Bharat Dynamics Ltd A large order pipeline just does not cut it

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1 INSTITUTIONAL EQUITY RESEARCH Bharat Dynamics Ltd A large order pipeline just does not cut it INDIA DEFENCE IPO Note Bharat Dynamics (BDL) is a government owned company, engaged in the manufacturing of missiles and torpedoes. In FY17, its revenues/ebitda/pat was Rs 46.3/8.3/6.6bn, translating into 17.9% EBITDA and 14.4% PAT margins. BDL has an order book of Rs 105bn as of January 2018, implying a book to bill of 2.2x FY17 revenues. About Bharat Dynamics Ltd (BDL) Incorporated in 1970, BDL is a government owned company with 'Miniratna (Category 1)' status. It is engaged in the manufacturing of Surface to Air missiles (SAMs), Anti Tank Guided missiles (ATGMs), underwater weapons (Torpedoes), launchers, countermeasures and test equipment. Currently, it is the sole manufacturer and supplier for SAMs, ATGMs and torpedoes to the Indian armed forces. IPO rationale: Offer for sale by government The IPO is an offer for sale by the government to raise Rs 9.5bn and dilution of shareholding by 12.3%. At the IPO price band of Rs , the stock trades at 12x FY17 PE on an adjusted equity base. Key positives BDL is currently the sole manufacturer for SAMs, ATGMs and torpedoes in India. It is capable of addressing 54% of India s missile demand over the next 10 years ( ). It benefits from a strong relationship with DRDO. BDL is part of the design and development stage of a project giving it a competitive advantage against other players. BDL is expanding its product base in SAM s and Torpedoes. Over the next ten years its revenues will be spread across multiple projects against the current scenario wherein Akash is a singular major project in its order book. Large opportunity pipeline of Rs 440bn FY19 22 against current order book of Rs 105bn. AVOID 12 March 2018 COMPANY DATA ISSUE OPENS 13th March 2018 ISSUE CLOSES 15th March 2018 PRE ISSUE EQUITY SHARES 183.3mn PRICE BAND Rs NO OF SHARES OFFERED 22.5mn ISSUE SIZE Rs bn MKT CAP Rs 78.4bn STANDALONE FINANCIALS Y/E Mar, Rs bn FY17 FY18E FY19E FY20E Net Sales EBIDTA Net Profit EPS, Rs P/E@Rs Key risks Projects that BDL is nominated to win over the next five years are large. Case in point VSHORAD is a $ 5bn project (including the share of foreign OEM); MRSAM is $ 2.5bn and Akash ($ 2bn). These should be prone to delays given their size. Share of revenues from high margin Akash missile program is expected to decline over FY In fact we expect BDL s earnings to de grow by 9% over FY17 20E. New projects such as VSHORAD and MRSAM are transfer of technology projects; initial profitability on these projects should be low. Our view: AVOID In our view, stocks with a single point investment thesis of a large order pipeline will not grab investor interest if those orders are not be accompanied by commensurate profitability. As is the case with BDL. We estimate BDL s order book to grow by 3.7x over FY19 22 on large orders such as VSHORADS, MRSAM and Akash. However in the near term based on its existing order book BDL s revenues/ebitda/pat would decline by 15%/18%/9% over FY17 20E. Additionally, even as BDL is expected to expand its product profile from single to multiple products the margin profile of new projects is expected to be materially lower than the current cyclically high margins of the company. At IPO price of Rs 428 BDL trades at 16x FY20E PE. BDL s valuation is in line with its listed global peers despite its smaller size and lack of research capabilities. We see downside risks overshadowing any positives of large order inflows whose benefits both in terms of execution and margin should be back ended. Hence AVOID. Jonas Bhutta ( ) jbhutta@phillipcapital.in Vikram Rawat ( ) vrawat@phillipcapital.in Page 1 PHILLIPCAPITAL INDIA RESEARCH

2 About the IPO Rs bn issue of 22.5mn shares at a price band of Rs per share Issue includes offer for sale by promoter 'Government of India (GoI)' Market capitalisation at price band: Rs bn. Post issue, GoI's shareholding to reduce to 87.8% from 100%. Bharat Dynamics Issue details ISSUE OPENS 13th March 2018 ISSUE CLOSES 15th March 2018 PRE ISSUE EQUITY SHARES 183.3mn LOWER BAND Rs 413 UPPER BAND Rs 428 PRICE BAND Rs FRESH ISSUE Nil OFS 22.5mn NO OF SHARES OFFERED FOR SALE 22.5mn RETAIL AND EMPLOYEE SHARE (%) 36.3% RETAIL DISCOUNT (RS) Rs 10 ISSUE SIZE Rs bn POST ISSUE EQUITY SHARES mn MKT CAP Rs bn Share holding pattern post issue Others 12.25% GOI 87.75% Allocation of shares offered in the IPO Shares (mn) % of Net/gross issue Retail % Non institutional % Mutual fund % Other QIBs % QIBs % Net Issue % Employees % Total Issue % Page 2 PHILLIPCAPITAL INDIA RESEARCH

