india aerospace & defence sector report

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India : Aerospace & Defence

Foreword

Dr. A. Didar Singh

Secretary General, FICCI

India has emerged as the worlds largest arms buyer over the last couple of years and is in the process of replacing an ageing Soviet-era military hardware with modern military weapons from major defence manufacturers such as USA, Israel, Russia, UK and France. The Indian defence sector is set to embark on a significant growth path in the near future as a result of a slew of initiatives taken by the Ministry of Defence, such as increase in FDI, delicensing of non-lethal and dual use items and a declared export strategy. With the announcement of the Make in India campaign by the government, the manufacturing sector is likely to gain momentum to which the defence sector expected to make a significant contribution.

FICCI has been a votary of a vibrant defence manufacturing base with a level playing field for the private sector. Ever since the defence sector was officially opened to the private sector in 2001, the Indian industry has welcomed the move and has expressed its desire to repeat the success stories of the space, atomic energy and automotive sectors in defence. This strategic sector till date has progressed slowly and India has taken gradual strides in evolving industry and investor-friendly policies. Defence has been accorded the highest priority by the present government with the Honble Prime Minister himself emphasizing the commitment and focus on defence on every major occasion. The government is further streamlining the acquisition process by simplifying the Defence Procurement Procedure to eliminate red tape and facilitate speedier acquisition for meeting the operational requirements of our forces.

FICCI has been at the helm of the policy dialogue with the Ministry of Defence, user and other stakeholders towards establishing a modern Defence Industrial Complex and many of its suggestions have been built into the policy framework.

The FICCI-Centrum Report has highlighted the recent initiatives undertaken by the government to encourage industry, to come forward to partake of the growth of this strategic sector. I believe that this report will help readers to gain a 3600 perspective on the Aerospace & Defence sector and opportunities in India. The snapshot of a few selected defence companies (representing Public, Private and MSME segment) has given valuable information which can be used by corporates to analyze the sector from an investors perspective.

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India : Aerospace & Defence

Foreword

Chandir Gidwani

Founder, Centrum Group

Indias security environment is defined by a complex interplay of regional and global imperatives and challenges. As India seeks to achieve transformative national growth and development internally, we have to pursue a robust defence strategy and policies which aim to address the wide spectrum of conventional and non-conventional security challenges faced by the country.

We at Centrum believe it is time for Aerospace & Defence Sector to be given its long over-due recognition as a core industry as is the case in most developed countries. With the Honorable Prime Ministers call for Make in India we believe the national priorities have been set and the Aerospace & Defence Sector will meet the challenge in building a vibrant Defence Industrial base in India. This would also encourage and attract investments in indigenous strategic Defence programs and the Indian Defence industry to be SFDLPOFEXJUI.

Emphasis should be given on public-private collaboration to bring in an efficient system in place and promote Bcompetitive environment whichXPVME help in setting up Bdefence industrial base in the DPVOUSZSimultaneously, there is a need to identify areas and critical technologies which are essential UPDSFBUFrobust Defence capabilities and to develop such technologies indigenously.

This is possible only through an investor friendly regulatory regime that provides for technological self-reliance in defence systems and encourages investment in developing critical infrastructure for the Aerospace and Defence industry. The report is also a ready compendium of the opportunities based on the current policy framework and assessing the future demand-supply scenario besides showcasing the way forward. I am sure stakeholders across the value chain of Aerospace & Defence Sector will find this report useful.

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About Centrum

Focused Approach to Defence Sector Advisory Centrum Capital Ltd. is a diversified financial services company listed on Bombay Stock Exchange with market capitalization of Rs8bn1. Centrums primary area of business is: x Syndication (Debt & Equity) x Mergers & Acquisition Advisory x Joint Venture Advisory x Institutional Broking x Portfolio Management Services x Wealth Management x Money Exchange Defence Sector is covered extensively at Centrum as we believe the sector presents a huge opportunity for Indian players in various segments. This coverage is under the guidance of Brig. Chacko Ipe (Retd) and supported by Sandeep Upadhyay and his team. We have handled advisory mandates in the Defence sector for leading players across various products including: x India Entry Strategy x Joint Venture x Fund Raising Some transaction closures in the past across sectors: x Leading Defence Company of USA India Entry Strategy x Adlabs Imagica (Theme Park) Debt Syndication of INR Rs14,000 Mn x Adlabs Imagica (Theme Park) Equity Syndication x Hindustan Dorr Oliver (EPC) Debt Restructuring x Dighi Port Limited Debt advisory of INR 15,500 Mn. x Transpole Logistics Raised PE of ~INR 70 mn from Fidelity x Hemavathy Power and Light Ltd M&A advisory for 100% sell out to Greenko Group Plc x Indrajit Infrastructure Debt advisory for 80 MW power project x Soham Renewable Energy India Private Equity x Aqua Logistics Lead Manager for the IPO x Aegis Logistics Advisor for raising Equity x Innovative B2B Logistics Raised debt for capital expansion

1 As on 29th January 2015

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Today India, Tomorrow World Secular Growth Sector

After growing in line with nominal GDP in the last decade, we believe Indian companies in the defence sector (in aggregate) are poised for sustained high growth in the next decade and address an opportunity that could reach $41bn in size by FY22 (7xFY14). We believe this will be driven by both higher domestic and external demand unlike in the past when it was entirely by the former. While higher indigenous content (currently at 30%) in the Indian defence capital spend will be the near term driver, we expect exports (hitherto negligible) to be a key long term factor (offsets to begin with, cost effectiveness driven outsourcing later on). We believe fiscal constraints in developed markets over the next 5-10 years will put defence spending under pressure. With intensifying competition between US and European systems integrators, price pressures are a certainty. Over the past 4-5 years we have seen an explosion in partnerships (JVs and MOUs) between Indian and global players (likely due to relaxation of controls on export of defence technology by the US and other countries and also by lack of choices as China is still on the banned list). These partnerships will exploit offset and indigenization related demand, near term. These would also set the stage for India becoming a critical part of the supply chain of global players for components and sub-assemblies, driving export growth, long term. There is evidence that such a move is already on. We believe India has some of the basic ingredients (large and relatively low cost engineering talent pool, comfort of western nations with India from a geo-political perspective) to deliver on this opportunity but will have to significantly improve on some others (technology, lack of a defence manufacturing ecosystem, etc). Besides, we believe the nature of warfare is becoming more software intensive, which plays into the strength of India with IT Sector Growth and its diversified presence. Post 10-15-year learning curve we expect some Indian companies to move up the value chain to become independent systems integrators across technology-design-system integration value chain in their own right or be part of significant consortia. The opportunity has critical mass, good growth and longevity: As it repairs its finances, we expect US to play a less active military role in the Asian region in the foreseeable future. This will coincide with the economic and military ascendancy of China that could lead to greater tensions with India. Already China has widened the lead with India in a number of areas of defence (3.5x Indias military spend in 2013 vs. 1.5x in 2000). With troubled borders, India will have to increase its defence spend/NGDP to 2-2.5% (vs. FY14 spend of 1.79%) to close the gap. This is also required to correct under spending on capex in the last 20 years. While the revenue part (60%) of the defence spend is largely internal, the capex (~40%) is largely import focused (70%+, India is among worlds largest arms importers) leading to a relatively small domestic defence sector with Defence PSUs (HAL, BEL, BEML, BDL, MDL, GRSE) having a significant share. Private companies, restricted from defence production until 2001, seem to have caught up lately. We believe the low base sets the stage for strong growth ahead for private companies. Credible defence initiatives have been taken over two decades by large industrial groups like Tatas, L&T, and in the past decade by M&M, Bharat Forge, Godrej, Pipavav, Rolta, among others. Competitive moats are fairly wide: Technology is the key driver of competitiveness. For Indian companies this has to be accessed either through DRDO, a foreign JV partner or developed through internal R&D spend. This we believe puts larger Indian companies (both PSU and private) in a significantly better position to be system integrators compared to smaller ones that will assume tierised roles. The role of MSMEs will be significant as they are houses of innovations and champions of niche technology and products. These niche technology and products along with system integrators will play a critical role in building Indias defence manufacturing base. With homegrown technology developed in a few segments and relatively under-developed in others, credibility and flexibility of foreign partners and their governments on flow of technologies and joint development will be winning factors for Indian players. However, in the long term, just as in the pharma, automotive and IT sectors we believe India has the capacity to be an R&D base. Also, with global systems integrators restructuring in the new normal defence spending era, and looking to diversify revenue streams, there will be many opportunities to buy assets in the developed world. Indian companies with deep pockets can potentially hasten their process of becoming systems integrators by buying some of these entities (eg: Mahindras bought Gipps Aero Australia and Aerostaff Australia, Piramal bought Bluebird Aero). Exports to be a large opportunity; driven by significant cuts in US spending: Of the $1.7trn defence spend (2013 SIPRI estimate), ~55% comes from the developed world with 37% from the US alone. With pressure to control fiscal deficits and lower Debt/GDP ratios, we believe defence spending will be a major casualty. Despite the financial crisis in 2008, defence spending sustained because of Iraq and Afghanistan wars. Post that, US indicated a cut of $450bn to $1.1trn over 10-12 years if other deficit reduction plans do not materialize. Western nations will however not want to compromise their national security even under these circumstances. This will lead to higher level of outsourcing as defence forces world-wide will seek better price from vendors. Opportunity for Investors will open up: We believe opportunities will expand both in PSUs (as government divests) and private companies (as conglomerates spin off defence entities, new pure play defence entities execute well and become larger) for financial investors. Defence sector has size, steady growth, longevity of opportunity, returns ratios, etc which will work in its favor compared to many other sectors in India. We believe large Indian private conglomerates with varied skill-sets currently housed in multiple unconnected subsidiaries will pounce on the opportunity. Frugal engineering and manufacturing practices, design skills and competence in software, metallurgy, understanding of export markets, ability to build relationships with foreign government will be the winners in the long term.

