October 22, 2020

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Dear Subscriber

Let me narrate a story that dates back to the year 1967.

It was the initial days of the famous Arab-Israel war. The Arabs, led by Egyptians, were
fighting with a lot of Russia made weapons while the US was a strong ally of Israel.

The first few days of the war left renowned investor, Jim Rogers, baffled. He was surprised
by how the Egyptian air force was shooting Israeli jets out of the sky.

Jim Rogers soon learnt that Egyptians had deployed advanced electronic warfare equipment
received from the Soviets. So, he immediately hopped onto a plane and started visiting US
defence contractors.

Lockheed (now Lockheed Martin), a company flirting with bankruptcy caught his attention.
The troubled company had an advanced projects division that had come up with just the
kind of sophisticated weaponry that the US needed to close the gap with the Russians.

Rogers investigated other companies like Northrop and then made his next big discovery
in the US capital of Washington.

He discovered that even the doves in the Congress - the so-called peace makers - were in
favour of the US Government spending on advanced electronic warfare.

Popular opinion at the time was that the US defense spending would be curtailed due to
the end of Vietnam war and that defense firms were not on a solid ground. Therefore, there
weren't many takers for defense stocks.

However, Rogers' meticulous research suggested otherwise. He was aware of big, fat
contracts of defense companies that if renewed, could provide new earnings to these
companies.

He was also aware of the changing nature of the modern battlefield. Rogers was convinced
that a lot of the incremental US defense spending would fall in the laps of companies like
Lockheed to help it achieve superiority over the Russians.

Thus, this high priority insight convinced Rogers and his partner to go big on defense stocks
and which is exactly what they did.

Guess how well did Lockheed perform over the next decades?

2 Defence Stocks Set to Go Vertical | 2

Well, it blew even the most optimistic projections out of the water. Lockheed went up a
hundred times over the next few decades.

The reason I narrated this story is because you are witnessing an inflection point in Indian
defence production just as Rogers was witnessing in the US in 1960s.

India has been a major arms importer since the war with China in 1962. Over these years,
very little efforts were made to become self-reliant in defence.

As a result, today India is second-largest arms importer in the world.

Just last year, in 2019, we spent Rs 429 bn on importing defence equipment.

Now it’s not that India is importing these weapons to go on a war with someone.

But the only way to secure our economy and keep our hostile neighbours at bay is to
build our own powerful military.

For the first time since India’s independence, India has decided to ban imports of specific
foreign weapons. And instead rely on domestic players to supply Indian armed forces with
advanced weaponry.

With this change in policy, the billions India was spending on imports will start to flow to a
handful of major Indian defence companies.

In fact, it is estimated that over the next 5-7 years itself the opportunity is worth over Rs
4 lakh crore.

As a result, a handful of Indian companies could reap solid profits from this opportunity.

I have identified two solid defence stocks for you which I believe will be amongst the biggest
beneficiaries of India indigenous defence production, over next few decades.

Do take note of the maximum buy price and maximum allocation to these stocks.

Safe investing!

Tanushree Banerjee

Editor - StockSelect

3 | 2 Defence Stocks Set to Go Vertical

Bluechip In the Line of Defence

Since 1977, Chinese military delegations travelled abroad to inspect defence equipment
and weapons. The strategy was to build domestic capability in defence products. And
raise production volume by reverse engineering weapons systems acquired from foreign
entities.

However, in the long run both military and civilian leadership recognised that this approach
would not stand them in good stead. For eventually, the lack of indigenous military
technology, research and innovation would hurt. So, Chinese policy makers and defence
equipment makers worked in tandem to produce indigenous weapon systems. China now
spends 1.9% of its GDP, or US$ 372 bn on defence related R&D.

India's spend on defence is about 2.1% of GDP and 0.85% of GDP (US$ 71 bn) is spent on
R&D.

In absolute numbers, China is spending almost four times as much as India on defence, five
times as much on R&D and exports twice the number of arms it did five years ago.

Given the rising political tensions, governments across the world are growing their defence
outlay.

Defence Expenditure on the Rise Globally

Source: SIPRI Military Expenditure Data 2020

2 Defence Stocks Set to Go Vertical | 4

As with most public-sector units, the growth of defence PSUs in India depends on the
growth in order book and execution of the same.

