June 3, 2008

Analysis - Bharat Electronic limited (BEL)

About
Bharat Electronics Limited (BEL) is the largest defense equipment company in India catering to Defense services electronic requirement. BEL enjoys near monopoly status in supplying high-tech defense products like radars, sonars, communication equipment, electronic warfare equipment to the armed forces. Other division manufacturing civilian products supplies communication equipment to the telecom industry, voting machines etc.

The defence sector contributed to 76% of the revenue and the rest was from the civilian sector.

The company has a government mandated near monopoly for the defence sector business. In addition foreign vendors as a part of localization are required to source from BEL

Financials

The company has shown considerable improvement in financial performance. Topline has grown by 10% p.a for the last 5 years. The net profit has however grown by almost 20% p.a during the same period.

The higher bottom line growth has been driven by an increase in net margins from 10% to around 17% in 2008. Total Asset ratios have improved from around 8.2 to around 9.2 in 2007. The Wcap is negative or zero and the inventory turns have also improved 2.1 to 3.3. Only the recievables ratio has dropped from 3.1 to 2.5 in 2007.

The management seems to be aware of this and in 2007 has indicated that this was mainly due to incomplete projects and should improve in the current year.

The company is a cash rich company with cash net of debt of around 2200 Crs which could improve further in the current year.

The ROE seems to be steady, however net of cash it has been improving and the Return on incremental invested capital has gone up a lot.


Positives
The financials have improved substanially in the last 5 years. The net margins and Return on capital has gone up. The company has considerable cash on books. In addition the company spends almost 3-4% on R&D.
The company has introduced almost 25 products and systems in 2007. The company plans to continue this pace of new products in the future too.
The company has an order book of almost 90000 million in 2007 which is equivalent to 3 years of revenue at the curent rate.
The company will also benefit from the mandatory offset clause where in foreign vendors have to procure some portion of the contract from BEL.

Risks
The margins have gone up from 10% to around 17% in the current year driven by Raw material cost reduction. I am not sure how sustainable this improvement is. The long term average is still around 10-12 % and the current rise could be temporary.
The defence spending dropped around 1996-1998 time period and the net profits were low during that period. It looks unlikely that the government would drop defence spending now, however the risk remains.
Competition is very low in the defence sector, however the other segments do have some competition.

Competitive analysis
BEL is one of those rare companies which have very substantial competitive advantages. These advantages are government mandated and I find it diffcult to see how these will go away. Across the world there is a preference for domestic companies for defence contracts, more so in india.


Valuation
With an assumption of current growth and margins, the Intrinsic value comes to around 2100 Rs/ share. However a senstivity analysis of margins and topline gives the following numbers
Topline – 10%, margin – 10-12 % (long term average): 1650
Topline – 14%, margin – 10-12% : 2200
Topline –14%, margin – 17% : 3300

The central point for the intrinsic value seems to be around 2000-2200.

Conclusion
The company seems to be trading at 30-40% discount to instrinsic value. This is however not a sexy company. This is a company with substantial competitive advantages and will continue to be very profitable. However I don’t expect the market to suddenly discover this company and give a higher valuation. Most likely one can expect decent returns in the long run.

6 comments:

Ninad Kunder said...

Hi Rohit

Good analysis.

I would just want to add one varaible. Though you have correctly pointed out that there is a quasi protection in place for the company, this might dilute over a period of time.

More than the competition from international defence contractors, the indian corporate sector is looking at defence aggressively. The Tata group is a case in example with Nelco & Tata Power's SED division ( Strategic Electronics).

This could affect the environment, otherwise a good pick.

Cheers

Ninad

Rohit Chauhan said...

Hi ninad
you are right that competition could increase. But i think the advantages which BEL has due to government mandate, close research tie ups with other research institution etc are fairly strong advantages. Like the case of concor, they are not easy to overcome, unless BEL starts doing something very stupid

regards
rohit

naveen said...

thanks a lot 4 ur info ... i am interested to know some more details of this company ,as in who all are the main compitetors ..what are the problem this company facing now ..hoping u reply soon .. this is my email id
naveen.pious@gmail.com

Crow said...

Hi Rohit,

I have recently got interested in value investing and I have learnt some useful things on your very educational blog.

I had also identified BEL as a potential high growth company

Its low Debt and dominant(almost assured)position is definitely working for it.

However, I always have a problem with DCF to arrive at the Intrinsic value - there seem to be too many assumption of linear growth continuing.
However, I think the valuation is reasonable because of the following logic :-
Basic driver for growth is the assumption that the defence spending relevant to BEL will continue to grow linearly- given the underdeveloped state of our defence forces this seems quite likely also.

Rohit Chauhan said...

Hi neerav
there are multiple factors driving the DCF, but in this case the growth and margins are key to figuring out the instrinsic value.
i have have used various scenarios as one can never be sure which one will play out. Now to these scenario we have to apply our subjective feel of probabilities. in this case , i can see the intrinsic value in worst case scenario is still higher than the current stock price

regards
rohit

Abhi said...

Hi Rohit,

Have you recalculated the intrinsic value of BEL/Crisil after the current results?

Abhi.