This sector report Is prepared jointly by: Federation of Indian Chambers of Commerce and Industry (FICCI)

AND Centrum Capital Ltd

6th Feb 2015

Sector Report

INDIA

India: Aerospace & Defence

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5 India: Aerospace & Defence

Executive Summary

Indian Defence Sector Secular Growth Story Indian defence sector is at the cusp of an inflexion point wherein the future growth will be propelled by indigenous manufacturing both for domestic & global clients. We believe the sector will witness strong growth over the next decade due to its current size, longevity, and competitive advantages.

Indian defence spend is large when compared to other spends in the economy but is under-represented in terms of market capitalization on listed stock exchanges. The defence spend has been in the 2-2.5% range of the nominal GDP in the past decade while market capitalization of Indian defence companies has never been above 0.7% of the GDP at any given point in time. The key reasons for this are:

A large part of spend (60% currently) is revenue expenditure which is internal in nature. Unlike in the US where some non-core functions are outsourced, Indian armed forces have always relied on doing these functions internally. We see these functions changing over the next 5 - 10 years though we believe this area is unlikely to grow as fast as the capex.

Of the capex (40% of the budgeted spend) about 70% is imported in fact India is among the largest importers of weapon systems globally. This is reflected in lower revenues of Indian corporates.

Major defence PSUs are HAL, BEL, BEML, Mazagon Docks Limited and Bharat Dynamics Limited. Of these, BEL & BEML are listed on Indian stock exchanges BSE & NSE.

Large private sector firms are all part of listed entities like L&T, Tata Power, Tata Motors, M&M, Bharat Forge, or unlisted unlisted holding companies like Tata Sons.

However we see this situation changing over the next 10-15 years. Our belief is based on the following:

We expect defence spend to move closer to 2.25% (from the lowest ever number in FY14 at 1.79%) of Nominal GDP as US repairs its financials. This we believe will be accompanied by an assertive and high spending China, which India will try to counter by increasing its own level of spending. While the Indian fiscal may not be in the best shape currently, we believe relatively better growth and increase in Tax/GDP ratio post implementation of tax reforms, widening of tax net and removal of exemptions, will give it fiscal firepower.

We believe the Capex/opex mix will shift towards capex in the coming decade. We expect the mix will shift towards 50:50 or higher vs. 60:40 in favor of opex now. We believe the focus will be on smaller, smarter and a more effective armed force.

o We believe indigenization will take center stage and gather pace going forward. Government took a number of steps in this direction, by opening up defence production to the private sector and allowing 26% FDI in 2001 and defined categorization hierarchy in favour of indigenous procurement in 2013. Recently, the FDI limit was further raised from 26 percent to composite cap of 49 percent (FDI and FII) through the Foreign Investment Promotion Board (FIPB) route with full Indian management and control. With technology transfers becoming easier in recent times, we believe this will gather pace. DPP 2013 furthers the cause of developing domestic defence sector by prioritizing procurement from Indian companies and buying from global companies as the last resort.

Under the Make in India initiative introduced by Honble Prime Minister Narendra Modi, simplification of the Make procedure, financial incentives in terms of a tax holiday and incentivizing R&D were announced. GoI has streamlined the offset policy with innovative components by giving thrust to MSME sector and streamlining export procedures. It has also been decided to promote defence and aerospace exports through an export promotion body. We believe that this initiative will incentivize private players to invest more into Aerospace and Defence sector and help exports grow.

The offset clause (which stipulates that 30-50% of the armament purchase value should be spent on buying Indian components, sub-systems and products) introduced in capital purchase agreements with foreign defence players will ensure that an ecosystem of suppliers is built

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domestically. Besides helping build domestic capabilities, it will bolster exports in the long term.

We also believe India will become a large sourcing base for components and sub-systems in the years to come for foreign systems integrators. We believe this will happen as these companies face price pressure in the years ahead as the large arms consumers US and the western developed world seek cut backs on defence spending to improve their financial position and rein in fiscal deficits and debt/GDP ratios. Already a number of JVs have been signed between Indian and foreign players. We also see initial signs of global players setting up R&D divisions in India and sourcing parts of final products from Indian vendors.

We believe India has some of the basic ingredients (large and relatively low cost (Frugal) engineering talent pool, comfort of western nations with India from a geo-political perspective) to exploit this opportunity but it will have to significantly improve on some others (technology, lack of a defence manufacturing ecosystem, etc). Also, we believe the nature of warfare is becoming more software intensive, which plays into the strength of India considering IT sector growth in the past two decades.

In the next 5-10 years we expect Indian players to become systems integrators. We believe this process could be hastened by inorganic initiatives by groups with deep pockets (L&T, Tata, Mahindra & Mahindra, Reliance Industries, Bharat Forge, etc) who may pick up assets divested by foreign defence players as they restructure and become trimmer (eg: Piramal bought Bluebird Aero of Israel in 2012).

While our expectation on defence exports ($17bn by FY22) may seem audacious considering the very small base, we have been in similar situation in other sectors too in the past (IT services, Pharma and Auto). Catalysts have brought out inherent strengths of the Indian corporate sector.

a. In the case of IT services it was Y2K phenomenon and the development of the internet (which made offshore delivery possible in large quantities). Later, it was the moving up the value chain from pure IT to IT enabled - Engineering Services offering high-skill high-talent pool for offloading design and engineering services to India.

b. In the case of the Pharma sector it was the genericisation of the space as patents expired in the developed world.

c. In the case of the Auto sector, it began with auto ancillaries and then low employee costs combined with an extensive supplier base led India to become the worlds small car hub.

Recently, during the US President visit, Indo-US ties reached a new high with President Barack Obama and Prime Minister Narendra Modis announcing the renewal of the expansive defense ties for another 10 years. India and the US decided to kick off joint manufacturing of four relatively modest military products and explore the development of two more high-end technologies. The two nations agreed to step up joint combat exercises, maritime security endeavors, intelligence-sharing mechanisms and military exchanges.

All these involve active support of the government through appropriate incentives.

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Financial Investors Should Look Forward to Increased Activity & Stable Returns

Significant wealth creation likely: While current investible universe is very small, we believe opportunities exist in both the PSUs (as government divests) and private companies (as conglomerates spin off defence entities, new pure play defence entities execute well and become larger). In our opinion, this is a sector where size, steady growth, longevity of opportunity, returns ratios, etc. will work in its favor compared to other sectors in the Indian investible universe. We believe large Indian private conglomerates that bring varied skillsets currently housed in multiple unconnected subsidiaries will pounce on the opportunity frugal engineering and manufacturing practices, design and software skills, expertise in metallurgy, understanding of export markets, ability to build relationships with foreign governments, will be winners in the long term. We see credible defence initiatives being taken up by large industrial groups like Tatas, Larsen Toubro, Mahindras, Bharat Forge, Rolta, SKIL Infra, among others. Besides these we believe PSU entities like HAL, BEL, BEML, BDL, MDL will also be significant beneficiaries.

We believe investors will have to look at the following points when considering investments:

That the opportunity will move up 7x over the next 8 years; Growing at rates higher than NGDP, this sector could be dubbed a growth sector attracting premium valuations. While some amount of competition driven margin pressure is likely, earnings growth should be higher than NGDP, if not in line with industry growth.

