Electronics Assumptions Exhibit 19: Key assumptions (` mn, unless specified) Key assumptions FY13 FY14 FY15E FY16E FY17E Comments Order Inflow -Total 54,740 47,300 60,000 70,000 81,900 YoY growth (%) -32.1% -13.6% 26.8% 16.7% 17.0% Closing order book 249, , , , ,424 Order Book YoY growth (%) -3.1% -7.0% -5.0% -6.0% -7.6% Order Book: Revenues Revenues 62,730 65,179 71,696 83,240 97,540 YoY growth (%) 6.1% 3.9% 10.0% 16.1% 17.2% Defence 53,321 53,446 58,791 68,786 81,200 YoY growth (%) 24% 0% 10% 17% 18% Non-defence 9,410 11,732 12,905 14,454 16,340 We estimate 20% FY14-17 order intake CAGR driven by 16% FY14-17 CAGR of defence electronics industry. We expect revenue growth to pick-up led by the execution of the Akash missile contract. BEL has signed an MoU of `68,500mn turnover with the Government. YoY growth (%) -41% 25% 10% 12% 13% EBITDA 6,282 9,222 10,177 12,122 14,794 We expect EBITDA margins to improve, given the marginal EBITDA margin 10.0% 14.1% 14.2% 14.6% 15.2% increase in the share of defence revenues and lower employee to sales ratio. Total R&D 5,099 5,461 6,186 7,390 8,903 The company will continue to increase R&D to remain competitive and innovate new products. R&D as a % of Sales 8.1% 8.4% 8.6% 8.9% 9.1% PBT before EO 11,449 12,061 12,995 14,929 17,283 PBT margin 18.3% 18.5% 18.1% 17.9% 17.7% Adjusted PAT 9,112 9,517 10,266 11,794 13,654 Net margin 14.5% 14.6% 14.3% 14.2% 14.0% EPS (`.) Working capital (excash & Current Inv) BEL received a large advance from the Government for the (8,518) 7,522 16,781 24,136 33,965 `76bn Akash missile project. We expect advances from the Advances from clients 58,900 54,771 50,908 46,814 42,321 Government to reduce, leading to lower working capital (7.4) turnover. Working Capital Turnover Ratio Gross block turnover Capital Employed 63,772 69,228 77,483 86,966 97,945 ROCE 6.5% 9.2% 9.2% 9.9% 10.9% BEL is currently operating at 60% utilisation rate. Thus, gross block turnover will increase in line with the revenue growth. BEL has capacity to report `100bn revenues. The RoCE will improve owing to higher gross block turnover and increase in EBITDA margins. CFO (13,511) 6,798 7,174 6,010 7,172 Pre-tax CFO to EBITDA would decline due to lower Pre-tax CFO/EBIDTA -176% 101% 97% 75% 73% working capital turnover. Capex (2,391) (3,530) (3,746) (2,440) (2,640) FCFF (15,902) 3,268 3,428 3,570 4,532 Source: Company, Ambit Capital research Exhibit 20: Ambit vs consensus (` mn, unless specified) Revenue (` mn) Consensus Ambit Divergence Comments FY15 70,096 71, % FY16 79,927 83, % EBITDA (` mn) FY15 9,181 10, % FY16 11,023 12, % EPS (adjusted) (`) FY % FY % Source: Ambit Capital research, Bloomberg Our revenue estimates are marginally ahead of consensus, as BEL has MoUs of `68.5n in FY15 and we estimate that the supply constraint of BDL would be resolved, leading to better execution of the Akash missile contract. Consensus estimates EBITDA margins to decline 90bps YoY in FY15. We estimate EBITDA margin would remain stable due to execution of the high-margin Akash missile contract and marginal increase in the share of defence revenues. Our other income estimates are lower than consensus. August 12, 2014 Ambit Capital Pvt. Ltd. Page 47

48 Bharat Electronics Quarterly performance summary Exhibit 21: BEL quarterly results summary (` mn, unless specified) Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Net Sales 22,321 7,792 10,399 14,437 27,273 8,846 10,093 11,724 30,560 9,967 YOY Growth -3.3% -15.4% -2.0% 0.8% 22.2% 13.5% -2.9% -18.8% 12.0% 12.7% Other operating income Total Operating Revenue 22,972 7,969 10,636 14,652 27,778 8,983 10,448 12,014 31,310 10,122 Total Expenditure 19,751 9,032 10,737 13,055 21,849 9,542 10,431 10,237 23,627 10,577 % of Revenue 88% 116% 103% 90% 80% 108% 103% 87% 77% 106% Raw material Consumed 15,184 5,292 6,912 9,457 16,405 5,617 6,187 6,248 18,257 6,514 % of Revenue 68% 68% 66% 66% 60% 63% 61% 53% 60% 65% Operating & Manufacturing Expenses 2, ,101 1,192 2, ,477 1,140 3,698 1,087 % of Revenue 10% 11% 11% 8% 9% 10% 15% 10% 12% 11% Employee Cost 2,410 2,858 2,725 2,406 3,120 3,016 2,767 2,849 1,672 2,977 % of Revenue 11% 37% 26% 17% 11% 34% 27% 24% 5% 30% EBIDTA 3,221 (1,063) (101) 1,597 5,929 (560) 17 1,777 7,683 (455) EBITDA margin (%) 14.0% -13.3% -1.0% 10.9% 21.3% -6.2% 0.2% 14.8% 24.5% -4.5% Depreciation EBIT 2,922 (1,369) (410) 1,279 5,555 (897) (325) 1,437 7,282 (819) Interest PBT (before other Income) 2,921 (1,372) (410) 1,278 5,551 (900) (325) 1,428 7,260 (819) Other Income 1,472 1,632 1,444 1,295 1,728 1,123 1,093 1,017 1,051 1,152 PBT 4, ,034 2,573 7, ,445 8, Exceptional Items PBT 4, ,034 2,573 7, ,445 8, Tax 1, , , Tax rate (%) 24% 26% 22% 23% 19% 23% 23% 22% 20% 23% Profit After Tax 3, ,976 5, ,917 6, EPS Source: Company, Ambit Capital research August 12, 2014 Ambit Capital Pvt. Ltd. Page 48