3 About the company Bharat Dynamics Ltd (BDL), incorporated in 1970, is a government owned company with 'Miniratna (category 1)' status. It is engaged in the manufacturing of Surface to Air missiles (SAMs), Anti Tank Guided missiles (ATGMs), underwater weapons (Torpedoes), launchers, countermeasures and test equipment as well as the refurbishment and extension of the life of missiles. It is currently the sole manufacturer for SAMs, ATGMs and torpedoes in India and also the sole supplier of SAMs and ATGMs to the Indian armed forces. It is also the co development partner with the DRDO for the next generation of ATGMs and SAMs. BDL currently has three manufacturing facilities in Hyderabad, Bhanur and Vishakhapatnam. It is also in the process of setting up two new manufacturing facilities at (1) Ibrahimpatnam, Telangana to manufacture SAMs and (2) Amravati, Maharashtra for Very Short Range Air Defence Missiles (VSHORADMs). BDL Manufacturing facilities Location Products Operational Hyderabad, Telangana SAMs, Milan 2T ATGMs, countermeasures, launchers and test equipment Bhanur, Telangana Konkurs M ATGMs, INVAR (3 UBK 20) ATGMs, launchers & spares Vishakhapatnam, Andhra Pradesh Under planning Ibrahimapatnam, Telangana Amravati, Maharashtra Light weight torpedoes, C 303 anti torpedo system, countermeasures & spares SAMs Very Short Range Air Defence Missiles (VSHORADMs) Details of the infrastructure facilities at each of the three manufacturing units Hyderabad > 6 Axis CNC machines > X Ray building > Robotic welding machine R&D facilities > Electron beam welding machine > Aerodynamics / high performance computing facility for CFD > 3D measuring machine > Computer aided design > CNC flow forming machine > Optics and lasers spectral radiometry > 5 Axis CNC machining center > RF lab > Combined altitude temperature and humidity chamber > Embedded systems design > Vibration test facility > Simulation and analysis facility > Vacuum furnace for heat treatment > Electronic circuit design and simulation. > Explosive storage and magazine building > Counter measures dispensing system lab > Unification / automation of cold and hot conditioning of missiles / subsystems including thermal shock capability. > Missile simulation mode > Spectro Radiometer Bhanur > Robotic welding machine > Armour room facility for high pressure testing > 3D measuring machine > Hybrid micro circuits in place of conventional SMD technology. > Tooled up CNC Turn mill center for Outer gimble of Konkurs M ATGM > Thin film hybrid technology for components of INVAR (3 UBK 20) ATGM > Mill turn with multitask CNC machine. > Vacuum furnace for heat treatment > X Ray machine > Explosive storage and magazine Building > Advanced universal testing machine > PLC based automatic loading & progression of jobs in electro plating > CNC flow forming machine production line > Environmental stress screening chamber > Introduction of lithium based high reliable thermal batteries > Vibration test facility > Flow forming in place of deep drawing process. Vishakhapatnam > Vibration test facility > Pressure testing tank Page 3 PHILLIPCAPITAL INDIA RESEARCH

4 BDL Products portfolio BDL Products SAMs ATGMs Torpedoes Launchers Countermeasures Decoy Systems Test Equipment Akash Missiles MILAN 2T, Konkurs M, INVAR (3 UBK 20) Light Torpedoes Launchers for Konkus M & MILAN 2T ATGMs Chadd & flare based air defence systems, C 303 topedo decoys Submarine fired decoys Health monitoring equipment for ATGMs Surface to Air Missiles Akash SAM is an all weather area defense system which can engage multiple targets simultaneously. It can target helicopters, fighter aircraft and unmanned aerial vehicles. In addition to Akash SAM, BDL will also supply the ground support system and construct infrastructure facilities for the Akash SAM. BDL is currently supplying Akash SAMs to MoD for Indian Army. LRSAM & MSRSAM is a high response quick reaction vertical launch supersonic missile to neutralise enemy aerial threats such as missiles, aircraft, guided bombs and helicopters. BDL is currently supplying LRSAMs and MRSAMs to MoD for Indian Army and Indian Navy respectively. Anti Tank Guided Missiles Milan 2T ATGM is a man portable second generation ATGM with a tandem warhead to destroy tanks. It can target both moving and stationary targets. BDL is currently supplying Milan 2T ATGMs to MoD for Indian Army. Konkurs M ATGM is a second generation, semi automatic tube launch optically tracked, wire guided and canard controlled missile which has been designed to destroy moving and stationary armoured targets. It can be launched from vehicles and ground launchers. BDL is currently supplying Konkurs M ATGMs to MoD for Indian Army. INVAR (3 UBK 20) ATGM is a second generation plus mechanized infantry weapon which can be fired from the gun barrel of a T 90 tank to destroy armored vehicles. BDL is currently supplying the INVAR (3 UBK 20) ATGMs to MoD for Indian Army. Page 4 PHILLIPCAPITAL INDIA RESEARCH

5 Underwater weapons Light weight torpedo (TAL) is used for anti submarine warfare and can be launched from a ship or a helicopter. BDL is currently exporting the light weight torpedo. Launchers Launchers for the Konkurs M ATGM and the Milan 2T ATGM. FLAME (Fagot Launcher Adapted to Milan Equipment) is a launcher for operation of Milan 2T ATGM. Countermeasures CMDS is a micro controller chaff and flare based airborne defence system. It can be activated by the pilot or the radar warning receiver of the aircraft. CMDS provides protection to the aircraft against radar guided and heat seeking missiles (air and ground) by dispensing chaff and / or flare payloads. BDL is currently supplying the CMDS to a defence PSU engaged in the manufacture of fighter aircrafts. C 303 Anti Torpedo Decoy launching system Anti Torpedo System is meant to counter the threat posed to any submarine by any active and / or passive homing torpedo. BDL is currently supplying Anti Torpedo System to a defence PSU engaged in the construction of submarines and warships. Submarine Fired Decoy (SFD) acts as preferred target in the presence of an own submarine to a passive or active homing torpedo. Test Equipment Konkurs missile and launcher test equipment monitor the health of prior generation Konkurs ATGM and current Konkurs M ATGM. Page 5 PHILLIPCAPITAL INDIA RESEARCH