We believe return ratios of some leaders should be significantly better than those of most other companies/sectors in the market.

Risks of investing in the sector Significant slippages on the fiscal front, lengthy procurement and evaluation processes and frequent changes in procurement organization, controversies related to corruption and disputes over short listing in competitive bids and public private partnerships will delay acquisition plans of the armed forces and impact timing of revenues and earnings of companies. With a stable government in place and its commitment on modernization and indigenization of the armed forces, we hope acquisition programs will be executed in a time bound manner.

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Deals in Aerospace & Defence Sector

Though deals in the defence space are very few, we believe, this sector will witness increasing number of deals as regulatory policies are streamlined driving the overall defence sector.

Exhibit 1: M&A Deals in the Defence Sector

Target Acquirer Industry Year Amt (US$ mn)

Aviation Software Devlp & Consult

TCS IT Products (Aviation) 2004 N.A.

Spectrum Infotech Larsen & Toubro Defense Electronics 2006 Avalon Aviation Aptech Aviation Training 2006 N.A. AST Security Equipment MKU Defense Products 2008 5 VISaer IBS Software Services IT Services (Aviation) 2008 4.5 Mahindra Aerospace Ltd & Kotak Private Equity

Buyout of Aerostaff Australia & GippsAero

High-precision aircraft components and assemblies

2009 $35mn

Indamer European Aviation Hold. Aviation (MRO) 2009 N.A. Vaksh Steels Pitti Laminations Manufacturing 2011 - GKN Aerospace Engineering Services

Quest Global BPO (Engg. - Aerospace) 2011 N.A.

3B The Fibreglass Company Binani Industries Mfg- Fibre Glass 2012 360 Aurora Integrated Systems Tata Advanced Systems IT & ITES 2012 - Bluebird (Israel) Piramal Enterprise Defence (Tactical UAV Systems) 2012 8 Tesco GO JBM Group Aerospace 2012 N.A. BF Elbit Advanced Bharat Forge Aerospace & Defence 2013 N.A. Cambric Corp Tata Tech Aerospace & Defence 2013 N.A. Thales Software India L&T Tech Aerospace & Defence 2014 N.A. Rangsons Electronics Cyient Elect. & Mfg (ESDM) 2015 NA

Source: Venture Intelligence

Exhibit 2: PE Deals in the Defence Sector Target Investor Industry Year Amount

(US$ mn) Astra Microwave Frontline Strategy (29%) Microwave 2002 N.A Turbotech Precision Eng. Micro-Turbines IFC 2004 0.6 Adayana Kubera Partners IT & ITES 2007 20.05 Pipavav Defence Citadel, Trinity & 2i Shipping & logistics 2007 77 Delopt Axis Holdings IT & ITES 2007 1.58 Air Works GTI Group Aviation MRO 2007 10 Delopt Axis Holdings IT Services (A&D) 2007 N.A. Trusted Aero & Engg. Subhkam Ventures Aerospace & Medical Comp 2007 N.A. MTAR Tech Blackstone Defence Tech 2007 65 Dynamatic Tech New Vernon, Others IT & ITES 2008 16.2 Dynaspede Integrated Kotak PE, SIDBI VC Manufacturing 2008 8 Trident Infosol SIDBI VC IT Products (Defense) 2010 3.3 Aero Facility India ME Sovereign Fund Aviation MRO 2011 10 Air Works NEA & Elephant Capital Aviation MRO 2011 27 Maini Global Aerospace Pinebridge Aerospace 2011 10 Air Works KKR Aviation MRO 2012 N.A.

Source: Venture Intelligence

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Current Domestic Defence Production is Insufficient

Although private players were allowed entry into the Indian defence market in 2001, they have struggled to gain significant market share until lately. For the better part of the last decade, defence PSUs dominated the market and continued to be nominated for almost all major orders. Compounding the late entry was lack of access to technology from western countries as export of military technology and dual use technology was banned post Nuclear Explosion in 1998. This is one of the main reasons behind domestic industrys lack of capacity in defence production outside Defence PSUs with a few exceptions in the private sector. This is despite the private sectors reasonably well-developed manufacturing capabilities. The AVRO case is a glaring example of public sector stalling private sectors effort to develop second line of aircraft manufacturing in India. In 2012, to meet the requirement of the Indian Air Force, the Defence Ministry tendered out 56 AVRO aircrafts for the IAF. The situation has changed with focused indigenization agenda starting with Defence Production Policy 2011 and Defence Procurement Procedure of 2013 that mandates hierarchical categorization of procurement in favor of indigenous buying. Along with it controls by foreign countries and OEMs on export of military technology to India were eased.

Key Players in Indian Defence Industry Historically, the government restricted private sector participation because of inherent security-sensitive nature of the industry. As such, the private sector is relatively young and is behind the DPSUs/OFs in terms of infrastructure and DRDO in terms of R&D capability. However, in recent years private sector has found favor with government and attracted increased interest from foreign systems integrators. With this combination of legislative support and capital/expertise inflow, private companies have experienced notable growth. They still have room to increase their market share. Exhibit 3 shows the current estimates of the market structure in the domestic defence industry.

Exhibit 3: Breakup of Domestic Defence Market

Source: Institute for Defence Studies and Analysis

1) Defence Public Sector Undertakings (DPSUs) The Indian government first created the DPSUs in early 1960s to demonstrate their intention to pursue self-sufficiency in defence production. Although the liberalization process in the 1990s led to India opening up private participation to 100% in the defence industry in 2001, the public sector still dominated. Currently, the public sector including OFB accounts for 60% of indigenous defence manufacturing and around 3/4th of which can be attributed to the 8 DPSUs. DPSUs have significant advantages over private peers because of their MoD ownership. Critically, they receive the following benefits and still enjoy their share of autonomy.

DPSUs37.5%

SMEs17.5%

Large enterprises32.5%

Ordnance Factories

12.5%

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Access to latest technologies through DRDO and till recently, exclusive rights to ToT (transfer of technology) from Foreign OEMs

Beneficial tax policies to DPSUs and their foreign partners Nomination for / Prioritization for defence contracts Favorable Payment terms (advances as well as multiple progress payments) and risk coverage

by Government for Forex content of nominated contracts

Indexation for Local Inflation Despite these benefits, DPSUs have grown at best in line with the defence spend and have not been able to displace foreign systems integrators and have borne the brunt of criticism from the armed services and government representatives. Problems include lack of emphasis on in-house R&D, technology dependence on Foreign OEMs for successive generation of equipment and systems and for upgrades, low labor productivity and decreasing value addition as a percentage of production. DPSUs have also been blamed for depending too much on external sources for production requirements, thus directly contradicting their main objective of achieving self-sufficiency. Ironically, most of this is outsourced to domestic private companies at prejudicial terms (delivery based payment terms) even though DPSUs themselves have been very vocal in their opposition to governments continued support of private participation in the defence industry.

Exhibit 4: Defence PSUs and their activities DPSU Product areas

Hindustan Aeronautics Limited (HAL)

Design, development, manufacture, repair and overhaul of aircraft, helicopters, engines and their accessories

Bharat Electronics Limited (BEL)

Design, development and manufacture of sophisticated state-or-the-art electronic equipment components for the use of the defence services, para-military organizations and other government users

Bharat Earth Movers Ltd (BEML)

Multi-product company engaged in the design and manufacture of a wide range of equipment including specialized heavy vehicles for defence and re-engineering solutions in automotive and aeronautics

Mazagon Dock Limited (MDL) Submarines, Larger Warships - destroyers, frigates and corvettes for the Indian Navy

Garden Reach Shipbuilders & Engineers Ltd (GRSE)

Builds and repairs smaller warships and auxiliary vessels for the Indian Navy and the Coast Guard

Bharat Dynamics Limited (BDL)

Missiles, torpedoes, torpedo counter measure system, counter measures dispensing system

Mishra Dhatu Nigam Limited (MIDHANI)

Special Ferrous and Non ferrous Alloys for Aeronautics, space, armaments, atomic energy, Navy special products like maraging steel, molybdenum wires and plates, titanium alloys and stainless steel tubes, alloys etc.

