Management Speak: Bharat Electronics (Outperformer) - Margin rationalisation to see limited impact

We hosted a call with the BEL mgmt. to understand the impact of the margin rationalisation by Ministry of Defence (MOD). Key takeaways:

• Margins rationalised from 12.5% to 7.5% on prospective nomination orders: The Ministry of Defence (MOD) has rationalised the threshold PBT margins on prospective contracts awarded on a nomination basis to 7.5% for all Defence PSUs vs 12.5% earlier. Earlier, BEL was eligible for 12.5% margin only on the value add part of the order. Under the new pricing policy, the 7.5% margin would be applicable on the entire order including buyer furnished equipment, software costs, development costs, etc which were disallowed earlier. Hence, mgmt. expects the OPM impact to be limited to 50bps.
• Nomination orders on a declining trend: As per the management, the nominated orders have been on a declining trend over the past decade (earlier 70-80%). Currently, nomination based orders are at ~50% of backlog and on the declining trend. The new norms would not be applicable to existing order backlog of Rs500bn or to the recently won LR-SAM order (Rs9bn) and the Akash order (~Rs50bn).
• Internal efficiencies, positive operating leverage driving higher margins: BEL had ~16% PBT margin over FY15-18 (excl other income) as also other DPSU’s (see pg 2). The higher margins was led by internal efficiencies and positive operating leverage on higher revenues. Moreover, as employee costs are likely to grow at a muted pace, mgmt. expects limited impact from the margin rationalisation.

Valuations and view

The rationalisation of margins has been done with the aspect to reduce negotiation on overheads, cost allowances, etc and thereby fast track closure of projects. We believe the impact on margins is likely to be limited to 100-200bps as the proportion of nominated orders decline and other costs also earn margins (see sensitivity on page 2) over the medium term (FY22-23 onwards). On the other hand, existing order backlog of Rs500bn (4.3x FY19E revenues) would drive a sustained 15% /12.5% revenue & EBITDA CAGR over FY18-20E (earnings to be impacted on lower other income). While the medium term growth may be restricted to ~10% (vs 12%+ earlier) on lower margins and warrants a de-rating, we believe the stock correction of 20%+ over the past week factors in the margin uncertainty. Hence, we believe valuations at 13x FY20E earnings are attractive as BEL is well-positioned to capture the growing defence spend led by its strong manufacturing capabilities and R&D focus. Outperformer.