49 Bharat Electronics Valuation TP of `2,082/share Our DCF-based target price for BEL is `2,082/share, implying 14.0x FY16E EPS. BEL is trading at 14.0x one-year forward P/E, 6% higher than its 10-year average oneyear forward P/E of 13.2x. We believe that BEL is trading at a justified premium to its historical valuations given the recent government initiatives to increase the focus on: (a) indigenous manufacturing with technology transfer and (b) time tendering and execution of defence projects. Whilst BEL s market cap is higher than Astra Microwave s, BEL is trading at 12.3x FY16E EPS, a 25% discount to Astra Microwave due to the higher RoE of Astra Microwave. However, the discount is overstated, as consensus has underestimated the earnings growth of Astra Microwave. 1QFY15 results and strong order book suggest that consensus revenue estimate of 7.6% revenue CAGR over FY14-16 is understated. DCF-based valuation of `2,082/share We prefer a DCF-based valuation for BEL, because we believe that this is the best way to value a company that is capital-intensive and on a high-growth trajectory. Our DCF-based valuation of `2,082 for BEL implies 14.3x FY16E EPS and 9.7x FY16E EBITDA. We have considered a terminal growth rate of 4% for the company post FY24 which is conservative, in our opinion, given India s high requirements for defence equipment such as aircrafts and helicopters and increasing share of electronics in complex high-technology products. We assume WACC of 14.5% equivalent to its cost of equity, given that BEL is a cash surplus company. Exhibit 22: DCF valuation summary Key parameters Total PV of free cash flow (a) (` mn) 48,953 PV of terminal value (b) (` mn) 68,857 EV (a) + (b) (` mn) 117,809 Net debt (` mn) (48,737) Equity value (` mn) 166,546 Implied share price (`) 2,082 Current share price (`) 1,743 Upside 19% Implied FY16E PE (x) 14.3 Implied FY16E EV/EBITDA (x) 9.7 Current FY16E PE (x) 12.0 Current FY16E EV/EBITDA (x) 7.5 Source: Ambit Capital research August 12, 2014 Ambit Capital Pvt. Ltd. Page 49

50 Bharat Electronics Exhibit 23: FCFF over FY ,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 (1,000) (2,000) (` mn) FY15 FY16 FY17 FY18 FY19 FY20 PV of FCFF at the end of FY14 Source: Company, Ambit Capital research FY21 FY22 FY23 FY24 FY25 25% 20% 15% 10% 5% RoCE (post tax, RHS) Exhibit 24: Terminal value forms 58% of the enterprise value Particulars ` mn Total PV of free cash flow (a) 48,953 PV of terminal value (b) 68,857 EV (a) + (b) 117,809 Net debt (48,737) Equity value 166,546 Implied share price (`) 2,082 Current share price 1,789 Upside 17% Source: Company, Ambit Capital research Exhibit 25: Sensitivity to our WACC and terminal growth rate Terminal growth rate 3% 3.5% 4.0% 4.5% 5.0% WACC Source: Ambit Capital research 13.5% 2,186 2,237 2,293 2,356 2, % 2,088 2,133 2,182 2,236 2, % 1,999 2,039 2,082 2,129 2, % 1,919 1,954 1,991 2,033 2, % 1,845 1,876 1,910 1,946 1,986 August 12, 2014 Ambit Capital Pvt. Ltd. Page 50

