Defence PSUs: Crimping value, government style
Given that the new pricing mechanism is applicable on prospective orders and the fact the existing order book will take around three years to execute, one may not see any near-term impact on earnings
In an irony of sorts, investors dumped shares of Bharat Electronics Ltd (BEL) even as the company announced receiving its single-largest order. The stock lost about a sixth of its value in the last two days on fears that lower margins on newer orders will hit the company’s profitability.
Ascertaining the exact impact is a conjecture, as full details are still to be known. Even then, the new pricing mechanism rattled investors, triggering a sell-off.
“The ministry of defence has slashed the benchmark margin on prospective contracts awarded on a nomination basis to 7.5% for both the value-added and bought-out components (versus 12.5% permitted for value-added earlier),” Edelweiss Securities Ltd said in a note.
Edelweiss said nomination contracts form 50-60% of BEL’s overall order intake. “Our apprehension that any change in government policy/terms for defence public sector undertakings (DPSUs) might hurt sustainable margins is manifesting,” it said.
Nomination contracts are those awarded by the government to PSUs through a cost-plus framework. The government spells out the product and service requirements and PSUs are asked to come up with price quotations.
Given that the new pricing mechanism is applicable on prospective orders and the fact the existing order book will take around three years to execute, one may not see any near-term impact on earnings.
According to analysts, the new mechanism allows BEL to bill related expenses over and above the stipulated margins, implying limited impact of the new guidelines. “The company believes that the new pricing guideline does not change margin structure meaningfully as several costs, which were earlier covered within 12.5% margin, will now be stated separately at bidding, and will be reimbursed by the user over and above the 7.5% margin,” Antique Stock Broking Ltd said in a note.
An analyst at a local brokerage firm said the rules are framed with an aim to standardize the procurement process, which should help fasten decision-making and awarding of contracts.
Investors don’t seem to be buying that argument. Some analysts said that by lowering the margins of the nomination contracts, the government is reducing the value of its assets. As Edelweiss points out, the margin reduction is a “structural negative” for DPSUs.
Another analyst warns the cap on margins will crimp valuations of DPSUs. This in turn can weigh on pricing of initial public offering-bound firms such as Garden Reach Shipbuilders and Engineers Ltd.
That said, one cannot find fault with government steps to streamline the procurement process, which should benefit DPSUs in the long run. But it should also be followed by efficiency improvement steps.
As Laxman K. Behera, research fellow at Institute for Defence Studies and Analyses, said in a paper last year, performance of DPSUs in terms of innovation, productivity, exports and customer satisfaction is anything but encouraging.
The only way these entities can be made to function better, said Behera, is by putting them under an efficient management. That will enhance efficiency and help them withstand margin shocks better, creating long-term shareholder value.
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