Goa Shipyard Ltd (GSL) Builds a variety of small size, special purpose ships and auxiliary vessels for the defence, Indian Coast Guard (ICG) and civil sectors

Hindustan Shipyard Ltd (HSL) Acquired from Ministry of Surface transport. Engaged in Ship and Submarine repairs, commercial ships and repairs of offshore rigs

Source: Respective Organization Website

2) Ordnance Factories The Ordnance Factories Board (OFB) is by far the most experienced defence manufacturing entity. First established in 1775, the OFB now operates directly under Ministry of Defence with the primary objective of achieving self-sufficiency in equipping the Indian Defence Forces. Currently there are 41 factories spread across the country active in the production of military equipment for the Army, Navy, and Air Force. Recent estimates put its contribution to total domestic defence production at 10-15%. As with the DPSUs, ordnance factories enjoy government funding and the latest available technology. They are often criticized for very low labour productivity and poor quality and increasingly subcontract to MSMEs

3) Defence Research and Development Organization (DRDO) The government established DRDO in 1958 as the research and development wing of the Ministry of Defence. DRDO receives allocation of 5% of total defence budget. Its primary objective is to develop cutting-edge technologies that can be implemented in weapons systems. Although DRDO has made good strides, with Rs1 trn worth orders for its systems to date, it has had to do so without technology from foreign sources. Till recently, the lack of transfer of technology provisions in partnerships with foreign contractors limited the ability of the DRDO to integrate new complex technologies in their systems.

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2001 2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2013

2014


Increasing FDI Limit is Not the Ultimate Remedy for Addressing Core Issue of Transfer of Technology The Indian government has been taking steps to develop a sophisticated domestic defence industry. To truly achieve self-sufficiency in military procurement, it still has some decisions to make and reforms to enact. FDI in the defence industry currently has a limit of 49% with an option to increase it to 100% if the deal involves high-end technology transfer and is approved by MoD. Post partial success of opening up the sector to foreign players on 49% FDI through automatic route, many stakeholders are seeking further increase in FDI cap up to 100%. We believe mere increase in FDI does not necessarily lead to Technology Transfer.

FDI limit has the potential to have the largest impact on shaping the industrys future. If we consider that many other sectors have had their FDI caps lifted (private banking at 49%, non-banking financial companies at 100%, power at 100%, pharma at 100%, real estate at 100%, public transportation at 100%) it is not unreasonable to expect the FDI cap in defence to be done away with completely.

Key Issues to be Given Importance While Approving Increased Defence FDI:

x Control in Indian hands: Defence being a strategic sector, the domestic partner should maintain 51% stake and Majority control in the JV all the time.

x OEMs Host Government Must Approve Transfer of Technology Agreement: It is a major factor affecting OEMs capability to share technology despite increase in FDI share. This is mainly because defence technologies are strategic assets and funded through taxpayers money limiting the intent to transfer / share with another country. Hence, the OEMs Host government should approve of the ToT Agreement with the Indian government / partner.

x IPRs to reside within India: The technology developed by the Indian Joint Venture should be of global standards and the IPRs should reside with the JV in India.

x Give Priority to Indian nationals in hiring and recruitment: The JVC should hire Indian nationals at operational and supervisory levels wherever possible. Only in situations, where it is imperative to have foreign nationals, such as in technology transfers, training etc, should they be hired.

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Technology Development

MoD revises offset policy to include Transfer of Technology (ToT)

The governments general stance on ToT was not conducive to domestic industrys development until two years ago. ToT was not included in the eligible product/service list for discharging offset obligations. A popular concern cited by the government was that no country, especially the United States, will be willing to hand over defence technology regardless of policy. Another reason for abstaining from this revision was the difficulty to quantify the value of technology, and that this could lead to foreign contractors misusing the policy to discharge offsets quickly.

However, MoD has included ToT in offset discharge obligation. In fact, if the technology is delivered to DRDO or MSME, the multiplier effect also comes in to play.

India is on a similar trajectory as other countries, and they have all at some stage realized that the pros far outweigh the cons. All of them have seen that developing technology is the single, most important step to establishing a sophisticated, self-sufficient defence industry. We believe this realization of the government is a positive step.

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DPP 2013 Provides Priority to Domestic Source of Acquisition

One of the major changes in DPP 2013 is the change in order of priority for procurement from indigenous sources. As per DPP 2013, the statement of case (SOC) seeking acceptance of necessity (AON) is required to include detailed justification for recommending categorization as well as reasons why each of the higher preferred categorization was not considered.

Exhibit 7: Preferred Categorization Of Capital Acquisition in DPP 2013

Source: Ministry Presentation

Key Highlights of changes in DPP 2013 x Indigenous content requirement will now extend all the way to lowest tier of sub vendor

making way for opportunities for vendors making components to compete against cheaper foreign components

x Penalties for not achieving stipulated indigenous content levels at each stage with a scope to make up for the deficiency at a later stage

x Inclusion of Field Evaluation Trials (FET) stage in maintaining offset requirement x Reducing validity of AoN from 2 years to one year except Buy and Make (Indian) x Provision of ToT to Indian Public/Private entity, for providing Maintenance Infrastructure, would

be applicable for BUY (Global) In a boost to the micro, small and medium enterprises sector, while DPP 2011 had identified setting up of a fund to provide resources for development of defence equipment, the source has been specifically identified in DPP 2013. Small Industries Development Bank of India (SIDBI) will earmark an amount of Rs. 500 crore for providing loans, and further, a fund of Rs. 50 crore for equity support out of India Opportunities Fund managed by its subsidiary SIDBI Venture Capital Ltd. Union Budget has made provisions for Rs1bn Technology Development Fund to support research and development of defence systems resources. The technology development fund will act like a venture capital fund for SMEs doing R&D in design and development encouraging innovations. (ToT is also defined in various categories in DPP 2013, which had not been included in DPP 2011. This will overcome ambiguity existing at present. There are five categories of ToT with the highest involving complete transfer and lowest where there is no transfer. Category 1: Complete transfer of technology. Category 2: Complete transfer of technology of sub-vendor. Category 3: Partial transfer of technology with non-transfer of technology of sub-vendor. Category 4: Only drawings will be provided. Category 5: Proprietary item no transfer of technology.

Buy (India)

Buy & Make (Indian)

Make (Indian)

Buy & Make

Buy (Global)

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Major developments for Defence sector in the past year

x Indo US Ties (Early 2015) o Indo US ties reached a new high when President of USA visited India for its Republic

day celebrations. Renewing their expansive defense ties for another 10 years, India and US decided to kick off joint manufacturing of four relatively modest military products and explore the development of two more high-end technologies. The two nations agreed to step up joint combat exercises, maritime security endeavors, intelligence-sharing mechanisms, military exchanges and the like through the framework, which has the key new element of Defence Trade and Technology Initiative (DTTI) to bolster India's fledgling defence-industrial base.

o The four products to be co-produced are the next-generation Raven unmanned aerial vehicles (UAVs), "roll-on, roll-off" intelligence-gathering and reconnaissance modules for C-130J Super Hercules aircraft, mobile electric hybrid power sources and "uniform integrated protection ensemble increment-2 (chemical, biological warfare protection gear for soldiers)".

o The Raven, for instance, is not an advanced spy or combat drone. A hand-launched mini drone, it is used by soldiers in the battlefield to keep tabs on enemy formations within a range of 10km. The two sides, however, plan to extend its range to 18km and flying endurance to six hours from the existing four hours. Similarly, the 12 C-130Js acquired by India from the US for over $2 billion since 2007 did not have the requisite surveillance modules that they will now get. They decided to setup working groups to explore development of aircraft carrier technologies and jet engines.

x Strong Push for Make in India Initiative for boosting manufacturing sector (Late 2014)

o The current focus as envisaged in recent statements and policy initiatives of the government has focused on the desire of not just greater indigenisation or India has a favorable manufacturing hub, but also India as exporting defence equipment and solutions to global market.

x Budget (Early 2014) o Defence budget marginally rose from Rs 2.24trn to Rs 2.29trn, an increase of Rs 50bn. o The government has budgeted Rs. 946bn under capital outlay. This amounts to Rs50bn

more than sanctioned in the interim budget of February 2014. o This increase of Rs 50bn (capital outlay) includes a sum of Rs 10bn for accelerating the

development of railway system in border areas. o FDI limit increased in defence from 26% to composite cap of 49% (FDI and FII) through

the Foreign Investment Promotion Board (FIPB) route with full Indian management and control.

o Rs 1bn Technology Development Fund to support research and development in defence systems resources.

Impact of the Budget announcements

o Development of railway system in border areas will help in strategic movement of defence forces and heavy defence machinery at a faster pace.

o Increase in FDI limit will attract foreign investors and bring defence technologies and much needed financial support to capital intensive defence sector.

o The technology development fund will act like a venture capital fund for SMEs doing R&D in design and development encouraging innovations.