51 Relative valuation The direct comparable domestic peer of Bharat Electronics is Astra Microwave. Whilst BEL s market cap is higher than Astra Microwave s, BEL is trading at 12.3x FY16E EPS, a 25% discount to Astra Microwave due to the higher RoE of Astra Microwave. However, the discount is overstated, as consensus has underestimated the earnings growth of Astra Microwave. BEL is trading at a discount to its global peers, as it is operating in an inefficient Indian defence industry with several challenges and vested interests. Bharat Electronics Exhibit 26: Relative valuation Mcap Revenues EBITDA Revenues RoE PE (x) EV/EBITDA (x) (US$mn) margin (%) Companies US$ CAGR FY14 FY15 FY14 FY15E FY16E FY15E FY16E mn FY14-16 Bharat Electronics 2,340 1, Astra Microwave Domestic Average Global Players Thales SA 11,453 18, Rockwell Collins Inc 9,918 4, L-3 Communications Holdings 9,033 12, Meggitt Plc 6,383 2, Cobham Plc 5,530 2, ITT Corp 4,287 2, CAE Inc 3,334 2, Heico Corp 3,061 1, Hafei Aviation Industry Co-A 2,897 1, Ultra Electronics Hldgs Plc 2,040 1, Global Average Source: Bloomberg, Ambit Capital research Cross-cycle valuation BEL is trading at valuation of 14.0x one-year forward P/E, a 7% premium to its 10- year average one-year forward P/E of 13.2x. We believe that BEL is trading at a justified premium to historical valuations, given the Government s recent initiatives to increase the focus on: (a) indigenous manufacturing with technology transfer and (b) time tendering and execution of defence projects. August 12, 2014 Ambit Capital Pvt. Ltd. Page 51

52 Bharat Electronics Exhibit 27: BEL trades at a marginal 10% premium to its 10-year average P/E Exhibit 28: BEL trades at a material premium to its 10-year average EV/EBITDA Aug-14 Jan-14 Jun-13 Nov-12 Apr-12 Sep-11 Feb-11 Jul-10 Dec-09 May-09 Oct-08 Mar-08 Aug-07 Jan-07 Jun-06 Aug-14 Jan-14 Jun-13 Nov-12 Apr-12 Sep-11 Feb-11 Jul-10 Dec-09 May-09 Oct-08 Mar-08 Aug-07 Jan-07 Jun-06 1-year fwd PE average 1-year fwd PE 1-year fwd EV/EBITDA average 1-year fwd EV/EBITDA Source: Bloomberg Source: Bloomberg August 12, 2014 Ambit Capital Pvt. Ltd. Page 52

53 Bharat Electronics Key catalysts Increase in government spending on defence electronics: We estimate the defence electronic industry to report 17% CAGR over FY14-19 led by clearance of projects worth `1,128bn. BEL is best placed to benefit from the rise in defence electronic spending due to its superior manufacturing base, strong relationship with the Government and high focus on indigenisation. BEL s JV with Thales and other foreign OEMs: BEL has formed several collaborations with noted global defence majors such as Thales, Sextant Avionics, Multitone Electronics, Sagem Systems, Textron Systems, Elbit Systems, General Electric Company, Oldelft and Israel Aerospace Industries. These collaborations would lead to higher offset contracts for BEL. Execution of Akash missile project would lead to pick-up in revenue growth and higher EBITDA margins. Indigenous manufacturing of missile projects in the medium and short range would lead to higher order intake for BEL. Risks Higher competition from private sector: The NDA Government has encouraged the private sector in defence procurement through favourable polices. We believe increase in competitive intensity would reduce BEL s market share and affect its pricing power. Lower advances from the Government: BEL has a cash surplus of `46bn due to advances from the Government for the Akash missile project. As a result, BEL had a negative working capital cycle in FY11 and FY12. Lower advances from the Government would increase the working capital cycle of BEL. Exhibit 29: Explanation for the flags on the cover page Field Score Comments Accounting Predictability Earnings momentum Source: Ambit Capital research GREEN AMBER GREEN In our accounting analysis of BSE500 companies, we have classified Bharat Electronics as an Industrials company. BELs ranks second in our accounting analysis of Industrials companies on account of a higher rank in cumulative FCF/median revenues, audit fees as % of revenues and capital WIP-gross block. The predictability is low as ~85% of the EBITDA is recognised in the fourth quarter of the financial year. Further, BEL s management does not conduct results conference calls or communicate with the sell-side equity research analysts Over the last six months, consensus EPS estimates for FY15 and FY16 have been revised upwards by 10%. August 12, 2014 Ambit Capital Pvt. Ltd. Page 53

54 Bharat Electronics Income Statement (` mn, unless mentioned) Particulars FY14 FY15E FY16E FY17E Revenue 65,179 71,696 83,240 97,540 % growth 3.9% 10.0% 16.1% 17.2% Total expenses 55,957 61,520 71,118 82,746 EBITDA 9,222 10,177 12,122 14,794 EBITDA margin 14.1% 14.2% 14.6% 15.2% Net depreciation 1,499 1,654 1,818 1,996 EBIT 7,723 8,523 10,304 12,798 Net interest Other income 4,373 4,487 4,529 4,310 Exceptional income Reported PBT 12,061 12,946 14,758 17,020 Provision for taxation 2,544 2,719 3,099 3,574 Reported PAT 9,517 10,227 11,659 13,446 Consolidated PAT 9,513 10,224 11,655 13,442 EPS (Diluted) ` Source: Company, Ambit Capital research Balance Sheet Statement (` mn, unless mentioned) Particulars FY14 FY15E FY16E FY17E Share capital Reserves and surplus 71,403 79,623 88,994 99,803 Total Networth 72,203 80,423 89, ,603 Minority interest Loans Government grants 2,206 2,206 2,206 2,206 Deferred tax liability (net) (3,015) (3,015) (3,015) (3,015) Sources of funds 71,433 79,657 89,032 99,844 Net block including CWIP 11,530 12,316 13,138 13,982 Cash and bank balances 46,045 48,740 49,033 50,841 Sundry debtors 41,559 41,786 43,953 46,159 Inventories 33,397 35,266 38,471 41,936 Loans and advances 12,585 13,844 14,932 16,161 Other Current Assets 1,626 1,788 2,076 2,433 Total Current Assets 135, , , ,530 Current Liabilities 69,258 68,031 66,519 65,617 Provisions 6,050 6,050 6,050 6,050 Current liabilities and provisions 75,308 74,081 72,569 71,667 Net current assets 59,904 67,341 75,895 85,862 Source: Company, Ambit Capital research August 12, 2014 Ambit Capital Pvt. Ltd. Page 54

