Paras Defence hits upper circuit twice, but analysts are unsure about the stock

The contract is to manufacture opto-electronic components for L&T’s close-in weapon system programme, a critical component of the Indian navy’s defence infrastructure.

The stock hit the upper 5% circuit on Monday to end at ₹1,268.75. It had reached the upper circuit on Friday, too. The shares fell 1.3% to ₹1,251 at 12:57 IST on Tuesday.

Analysts said investor optimism over the company’s valuation has already outpaced its fundamentals and it is only a matter of time before they realise this.

Also Read: Up 275% in a year, this defence stock's growth is just getting started

Jyoti Gupta, a research analyst at Nirmal Bang Institutional Equities, recommended a “sell" rating on the stock following Paras Defence’s Q1 earnings this month, when it reported its highest quarterly revenue of about ₹84 crore.

“The (defence) stocks, including Paras, peaked out in July. Ever since then, the stock (Paras) has been falling," Gupta told Mint. “However, strong retail buying has stopped it from falling enough. It should be trading at a lower price right now."

Both the stock and the benchmark Nifty India Defence index have fallen 5% in the past one month, according to Bloomberg data, indicating a broader correction in the sector. However, analysts remain wary of the pockets of froth still building up in this sector.

“Even though there is good earnings visibility for the overall sector, from here on, it is largely going to be a stock-specific play in the defence sector," Kranthi Bathini, director of equity strategy at WealthMills Securities, told Mint. “This is a sector where valuations have been stretched based on huge revenue and high return on capital expectations."

However, companies including Paras Defence are yet to meaningfully execute their contracts to be commanding such high premiums, analysts told Mint.

Orderbook exuberance

Paras Defence designs, manufactures and exports products and solutions mainly for government entities in the defence and space sector. The company’s optics and optronic systems division produces highly sophisticated components and subsystems like gratings and mirrors for spaceships and periscopes for submarines, among other things. The defence engineering segment manufactures drones, hollow tubes for rockets and missiles, and remote-control border systems.

In April, the company’s order book was at ₹600 crore and the company expects to execute 50-60% of its current contracts by FY25. Paras Defence expects its order book to swell to ₹2,500 crore by FY28, and it plans to deliver 60% of its contracts by then.

Also Read: Armour-plating your portfolio: Explore the potential of defence stocks and ETFs

“Much of the hype is built around the order book as it offers some revenue visibility. However, people are overlooking whether they (Paras) will be able to successfully execute these orders," Gupta said. “In (the) defence (sector) anything can go wrong at any point. An entire order can get halted if geopolitical scenarios change."

Moreover, since the products are sophisticated, it takes time to produce them. As a result, companies often realise their actual revenue quite late, analysts said.

Since the government is the main customer and the market is not expansionary, it is difficult for companies such as Paras Defence to continually increase their margins. The profit margin will stabilise after a point, irrespective of the size of the order book, analysts said.

Stretched valuation

In Q1 of FY25, the company delivered one submarine periscope worth ₹30 crore, which led to a 73% on-year rise in revenue to ₹84 crore. Net profit in the quarter ended June rose 147% on year to about ₹15 crore, mainly due to the statistical effect of a low base. However, profitability improved 650 basis points on year to 29% owing to a fall in raw material costs.

Gupta expects the company’s earnings to fall in the next two quarters as it continues to focus on orders for its defence engineering division, which is less profitable than its optics and optronic systems division.

Also Read: India needs PLI for drone design: Paras Aerospace CEO

The defence segment contributed 54% to the company’s Q1 revenue, while the remaining came from the optics division, according to Nirmal Bang.

According to an ICRA report published in April, rising employee costs have eaten away the company’s profit margin. A delay in collection of payments from customers forced the company to use a larger portion of its operating income to fund its working capital needs.

A drop in the unencumbered cash balance forced the company to use about 92% of its available credit line, increasing its reliance on borrowed funds. The rating company revised Paras Defence’s credit rating outlook to negative from stable, while maintaining an ‘A-’ rating on its long-term loans.

Based on its Q1 performance and current fundamentals, analysts said the stock is overpriced and there is no need for additional exuberance.

Currently, Paras Defence has a trailing 12-month P/E ratio of 154, while its benchmark Nifty India Defence index trades at a P/E ratio of 67, according to Bloomberg data.

“The government’s focus on self-reliance in the defence sector is going to sustain for at least the next 7-8 years. This notion has been driving the bull run and exuberance in the defence sector over the last couple of years," Bathini said.

But how long this will sustain the lofty valuation of Paras Defence is anybody’s guess.