Bharat Electronics (BEL), however, has a different story to tell. Being a systems integrator,
BEL caters to a wide range of projects as well as customers. Its fortunes are not tied to one
platform. And hence, it enjoys better visibility on the execution front, backed by a healthy
order book.

With capacity utilization of 70%, Bharat Electronics has enough room to execute. The
company has over the years excelled at both planning and execution.

Bharat Electronics' - Product Segments

The company’s FY20 order book stood at Rs 518 bn which is 4 times the revenues during
the fiscal. This provides strong revenue visibility for the company over the next 3 to 5 years.
Apart from this, orders from Akash Missile Systems (Rs 60 bn) and Long range Surfact-to-air
(LR SAM) (Rs 70 bn) are big ticket orders which are expected to be added in coming years.

Bharat Electronics is focused to fetch about 85% of its revenues from indigenously
developed products.

5 | 2 Defence Stocks Set to Go Vertical

Products developed in-house currently account for 41% of its revenues, while products
developed in association with DRDO and other national laboratories account for about 50%
of revenues.

The company has so far filed for 175 patents and 127 copyrights in the areas of electro
optics, surveillance, radar technology, communication technology and software technology.

Bharat Electronics' R&D Structure

Financials
Bharat Electronics has been able to maintain and slightly improve its operating margins
consistently over the years. As a result, bottom-line has grown at a much faster rate than
the topline for Bharat Electronics. The company has also managed to grow at a steady pace
without taking any debt on its books.

2 Defence Stocks Set to Go Vertical | 6

 Return on Equity Net Sales
22.0 140,000

20.0
120,000

(Rs million)
18.0
(%)

100,000
16.0

14.0 80,000

12.0 60,000
FY16 FY17 FY18 FY19 FY20 FY16 FY17 FY18 FY19 FY20

Dividend Payout Net Profit

45.0 20,000

40.0 18,000

(Rs million)
(%)

35.0 16,000

30.0 14,000

25.0 12,000
FY16 FY17 FY18 FY19 FY20 FY16 FY17 FY18 FY19 FY20

Equitymaster

The Upside Potential

Bharat Electronics has enjoyed 60-65% share in the Indian defence electronics market. With
more new orders being accessible to the private sector, it is critical that Bharat Electronics
maintains its share and also grows the same. A few areas where we expect competitive
intensity to rise are radars, optronics and communication devices. These are relatively low
tech compared to other products and the levels of investment required are also lower.

However, Bharat Electronics has wide moat in the form of a big R&D budget (at 9-10% of
sales), ability to upgrade defence supplies for the next 15-20 years and long term projects
with the DRDO. In addition to this, exports, primarily to neighbouring countries, is a key
focus area and could double from the existing 5% of sales.

With its strong positioning in the sector, lean balance sheet and attractive dividend yield,
we believe BEL provides a sufficient margin of safety at the current market price.

We recommend subscribers to buy the stock of Bharat Electronics at the current price.

The FY23 target price for the stock is Rs 150. The stock is expected to generate CAGR
of around 16% (excluding 2.2% dividend yield) over the next three to four years from the
recommended buy level.

7 | 2 Defence Stocks Set to Go Vertical

 Action to Take

• Buy Bharat Electronics at current price or lower

• Maximum Buy price: Rs 110

According to us, in a scenario of ideal allocation of funds, bluechip stocks could be

considered to comprise at least 60% of one's total equity portfolio. Further, we believe
that a single bluechip stock should ideally not form more than 5-6% of the total portfolio.
However, please note that this allocation will vary from person to person. For something
that works best for you, we recommend you talk to your investment advisor.

Please keep referring to the StockSelect Performance Review, which is part of the
StockSelect recommendation report, scheduled to reach your mailbox, on or before the
last Friday of every month.

Market Data

Price on reco. date (Rs) 92

52 week H/L 122 / 56
NSE symbol BEL
BSE code 500049

No. of shares (m) 2,436.5

Face value (Rs) 1.0

FY20 dividend/share (Rs) 2.8

Dividend yield 3.0%

Market cap (Rs m) 224,158

Price to book* (times) 2.2

Price to earnings* (times) 12.3

*Based on trailing 12 month earnings

2 Defence Stocks Set to Go Vertical | 8

Towering Performer in a Difficult Sector

The commercial shipbuilding industry is highly cyclical in nature. Plus, it is very sensitive to
the cyclical industries that it caters to, such as oil, natural gas, shipping and transportation.

