The Indian defence sector has only recently come to the notice of investors. For decades, the industry was closely controlled by the government, and the result was a clutch of highly bureaucratic public sector units manufacturing equipment, with low innovation and significant red tape. The sector lagged significantly behind the world in defence production. 

All of this has changed in the past few years, thanks to  initiatives like “Atmanirbhar Bharat” where the majority of equipment and armaments are now manufactured in India itself. From being one of the world's largest importers of defence equipment, India today exports defence products to nearly 75 countries. Exports in FY22 at Rs 12,815 crore were almost six times that in FY16. India’s defence exports were worth Rs 8,434 crore in FY21 and Rs 2,059 crore in FY16. India’s exports mainly to countries like the US, the Philippines and countries in South-East Asia, the Middle East and Africa.

Quick Takes

• India’s defence exports have grown by 334% over last five years clocking export revenue of Rs 12,815 crore in FY22
• In June 2020, the government announced increasing the foreign direct investment (FDI) limit from 49% to 74% under the automatic route and up to 100% through the government route in the defence sector
• In order to promote 'Make in India' in the defence sector, the government has issued 584 defence licences to 358 private companies
• The government has also issued 107 licences for manufacturing of weapons
• State governments of Karnataka and Haryana have announced policies to promote Aerospace and defence manufacturing in their respective states.
• Though highly ambitious, the “Make in India” guidelines for the defence sector are still not clearly defined, and may not meet the target to indigenise all the equipments and components listed in the policy
• Some complex systems like diesel-electric submarines and twin-engine fighters are still imported and it will be some time before these are locally manufactured

PSUs in the defence sector spring a surprise

Many PSU companies from the defence sector have changed their strategy over the past few years and from an investment standpoint, are trying to move away from the white elephants - unproductive money sinks - they were in the past.  These include HAL (Hindustan Aeronautics), BEL (Bharat Electronics) and  BDL (Bharat Dynamics) who are also now among the top three players in the defence sector by market capitalisation.

HAL was able to successfully produce Tejas, a light combat aircraft. It received an order from the government last year for manufacturing 83 Tejas jets to be delivered by 2023. Tejas will replace the existing ageing fleet of Jaguar and Mirage 2000 aircrafts. The Tejas LCA is one of the frontrunners to replace the Mig-29 fleet of the Malaysian air force. Enquires have also been received from Argentina, Egypt and Indonesia.

Similarly, another PSU, BEL, specialises in manufacturing defence electronics and is emerging as a key beneficiary of the increase in defence capital expenditure. BEL offers products and services in a wide spectrum of technology like radars, military communications, naval systems, electronic warfare systems, telecommunications, sound & vision broadcasting, and so on. 

Some of the orders in BEL’s pipeline are Akash Prime from Bharat Dynamics worth Rs 4,000 crore, Himshakti Electronic Warfare (EW) worth Rs 3,200 crore, Arudhra Radar worth Rs 3,000 crore, EW system for Mi-17 helicopters worth Rs 1,500 crore, Electronic Warfare Systems for Ships worth Rs 12,000 crore and 12 WDR (Weapon Detecting Radars) worth Rs 1,000 crore.

The third PSU, BDL, is engaged in the manufacture of missiles. The company has planned  investments to augment capacity including establishing Seeker Facility Centre and Warhead Production facility along with three new upcoming facilities at Ibrahimpatnam (Telangana), Jhansi (UP) and Amaravati (Maharashtra).

The PSU’s have performed exceptionally well over the past few years, but whether they will be able to sustain this momentum remains to be seen. Changing dynamics in world politics have a major impact and India’s relationship with the importing countries will be key to maintaining sustained order flows in exports.

It is also difficult to access some data given the sensitivity in terms of national security and confidentiality. However, there are other indicators that point to the growing interest in this sector.

While there has been direct investment in terms of FDI, many institutional investors are also stacking up on the defence sector stocks. According to the latest data, more that 20% of BEL stocks is held by different schemes of mutual funds. Similarly, among the private sector defence companies, mutual funds hold more than 20% of shares in Mtar Tech. The share of mutual funds in HAL has risen to 7.37% in Q1FY23 from 4.7% in Q1FY22. For BDL, the mutual funds holdings have increased to 8.27% in Q1FY23 from 6.89% in Q1FY22.

Private sector players are emerging

The easing of norms has seen many players get listed on the exchanges in the past few years. Paras Defence will complete a year of listing in October 2022, Mtar Tech got listed in March 2021 and Data Pattern in December 2021. 

Paras Defence has five principal categories of product offerings: Defence and space optics, defence electronics, EMP protection, heavy engineering for defence and niche technologies. The company is one of the leading ‘Indigenously Designed Developed and Manufactured’ (“IDDM”) category private sector companies in India who is also the sole Indian supplier of critical imaging components such as large size optics and diffractive gratings for space applications. 

Data Pattern is a vertically integrated defence and aerospace electronics solutions provider catering to the indigenously developed defence products industry. The management expects orders worth Rs 2000-3000 crore over the next three to four years. Fire control systems for the BrahMos Missile, Avionics for LCA, RWR for Fighter Aircraft, ELINT for Airborne and ground platform and Radar Subsystems are some key orders in the pipeline for FY23.

Apart from these companies, other players include Solar Industries, which makes grenades, Larsen and Toubro which also supplies critical equipment and Bharat Forge, which makes an armoured combat vehicle, the Kalyani M4 which can be used in difficult terrain. Defence remains a smaller segment of their overall businesses, but a growing one at that.

State governments vie with each other to promote defence sector

Two defence industrial corridors have been established, one each in Uttar Pradesh and Tamil Nadu to bolster indigneous manufacturing.

In May 2022, the Haryana government announced the Haryana Aerospace and Defence Production Policy, 2022, aimed at attracting investments of at least US$1 billion and providing employment opportunities to around 25,000 people in five years. 

Not to be left behind, in August 2022, the Karnataka state government approved the Karnataka Aerospace and Defence Policy 2022-27 to attract investment of ?45,000 crore in the next five-year period and extend concessions for investors in the sector.

The policy aims at attracting more investments and to establish Karnataka as the preferred investment destination for Aerospace and Defence manufacturing and promote development of indigenous and advanced technologies. The policy noted that 25% of India’s aircraft and spacecraft industry is based in Karnataka; and 67% of all aircraft and helicopters manufacturing for defence services is done in the State. Karnataka contributed to 65% of the country’s aerospace related exports from India.

While a lot of infrastructure support is available from governments, procurement of many items still remains a concern. Though the policy plans to indigenise almost every critical equipment and weaponry, it may not be able to meet the target for every item listed. Hence, there still exists a set of equipment and armaments that fall under emergency procurement, which need to be imported.

The geopolitical situation today, and the stand taken by India on various world matters will also play a role in the relationship of India’s defence exports. Even though this industry may look to be in a bright spot today, several factors are simultaneously key at various levels, including legacy issues like a complex tendering process, slow decision making by the bureaucracy and ministries involved, which may have improved in the past few years, but still have a long way to go. Changing geopolitical situations and consistency of India’s defence policies over the next few years will determine whether the defence sector can continue to be an outperformer.

Given the strained relationship India shares with its two neighbours China and Pakistan, and the chances of aggression in the future amidst escalating geopolitical tensions, defence as a sector plays a crucial role. The central government has taken proactive steps to make India Atmanirbhar or self-reliant in the defence sector in the past few years, but will take a few more years to become completely independent.

Also in view of the escalating geopolitical tensions after the Russia-Ukraine war, it appears that this drive for greater self-reliance is likely to accelerate, making this sector a potential outperformer.