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Defence Opportunity has size, growth and longevity going for it Indias defence spend has critical mass when compared to sectors of the economy where investors traditionally have taken exposure. The spend on an average was 2.12% of the nominal GDP in the past decade. However, a large part of this defence spend is not reflected in revenues of domestic companies and therefore has not resulted in larger addressable market for domestic companies, because of the following:

A large part of it (60% currently) is revenue expenditure which is internal in nature. Unlike in the US where some of the peripheral/support functions are outsourced, Indian armed forces have always relied on doing them internally. We do not see this situation changing over the next 2 decades though we believe the spend in this area is unlikely to grow as fast as capex.

Of the capex (43% of the budget) about 70% is imported in fact India has been the largest importer of weapon systems globally in recent times. This gets reflected in lower revenues of Indian corporates involved in the sector. This has meant that the industrial base necessary to support this capex has not been built up adequately.

Besides the domestic defence spend there lies the large opportunity of addressing global markets. However, exports have been miniscule. Over the past decade from FY00-12, cumulative exports by India were only $172m (going by SIPRI data).

We believe the opportunity for Indian companies in the next 8 years (FY14-FY22) will cumulatively be in the region of $251bn (this is only the arms acquisitions that India is likely to make) with domestic contribution of $105bn. We believe offsets (which will fall under exports to contribute to as much as $41b cumulatively in the next 8 years.

Expect solid growth: The opportunity addressed by Indian companies will grow at a higher rate than Nominal GDP as a) Indias defence spend/GDP ratio inches up to 2.25% on a conservative basis in FY22 from 1.79% of FY14. b) capex (part relevant to Indian corporates) will increase as a percentage of total spend. c) there is going to be greater focus on indigenization. d) offsets are going to be a big driver of revenues going forward for the industry. e) outsourcing to Indian companies by global systems integrators will gather pace as price pressure emerges in developed markets.

Exhibit 8: Estimation of size of defence opportunity for Indian corporate sector (PSU and Private)

Source: SIPRI, Indian budget documents

Indian Defence Spending

Revenue ExpenditureCapex

DomesticImport

Offset

FY14E:$14bn FY22E:$57bn

FY14E:$8bnFY22E:$24bn FY14E:$4bnFY22E:$24bn

FY14E:$19bnFY22E:$56bn

FY14E:$2.4bn FY22E:$7.3bn

Global Defence Spend

Outsourcing

FY14E:$0.1bnFY22E:$9.7bn

FY14E:$1.7trFY22E:$1.5tr

OutsourcingtoIndiatoincreasedueto: Pressureonspending Highcompetitiveintensity NoaccesstoChinamarket India s Engineering work force

OpportunitySizeIndianPSU/Private/SME

FY14E:$6bnFY22E:$41bn

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Estimation of the Size of the Opportunity

We estimate the market opportunity for Indian companies (PSU + Pvt) will grow 7x from $6bn in FY14 to $41bn by FY22. We believe our numbers are realistic as we have assumed nominal GDP growth of 12.3% (~7% real GDP growth and ~5% inflation) during this period, which takes into account slower developed market growth and the impact it will have on Indias growth. Based on the estimates worked out in Exhibit 11, $41bn in FY22 will be contributed largely by domestic (60%) and export revenues (40%). Some of the other key assumptions made in this exercise are that INR/USD rate would be at Rs62 and the imported part of defence acquisitions will fall to 50% from current 70%.

Some of the key conclusions that we arrive at based on this exercise are that the cumulative defence spend over FY14-FY22 will hit close to $620bn. Capex will form half of this. New armament spend will be $251bn with imported equipment spend at $146bn.

Exhibit 9: Summary of our estimates Summary of the projections FY14-FY17 FY17-FY22 FY14-FY22Defence Spend (Rsbn) 10,851 27,617 38,468Defence Spend ($bn) 175 445 620Capex Spend (Rsbn) 4,805 13,488 18,293Capex Spend ($bn) 77 218 295New Armament Spend (Rsbn) 4,084 11,465 15,549New Armament Spend ($ bn) 66 185 251Of which Imported Equipment Spend (Rsbn) 2,707 6,320 9,027Imported Equipment Spend ($ bn) 44 102 146Domestic Equipment Spend (Rsbn) 1,377 5,144 6,521Domestic Equipment Spend ($ bn) 22 83 105Offsets Addressable Opportunity (Rs bn) 812 1,896 2,708Addressable Opportunity ($ bn) 13 31 41

Source: Centrum

Exhibit 10: Assumptions made in our projections Stage I Stage II FY14 FY14-FY17 FY17-FY22 Rs/$ 62 62 62 Average Real GDP growth 7.5% 6.5% 5% Average Inflation 5% 4% 8.0% Defense Budget/NGDP 2.00% 2.25% 1.8%

Capex/Defense Budget Increasing by 1% every year

Increasing by 1% every year 42%

Import/Capex Decreasing by 1% every year

Decreasing by 3% every year

70%

Offset 30% 30% ~35% Export Growth (non offset) 120% 100% Armament Acquisition/Capex 85% 85%

Source: Centrum

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Domestic revenues to pick up pace

Domestic revenues (using HAL+ BEL revenues as proxy) grew in line with nominal GDP in the last decade. We expect domestic opportunity for Indian companies (from arms acquisitions) to grow from $4bn in FY14 to $24bn in FY22 at 23% CAGR. The faster growth predicted is on the back of the following:

Indian defence budgets to grow faster than nominal GDP growth as they have fallen below historical levels. 50% of Indian defence equipment is obsolete.

The gap between India and China has widened from a military capability perspective with the Chinese surging ahead in a number of areas (including stealth weapons, anti-satellite weapons, etc) driven largely by domestic R&D and reverse engineering as western technology has been denied to it since 1989. The surge in capabilities has been accompanied by a geopolitically assertive China. Strong economic growth and high savings rate has helped China deliver on this. With US likely to be less active in the Asian region as it repairs its financials, we believe India will have to spend more to bridge the widening gap

Capex to opex ratio will change in favor of Capex. as the latter will be capped. We believe that India will aim at a smaller, smarter and more effective armed force as many other countries have done.

Indigenization will gain momentum. We believe that from 30% indigenous components in new acquisitions the number can go up to 50% in the next 10 years. However, this will still be lower than governments aspiration of 70%.

A freer technology transfer regime may be prompted by better perception of India among Western nations. This is likely due to declining sales opportunities in the western world and better bargaining power of the buyer (India) under current market conditions.

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Indian Defence Budgets To Witness Higehr Growth Rates

We believe Indias defence budget will grow at a CAGR of 15% over FY14-22 slightly ahead of expected nominal GDP growth of 12.5%. In the past decade (FY01-FY14) defence budgets grew at 12% CAGR and capital expenditure budgets by 14.7% (when Nominal GDP grew by 14%). We expect India to expand its defence budget 1) as it seeks to maintain a semblance of geo-political balance in Asia as US is likely to withdraw to repair its financials and narrow the large gap that has developed with China militarily 2) Massive modernization undertaken as 50% of current equipment is obsolete due to less than adequate spend on defence in the past 3) reasonably comfortable funding position on the back of healthy tax revenues and comfortable debt/GDP ratio relative to other nations and Indias own history.

Defence Spend/NGDP ratio to improve after a decade low in FY14 After clocking a 2%-2.5% over FY01-11, the defence budget/NGDP ratio has fallen to 1.79%-1.93% range with an all-time low of 1.79% in FY14. We believe this is likely revert to the mean of 2.25% by the second part of the coming decade as much of Indias equipment is obsolete and it has under spent on its defence budget. After withdrawal from Afghanistan and Iraq, US has also lowered its role in Asian geopolitics as its defence spending has come under severe scrutiny. Recent budget pledges by the US government indicate a cut of $450bn over the next 12 years with the number going up to $1.1trn automatically if no areas of deficit reduction are identified by the Super committee.

Exhibit 12: The Indian domestic corporate sector (largely PSU) has grown in line with NGDP

Source: Company

China has significantly increased the gap with India militarily Relative analysis of key adversaries India and China is given in Exhibit 17. Due to denial of defence technology by western powers since the Tiananmen incident in 1989, the Chinese Defence and aerospace fraternity got its act together by spending considerable amount of energy and money in indigenous R&D and in reverse engineering some American and Russian equipment. In recent times it closed the gap with the Americans in specific areas of technology (and naturally increased the gap with India). To reduce the gap with the Chinese, Indian defence spending will have to increase substantially as it cannot always look up to the western powers to maintain the current power balance in the Asian region.

A look at defence spending data collected by SIPRI in 2000 shows, Chinese spends were 1.5x Indias. In 2013 the number went up to ~3.5x. This increased spend was entirely channelized internally as there was no access to western technology. This will turn out to be the best to happen to China. This led to the creation of a large industrial base and significant R&D facilities in the defence sector.