The fall in global crude prices contributed to the recession in the shipbuilding industry.
International oil companies reduced capital expenditure and delayed or cancelled orders
for drill ships and offshore rigs. The big three players, Hyundai Heavy Industries, Samsung
Heavy Industries and Daewoo Shipbuilding & Marine Engineering are reeling under losses.

Cochin Shipyard (CSL) is a government-owned Miniratna and India's largest public-sector

shipyard by capacity. It is also the most profitable in the domestic industry (including private
shipyards).

Even though it is registered as a commercial shipyard, CSL derived 80% of its FY20
revenues from building and repairing defence ships. It derives 20% of revenues from
commercial shipbuilding and ship-repair. CSL also built India's first indigenous aircraft
carrier (IAC-1) for the Indian Navy.

What impressed us about CSL is not just the fact that it is a unique player to ride the
potential in India's defence manufacturing space. But its towering performance in a difficult
sector also lends it fundamental merit.

Twenty-seven private shipyards in India are currently reeling under massive losses. They
have a mountain of debt and lack of orderbook. They are likely to reel under lower capacity
utilisation and losses for some time.

However, CSL is an exception.

CSL has grown its profits continuously in the last five financial years. CSL reported
operating margins between 19% and 21% over last five years. Most importantly, CSL has
a marginal debt (debt-to equity of 0.03x). A cash and bank balance of nearly Rs 22 bn in
FY20 (Rs 15 bn excluding customer advances) equips it with the war chest to withstand
headwinds. The company has also sustained an average dividend payout of 29% in the last
five fiscals.

Apart from the upside in the defence sector, CSL's revenue stream will be stable going
forward. A strong order book for ship building portfolio and revenues from the ship repair

9 | 2 Defence Stocks Set to Go Vertical

segment makes the PSU one of the safest bets to ride the growth story. Due to continuous
order flow from the defence sector, CSL fared better compared to its competitors from the
private sector.

CSL's shipyard is strategically located along the west coast of India, midway on the main
sea route connecting Europe, West Asia and the Pacific Rim, a busy international maritime
route. In addition, CSL's shipyard is located close to offshore oil fields on the western coast
of India and relatively close to the Middle East. The shipyard is located close to the Cochin
port and is well positioned to benefit from the port's location and infrastructure facilities.

International trade routes offer an opportunity to cater to vessels plying on these routes
and presenting a major opportunity for repairs.

CSL’s Strategic Location Advantage

Cochin, an all-weather natural harbor, is located strategically close to the busiest international
sea routes:

• Gulf to Singapore and Far East (Distance from Cochin Port -11 Nautical Miles)

• Suez to Singapore / Far East (Distance from Cochin Port -74 Nautical Miles)

2 Defence Stocks Set to Go Vertical | 10

Among all major Indian ports, Cochin is the closest to the International East West Shipping
routes. This geo-strategic location gives Cochin port a distinct advantage and a big moat
to CSL.

Due to the government’s recent efforts towards indigenization of defence production, the
defence fleet has seen significant additions from the domestic shipbuilding industry in the
past two years.

Cochin Shipyard's Share of Revenues

Activity Defence Clients Commercial Clients

Shipbuilding 69.4% 12.7%
Ship repairs 10.4% 6.9%
Other Operating Revenue 0.5% 0.0%
Total 80.3% 19.7%
Source: Company's Reports

CSL is currently building India's first Indigenous Aircraft Carrier (IAC) for the Indian Navy.
Similarly, the company recently delivered the last Fast Patrol Vessels (FPV) to the Indian
Coast Guard.

In addition to shipbuilding, CSL also undertakes ship repair for the Indian Navy and repaired
about 15 Indian Naval Ships (on an average per year in the last three years). Recently CSL
completed refits of INS Aditya, INS Sukanya, INS Shardul and INS Viraat for the Indian Navy.

The Indian Navy has plans to increase its vessel fleet from the present 137 to 200 by
2027. This is expected to provide a spurt in the indigenous shipbuilding. Besides, the Indian
Navy’s indigenization plan is also expected to give a fillip to the growth of ancillaries and
generally improve the shipbuilding environment in the country.

