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Robust margins, robust orderbook

Hindustan Aeronautics (HAL) reported strong performance in Q2FY23. Key highlights: 1) EBITDA margin at 31% was ahead of the 25-26% guidance for FY23- FY25; 2) provisions during the quarter reverted to 7% (in line with historical range of 6-7%); 3) in our view, repair and overhaul (RoH) and spares revenue must have dominated Q2FY23 execution to justify such a strong margin-accretive growth (gross margin was 64% in Q2FY23; 4) Board has recommended the first interim dividend of Rs20/share. Going ahead, we believe ROH and spares revenue are likely to dominate, leading to strong margins. That said, the orderbook remains impressive and the pipeline is significant. Besides, focus on exports remains intact with the company signing an MoU for opening an office in Malaysia. We reinitiate coverage on HAL with BUY. Our target price of Rs3,170/share is based on the DCF methodology. Delay in execution of manufacturing orders remains a key risk to our thesis.

* Splendid Q2FY23 performance. HAL reported its Q2FY23 EBITDA at Rs16.2bn (up 30.8% YoY, 96.3% QoQ). Key highlights: 1) gross margin at 64% was elevated for the second quarter in a row, possibly due to higher ROH and spares revenue; 2) provisions were down 21.2% YoY (25.4% QoQ) to Rs3.4bn – reverting to historical 6~7% level as there were no one-off incidents in FY22; 3) focus on exports remains intact as HAL has executed an MoU for establishing an office in Malaysia to tap new business opportunities for Fighter Lead-in Trainer (FLIT) LCA, Su-30 MKM and Hawk upgrades besides others; 4) Board has recommended an interim dividend of Rs20/share. Going ahead, we believe, in the near term, ROH and spares revenue would aid margins while the firm orderbook and order funnel continue to be strong. Hence, we believe the company is at a vantage point to increase its earnings over the next few years.

* Impressive orderbook and order funnel gives comfort. HAL’s firm orderbook of US$7.3bn comprises: 83 nos. LCA MK-1A, 10 nos. LCA, 9 ALH, 9 LCH and upgrade opportunities. Besides the company has also concluded a contract with Indian Air Force for 70 nos. HTT-40 indigenous trainer aircraft worth Rs68bn. In the medium term (12-18 months), orders worth US$5bn are expected – comprising 25 nos. ALH, 12 nos. LUH, 12 SU-30, etc. In the longer term (3-5 years), the company is expecting orders worth Rs8.8bn comprising 145 nos. LCH, 175 nos. LUH, 60 UHMs, 36 HTTs among others. Besides, the company is targeting to derive 10% of its revenue from exports. Furthermore, HAL has increased its R&D reserve to 15% (from 10%) to focus on new programmes required in the future.

* Outlook: Bright prospects, robust margins in the near term We see HAL in a sweet spot, riding on the solid orderbook (highest among defence companies under our coverage). We reinitiate coverage with a BUY rating and target price of Rs3,170/share based on DCF methodology. Delay in execution is a key risk to our thesis.

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