6 Indian guided missile and torpedo market outlook As per Frost & Sullivan, Indian guided missiles and torpedoes market will be of US$24.5bn during which will be driven by: 1. Committed and planned missile procurement underway such as S 400 Triumf advanced air defence systems, Barak 8 SAMs, Hellfire ASMs, Harpoon anti ship missiles and heavy weight torpedoes etc. 2. Modernization and refurbishment of deployed and stored missile systems used on existing air, land, and seabased platforms such as missile system upgrades in existing Talwar class frigates (FFGs), ATGM upgrades etc. 3. Missile procurements expected as a result of procurement programs initiated during the forecast timeline such as new fighter procurements, Project 28A (Next Generation Missile Corvette), Project 17A (FFG), Project 75I (Diesel Electric Submarines with Air Independent Propulsion) etc. Indian guided missile market will be dominated by Tactical missiles during with share of 80%, followed by Torpedo (9%) and Cruise Missile (7%) segments. Within Tactical missiles, SAM (US$ 9.8bn, 50% share) and ASM (31%) will be the key contributor. Tactical missiles (with 80% share) to be the key driver of the Indian guided missiles market during Guided missiles & Topedoes market ( ) Special mission, $0.2bn Torpedo, $2.2bn Ballistic, $0.7bn...which will be driven by the Surface to Air (50% share) and Air to Surface (31%) missiles Tactical missile market ( ) ATGM, $1.7bn Surface to Surface, $0.6bn Cruise, $1.7bn Air to Air, $1.8bn Surface to Air, $9.8bn Tactical, $19.6bn Air to Surface, $6.1bn Source: RHP, Frost & Sullivan, PhillipCapital India Research Page 6 PHILLIPCAPITAL INDIA RESEARCH

7 India's major missile procurement and modernization programs Program name & procurement timeline Status Remarks Akash missile ( ) Barak 8 ( ) VSHORADS ( ) MRASM ( ) Heavy Weight Torpedo ( ) Barak 1 ( ) S 400 Triumf ( ) ATGM ( ) Arrow 2 ( ) Stinger ( ) MICA ( ) AGM 114L 3 Hellfire Longbow missile ( ) Purchase cleared Purchase cleared Planned Planned Planned Purchase cleared Purchase cleared To be approved Planned Purchase cleared Purchase cleared Purchase cleared Source: RHP, Frost & Sullivan, PhillipCapital India Research Cabinet Committee on Security (CCS) is set to clear the procurement of Akash missiles for IAF, enhancing supersonic missile capability to intercept fighter jets, cruise missiles, ballistic missiles etc. The production of Akash systems is also to enhance production capacity to meet demand / requirements. CSS has approved the procurement of MRSAM (Medium range land /Long range naval) systems, further strengthening the defence capabilities to intercept aircraft, UAS and missile systems. IAI and DRDO have partnered for co development of both long range (Naval) and medium range (Land) versions of the missile. BDL is manufacturer in India. Field trial for a US$ 5.2bn the weapon system contract under underway. The total contract is for the supply of 5175 missiles and 1276 single/multi launchers with streamlined technology transfer for the DPSUs. MBDA, Saab & Rosboronexport participating in bid. BDL is the nominated production agency for the program. Indian Navy has invited RFI for supply of medium range anti ship missiles procurement of which is expected to begin by early Combat missiles, practice missiles, training missiles, cut section missiles; dummy missiles and systems for fitment on board ships will be procured. As India is inducting Kalvari class submarines into the fleet, heavy weight torpedoes may be procured to improve kill capabilities. GoI has approved procurement of Barak 1 missile systems. The contract is worth over US$ 78mn and will be delivered over a period of 5 years from 2017 onwards. India & Russia have reached an agreement for over US$ 5bn for procuring S 400 Triumf air defence system. Technical discussion is underway post which contracts to be penned down. Contract is being executed by Rosboronexport and deliveries are expected to be within 3 years from the agreement. Mod has forwarded a request for the procurement of Spike ATGMs to Defence Acquisition Council (DAC) for approval. This contract is expected to be worth US$ 1bn to be supplied by Rafael Advanced Defence Systems. Earlier, Indian interest for procuring the Arrow 2 missile was not addressed due to the MTCR regulations. An RFQ can be expected to be released in the near future for procurement. GoI has approved the purchase of air to air missiles to be supplied by Raytheon, which is a part of US$ 3.1bn India US defence contract. Stingers will be equipped on the fleet of light attack and advanced light attack helicopters, apart from the Apache 64 E helicopters being procured. CCS approved procurement of MICA multi mission air to air missiles available in two configurations (IR & RF) for upgrading Mirage 2000 jets and will be supplied by MBDA. The missiles will also be loaded on the Rafale combat jets to be delivered from 2019 onwards. MBDA L&T has also entered into a JV for joint development of missile systems and high speed UAS. CCS has approved the procurement of Hellfire 812 AGM 114L 3 missiles for Apache 64 E attack helicopter (part of US$3bn contract between India & US which also includes 542 AGM 114R 3 Hellfire II missiles along with Chinook and AH 64 helicopters and associated electronics systems. As per DPP 2016, the contract will have a 30% offset clause and the armaments have been procured through a contract under Foreign military sale (FMS) agreement. Page 7 PHILLIPCAPITAL INDIA RESEARCH

8 Competitive landscape and BDL's positioning BHARAT DYNAMICS LTD IPO NOTE Global competitive landscape The guided missile and torpedo systems competitive landscape is dominated by 22 global players. However, most companies do not offer solutions across the entire gamut of guided missile product segments and tend to specialize in segments where revenue opportunities are high. Also, export restrictions on theatre warfare weapons such as ICBMs, IRBMs etc. prevent many firms from developing newer solutions in this segment as there is a constraint on realizable opportunities. In such cases, OEMs only start developing solutions as and when there is an explicit demand from respective MoDs for such systems. Guided missile & torpedo market landscape Source: RHP, Frost & Sullivan, PhillipCapital India Research Ballistic missile: There are over 60 solutions available globally, with majority of solutions provided by Tactical Missiles Corporation (a holding corporation comprising over 20 Russian specialized munitions solution providers). In the cruise missile segment, about 26 solutions (includes variants) are marketed today by 8 major firms. Tactical missile segment has a large expansion in terms of the number of solutions and the companies providing them. ATGM is the most competitive, within the tactical missile segment, with majority of the companies having at least one solution because of the high demand and relatively low costs associated to it. It is also the segment straddling the lowest price points vis à vis other segments. Surface to Air and Air to Surface segments are both broad product lines indicating a high variation in customer requirements. There are over 480 solutions available for these two segments globally. Air to Air and Anti Ship missile segments also exhibit similar characteristics. Increasing demand is also driving the production of specialized solutions within the segment. Also, as improved electronic countermeasures systems are deployed on aircraft, smarter new age Air to Air missiles impervious to jamming are being developed. Today, there are about 166 Air to Air missile solutions available in the market. Within the Surface to Surface segment there are more solutions and market players in the medium range category as opposed to the long range category. The two categories combined together present over 250 solution types globally. Page 8 PHILLIPCAPITAL INDIA RESEARCH