55 Bharat Electronics Cash Flow Statement (` mn, unless mentioned) Particulars FY14 FY15E FY16E FY17E PBT 12,061 12,946 14,758 17,020 Depreciation 1,499 1,654 1,818 1,996 Others (4,338) (4,423) (4,454) (4,222) Direct taxes paid (2,544) (2,719) (3,099) (3,574) Change in working capital (12,316) (4,744) (8,260) (8,159) CFO (5,638) 2, ,060 Purchase of fixed assets (3,746) (2,440) (2,640) (2,840) Others 4,373 4,487 4,529 4,310 CFI 626 2,047 1,889 1,470 Proceeds from borrowings Change in share capital Interest paid (35) (65) (75) (88) Dividends paid 1,864 2,003 2,284 2,634 CFF (1,829) (1,939) (2,209) (2,546) Free cash flow (9,385) 275 (1,877) 220 Source: Company, Ambit Capital research Key ratios Particulars FY14 FY15E FY16E FY17E Gross block turnover Net Block turnover Working Capital turnover Net debt/equity -63.8% -60.6% -54.6% -50.5% ROCE 9.2% 9.2% 9.9% 11.0% ROIC 34.0% 23.9% 23.0% 22.7% ROE 14.3% 13.9% 14.2% 14.6% Source: Company, Ambit Capital research Valuation Ratios Particulars FY14 FY15E FY16E FY17E Adjusted EPS basic (`) BVPS (`) 903 1,005 1,122 1,258 DPS (`) P/E (x) P/B (x) EV/Sales (x) EV/EBITDA (x) Source: Company, Ambit Capital research August 12, 2014 Ambit Capital Pvt. Ltd. Page 55

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57 L&T SELL COMPANY UPDATE LT IN EQUITY August 12, 2014 Beneficiary but gains not substantial L&T has a diverse defence product portfolio, comprising shipyards, missile systems and artillery guns. Its FY14 defence revenues were ~`5bn, with an order book of ~`10bn. L&T s shipyards are best placed to capitalise on the supply constraints of defence PSU shipyards. Whilst L&T has several collaborations such as L&T Cassidian, these have not yielded results due to lack of orders. L&T would be the key private sector beneficiary of the Government s progressive defence sector policies, but defence accounts for less than 1% of its total revenues, which is too small to impact our target price. We reiterate SELL, owing to a marginal RoE increase of 10bps in FY14-16 and cost overrun-led losses in the hydrocarbon segment. Competitive position: STRONG Changes to this position: STABLE Diverse defence portfolio with high focus on Navy s requirements L&T has a wide product portfolio with a high focus on Indian navy. Its revenues from defence sector were ~`5bn in FY14 with an order book of ~`10bn. L&T has tie-up with Samsung Techwin (Korea) for tracked howitzers and a tie-up with Nexter (France) for towed and wheeled howitzers. In partnership with Tata Power SED, L&T manufactured the Pinaka missile s weapon delivery systems. L&T Shipyards: Ranked 1 in our competitive mapping but no orders L&T s Shipyards is ranked higher than MDL due to MDL s capacity constraint, L&T s superior financial strength and L&T s efficient decision-making process. L&T constructed the hull of INS Arihant, a nuclear submarine. It can construct interceptor vessels and covets. Whilst L&T has not won any major orders, it will be the key beneficiary of the supply constraints of PSU shipyards such as MDL. Slow progress made by L&T s JVs and collaborations L&T has collaborations with Boeing, EADS, Raytheon, Pratt & Whitney, Fincanteri and Thales. L&T had formed a JV with Cassidian in 2011 to manufacture electronic equipments but this JV has not yet began operations. In addition, L&T in consortium with TCS and HCL Tech was shortlisted for the phase-1 of the tactical communication system project. Key defence beneficiary but defence revenues too small to impact TP L&T would be a key beneficiary of the Government s policies to encourage private sector participation in defence, but its manufacturing defence sector accounts for less than 1% of total revenues. Thus, high growth in the defence sector on a low base would not materially increase L&T s fair valuation. We retain SELL stance, with a TP of `1,367, as valuation at 18.0x FY16 P/E, excluding the embedded value, is rich, given a marginal RoE improvement of 10bps in FY14-16 and cost overrun-led losses in the hydrocarbon segment. Key financials including hydrocarbon Year to March FY13 FY14 FY15E FY16E FY17E Net Revenues (` bn) ,049.4 EBITDA (` mn) 63,935 69,650 75,949 92, ,446 Net Profits (` mn) 44,963 48,194 52,901 59,326 72,532 Diluted EPS (`) RoE (%) 16.5% 15.5% 15.3% 15.6% 17.1% Working capital to sales 15.4% 20.1% 19.9% 19.4% 18.1% P/E excl. embedded value(x) Source: Company, Ambit Capital research Engineering & Construction Recommendation Mcap (bn): `1,198/US$19.9 6M ADV (mn): `2,949/US$49 CMP: `1,467 TP (12 mths): `1,367 Downside (%): 6 Flags Accounting: Predictability: Earnings Momentum: Catalyst AMBER AMBER AMBER Sustained high working capital cycle Lower margins of projects won in last 18 months Continued weak performance of hydrocarbon segment Performance (%) 27,000 25,000 23,000 21,000 19,000 17,000 15,000 Aug-13 Oct-13 Dec-13 Sensex Feb-14 Apr-14 Jun-14 Aug-14 L&T (RHS) Source: Bloomberg, Ambit Capital Research Analyst Details Nitin Bhasin nitinbhasin@ambitcapital.com Tanuj Mukhija, CFA tanujmukhija@ambitcapital.com Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