CSL is also currently constructing two 500 passenger-cum-150-ton cargo vessels and two
1200 passenger-cum-1000-ton cargo vessels for the A&N administration and a vessel for
one of the government's projects.

Apart from defence, CSL clients from the commercial space include SCI, ONGC, DGLL,
and DCI. The company has also undertaken major revamping and refurbishing of oil rigs
involving steel renewal, up-gradation of drilling, cementing, mechanical, HVAC and piping
systems in almost all the major offshore vessels and rigs of ONGC.

11 | 2 Defence Stocks Set to Go Vertical

CSL has also successfully worked with leading technology players and has forged
partnerships with leading technology players. MoUs with Mitsubishi Heavy Industries,
Samsung Heavy Industries, Rolls Royce Marine and other major players have given CSL
access to modern technical know-how.

With such client base and diverse experience and multiple offerings puts CSL in a good
position to benefit from the recent 'Make in India' initiative introduced by the government.

CSL currently has order book of Rs 146 bn, which is 4.2 times FY20 revenues. The order
book shows continuous flow of work and preference to CSL for ship building. Further, the
government's boost to shipyards, by conferring infrastructure status, will help to gain new
work orders and avail loans at competitive rates.

The company has an order pipeline of Rs 150-180 bn which includes…

1. Next generation missile vessels,

2. Multi-purpose vessels

3. New generation offshore patrol vessels.

4. Large ship-repair order of INS Vikramaditya (aircraft carrier) is also expected in

next two years.

Financials
Cochin Shipyard has been able to maintain and slightly improve its operating margins
consistently over the past five years. As a result, bottom-line has grown at a much faster
rate than the topline. The company has also managed to sustain its average return on
equity at 16%, without taking any debt on its books.

2 Defence Stocks Set to Go Vertical | 12

 Return on Equity Net Sales
21.0 40,000

18.0 35,000

(Rs million)
(%)

15.0 30,000

12.0 25,000

9.0
20,000
FY18 FY19 FY20 FY18 FY19 FY20

Dividend Payout Net Profit

45.0 7,000

40.0 6,000

(Rs million)
(%)

35.0 5,000

30.0 4,000

25.0 3,000
FY18 FY19 FY20 FY18 FY19 FY20

Equitymaster

The Upside Potential

Besides being the second largest shipyard in the country, over time, CSL has carved
a niche for itself in catering to defence sector clients. It has successfully entered into
technological partnerships with global shipbuilders and has stayed ahead of the curve.

Backed by a strong shipbuilding orderbook and a revenue from ship repairs, CSL has
posted profits continuously in the last five financial years. The planned expansion through
the dry dock and IFRS will help leverage its leadership position in the ship repairs
segment and drive growth in the shipbuilding segment.

CSL is in the process of building a dry dock at a total estimated cost of Rs 17.9 billion. The
larger size of the proposed dry dock will enable CSL to build and repair ships of higher
capacity and large naval vessels such as aircraft carriers. Further, the greater width of dry
dock will also enable the company to undertake building and repair of rigs, within CSL's
shipyard.

Due to the asset heavy and cyclical nature of the shipbuilding business, we have,
however, valued the stock based on its estimated FY23 book value.

We recommend subscribers to buy the stock of Cochin Shipyard at the current price.

13 | 2 Defence Stocks Set to Go Vertical

The FY23 target price for the stock is Rs 480.

The stock is expected to generate CAGR of around 15% (excluding 4.7% dividend yield)
over the next three to four years from the recommended buy level.

Action to Take

• Buy Cochin Shipyard at current price or lower

• Maximum Buy price: Rs 350

According to us, in a scenario of ideal allocation of funds, bluechip stocks could be

considered to comprise at least 60% of one's total equity portfolio. Further, we believe
that a single bluechip stock should ideally not form more than 5-6% of the total portfolio.
However, please note that this allocation will vary from person to person. For something
that works best for you, we recommend you talk to your investment advisor.

Please keep referring to the StockSelect Performance Review, which is part of the
StockSelect recommendation report, scheduled to reach your mailbox, on or before
the last Friday of every month.

