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Diversification on track; rising indigenization bodes well

* Scaling up the non-Defense business: The management’s target of scaling up the non-Defense business remains on track. It is aiming at a 20-30% share in total revenue over the next few years (~10% now). BHE has received a trail order from Delhi Metro, which marks its beginning in the Railways and Metro business. In Medical Electronics, it is working with aggregators who can undertake deliveries and installations across hospitals. It entered SaaS last year and aims to scale the business to INR50b over the next three years. The capex requirement in the non-Defense business is moderate as most of these products are modifications of its existing Defense products.

* Higher indigenization in line with ‘Make in India’: In line with the government’s Make in India initiative, there are 692 items which have been identified by the Ministry of Defense’s (MoD) under its Indigenization portal (Srijan) from which BHE stands to benefit. Under the MoD’s ‘Make-II’ list (items barred for imports), BHE has expressed interest in 69 items, of which 30 are under various stages of development. With respect to raw materials, almost 50% is imported (mainly at the component level), owing to lack of availability in India. The management aims to indigenize ~10% of it in India.

* Order inflow pipeline healthy, order book robust: Order inflows stood at INR53b in FY22 YTD. Its order book stood strong at INR558b. With strong order prospects in place, the management is confident of an order inflow run-rate of INR150-170b in FY22. It expects revenue growth of 12-15% CAGR over the next 3-4 years, led by a strong order book, robust order inflows, and the MoD’s indigenization drive.

* Expect revenue from services to scale up: The management is targeting annual maintenance contracts and certain civilian segments to scale up its revenue from services. As against 10-12% of Defense business revenue currently, it aims to ramp up its services revenue share to ~25% over the next five years.

* Strong focus on R&D to continue: Owing to COVID-led disruption, R&D spending stood ~6.3% of FY21 revenue as against an average of ~9% over FY11-20. The management aims to revert R&D spending to 9-10% of sales. Around 80% of FY21 revenue is via indigenous R&D.  Capex intensity to remain intact: BHE aims to incur ~INR18b on capex over the next three years. Some of the key projects with higher capex are: LRSAM (INR3b), missile and seekers (INR3b), and Electronic Warfare systems (INR 2b).

* Valuation and view: We forecast a revenue/EBITDA/PAT CAGR of 11%/8%/10% over FY21-24E. We have built in a sufficient margin cushion as we assume an EBITDA margin of ~21% over FY22-24E (v/s 22.6% reported in FY21). We roll forward our valuation to Sep’23E. Our TP stands at INR240/share (22x Sep’23E EPS). At the CMP, the stock trades at 20x/19x FY23E/FY24E P/E, despite a RoE/RoCE of ~18%/19% (FY23E), dividend yield of ~2%, and FCF yield of 2-3%. We maintain our Buy rating. Higher growth in the non-Defense business poses an upside risk to our EPS estimates, while working capital deterioration presents a key downside risk to valuations.

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