9 Torpedo: Light torpedo is a more competitive segment with more choice of naval solutions available in the market. There are only about 14 major heavy water torpedo solutions available globally whilst there are 30+ solutions available in the light water torpedo segment. Guided missile & torpedo manufacturers and solutions Source: RHP, Frost & Sullivan, PhillipCapital India Research Main players, benchmarked by Frost & Sullivan, in the guided missile and torpedo market as per their capabilities Source: RHP, Frost & Sullivan, PhillipCapital India Research Note: CASIC is left empty because of opacity of the Chinese markets in identifying product portfolios Page 9 PHILLIPCAPITAL INDIA RESEARCH

10 Indian competitive landscape Presently, Indian guided missile and torpedo market is dominated by DPSU produced missiles and foreign solutions. Solutions from Russia, Israel, Europe and US are well entrenched in the Indian market. Indigenous development and manufacturing is carried out by three DPSUs DRDO, BDL, and BEL. Amongst the three BDL is the main player in manufacturing and is the sole manufacturer in India for SAMs, torpedoes, ATGMs. However, there is a drive within the establishment to indigenize missile production as much as possible in order to extricate the armed forces from any external dependencies for missile systems in the future. Popular solutions for guided missile and torpedo in India RUSSIA Igla Strela S 400 Triumf 2K12 Kub/Kvadrat APR 3 E ISRAEL Barak 1 Arrow 2 Spike Python 5 Spyder Key players in Indian guided missile & torpedo market RUSSIA ISRAEL INDIA PRIVATE INDIA Invar, Konkurs, MILAN 2T (produced by BDL post TOT) Light Weight Torpedo (produced by BDL) MAJORSOLUTIONS KEY PARTICIPANTS INDIA DPSU/Govt. EUROPE MICA BlackShark Exocet Sea Eagle NORTH AMERICA HellFire Harpoon Stinger Hydra EUROPE NORTH AMERICA Source: RHP, Frost & Sullivan, PhillipCapital India Research Strong opportunities in Indian market, coupled with the Make in India initiative and DPP 2016 has stimulated an interesting market dynamic in India. Foreign OEMs accord high priority to the Indian market because of assured opportunities but has come to realize that partnering with DPSUs and private companies is the way ahead. This has resulted in many partnerships in the field, as well as stand alone indigenous development. Foreign OEM s have entered into arrangements with domestic companies Company Brief Tata Advanced Partnered with Raytheon to produce components for Stinger missile systems which will be deployed Systems at platoon levels and also on board AH 64 Apaches being procured by India Reliance Defence Signed JV agreement with Rafael Advanced Systems to build Air to Air missile systems Kalyani Strategic Formed JV with Rafael Advanced Systems to manufacture high technology defence components in Systems India. Also, signed MoU with IAI to form a JV to build air defence, ground to ground and ground to sea munitions in India. Punj Lloyd Acquired licenses for manufacturing missiles and rockets in India. Tie up with Weapon Industries (IWI) to manufacture small arms and may venture into the guided missile space in the future. L&T Entered into a JV with MBDA to produce 5th generation ATGMs in India. Also, BDL and L&T entered into an agreement to export light torpedo solutions BDL manufactures light torpedoes, whilst L&T has expertise in tube torpedo launchers. BDL Exploring possibilities of technology transfer with Thales with respect to the Star STREAK missile system Source: RHP, Frost & Sullivan, PhillipCapital India Research Page 10 PHILLIPCAPITAL INDIA RESEARCH

11 Key strengths A play on India's defence BDL offers investors an opportunity to play the India defence sector, as there are not many sizeable companies currently. It derives 97% of its revenues from the defence sector. BDL have strong track record of guided missile production with a well reinforced and holistic value chain in the same. BDL derives almost whole of its revenues from MoD % 80% 60% 79.3% 92.9% 97.3% 98.3% 40% 20% 0% FY15 FY16 FY17 1HFY18 Revenue from MoD (%) Product offerings addresses 54% of the Indian guided missile and torpedoes market BDL is the leading DPSU in India in manufacturing guided missile systems. Its product offerings are capable of addressing 54% of the total guided missile and torpedoes market in India over BDLs product offerings capable to address 54% of the total missile market led by Tactical missiles and Torpedoes... Market % of Addressed by BDL's Segment (US$ bn) total BDL (US$ bn) share (%) Ballistic 0.7 3% 0% Tactical % % Cruise 1.7 7% 0% Special mission 0.2 1% 0% Torpedo 2.2 9% % Total % % Unaddressed 19.4 Source: RHP, Frost & Sullivan, PhillipCapital India Research...with strong presence in tactical missiles (largest segment) where it addresses 58% market of SAMs and ATGMs Market % of Addressed by BDL's Segment ($ bn) total BDL (US$ bn) share (%) Surface to Air % % Air to Surface % 0% Air to Air 1.8 9% 0% ATGM 1.7 9% % Surface to Surface 0.6 3% 0% Tactical missiles % % Developing new products and partners with DRDO BDL planning to develop new products such as new generation SAMs, ATGMs, and heavy weight torpedoes to further increase its offerings. It is also the joint development partner with the DRDO for the next generation of ATGMs and SAMs. MoD has identified it as the production agency and the lead integrator for one of the new generation of SAMs and the nominated agency for the third generation of ATGMs. Additionally, BDL has entered into license agreements, principles of cooperation, MoUs and non disclosure agreements with companies / organisations in France, Israel, Russia and UK for its existing products and for the development of new products. It is also exploring possibilities of technology transfer with Thales with respect to the StarSTREAK missile system Page 11 PHILLIPCAPITAL INDIA RESEARCH