SIPRI data shows Chinese defence spending grew 11% against Indias 5% between FY02-13.

16%

11%

14%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

HAL BEL CombinedCAGR(FY01-FY13)

(%)

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Exhibit 13: Defence Spending by top 10 spenders

($m) 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

2002-2007

CAGR

2007-2013

CAGR

USA 4,46,142 5,07,781 5,53,441 5,79,831 5,88,837 6,04,292 6,49,003 7,01,048 7,20,282 7,11,338 6,71,097 6,18,681 6.26% 0.39%

China, P. R. 52,832 57,390 63,560 71,496 83,928 96,782 1,06,640 1,28,734 1,36,239 1,47,268 1,59,620 1,71,381 12.87% 9.99%

France 62,840 64,749 66,526 65,123 65,470 65,691 65,037 69,426 66,251 64,633 63,736 62,272 0.89% -0.89%

UK 53,179 57,005 57,665 58,150 58,527 60,375 63,070 64,297 62,942 60,284 57,717 56,231 2.57% -1.18%

Russia 37,300 39,100 40,870 46,446 51,404 55,954 61,484 64,504 65,807 70,238 80,995 84,864 8.45% 7.19%

Japan 60,701 61,460 61,201 61,288 60,892 60,574 59,140 59,735 59,003 60,452 59,571 59,431 -0.04% -0.32%

Germany 49,920 49,237 47,726 46,983 45,899 45,940 47,259 49,046 49,583 48,164 49,312 49,297 -1.65% 1.18%

Saudi Arabia 25,762 25,951 28,850 34,763 39,600 45,617 44,771 46,011 47,881 48,531 54,913 62,760 12.11% 5.46%

Italy 43,513 43,867 44,011 42,342 40,976 39,736 41,160 40,002 38,876 38,149 35,436 32,663 -1.80% -3.21%

India 28,528 29,165 33,879 36,054 36,225 36,664 41,585 48,963 49,159 49,634 49,459 49,091 5.15% 4.98%

Total Spending

8,60,717 9,35,705 9,97,729 10,42,476 10,71,758 11,11,625 11,79,149 12,71,766 12,96,023 12,98,691 12,81,856 12,46,671 5.25% 1.93%

Source: SIPRI

Exhibit 14: Share of Spending among the top 10 spenders

(%) 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

USA 51.8 54.3 55.5 55.6 54.9 54.4 55.0 55.1 55.6 54.8 52.4 49.6

China, P. R. 6.1 6.1 6.4 6.9 7.8 8.7 9.0 10.1 10.5 11.3 12.5 13.7

France 7.3 6.9 6.7 6.2 6.1 5.9 5.5 5.5 5.1 5.0 5.0 5.0

UK 6.2 6.1 5.8 5.6 5.5 5.4 5.3 5.1 4.9 4.6 4.5 4.5

Russia 4.3 4.2 4.1 4.5 4.8 5.0 5.2 5.1 5.1 5.4 6.3 6.8

Japan 7.1 6.6 6.1 5.9 5.7 5.4 5.0 4.7 4.6 4.7 4.6 4.8

Germany 5.8 5.3 4.8 4.5 4.3 4.1 4.0 3.9 3.8 3.7 3.8 4.0

Saudi Arabia 3.0 2.8 2.9 3.3 3.7 4.1 3.8 3.6 3.7 3.7 4.3 5.0

Italy 5.1 4.7 4.4 4.1 3.8 3.6 3.5 3.1 3.0 2.9 2.8 2.6

India 3.3 3.1 3.4 3.5 3.4 3.3 3.5 3.9 3.8 3.8 3.9 3.9

Total Spending 100 100 100 100 100 100 100 100 100 100 100 100

Source: SIPRI

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Exhibit 15: Comparison: India, China and Pakistan on defence parameters India China Pakistan

Total Population 1,220,800,359 1,349,585,838 193,238,868

Military Manpower Available 615,201,057 749,610,775 93,351,401

Fit for Military Service 489,571,520 618,588,627 75,326,989

Reaching Military Age Yearly 22,896,956 19,538,534 4,342,629

Active Military Personnel 1,325,000 2,285,000 617,000

Active Military Reserves 2,143,000 2,300,000 515,000

Total Aircraft 1,785 2,788 847

Total Land-Based Weapons 15,681 23,664 10,244

Total Naval Units 184 520 74

Towed Artillery 6,445 6,246 3,263

Merchant Marine Strength 340 2,030 11

Major Ports and Terminals 7 15 2

Aircraft Carriers 2 1 0

Destroyers 11 24 0

Frigates 15 45 11

Submarines 17 69 8

Patrol Coastal Craft 32 353 12

Mine Warfare Craft 7 119 3

Corvettes 24 9 0

Defense Budget / Expenditure $46,000,000,000 $126,000,000,000 $7,000,000,000

Foreign Reserves $297,800,000,000 $3,341,000,000,000 $13,800,000,000

Purchasing Power $4,716,000,000,000 $12,260,000,000,000 $546,700,000,000

Major Serviceable Airports 346 507 151

Source: Globafirepower.com (As updated on January 2015)

Exhibit 16: Size of Indian Defence spend compared to other nations

Source: SIPRI Note: This does not include data on US whose defence spend is almost 4x of Chinas.

France

China

UKGermany

India*

0

20

40

60

80

100

120

140

160

180

200

(2) (1) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Mili

tary

Spe

ndin

g ($

bn)

CAGR (2000-2012)

France China UK Germany India*

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Exhibit 17: Military spend Growth comparison (%)

Source: SIPRI, LC = Local Currency

Exhibit 18: Widening gap between India and China

China's widening gap with India Description China's defence spend/GDP Chinas spend has been growing at a much faster clip compared to that of Indias

even if one were to adjust for local currency. Chinas spend used to be 1.5x Indias in 2000. In 2012 it was 3.3x. India's. Defence spending to GDP ratio is still much below 3 per cent level defined as an adequate level of expenditure in Indias first ever Strategic Defence Review prepared by the National Security Advisory Board in 2000.

Military might According to a Pentagon report

China is pursuing a major military buildup in a "secretive manner" developing survivable nuclear delivery system, a 1,500 km range anti-ship missile to hit aircraft carriers and has the most active land based ballistic and cruise missile program in the world Beijing is acquiring 'capabilities' to strike from a distance.

Beijing has developed missiles capable of striking targets in space and is also expanding its fleet of conventional and nuclear submarines China has the most active land-based ballistic and cruise missile program in the world

China is developing and testing several new classes of offensive missiles, qualitatively upgrading certain missile systems and developing methods to counter ballistic missile defenses In January 2007, China launched a kinetic kill vehicle (KKV) to smash into its own aging Fengyun (FY-1C) satellite China has at least 53 conventional and seven nuclear attack submarines (SSNs)

Science and Technology China targets fifth place from current sixth in global innovativeness ranking by 2020.

By 2040-50, China aims at science and technology (S&T) parity with US

R&D There has been surging growth in the innovativeness of Chinese defence industry. In 1998, it filed for 313 patents. In 2008, it filed 11,000 patents. and In 2010, 15,000 patents.

Source: Media

8.0

3.9

1.1

(1.5)

14.1

5.4

9.5

0.8

(0.4) (0.6)

0.6

11.5

3.9

13.4

3.5

1.2 0.1

(0.2)

12.5

4.5

11.9

(4)

(2)

0

2

4

6

8

10

12

14

16

USA UK France Germany China India India (LC)

CAGR (2000-2005) CAGR (2005-2013) CAGR (2000-2013)

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Exhibit 19: India and China Recent points of friction between the two

Date Anecdotes Nov-06 China and India had a verbal spat over the north-east Indian state of Arunachal

Pradesh. India claimed that China was occupying 38,000 square kilometers of its territory in Kashmir, while China claimed the whole of Arunachal Pradesh as its own

May-07 China denied the application for visa from an Indian Administrative Service officer in Arunachal Pradesh. According to China, since Arunachal Pradesh is a territory of China, he would not need a visa to visit his own country

Jun-09 The People's Daily, a Communist Party mouthpiece that serves as a window to the thinking of Beijing's insular leadership, published an exceptional broadside against New Delhi on June 11. It described India's "tough posture" as "dangerous," and asked India to "consider whether or not it can afford the consequences of a potential confrontation with China."

Dec-07 The Indian Air Force announced it will station two squadrons of advanced Sukhoi-30 MKI aircraft in Tezpur, in Assam.

