Nirmal Bang cuts defence sector rating to ’sell’ on expensive valuations, has bullish long-term view

Indian defence stocks have seen a remarkable rally in recent years, fueled by strong order wins, revenue growth, and the government’s significant push for indigenisation in the defence sector.

However, this impressive surge has led many of these stocks to trade at high valuations, raising concerns about their potential for further gains.

Amid this backdrop, domestic brokerage firm Nirmal Bang has downgraded its rating on the defence sector to 'sell,' adjusting ratings for the majority of the stocks and lowering target prices.

The defence stocks tracked by the brokerage have delivered substantial returns: 58% over the last three months, 75% over the last six months, 148% over the last year, and an astounding 776% over the past three years.

The brokerage believes that the exuberance around the defence sector has been built solely around strong order books for assigning high valuations. Therefore, the conventional financial metrics do not fully capture the industry's true value, particularly cyclicality, profitability, and efficiency.

While it remains structurally positive on the defence sector, it said the current steep valuations (stocks are trading well above their +2SD valuations despite assuming extremely aggressive earnings growth) do not take into account the risks from execution hiccups, rise in raw material costs, competitive pressures, and cash flow generation.

"Despite assuming extremely strong earnings growth, the ROE estimate for FY26 remains 10–30% for coverage stocks, making it difficult for us to justify exorbitant multiples," said Nirmal Bang.

The brokerage prefers to remain on the sidelines until valuations return to reasonable levels. Therefore, it downgrades the defence sector to 'SELL'.

Target prices and ratings were adjusted

The brokerage has revised target prices and ratings for several stocks. The target price for Astra Microwave Products has been reduced to ₹894 per share from the previous ₹968, with a rating adjustment from 'buy' to 'accumulate.'

Similarly, Bharat Dynamics' target price has been lowered to ₹1,508 per share from ₹1,563, maintaining the 'accumulate' rating. Bharat Electronics has been downgraded to 'sell' from 'buy,' with a significant 22% reduction in the target price to ₹256 per share.

Data Patterns (India) also saw a revised target price, now set at ₹3,017 per share, down from ₹3,226, while retaining the 'accumulate' rating. HAL's rating has been downgraded to 'sell' from 'buy,' with the target price cut to ₹4,380 per share from ₹5,469.

Conversely, the brokerage has increased the target price for Bharat Earth Movers to ₹4,954 per share from ₹3,676, while maintaining the 'accumulate' rating. Mazagon Dock Shipbuilders target price has been upgraded to ₹4,143 per share from ₹3,724, though its rating has been lowered to 'sell.'

Paras Defence & Space Technologies rating has been revised to 'sell,' with the target price raised to ₹1,181 per share from ₹916.

Q1FY25 results preview: slow execution despite a solid order book

"Weak quarter for the defence industry due to sluggishness in executing orders. While the management of companies in our coverage universe has guided the delivery of programs and platforms in FY25, the timelines are not well defined," said Nirmal Bang.

During the interactions with the management, the brokerage gathered likely delays in order inflows and receipt of payments despite timely execution of projects due to elections in the June quarter.

Long-term outlook: Positive

From FY18 to FY24, the companies covered by the brokerage have achieved a CAGR of 6% in order book, 8% in revenue, 17% in EBITDA, and 20% in PAT. Looking ahead, the brokerage forecasts a CAGR of 20% in revenue, 27% in EBITDA, and 25% in PAT for FY25E–FY26E.

Considering the substantial opportunities both domestically and in exports, the defence sector is well-positioned for long-term growth. Recent conflicts in regions near India, Europe, and other parts of the world have underscored the need to expand defence capital expenditure and localise defence manufacturing, according to the brokerage. 

Disclaimer: The views and recommendations given in this article are those of individual analysts. These do not represent the views of Mint. We advise investors to check with certified experts before taking any investment decisions.