12 BDL partnership with DRDO and Foreign OEMs Partner Type of agreement Scope of work DRDO, GoI MoU Co development of next generation man portable ATGM DRDO, GoI MoU Co development of next generation man portable SAM DRDO, GoI MoU Co development of next generation ATGM DRDO, GoI MoU Enhancement of missile and other weapon support systems Euro Missile, France Licence TOT Milan 2 ATGM and Milan 2T ATGM KBP, Tula, Russia Licence TOT Konkurs ATGM and Konkurs M ATGM Modern manufacturing infrastructure to add timely execution of orders Over the last 5 years, BDL has invested Rs 7bn for modernisation of its manufacturing plants. Its plants are equipped with robotic welding machines, four axis machines, flow forming machines, vacuum furnace for heat treatment, automated electroplating shop, 3D coordinating measuring machine, climatic chambers and 800G acceleration measuring fixture. Its Hyderabad manufacturing unit has been automated for material handling and grain loading of SAMs. Further, Vishakhapatnam plant is exclusively for the manufacturing of torpedoes. Rs 9.7bn of capex over last 5 6 years of which Rs 7bn spend for the modernization of its manufacturing infrastructure facilities Capex FY13 FY14 FY15 FY16 FY17 1HFY18 Experienced management with bandwidth BDL has a capable management having several years of experience in the defence industry. Its current Managing Director has been with the company for 28 years, with good credentials. Similarly, its Directors production and technical have been with the firm for 32 and 30 years respectively. During the IPO meet, we interacted with the middle management team in finance and business development and found them well experienced. Further, it has a large pool of experienced engineers as of January 2018 engineers constitute 28.4% of its total employees. Page 12 PHILLIPCAPITAL INDIA RESEARCH

13 Key management personnel Name Mr. V. Udaya Bhaskar Designation Chairman & Managing Director S. Piramanayagam Director (Finance) & Chief Financial Officer V. Gurudatta Prasad Director (Production) K. Divakar Director (Technical) Age (years) Qualification 59 Joined BDL in 1990 and appointed as CMD on January 30, Prior to BDL, he was associated with Bakelite Hylam Ltd, Dytron (India) Ltd and SIP Resins Ltd B. Tech in Plastics Technology & Chemical Engineering from H.B Technological Institute, Kanpur M. Tech Technology Polymer Science & Technology from Indian Institute of Technology, Delhi 57 He has been on the board of BDL since January 01, Prior to BDL, he has worked as a GM (finance) of BEML and also at NLC India for ten years in the middle management B. Sc. from Madurai Kamraj University and associate member of the Institute of Chartered Accountants of India 58 Associated with BDL since 1986 and prior to appointment as Director, served as GM at BDL's office in Bhanur in the capacity of Unit Head. Prior to BDL, he was working with Hyderabad Allwyn Ltd He is a recipient of the Raksha Mantri s Innovation Award for the year Bachelors in Mechanical Engineering from Bangalore University M. Tech (Industrial Engineering & Management) from Jawaharlal Nehru Technological University, Hyderabad 59 Associated with BDL since 1988 and has served as GM (Design & Engineering), headed the Milan, Refurbishment and Explosive divisions. Also played an instrumental role in establishing the naval division at Vishakhapatnam. He is experienced in various areas of missile production. Prior to BDL, he has worked with Indian Telephone Industries Ltd. B. Tech in Mechanical Engineering from Jawaharlal Nehru Technological University, Andhra Pradesh Post graduate course in tool, die and mould design from Central Institute of Tool Design, Hyderabad Focusing on R&D and efficiency improvements to address competition from private To address competition due to opening of defence for the private players, BDL is focusing on (1) increasing its R&D activities to provide novel and better products to customers; and (2) process improvements to increase operational productivity and efficiency to lower costs. Its R&D expenses grew at a CAGR of 23.6% to Rs 347mn in FY17 from Rs 227mn in FY15. BDL has established a missile development group to design and develop missiles and various technological labs such as RF labs, laser labs, aerodynamic labs and seeker labs to develop seeker technologies. It is also conducting R&D for an improved version of the second generation of the Konkurs M ATGM. Export market an emerging opportunity GOI has set an ambitious target to export US$ 2bn worth of defence equipment by Consequently, policy changes have been made to ease exports. DPSUs have been allowed to export 10% of their annual production. The process of obtaining No Objection Certificates (NOCs) has also been streamlined, web based and time bound. BDL and L&T has entered into an agreement to export light torpedo solutions. BDL manufactures light torpedoes, whilst L&T has expertise in tube torpedo launchers. Page 13 PHILLIPCAPITAL INDIA RESEARCH

14 Capacity expansion plans In order to address the expected demand of new products, BDL is setting up two new manufacturing facilities at (1) Ibrahimapatnam, Telangana for the manufacturing of SAMs (including new gen SAMs); and (2) Amravati, Maharashtra for the manufacturing of VSHORADMs. The company will be investing ~Rs 7bn over the next 3 4 years on these new facilities. Planned new manufacturing facilities Location Products Ibrahimapatnam, Telangana SAMs Amravati, Maharashtra Very Short Range Air Defence Missiles (VSHORADMs) Further, it is planning to automate production system at its existing manufacturing facility in Hyderabad to increase the production of SAMs. It is also in the process of setting up a test fire range in Rachakonda, Telangana which will lead to operational advantage and cost efficiencies. Key risks Delay in award of expected large orders Lack of award of large orders has led to depletion in BDL's order book (2.2x Jan'18 book to bill vs 21x in FY11) since its peak in FY11 when it had won its largest ever order (Rs 142bn) for Akash SAM for the army. Though, BDL has a large pipeline of orders but these projects could be delayed due to their large size and inter government agreements. This will have the risk to visibility of its sales and capacity utilization. Further, BDL enjoys a negative working capital position/large cash balances due to huge customer advances resulting in earning of significant interest income. However, in past a few years its interest income has declined due to lower cash balances mainly on account of reduction in customer advances. Hence, any delay in expected large orders may further lead to decline in its interest income. Order book depleting since FY11 due to lack of large orders Akash SAM for Army Order book Book to bill (x) Source: RHP, Frost & Sullivan, PhillipCapital India Research FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 Jan' also decline in other income on decline in customer advances Customer advances (LHS) Other income (RHS) FY11 FY12 FY13 FY14 FY15 FY16 FY17 1HFY Page 14 PHILLIPCAPITAL INDIA RESEARCH

