Given the equipment requirements for the modernization of India’s armed forces and the government’s “Make in India” initiative, the Indian defense manufacturing sector presents an opportunity worth $245 billion over the next 10 years, notes Citi.

Venkatesh Balasubramaniam and team at Citi in their March 31, 2015 research report titled: “India Defence Manufacturing – All Set to Fire – US$245bn Opportunity Over Next Decade” point out, however, that the opportunity will be more back-ended given the long procurement cycles in defense.

Consistent decline in India’s defence spending

The Citi analysts point out that India’s defense spending has been consistently declining as a share of GDP over the last few years, resulting in India’s military outlay being only one-quarter that of China’s in 2013.

Declining defence spend

The analysts note India’s defence budget grew at a CAGR of 10% over FY 2000-14. Moreover, defence spending under the new government is set to increase at a CAGR of 10% over FY 14-16E. Despite the absolute increase in defence spending, it has been accounting for a declining share of India’s rapidly expanding GDP.

The report notes dependence on inefficient DPSUs/OFBs led to India being the world’s largest importer of major weapons in 2009-13, accounting for 14% of the total, followed by China and Pakistan each accounting for 5%.

Major arms importers

The Citi analysts point out that capex was only about 38% of defense spending over FY08-14, with the remainder of the budget being spent on pay and operations costs for the armed forces. As can be deduced from the following graph, for FY 16E, capex is pegged at 38% of the total defense budget at $15 billion. Moreover, capex also includes committed liabilities, which leaves limited room for buying equipment.

Capex portion of defence expenditure

India’s defense – at an inflection point

Venkatesh Balasubramaniam et al note that due to a series of initiatives related to the defense sector initiated by the Government of India, defense manufacturing in India is at an inflection point. Some of the initiatives taken include: (a) defense being one of the 25 sectors in the government’s ‘Make in India’ initiative, (b) the FDI limit for the defense sector being lifted to 49% from 26%, (c) greater focus on procurement of locally made equipment, (d) liberalization of licensing policies, (e) approval for projects worth more than US$28bn aimed at kick-starting the sector.

These initiatives have started bearing fruit for the defense manufacturing sector. For instance, from July 2014 to February 2015, DAC approved projects worth over $28 billion to kick-start the revival of the sector for the modernization of the armed forces.

The Citi analysts point out that these modernization initiatives and “Make in India” programs will make India to commence one of the world’s largest procurement cycles. They anticipate the opportunity of the Indian defense manufacturing sector to be worth $245 billion over the next 10 years, assuming defense capex to be 0.68% of a nominal GDP growing at an annual rate of 10%.

The analysts anticipate the key beneficiaries of the India defence manufacturing opportunity as being L&T, Bharat Forge, Ashok Leyland, Mahindra & Mahindra, Reliance Infrastructure, Tata Motors and Tata Power.

India defence valuation comparable

They project defense to contribute $2-3 billion in revenues for L&T over the next five years, from the current $300 million, while Bharat Forge’s defense contribution could rise to $100 million in sales in five years.

Moreover, the analysts also believe Boeing, Lockheed Martin and Raytheon might potentially benefit over the long term from the India defense opportunity.

Global defence valuation comparable