58 L&T Standalone Income statement (including hydrocarbon segment) Y/E March (` mn) FY14 FY15E FY16E FY17E Revenue 666, , ,140 1,049,396 EBITDA 69,650 75,949 92, ,446 EBITDA margin 10.4% 10.2% 10.5% 10.7% Net depreciation 8,649 9,614 10,594 11,714 Net interest 6,563 8,370 8,119 8,894 Other income 13,681 16,002 16,493 17,549 Provision for taxation 19,981 17,411 28,749 35,004 Adjusted PAT 48,194 52,901 59,326 72,532 Adjusted PAT margin 7.2% 7.1% 6.8% 6.9% Adjusted EPS diluted (`) Core EPS diluted (`) Source: Company, Ambit Capital research Standalone Balance sheet (including hydrocarbon segment) Y/E March (` mn) FY14 FY15E FY16E FY17E Total Networth 330, , , ,232 Loans 116, , , ,342 Sources of funds 450, , , ,139 Net block 85,492 88,878 93,284 98,570 Investments 190, , , ,891 Cash and bank balances 15,085 48,917 65,270 88,328 Sundry debtors 241, , , ,132 Inventories 21,259 23,937 27,997 33,371 Loans and advances 96, , , ,463 Current liabilities and provisions 354, , , ,197 Net current assets 169, , , ,708 Source: Company, Ambit Capital research Standalone Cash flow statement (including hydrocarbon segment) Y/E March (` mn) FY14 FY15E FY16E FY17E Cash flow from operations 21,777 43,342 48,653 66,209 Purchase of fixed assets (11,000) (13,000) (15,000) (17,000) Investments/loans to subs (29,105) (2,989) (11,557) (17,207) CFI (26,505) 13,967 (2,450) (20,143) CFF 4,866 (23,478) (29,850) (23,007) Free cash flow 10,777 30,342 33,653 49,209 Source: Company, Ambit Capital research Standalone Valuation and ratios (including hydrocarbon segment) Y/E March FY14 FY15E FY16E FY17E Debt:Equity Working capital turnover (x) ROCE 14.2% 13.8% 13.8% 15.0% ROIC 24.1% 21.9% 21.2% 23.1% ROE 15.5% 15.3% 15.6% 17.1% DPS (`) P/E excl. embedded value (x) P/B (x) EV/EBITDA(x) Source: Company, Ambit Capital research August 12, 2014 Ambit Capital Pvt. Ltd. Page 58

59 Tata Group Subsidiaries NOT RATED COMPANY UPDATE August 12, 2014 The diversified leader Tata Group has built the largest defence product portfolio such as missile systems, armored vehicles, radars and aerospace components through foreign collaborations and indigenous R&D. The defence revenues were `25bn with `80bn order book in FY14. The jewels in the group are Tata Advanced Systems (TASL) and Tata Power SED. TASL is the sole OEM supplier for Sikorsky helicopter cockpits and tails for Lockheed Martin. Tata Group is best placed to win contracts from the US$10bn future infantry combat vehicle and offset contracts from US$2bn helicopter projects. But, its defence companies are not listed or account for small share of listed entities Tata Power, Tata Motors Competitive position: STRONG Changes to this position: POSITIVE Tata Group Largest private Indian defence manufacturer The Tata Group, through its 14 subsidiaries, has the largest defence product portfolio amongst Indian companies. Their product portfolio includes missile systems, helicopter cockpits, aerospace components, armored vehicles, defence electronics such as radars, electronic warfare. The Tata Group s FY14 revenues from defence sector were `25bn and the order book was `80bn (3.2X book-tobill ratio. The key defence subsidiaries of Tata Group are Tata Advanced Systems (TASL) with `4bn revenue and order book of `45bn, Tata Motors with `10bn revenues and Tata Power Strategic Electronics Division (SED) with `2.4bn revenues in FY13 and `27.7bn order book. Tata Power SED; TASL Leaders amongst private companies According to our competitive mapping of defence electronics companies, Tata Power SED is ranked 2, below BEL. Tata Power SED has the second highest gross block and R&D to sales ratio of 8.9%. However, its gross block turnover was 0.4x in FY13. TASL, gem in Tata s defence portfolio, is the leader amongst private players in aerospace. It accounts for 56% of total defence order book of Tata Group. TASL manufactures aerospace and aero-structures, missile systems and radar systems. Tata Motors Defence Solution supplies buses and trucks to the army. The company has developed prototype of two armored vehicles LamV and Kestrel, competitors to the controversial Tatra armored vehicles sourced by BEML. Built capability in aerospace through collaborations with global OEMs The Tata Group has formed collaborations with noted global manufacturers such as Sirkorsky Aircraft, Israel Aerospace Industries, EADS, Thales, Boeing and Lockheed Martin. These collaborations have enabled Tata Group to manufacture aerospace components, Optronics and tactical communication systems. In fact, TASL is the single global supplier for the Sikorsky S-92 helicopter cabin assembly and Lockheed Martin C-130 J Empennage and center wing box assembly. Opportunities for Tata Group FICV, offsets from aerospace projects Sikorsky Aircraft won a US$1.2bn contract from the US Government to supply six helicopters. TASL will be the sole global OEM supplier to manufacture helicopter cabins for this project. TASL would benefit from the offsets for US$1.1bn order for 22 Boeing Apache attack helicopters and US$1bn for 197 light utility helicopters. The key domestic order for the Tata Group could be US$10bn future infantry combat vehicle as it can indigenously manufacture armored vehicles, missile systems and radars. Capital Goods - Defence Analyst Details Tanuj Mukhija, CFA tanujmukhija@ambitcapital.com Nitin Bhasin nitinbhasin@ambitcapital.com Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