15 Risk to margins which are at cyclically high levels We see a two pronged risk to BDL s EBITDA margins viz. a) Share of revenues from indigenously developed Akash SAM is expected to reduce over the next two years as the project reaches completion and the follow up order is still some time away. Akash contributed about 75% of BDL s sales in FY17. Ever since its execution picked up BDL s margins have expanded 1900bps between FY b) New order wins in the near term such as VSHORAD (Rs 130bn) and MRSAM (Rs100bn) would involve transfer of technology (ToT) initially and should be low margin projects initially. BDL's EBITDA margins expanded 1900bps over FY13 17 led by pick up in execution of Akash Revenues EBITDA margins (%) % 20% % 15% 9.9% 24 10% 4.6% 12 5% 0 1.2% 0% 12 FY13 FY14 FY15 FY16 FY17 5% Delay in execution may lead to levy of penalty or liquidated damages as well as termination of contracts: Any delay in the supply of goods by BDL may lead to the levy of liquidated damages or invocation of the indemnity bond / performance bank guarantee (5% to 10% of the contract value) by its customers. Further, BDL's contracts with MoD permit the later to terminate the contract for any delay of more than 24 months after the scheduled delivery (unless attributable to force majeure) as well for default in the event of any breach. BDL has provided Rs 7bn for liquidated damages since FY Liquidated damanges 6.5% % of Sales 7% % 6% 2.0 5% % 3.9% 4.1% 4% % FY13 FY14 FY15 FY16 FY17 1HFY18 3% 2% Page 15 PHILLIPCAPITAL INDIA RESEARCH

16 Increased competition due to opening up of defence to private sector: BDL faces competition largely from global players particularly from Europe and USA (such as Boeing, Raytheon, Lockheed Martin, Rafael Advanced Defence Systems and Roketsan). However, due to implementation of recent policies (DPP, 2016), private companies will be allowed to manufacture and bid for missiles, torpedoes and countermeasures. Private players are scrambling to ready themselves for opportunities by setting up manufacturing facilities in India and securing production licenses. They are positioning themselves as able partners for foreign OEMs in the guided missile space to enter into partnerships with. Over dependence on a single customer: BDL primarily dependent on a single customer, the Indian armed forces through the Ministry of Defence which contributed 97% of its FY17 revenues. This exposes BDL with material adverse impact due to any decline or reprioritization of the Indian defence budget, reduction in their orders, termination of contracts or failure to succeed in tendering projects and deviations in the short and long term policies of the MoD or the Indian armed forces in the future. BDL is primarily dependent on the MOD for orders 100% 80% 60% 79.3% 92.9% 97.3% 98.3% 40% 20% 0% FY15 FY16 FY17 1HFY18 Revenue from MoD (%) Page 16 PHILLIPCAPITAL INDIA RESEARCH

17 Historical financial performance in charts BHARAT DYNAMICS LTD IPO NOTE Order book depleted due to lack of large orders... Order book Book to bill (x) FY13 FY14 FY15 FY16 FY17 Jan' Revenues grew 44% CAGR led by execution of Akash missiles Revenues 44.0% CAGR % yoy FY13 FY14 FY15 FY16 FY17 1HFY18 75% 60% 45% 30% 15% 0%... strong growth in EBITDA driven by execution and operating leverage led margin expansion... However, PAT grew at 24% CAGR due to decline in other income on lower cash balances 10 EBITDA EBITDA margin (%) 20% 8 Rec PAT % yoy 35% (0.1) FY13 FY14 FY15 FY16 FY17 1HFY18 15% 10% 5% 0% 5% % CAGR FY13 FY14 FY15 FY16 FY17 1HFY18 30% 25% 20% 15% 10% 5% 0% RoE expanded to 32.7% (vs 31.3%) on improved assets turnover... Free cash flow remains negative mainly due to decline in advances from customers and capex 33% 30% 31.3% 30.9% RoE (%) 30.3% 32.1% 32.7% 3 (3) (6) (9) (6.9) 0.9 Free cash flow (8.7) (4.7) % (12) (15) (14.8) 24% FY13 FY14 FY15 FY16 FY17 (18) FY13 FY14 FY15 FY16 FY17 1HFY18 Page 17 PHILLIPCAPITAL INDIA RESEARCH

18 Our view: AVOID Multiple risks overshadow the opportunity pipeline We agree that BDL has a significant pipeline of order inflows over the next five years, we estimate new order inflows of Rs 440bn over FY19 22 increasing its order book by 3.7x over its FY17 base. However, we believe that only order inflows will not help the stock re rate and we see multiple risks to current valuations. 1. Share of indigenously developed missile system Akash is expected to reduce over the next two years. 2. New orders such as VSHORADS (Rs 130bn) and MRSAM (Rs 100bn) are technology of transfer projects. 3. Even as we agree that BDL is expanding its product profile from a single product (Akash) to multiple products (VSHORAD, MRSAM and Torpedoes) the benefits would be back ended. 4. Consequently, BDL s margins which are at cyclically high levels have downside risks as new projects would have a learning curve impact on margins. 5. Going forward, BDL might have to share a certain percentage of the development cost with DRDO and also have a revenue share for projects developed by DRDO. Both of these would have a bearing on margins which are currently not priced in. 6. Though pipeline of orders is large but these projects could be delayed due to their large size and inter government agreements. IPO valuations are cheap and rightly so At its IPO price of Rs 428 BDL trades at 16x PE FY20E based on our estimates. One would argue that current valuations are undemanding. However, we believe that with the above risks coupled with a 9% decline in earnings over FY18 20E the stock does not have room for upside in the near term. Valuations in line with global peers BDL s IPO valuation would peg it in line with its global peers despite its relatively smaller size and lack of research capabilities. What would make us revisit our thesis? We would have a relook at our view incase of additional information on the potential size of the projects and any change in BDL s work share agreement in the ToT projects. Page 18 PHILLIPCAPITAL INDIA RESEARCH