Market Data
Price on reco. date (Rs) 326
52 week H/L 491 / 209
NSE symbol COCHINSHIP
BSE code 540678

No. of shares (m) 131.5

Face value (Rs) 10.0

FY20 dividend/share (Rs) 16.6

Dividend yield 4.7%

Market cap (Rs m) 42,869

Price to book* (times) 1.2

Price to earnings* (times) 6.8

*Based on trailing 12 month earnings

2 Defence Stocks Set to Go Vertical | 14

 DISCLOSURES UNDER SEBI (RESEARCH ANALYSTS) REGULATIONS, 2014

INTRODUCTION:
Equitymaster Agora Research Private Limited (hereinafter referred to as "Equitymaster"/"Company") was
incorporated on October 25, 2007. Equitymaster is a joint venture between Quantum Information Services
Private Limited (QIS) and Agora group. Equitymaster is a SEBI registered Research Analyst under the SEBI
(Research Analysts) Regulations, 2014 with registration number INH000000537.

BUSINESS ACTIVITY:
An independent research initiative, Equitymaster is committed to providing honest and unbiased views,
opinions and recommendations on various investment opportunities across asset classes.

DISCIPLINARY HISTORY:
There are no outstanding litigations against the Company, it subsidiaries and its Directors.

GENERAL TERMS AND CONDITIONS FOR RESEARCH REPORT:

For the terms and conditions for research reports click here.

DETAILS OF ASSOCIATES:
Details of Associates are available here.

DISCLOSURE WITH REGARDS TO OWNERSHIP AND MATERIAL CONFLICTS OF INTEREST:

a 'subject company' is a company on which a buy/sell/hold view or target price is given/changed in this
Research Report.

b Equitymaster holds 1 share of Bharat Electronics Limited as per the guidelines prescribed by the Board of
Directors of the Company. The investment is made for research purposes only.

c Equitymaster has no other financial interest in Bharat Electronics Limited.

d Equitymaster has no financial interest in any other subject company.

e Equitymaster's Associates and Research Analyst or his/her relative doesn't have any financial interest in
the subject company.

15 | DISCLOSURES UNDER SEBI (RESEARCH ANALYSTS) REGULATIONS, 2014

f Neither Equitymaster, it's Associates, Research Analyst or his/her relative have actual/beneficial
ownership of one percent or more securities of the subject company at the end of the month
immediately preceding the date of publication of the research report.

g Neither Equitymaster, it's Associates, Research Analyst or his/her relative have any other material conflict
of interest at the time of publication of the research report

DISCLOSURE WITH REGARDS TO RECEIPT OF COMPENSATION:

a Neither Equitymaster nor it's Associates have received any compensation from the subject company in
the past twelve months.

b Neither Equitymaster nor it's Associates have managed or co-managed public offering of securities for
the subject company in the past twelve months.

c Neither Equitymaster nor it's Associates have received any compensation for investment banking or
merchant banking or brokerage services from the subject company in the past twelve months.

d Neither Equitymaster nor it's Associates have received any compensation for products or services other
than investment banking or merchant banking or brokerage services from the subject company in the
past twelve months.

e Neither Equitymaster nor it's Associates have received any compensation or other benefits from the
subject company or third party in connection with the research report.

GENERAL DISCLOSURES:

a The Research Analyst has not served as an officer, director or employee of the subject company.

b Equitymaster or the Research Analyst has not been engaged in market making activity for the subject
company.

DEFINITIONS OF TERMS USED:

a Buy recommendation: This means that the subscriber could consider buying the concerned stock at
current market price keeping in mind the tenure and objective of the recommendation service.

b Hold recommendation: This means that the subscriber could consider holding on to the shares of the
company until further update and not buy more of the stock at current market price.

DISCLOSURES UNDER SEBI (RESEARCH ANALYSTS) REGULATIONS, 2014 | 16

c Buy at lower price: This means that the subscriber should wait for some correction in the market price so
that the stock can be bought at more attractive valuations keeping in mind the tenure and the objective
of the service.

d Sell recommendation: This means that the subscriber could consider selling the stock at current market
price keeping in mind the objective of the recommendation service.

FEEDBACK:
If you have any feedback or query or wish to report a matter, please do not hesitate to write to us.

17 | DISCLOSURES UNDER SEBI (RESEARCH ANALYSTS) REGULATIONS, 2014

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Disclaimer | 18