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61 Pipavav Defence NOT RATED COMPANY UPDATE PIPV IN EQUITY August 12, 2014 Growth certain but profitability? Pipapav Defence has the second-largest dry-dock in the world with an order book of US$1.1bn. The shipyard was designed by Komac, leading consultant but Pipavav modified the shipyard design leading to an inefficiently designed linear shipyard. Pipavav is ranked lower than L&T and MDL in our competitive framework due to its leveraged balance sheet and the tax evasion allegations against its holding company, SKIL Infrastructure. The Indian Navy qualified Pipavav Defence and Saab to modernise 100 fighting ships. Its order book could grow multifold given 13% CAGR of navy capital expenditure over FY14-19 and higher share of the private sector. However, the stock trades at an expensive 1.7X FY14 P/B given 5-year trailing average RoE of 0.5%. Competitive position: MODERATE Changes to this position: POSITIVE Second-largest dry-dock but inefficient design, according to experts Pipavav Defence has the second-largest dry-dock shipbuilding facility in the world along with good infrastructure connectivity. The shipyard was designed by Korea Maritime Consultants (KOMAC), a leading shipbuilding consultant. According to shipyard experts, Pipavav made modifications to the design submitted by KOMAC, leading to an inefficiently designed linear shipyard. Competitive mapping: Leveraged balance sheet Pipavav Defence has the largest shipyard in India, with supporting infrastructure that allows low-cost assembling near the shipyard. However, Pipavav Defence has a leveraged balance sheet limiting its investment appetite. The offices of SKIL Infrastructure, holding company of Pipavav Defence, were raided by the Income Tax Department for tax evasion. Hence, Pipavav Defence is ranked lower than L&T and MDL amongst defence shipyards in India. Order book of US$1.1bn could grow multi-fold Pipavav has a tie-up with Saab and Babcock to design naval combat vessels and warships. The Indian Navy qualified Pipavav Defence and Saab to modernise 100 fighting ships over the next 10 years. In addition the company won a `25bn contract to manufacture gun boats due to its aggressive bidding. Pipavav s order book of US$1.1bn could grow multifold given 13% CAGR of Navy capital expenditure over FY14-19 and higher share of private sector. Pipavav Defence trading at 1.7X FY14 P/B and FY14 RoE of 0.5% Pipavav has a large shipyard with supporting infrastructure and good relationships with armed forces which could lead to strong growth in its order book and hence revenues over FY However, Pipavav Defence is trading at expensive 1.7X FY14 P/B given its five-year trailing average RoE of 0.5%. Key financials Year to March FY10 FY11 FY12 FY13 FY14 Net Revenues (` mn) 6,294 8,599 18,671 25,865 25,337 Operating Profits (` mn) -13 1,325 4,202 5,442 6,255 Net Profits (` mn) Diluted EPS (`) RoE (%) -3.2% 2.6% 1.1% 1.5% 0.1% P/E (x) N.A P/B (x) Source: Company, Ambit Capital research Capital Goods-Defence Recommendation Mcap (bn): 6M ADV (mn): CMP: TP (12 mths): Downside (%): Flags Accounting: Predictability: Earnings Momentum: Performance (%) 27,000 25,000 23,000 21,000 19,000 17,000 15,000 Aug-13 Sensex Oct-13 Dec-13 Feb-14 Source: Bloomberg, Ambit Capital Research Analyst Details `36.4/US$0.6 `17/US$0.3 `49 N.A. N.A. Apr-14 Jun-14 AMBER RED AMBER Aug Pipavav Defence (RHS) Tanuj Mukhija, CFA tanujmukhija@ambitcapital.com Nitin Bhasin nitinbhasin@ambitcapital.com Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