Oct-09 Asian Development Bank formally acknowledging Arunachal Pradesh as part of India approved a loan to India for a development project there. Earlier China had exercised pressure on the bank to cease the loan

Jan-11 India claimed that armed Chinese soldiers had infiltrated Indian territory and threatened construction workers near a disputed border. New Delhi says China is illegally occupying 38,000 square kilometers of its northwestern territory, while Beijing claims a 90,000 square-kilometer chunk in northeastern India.

Sept-14 In one of the many cases of cross-border incursion, Chinese troops infiltrated Indian territory in Ladakh and broke a camera set up by the Indian Army at the Line of Actual Control (LAC). These cameras were of high resolution and had been put up by the Indian soldiers to keep an eye on Chinese soldiers. The Chinese troops also demolished the temporary structures built by the Indian Army and threatened the Indians living in area to evacuate the place immediately.

Source: Media

Under spending across the board leading to obsolescence Although defence expenditure budget and actual defence spending have been increasing in line with NGDP since FY2001, there has been a trend of under spending by defence forces, particularly in capital expenditure. From FY2001-2013 approximately INR 515 bn, or 13% of the cumulative capital expenditure budget, was under-spent

Exhibit 20: Under spending in absolute terms Exhibit 21: Under spending in % terms

Source: Union Budget and Economic Survey Source: Union Budget and Economic Survey

A close inspection of each service divisions spending habits also reveals consistent under spending. On average for the past 12 year between 2001-13: the Army underspends by 13%, the Navy underspends by 5%, and the Air Force underspends by 14%. When you consider 2011 & 2012 as an outlier for Navy and take it out of the calculation, the Navys average under spending jumps up to 11.3%.

(200)(150)(100)

(50)0

50100150200

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

(Rsbn)

Revenue Capital

(40)%

(30)%

(20)%

(10)%

0%

10%

20%

30%

40%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013Revenue Capital

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Exhibit 22: Under spending has been highest in Air Force followed by Army and Navy in absolute terms.

Exhibit 23: Under spending has been highest in Air Force followed by Army and Navy in % terms.

Source: Union Budget and Economic Survey Source: Union Budget and Economic Survey However capital expenditure will pick up as Capex to Opex mix will improve from the current level. We expect the country to focus on controlling the operating expenditure and focus on capital acquisitions going forward. The focus would be on a smaller, leaner and a more effective armed force. We believe about $77bn would be spent on arms capex till FY17 cumulatively and about $295bn till FY22.

Exhibit 24: Defence spending to GDP ratio - Behavior of various components

Source: Union Budget and Economic Survey

-60-40-20

020406080

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

(Rsbn)

Army Navy Air Force

(40)%(30)%(20)%(10)%

0%10%20%30%40%50%

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Army Navy Air Force

(%)

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

1992 1997 2002 2007 2012

Revenue/GDP Capital/GDP Total/GDP

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Exhibit 25: Governments Projection of Defence Spending Till FY22


124

796 867

3,537

0

500

1000

1500

2000

2500

3000

3500

4000

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

FY18

FY19

FY20

FY21

FY22

(RsBn)

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Modernization to be a key driver for Indian defence acquisition Currently 50% of the military equipment is estimated to be obsolete and only 15% state-of-the-art. The Ministry of Defence (MoD) aims to reduce the former by 20% and to increase the latter by 15%.

Exhibit 26: Indian Defence Equipment Profile Current Exhibit 27: Indian Defence Equipment Profile Target

Source: 2nd Indian Regional Offset Conference Source: 2nd Indian Regional Offset Conference

MOD has allocated approximately 40% of total Defence spending to capital outlays to support its modernization efforts. Capital outlays constitute expenditure on arms procurements, construction, infrastructure and other military equipment.

The capital expenditure budgets have seen good growth rates (CAGR of 13% between 2001-14) Over the past decade between 2001 to 2013, the capital expenditure budgets have been increasing at a CAGR of 13% and the total defence expenditure budgets at 10%. The same period has seen Indias GDP grow at 14% in nominal terms. The capital component has been increasing steadily increasing as a percentage of the total budget from 31% in FY2001 to 43% in FY2014. These numbers demonstrate Indias appetite for procurement of state-of-the-art military equipment. Statements from MoD indicate that India does not intend to slow down its purchase plan despite already engaging in a decade of intensive acquisitions.

Exhibit 28: Indias Defence Budget (FY2001-FY2014)

Source: Union Budget and Economic Survey Note: The defence budget consists of two main parts, capital and revenue expenditures. Capital expenditures include the costs of the development of infrastructure as well as procurement of military equipment, other armaments, and land. Revenue expenditures include everyday operating expenses of the Indian Defence Force such as wages and salaries, which account for about half of the revenue budget. The other components of the operating expenses are Interest payments, Payment to subsidies, Pension andPaymenttopolicebycentralgovt.The key component here is the capital expenditures budget, of which the majority is allocated to procuring new equipment from foreign or domestic sources. Roughly 75-85% of the capital expenditures budget has historically gone to arms procurement, and this proportion is not likely to change.

Obselete50.0%

Matured35.0%

State-of-the-art15.0%

State-of-the-art30.0%

Matured40.0%

Obselete30.0%

0

200

400

600

800

1,000

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

(Rsbn)

Revenue Capital

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Exhibit 29: Trend between Opex and Capex in the defence budget


Exhibit 30: Capex spend in the overall budget spend has been improving Defence Expenditure Historical Trend


capital expenditures by service division On average over the past decade between 2001-2014, the Army accounts for 23% of the capital expenditure, the Navy 29%, and the Air Force 48%. The trend over the years indicates that the Air Force has increased its share and cut into the budgets of other forces over the years. All three divisions expenditures have grown rapidly along with the total defence budget.

0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Reveue Capital

(Rs)

31% 32%33% 32%

43%41% 42%

44% 45%

39%41% 42% 41%

43%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Capexastotal%ofDefexp

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Exhibit 31: Capital Expenditure Budgets by Service Division, in real terms


Exhibit 32: Capital Expenditure Budgets by Service Division, % terms


0

50

100

150

200

250

300

350

400

450

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

(Rsbn)

Army Navy Air Force

0%

20%

40%

60%

80%

100%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Army Navy Air Force

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Current acquisition plans indicate significant buying ahead The acquisitions plans laid out by the Indian forces indicate that the there is considerable buying ahead over the next 5 years.

Exhibit 33: Acquisition plans of the various branches of the armed forces Segment Category Indicative Items Qnty Size($Bn)Air Helicopters Indigenous Advanced Light Helicopter (ALH) - Dhruv 159 7.20

Medium lift Helicopters 80 1.20 VVIP helicopters 12 0.83 Light Utility Helicopter (HAL) 65 1.27 Combat / Attack Helicopter 22 1.40 Heavy Lift helicopters 15 0.60

Missile Systems Short Range Surface to Air Missile System (SRSAM) 5,000 6.00

Medium Range Surface to Air Missile Systems (MRSAM) - Akash 2,000 5.00

Long Range Surface to Air Missile Systems (LRSAM) 1,500 5.00

Transport and other aircraft C-17 Military transport Aircrafts 10 4.10

Medium-Lift Transport Aircraft 56 2.45 PC 7 MK II Basic Trainer Aircraft 181 1.20 Hawk Mk 132 Advanced Jet Trainer 143 2.90 C 130J Hercules aircraft 12 1.20 AN-32 Upgrade 104 0.40 Embraer Jets 3 0.21 Israeli Harop killer UAVs 10 0.10 Multi-Role Tanker Transport 6 2.00 Indigenous Airborne Warning and Control System (2 + 4) 6 1.09

Interaction ongoing between IAF and Industry

Advanced Medium Combat Aircraft

LCA - Mark -2 Unmanned Fighter Aircraft

Fighter Aircrafts Su-30 MKI 272 12.38

Medium Multi Role Combat Aircraft (MMRCA) - (126 with an option for 64-74 more) 126 20.00

Fifth Generation Fighter Aircraft (FGFA) (India and Russia) 214 30.00 Mirage 2000 Upgrade 51 2.20 MiG-29 Upgrade 63 0.70 LCA (Tejas) - Includes 54 Indian Navy 244 3.36

Others Airfields for infrastructure upgrade 30 Land Artillery 155 mm Mounted Howitzer 814 2.00

155 mm Wheeled Self-Propelled Guns 180 0.60 155mm ammunition rounds all types 1,50,000 155mm precision guided munitions 50,000 Air Mobile Ultra light howitzers (ULH) 145 0.90 155 mm Towed Howitzer (410 + 1170) 1,580 1.78 130mm M-46 Upgrade 300

