Hindustan Aeronautics Limited Primary Offer: A good defensive play

Being the only Indian company having the capability and specialisation in aircraft manufacturing — either indigenously designed or produced under licence — Hindustan Aeronautics Limited (HAL) is the main aeronautics supplier for Indian Defence Services.

Promoted and wholly-owned by the Government of India, the company has enjoyed strong support from the government, deriving a chunk — 93 per cent — of its FY17 revenues from sales to the Indian Defence Services. The company, an integrated player, has developed capabilities across product research, design and manufacturing, and provides maintenance, repair and overhaul services.

Advance funding and milestone payments by its customer also take care of its working capital needs, resulting in negligible borrowings for the company. As of September 2017, HAL had cash of around ₹11,699 crore.

While the company’s dominant position and diverse portfolio should keep revenue in good stead; a lot hinges on the Centre’s defence outlay, which has not been heartening. The allocation of ₹2,95,511 crore for Defence in the Budget 2018-19, represents a growth of just 5.9 per cent (over 2017-18). This works out to a meagre 1.57 per cent of GDP, the lowest in many years. In fact, of the total allocation, capital outlay on defence services is just ₹93,982 crore for new weapon systems and modernisation. What’s more, Indian Army accounts for more than half of the share in the Defence Budget; for HAL on the other hand, Indian Air Force accounts for the largest share in its revenues.

That said, given the Centre’s push towards ‘Make in India’— currently 60 per cent of our Defence requirement is met through imports — HAL, being the only Indian company with capability to produce fighter aircraft and helicopters, stands to gain. The DPP 2016 (Defence Procurement Procedure) mandates first priority to products that are indigenously designed, developed and manufactured (IDDM category) in India.

Many of the products coming out of its design centres are in the nature of IDDM — light combat aircraft, light combat helicopter (LCH), light utility helicopter (LUH), advanced light helicopter (ALH), HTT-40, etc — which puts it on top of the priority list, when it comes to procurement by the government. HAL makes 31 types of aircraft, of which 17 are of indigenous design and 14 are being produced under licence. Light combat aircraft ‘Tejas’ , Sukhoi (major revenue earner) licensed from Rosoboronexport, Moscow, and other indigenously manufactured helicopters — Cheetal and Dhruv — are its key revenue generators.

The company’s revenues have grown by a steady 9 per cent annually over the past two years — between FY15 and FY17 (under Ind AS). Given that the demand is not market-driven, but limited from the Defence sector, revenue growth is not expected to be spectacular, but steady nonetheless — in line with other DPSUs (defence public sector undertakings) such as BEML and Bharat Electronics. Additionally, HAL is the largest DPSU in terms of production value. HAL’s order book is strong at ₹68,461 crore as of December 2017— about 3.7 times FY17 gross revenues.

In 2016-17, HAL’s profit before tax grew by 11.7 per cent Y-o-Y and profit after tax grew by a higher 31 per cent, due to reduction in tax (on account of certain provisions not required that were made in the previous years). Profit for FY15 may not be comparable due to adjustments related to first-time adoption of Ind AS. Going ahead, earnings are likely to be commensurate with the growth in revenues.

At the upper band of ₹1,240, the valuation multiple works out to about 17 times FY17 earnings and about 10 times EV/EBITDA. The valuations seem cheap when compared to other DPSUs such as Bharat Electronics (24 times P/E and 17 times EV/EBITDA). But Bharat Electronics has a higher revenue visibility owing to stronger order book (over 4.6 times FY17 revenues) and good track record of profitability. The recent IPO of another DPSU, Bharat Dynamics, was at a valuation of about 16 times FY17 earnings, but much smaller in size than HAL (about a fourth in terms of revenues).

While spectacular gains are unlikely, given the modest growth in earnings, investors with a long-term horizon wanting to bet on the prospects of the Defence sector, can subscribe to the HAL issue.

The IPO is an offer-for-sale of 3.4 crore equity shares. Retail investors and employees get a discount of ₹25 per share.

Sound business

Along with strong capability in manufacturing, HAL has expertise in providing support for maintenance, repair and overhauling of manufactured aircraft and helicopters.

This helps bring in a steady stream of income. In FY17, while sale of products fell by 3.9 per cent Y-o-Y, a robust 42 per cent increase in sale of services helped in clocking 8.1 per cent growth in revenues from operations. Given that HAL has delivered close to 600 aircraft in the past and margins from services are similar to that from products, earnings should remain in good stead. The share of revenue from services has gone up to 31 per cent in FY17 from 21 per cent in FY15.

HAL’s EBITDA margins are at a healthy 18 per cent (excluding other income) as of FY17. HAL’s product consists of imported components which are subject to foreign exchange rate variation. In terms of price of the aircraft, 30-35 per cent are imports. HAL’s contracts with the Indian Defence Services are typically on a fixed-price basis, with a reimbursement to account for foreign exchange variance.

HAL receives a 15 per cent advance and milestone payments during development phase, which takecare of its working capital requirements. However, the company may have to pay liquidated damages in case of delays.

For the half-year ended September 2017, revenues stood at ₹5,277 crore, which appear tepid when compared to the FY17 revenues of ₹18,555 crore. But the results of the first half of the fiscal are generally modest, as HAL recognises revenue only when the product is developed and delivered to the customer.

Risks

HAL depends heavily on contracts from the Ministry of Defence, and hence, pruning of or tepid budgetary allocation to the defence sector will directly impact the growth prospects of the company.

Also, until now, a substantial portion of HAL’s business has been awarded through nomination. With the opening up of the Defence sector, the company will have to participate in competitive bidding.

It is still early days to see how this pans out. Also, last year, the Centre had introduced a strategic partnership model under DPP 2016 under which it would identify Indian private companies that would initially tie up with a few foreign original equipment manufacturers to manufacture military platforms and equipment. These policies could increase the level of competition for HAL, hitherto enjoying a dominant position in the domestic market.

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