62 Pipavav Defence Income statement (` mn) Particulars (` mn) FY10 FY11 FY12 FY13 FY14 Revenue 6,294 8,599 18,671 25,865 25,337 Total expenses 6,306 7,275 14,468 20,422 19,081 EBITDA -13 1,325 4,202 5,442 6,255 EBITDA margin -0.2% 15.4% 22.5% 21.0% 24.7% Net depreciation ,103 1,272 1,665 Net interest 730 1,193 2,577 3,988 4,775 Other income Provision for taxation Consolidated PAT (461) Source: Ambit Capital Research, Company Balance Sheet (` mn) Particulars (` mn) FY10 FY11 FY12 FY13 FY14 Reserves and surplus 9,882 10,206 12,572 13,563 16,068 Total Networth 16,540 17,489 19,883 20,779 23,430 Loans 13,299 20,209 30,101 49,739 48,007 Sources of funds 29,854 37,814 50,656 71,327 72,427 Net block including CWIP 25,830 28,485 29,273 50,582 60,827 Cash and bank balances 6,402 4,277 2,783 3,756 3,844 Sundry debtors 70 2,050 9,094 8,960 13,956 Inventories 1,330 2,453 3,391 1,628 2,309 Loans and advances 1,902 3,674 7,312 7,396 11,907 Other Current Assets 3,484 4,345 7,923 9,458 7,966 Current liabilities and provisions 9,243 7,701 9,228 10,516 28,400 Net current assets 3,946 9,098 21,275 20,682 11,581 Source: Ambit Capital Research, Company Cash flow statement (` mn) Particulars (` mn) FY10 FY11 FY12 FY13 FY14 PBT (444) Change in working capital (6,691) (6,052) (9,597) (514) 656 CFO (5,088) (4,912) (6,153) 6,217 6,731 Purchase of fixed assets (580) (3,372) (5,275) (19,756) (11,909) CFI 1,312 (3,217) (4,672) (19,490) (11,519) CFF 10,449 10,926 17,002 (2,161) 4,775 Free cash flow (5,668) (8,283) (11,428) (13,539) (5,178) Source: Ambit Capital Research, Company Key ratios Particulars FY10 FY11 FY12 FY13 FY14 Net debt/equity 41.7% 91.1% 137.4% 221.3% 188.5% ROCE -1.5% 1.9% 2.0% 4.7% 0.8% ROIC -2.0% 2.3% 2.1% 5.0% 0.9% ROE -3.2% 2.6% 1.1% 1.5% 0.1% P/E (x) N.A EV/EBITDA (x) N.A Source: Ambit Capital Research, Company August 12, 2014 Ambit Capital Pvt. Ltd. Page 62

63 Pipavav Defence Institutional Equities Team Saurabh Mukherjea, CFA CEO, Institutional Equities (022) Research Analysts Industry Sectors Desk-Phone Nitin Bhasin - Head of Research E&C / Infrastructure / Cement (022) nitinbhasin@ambitcapital.com Aadesh Mehta Banking / Financial Services (022) aadeshmehta@ambitcapital.com Achint Bhagat Cement / Infrastructure (022) achintbhagat@ambitcapital.com Aditya Khemka Healthcare (022) adityakhemka@ambitcapital.com Akshay Wadhwa Banking & Financial Services (022) akshaywadhwa@ambitcapital.com Ashvin Shetty, CFA Automobile (022) ashvinshetty@ambitcapital.com Bhargav Buddhadev Power / Capital Goods (022) bhargavbuddhadev@ambitcapital.com Dayanand Mittal, CFA Oil & Gas / Metals & Mining (022) dayanandmittal@ambitcapital.com Deepesh Agarwal Power / Capital Goods (022) deepeshagarwal@ambitcapital.com Gaurav Mehta, CFA Strategy / Derivatives Research (022) gauravmehta@ambitcapital.com Karan Khanna Strategy (022) karankhanna@ambitcapital.com Krishnan ASV Real Estate (022) vkrishnan@ambitcapital.com Pankaj Agarwal, CFA Banking / Financial Services (022) pankajagarwal@ambitcapital.com Paresh Dave Healthcare (022) pareshdave@ambitcapital.com Parita Ashar Metals & Mining / Oil & Gas (022) paritaashar@ambitcapital.com Pratik Singhania Retail (022) pratiksinghania@ambitcapital.com Rakshit Ranjan, CFA Consumer / Retail (022) rakshitranjan@ambitcapital.com Ravi Singh Banking / Financial Services (022) ravisingh@ambitcapital.com Ritesh Vaidya Consumer (022) riteshvaidya@ambitcapital.com Ritika Mankar Mukherjee, CFA Economy / Strategy (022) ritikamankar@ambitcapital.com Ritu Modi Automobile (022) ritumodi@ambitcapital.com Sagar Rastogi Technology (022) sagarrastogi@ambitcapital.com Sumit Shekhar Economy / Strategy (022) sumitshekhar@ambitcapital.com Tanuj Mukhija, CFA E&C / Infrastructure (022) tanujmukhija@ambitcapital.com Utsav Mehta Technology (022) utsavmehta@ambitcapital.com Sales Name Regions Desk-Phone Sarojini Ramachandran - Head of Sales UK +44 (0) sarojini@panmure.com Deepak Sawhney India / Asia (022) deepaksawhney@ambitcapital.com Dharmen Shah India / Asia (022) dharmenshah@ambitcapital.com Dipti Mehta India / USA (022) diptimehta@ambitcapital.com Nityam Shah, CFA USA / Europe (022) nityamshah@ambitcapital.com Parees Purohit, CFA UK / USA (022) pareespurohit@ambitcapital.com Praveena Pattabiraman India / Asia (022) praveenapattabiraman@ambitcapital.com Production Sajid Merchant Production (022) sajidmerchant@ambitcapital.com Sharoz G Hussain Production (022) sharozghussain@ambitcapital.com Joel Pereira Editor (022) joelpereira@ambitcapital.com Nikhil Pillai Database (022) nikhilpillai@ambitcapital.com E&C = Engineering & Construction August 12, 2014 Ambit Capital Pvt. Ltd. Page 63