Helicopters Light Utility Helicopters 197 0.75 Missiles ICV-mounted anti -tank guided missiles 1,000 Tanks and Vehicles Arjun Tank 242 0.38

Futuristic Infantry Combat Vehicle (FICV) 2,600 10.00 Futuristic Main Battle Tank (FMBT) 1,000 5.50 Light Specialist Vehicles (LSVs) 3,000 0.27 Light Multi utility Recce Vehicles (LAM) 800 0.20

Air Defence Very Short Range Air Defence Missiles (VSHOARD) 5,175 4.50 ZU-23-2 anti-aircraft upgrade 468 0.30 40 mm Anti- aircraft Gun 115 0.30

Others Battlefield Management System (BMS) 500 7.27 Multirole Assault Rifles 65,768 0.25 Tactical Communications System (TCS) 7 1.80 Bullet proof jackets 59,000 Mini Unmanned aerial vehicles 1,000 FINSAS - Futuristic Infantry Soldier As a System

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Mine field breaching systems 0.25 Segment Category Indicative Items Qnty Size($Bn)Navy Helicopters Advanced Light Helicopters 47 7.20

Naval Utility Helicopters 56 1.00 Advanced multi role Naval Helicopters 123 6.80

Navalised Aircraft MiG-29K 29 2.25 Fighter Aircrafts for IAC 2 Long Range Maritime Patrol Aircraft - Boeing P8-I 20 2.07 Medium-range Maritime Reconnaissance Aircraft 6 1.00

Submarines Midget Submarines 5 0.50 Stealth Submarines - Project 75 India (P-75I) 6 8.00

Warships Survey Training Vessels 4 0.47 Project 17 A Frigates 7 8.18 Landing Platform/dock (LPD) 4 3.50 Survey vessels 6 Off-shore Patrol Vessels 9 Indigenous Aircraft Carriers 2 0.45 ASW Shallow Water Crafts 16 2.00 Mid-Life Upgrades of the Kirch Class Corvettes 5 Sail Training Ship 1

Others 30 - 40 mm Gun With EOFCS 116 0.27 Autonomous Underwater Vehicle (AUV) 10 0.01 Portable diver detection sonar (PDDS) systems 78 0.07 Heavy Weight Torpedoes (Surface) 98 0.25 Surface Surveillance Radars 31 0.30 20-30 mm Close In Weapon System 25 0.20 Mobile Missile Coastal Battery 15 0.25 NTDS 12

Source: FICCI, Media, and compiled by Centrum

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Precedents show that developing technology is the key

Looming threats from neighbors and the reality of its obsolete military equipment have forced India to step up its modernization efforts. However, the domestic defence industry is unable to keep up with the huge demand and does not possess the technology required to manufacture complex military equipment needed by defence forces. Therefore, India has had to rely heavily on imports to meet as much as 70% of its procurement needs. Despite this, the Ministry of Defence has made it clear that it wants to pursue indigenization in the long term and eventually achieve self-sufficiency in military production. India is not the first nation to face such a daunting task. Other countries have succeeded in developing and transforming their defence industries. The common catalyst is technology.

In all of these cases, the key catalyst to the industrys progress was developing technological capability in defence systems. Without it, these nations would still largely rely on imports for complex military equipment. Each went about this in a different way: Israel worked its way around arms embargoes to procure key technologies, Brazil absorbed technology through joint ventures with foreign contractors, and South Korea invested heavily in R&D and its infrastructure from the very start. China has also transformed itself into a largely indigenously equipped military because of its emphasis on R&D. Due to an official roadmap for science & technology, China jumped from a global innovativeness ranking of 24 in 2004 to 6 in 2009. Its defence industrys innovativeness also saw vast improvement. In 1998, it had filed for 313 patents whereas in 2013 the same statistic had gone up to 15000 patents.

Countries in similar positions to India include Turkey, Peru, Chile, and Korea. Turkey, realizing the importance of technological capability in long-term self-sufficiency, is investing heavily in R&D. In 2012 it invested USD 600 mn, up 32% YoY. This emphasis on R&D is already paying dividends: the domestic defence industry accounted for more than half of procurement spending in 2012 of around $4bn. Indias R&D spending is dismal compared to Turkeys. It spends roughly the same as Turkey on R&D, but has a procurement budget more than three times larger and a GDP more than two times larger. Clearly if India wishes to develop a more sophisticated defence industry, it will have to focus on advancing technological capability by 1) investing larger amounts in R&D and 2) pushing for ToT in defence procurement deals.

Israel

Background on domestic defence industry In 1960s, escalating conflicts with its Arab neighbors, combined with arms embargoes and broken agreements by foreign suppliers forced Israel to begin its initial indigenization efforts. Israel soon realized that financial and technological constraints made immediate self-sufficiency in military equipment impossible. The government then pursued a two-pronged strategy: it continued to purchase whatever it could from foreign sources but also invested heavily in developing its defence industry, primarily in R&D and infrastructure. Acquiring the knowledge and technology to manufacture complex military equipment and systems was crucial. Because of the ongoing arms embargoes, Israel had to resort to smuggling, reverse-engineering and global networks to acquire the expertise needed for the development of these technologies. By the 1980s, Israel had a sophisticated defence industry that was able to capture significant revenues through exports to Iran, South Africa, China, Singapore, and Chile. Incidentally, these revenues helped finance new R&D development during a period of budget cuts that would have otherwise eaten into the R&D component. India needs an institution like SIBAT, Israel to promote indigenized products in the defence sector

Private firms success in Israel By the 1990s, private firms were winning a larger share of the Ministry of Defences contracts. This resulted in the Mandatory Tender Law, which established a competitive bidding system for all MoD contracts. This made the tender process more transparent and subsequently led to greater private involvement in government projects. At the beginning of the 21st century, private firms accounted for 33% of domestic defence production in a country that was once dominated by the public sector. The next few years saw the privatization of several public defence companies and the merging of many private defence firms. It is important to note that in Israel major cuts in the defence budget

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forced most private firms to diversify and rely more on foreign clients. They engaged in joint ventures and acquisitions to secure footholds in overseas markets, which now account for an astonishing 80% of revenues. The Defence Ministry of Israel stated that the sector racked up sales of USD 7.4 bn in 2012, (See Exhibit No 55). Most of the sales were by Israel's four biggest Defence companies, IAI, Elbit, Rafael and IMI.

Brazil Background on domestic defence industry Brazil began focusing on military industrialization in the late 1960s. This was not driven by military threats in the traditional sense. Rather, Brazils leaders believed that the growth of the military industry would have the added benefit of stimulating development in the civilian industrial sector as well. This in turn would advance the countrys technological position and help it become one of the leaders in the global economy. Brazils main pioneer in indigenous defence production, aeronautics major Embraer Corporation, was established in 1969 and it started absorbing foreign technologies immediately to promote indigenization. Most of these technology transfers came as a package within Brazils offset deals. Embraer effectively used the extensive industrial base that already existed in the country to efficiently and cheaply produce equipment.

Focus on technology acquisition Historically, the countrys leaders have not put as much emphasis on balancing the import-export ratio as they have on technological development through transfer agreements, joint ventures, and collaboration with foreign contractors. Global arms producers found Brazils defence industry very attractive because of cheap labor, abundant raw material supply, and governmental support through accommodative policies and heavy investments in the countrys infrastructure. Because of these dynamics, Brazil transformed from a conventional developing country with heavy defence imports to one of the top 10 arms exporters in the world by the 1980s. Brazil has a relatively small procurement budget so its industry now relies on exports for most of its turnover. Its early actions in acquiring the latest technologies and establishing partnerships with key players have helped Brazil develop an autonomous technological capability to the extent that it participates in international collaborative projects for design/development of advanced military equipment.

South Korea Background on domestic defence industry Until the mid 1960s, Korea depended completely on military aid and imports from the United States to meet its defence procurement needs. The Ministry of Defence soon took action and set up the Defence Procurement Agency in 1971 as the countrys first integrated acquisition body for the defence forces. Korea began weapons production for the army in 1971 when the Ministry of Defence built an assembly plant to put together Colt M-16 rifles designed by long-time partner United States. By the 1990s, Korea possessed one of the largest defence industries in the world and domestic procurement was about 70 percent. It spent more than USD14 bn per year on defence-related activities. The majority of weapons systems production was concentrated in a few of the countrys large corporations, which had also taken the lead in research and development of their products. These companies had by this time taken the responsibility to enhance Koreas technological capabilities in defence production. They outsourced and subcontracted much of their production to smaller companies, who continued to play a

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