19 Global valuations comparison Sales (LC bn) EBITDA (LC bn) EBITDA margin (%) PAT (LC bn) Company name FY18E FY19E FY20E FY18E FY19E FY20E FY18E FY19E FY20E FY18E FY19E FY20E Indian companies Bharat Dynamics Bharat Electronics Cochin Shipyard US companies Boeing Lockheed Martin Raytheon European companies BAE Systems Thales Leonardo Finmeccanica SAAB AB Average Price Shares Mkt cap PE (x) EV/EBITDA RoE (%) Company name (LC) O/s (mn) (USD mn) FY18E FY19E FY20E FY18E FY19E FY20E FY18E FY19E FY20E Indian companies Bharat Dynamics , Bharat Electronics 148 2,457 5, Cochin Shipyard , US companies Boeing ,08, , Lockheed Martin , Raytheon , European companies BAE Systems 602 3,187 26, Thales , Leonardo Finmeccanica , SAAB AB , Average Source: RHP, Frost & Sullivan, PhillipCapital India Research Page 19 PHILLIPCAPITAL INDIA RESEARCH

20 Financial outlook in charts Order book to pick up from FY19 onwards led by award of large orders Order book Book to bill (x) FY16 FY17 FY18e FY19e FY20e FY21e FY22e However, revenues will decline by 15% over FY17 20 on depleting Akash order and back ended execution of new orders Revenues % yoy 15.3% CAGR FY16 FY17 FY18e FY19e FY20e 45% 30% 15% 0% 15% 30% 45%... EBITDA to decline at 18% CAGR due to weak execution and lower margins impacted by negative operating leverage % EBITDA EBITDA margin (%) 17.9% 18.3% 17.6% CAGR 19.7% 16.5% FY16 FY17 FY18e FY19e FY20e 22% 20% 18% 16% 14% 12% 10% However, PAT to decline at 9.5% CAGR due higher other income on customer advances led improved cash balances Rec PAT 9.5% CAGR % yoy 4.9 FY16 FY17 FY18e FY19e FY20e 30% 20% 10% 0% 10% 20% 30%... lower assets turnover will lead to sharp contraction in RoE (18% vs 32.7% in FY17)... 35% 30% 25% 20% 15% 10% 32.1% 32.7% RoE (%) 28.4% 27.7% 18.0% FY16 FY17 FY18e FY19e FY20e However, the improved cash balances led by customer advances will result in free cash flow of Rs 38bn (5) (10) (15) (20) (4.7) (14.8) Free cash flow FY16 FY17 FY18e FY19e FY20e Page 20 PHILLIPCAPITAL INDIA RESEARCH

21 Annexure Frost & Sullivan has segmented the market into 5 major segments Missile Systems and Torpedoes Ballistic missile Tactical missile Cruise missile Special mission Torpedo systems Intercontinental (ICBM), Intermediate range (IRBM), Medium range (MRBM), Short range (SRBM), Tactical Ballistic Missiles (TBM) Surface to Surface (SSM), Surface to Air (SAM), Air to Air (AAM), Air to Surface (ASM), Anti Tank Guided Missiles (ATGM) Long range, Medium range, Short range Anti radiation, Anti Satellite, Electro Magnetic Pulse Light Torpedoes, Heavy Torpedoes Segment / sub segment Definition/ Brief Example Ballistic Missile A missile delivery system which follows a ballistic trajectory. Major part of its flight stage will be unpowered and governed by gravity and air friction. It may also have the capability to carry Multiple Independently Targetable Re entry Vehicles (MIRVs). These missiles may be silo launched, canister launched, ship launched or submarine launched. Some ballistic missiles (such as the Indian Dhanush) can perform mid course missile correction manoeuvres. Minuteman ballistic missile systems of USA Dongfeng missile systems of China Intercontinental Ballistic Missile (ICBM) Intermediate Range Ballistic Missile (IRBM) Medium Range Ballistic Missile (MRBM) Short Range Ballistic Missiles (SRBM) Tactical Ballistic Missile Systems (TBM) Tactical Missile Systems Surface to Surface Missiles (SSM) Surface to Air Missiles (SAM) Air to Air Missiles (AAM) Air to Surface Missiles (ASM) Anti Tank Guided Missiles (ATGM) Range over 5,500 kms Range between 3,000 to 5,500 kms Range between 1,000 to 3,000 kms Range between 300 to 1,000 kms Range of 500 kms or less TMS are used to counter land, sea or air based threats. It has a shorter range and unlike ballistic missile, majority of its flight time is unguided. Launched from man portable packs, vehicle mounted, fixed or shipbased installations to destroy other stationary/mobile ground targets Launched from ground to destroy aircraft or other missiles under this category. Missile defence interceptors also fall in this category. Launched by air platforms intended to destroy other air targets in this category. These missiles may be visual range missiles or beyond visual range missiles. Certain modern Air to Air missiles are capable of mid mission course correction and active guidance. Launched by air platforms intended to destroy other stationary or mobile ground targets Man portable or platform launched missiles with a specific role of destroying armoured vehicles LGM 30 Minuteman II system of USA Jericho III missile system of Israel DF 26 missile system of China PGM 17 Thor missile system of USA (retired) Shaheen III missile system of Pakistan Jericho I of Israel Grom missile of Ukraine (under development) Nasr missile of Pakistan 9K720 Iskander missile system of Russia 9K720 Iskander LORA Lockheed Martin s MGM 140 Army Tactical Missile System (ATacMS) used by USA Army MIM 104 Patriot RIM 7 Sea Sparrow MBDA Meteor used in the Eurofighter Typhoons PARS 3 LR FGM 148 Javelin Cruise Missile Cruise missiles are used to destroy terrestrial targets and designed Tomahawk missile system of USA to glide at fairly constant speed in order to deliver heavy warheads with high precision. They can be hypersonic, supersonic or subsonic as far as speed is concerned. Long Range With ranges in excess of 1000 kms Kh 55 missile system of Russia Medium Range With ranges in between 300 to 1000 kms AGM 158C LRASM of USA Babur missile system of Pakistan Page 21 PHILLIPCAPITAL INDIA RESEARCH