64 Pipavav Defence Explanation of Investment Rating Investment Rating Expected return (over 12-month period from date of initial rating) Buy >5% Sell <5% Disclaimer This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of Ambit Capital. AMBIT Capital Research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities is available on request. Disclaimer 1. AMBIT Capital Private Limited ( AMBIT Capital ) and its affiliates are a full service, integrated investment banking, investment advisory and brokerage group. AMBIT Capital is a Stock Broker, Portfolio Manager and Depository Participant registered with Securities and Exchange Board of India Limited (SEBI) and is regulated by SEBI 2. 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AMBIT Capital makes best efforts to ensure that conflicts are identified and managed and that clients interests are protected. AMBIT Capital has policies and procedures in place to control the flow and use of non-public, price sensitive information and employees personal account trading. Where appropriate and reasonably achievable, AMBIT Capital segregates the activities of staff working in areas where conflicts of interest may arise. However, clients/potential clients of AMBIT Capital should be aware of these possible conflicts of interests and should make informed decisions in relation to AMBIT Capital s services. 16. AMBIT Capital and/or its affiliates may from time to time have investment banking, investment advisory and other business relationships with companies covered in this Research Report and may receive compensation for the same. Research analysts provide important inputs into AMBIT Capital s investment banking and other business selection processes. 17. AMBIT Capital and/or its affiliates may seek investment banking or other businesses from the companies covered in this Research Report and research analysts involved in preparing this Research Report may participate in the solicitation of such business. 18. In addition to the foregoing, the companies covered in this Research Report may be clients of AMBIT Capital where AMBIT Capital may be required, inter alia, to prepare and publish research reports covering such companies and AMBIT Capital may receive compensation from such companies in relation to such services. However, the views reflected in this Research Report are objective views, independent of AMBIT Capital s relationship with such company. 19. In addition, AMBIT Capital may also act as a market maker or risk arbitrator or liquidity provider or may have assumed an underwriting commitment in the securities of companies covered in this Research Report (or in related investments) and may also be represented in the supervisory board or on any other committee of those companies. Additional Disclaimer for U.S. Persons 20. The research report is solely a product of AMBIT Capital 21. AMBIT Capital is the employer of the research analyst(s) who has prepared the research report 22. Any subsequent transactions in securities discussed in the research reports should be effected through J.P.P. Euro-Securities, Inc. ( JPP ). 23. JPP does not accept or receive any compensation of any kind for the dissemination of the AMBIT Capital research reports. 24. The research analyst(s) preparing the research report is resident outside the United States and is/are not associated persons of any U.S. regulated broker-dealer and that therefore the analyst(s) is/are not subject to supervision by a U.S. broker-dealer, and is/are not required to satisfy the regulatory licensing requirements of FINRA or required to otherwise comply with U.S. rules or regulations regarding, among other things, communications with a subject company, public appearances and trading securities held by a research analyst account. Additional Disclaimer for Canadian Persons 25. AMBIT Capital is not registered in the Province of Ontario and /or Province of Québec to trade in securities nor is it registered in the Province of Ontario and /or Province of Québec to provide advice with respect to securities. 26. AMBIT Capital's head office or principal place of business is located in India. 27. All or substantially all of AMBIT Capital's assets may be situated outside of Canada. 28. It may be difficult for enforcing legal rights against AMBIT Capital because of the above. 29. Name and address of AMBIT Capital's agent for service of process in the Province of Ontario is: Torys LLP, 79 Wellington St. W., 30th Floor, Box 270, TD South Tower, Toronto, Ontario M5K 1N2 Canada. 30. Name and address of AMBIT Capital's agent for service of process in the Province of Montréal is Torys Law Firm LLP, 1 Place Ville Marie, Suite 1919 Montréal, Québec H3B 2C3 Canada. Copyright 2014 AMBIT Capital Private Limited. All rights reserved. Ambit Capital Pvt. Ltd. Ambit House, 3rd Floor 449, Senapati Bapat Marg, Lower Parel, Mumbai , India. Phone: Fax: CIN: U74140MH1997PTC August 12, 2014 Ambit Capital Pvt. Ltd. Page 64