22 Short Range With range upto 300 kms Nasr 1 missile system of Iran Special Mission Missile These missiles are developed for a specific mission type. Standard missiles can also be modified to perform special missions Raytheon s Counter electronics High powered Advanced Missile Project (CHAMP) EMP weapon Anti Satellite Missiles Strategic military weapons used for destroying satellites Arrow 3 missile system used by Israel can be used for an exo atmospheric interception role. Anti Radiation Missiles Electromagnetic Pulse Missiles Detect enemy radio sources such as radar stations and home in on the target. They can be surface to surface, air to air or surface to air. Missiles designed to produce a short burst of electromagnetic energy which will cripple or disable all electronic equipment. BAE System s ALARM (Air Launched Anti Radiation Missile) used by Saudi Arabia and UK Raytheon has tested an EMP missile weapon Counter electronics High powered Advanced Missile Project (CHAMP) in USA Whitehead Alenia Sistemi Subacquei Blackshark torpedo system Torpedo System Torpedoes are self propelled weapons used to destroy or incapacitate ships, submarines and mines. Light Weight Torpedoes Warhead weight is less than 100 kg Raytheon s Mk 54 used by USA Heavy Weight Torpedoes Warhead weight is greater than 100 kgs Mark 48 torpedo used by USA Page 22 PHILLIPCAPITAL INDIA RESEARCH

23 Financials Income Statement Y/E Mar, Rs mn FY17 FY18e FY19e FY20e Net sales 46,301 44,943 43,494 28,174 Growth, % 22.3 (2.9) (3.2) (35.2) Raw material expenses (30,195) (28,245) (26,411) (16,545) Employee expenses (3,884) (4,486) (4,673) (4,906) Other Operating expenses (3,929) (3,984) (3,855) (2,075) EBITDA (Core) 8,293 8,229 8,555 4,648 Growth, % 61.6 (0.8) 4.0 (45.7) Margin, % Depreciation (622) (699) (762) (797) EBIT 7,671 7,530 7,793 3,851 Growth, % 66.8 (1.8) 3.5 (50.6) Margin, % Interest paid (37) (38) (38) (39) Other Income 2,298 1,928 2,190 3,658 Pre tax profit 9,933 9,421 9,944 7,469 Tax provided (3,286) (3,203) (3,381) (2,540) Net Profit (recurring) 6,647 6,218 6,563 4,930 Growth, % 18 (6) 6 (25) Net Profit (reported) 4,903 6,218 6,563 4,930 Unadj. shares (m) Wtd avg shares (m) Balance Sheet Y/E Mar, Rs mn FY17 FY18e FY19e FY20e Cash & bank 17,380 13,370 31,825 52,437 Debtors 3,564 3,460 3,348 2,169 Inventory 22,511 21,058 19,691 12,335 Loans & advances Other current assets 32,042 27,543 24,152 13,112 Total current assets 75,498 65,430 79,015 80,053 Investments Gross fixed assets 9,466 10,366 11,266 11,366 Less: Depreciation (1,812) (2,510) (3,272) (4,070) Add: Capital WIP 1,312 1,812 3,212 6,212 Net fixed assets 8,967 9,669 11,207 13,509 Total assets 84,495 75,128 90,251 93,592 Current liabilities 57,472 48,781 59,889 62,116 Provisions 6,412 6,261 6,077 4,035 Total current liabilities 63,883 55,043 65,966 66,151 Non current liabilities (1,513) (1,513) (1,513) (1,513) Total liabilities 62,370 53,529 64,452 64,638 Paid up capital 1,222 1,833 1,833 1,833 Reserves & surplus 20,903 19,766 23,966 27,121 Shareholders equity 22,125 21,599 25,799 28,954 Total equity & liabilities 84,495 75,128 90,251 93,592 Source: Company, PhillipCapital India Research Estimates Cash Flow Y/E Mar, Rs mn FY17 FY18e FY19e FY20e Pre tax profit 7,322 9,421 9,944 7,469 Depreciation Chg in working capital (5,055) (2,783) 15,793 19,760 Total tax paid (3,349) (3,203) (3,381) (2,540) Cash flow from operating activities (232) 2,243 20,966 21,869 Capital expenditure (1,360) (1,400) (2,300) (3,100) Chg in investments Cash flow from investing activities (110) 558 Free cash flow (14,773) ,666 18,769 Equity raised/(repaid) (4,505) Debt raised/(repaid) Dividend (incl. tax) (1,220) (2,238) (2,363) (1,775) Other financing activities (442) (38) (38) (39) Cash flow from financing activities (1,662) (6,781) (2,401) (1,814) Net chg in cash (1,863) (4,010) 18,455 20,612 Valuation Ratios FY17 FY18e FY19e FY20e Per Share data EPS (INR) Growth, % 18.3 (6.5) 5.6 (24.9) Book NAV/share (INR) FDEPS (INR) CEPS (INR) DPS (INR) Return ratios Return on assets (%) Return on equity (%) Return on capital employed (%) Turnover ratios Asset turnover (x) Sales/Total assets (x) Sales/Net FA (x) Working capital/sales (x) (0.1) (0.1) (0.4) (1.4) Working capital days (45.5) (24.2) (157.6) (499.2) Liquidity ratios Current ratio (x) Quick ratio (x) Interest cover (x) Dividend cover (x) Total debt/equity (%) Net debt/equity (%) (0.8) (0.6) (1.2) (1.8) Valuation PER (x) PEG (x) y o y growth 0.6 (2.0) 2.1 (0.6) Price/Book (x) Yield (%) EV/Net sales (x) EV/EBITDA (x) Page 23 PHILLIPCAPITAL INDIA RESEARCH