Hindustan Aeronautics | Ready to fly higher; Initiate at OW

India's aerospace industry has a long runway for growth. We estimate HAL's existing products could see orders worth over US$60bn in the manufacturing segment alone. Beyond this, upgrades, engine replacement, services, and exports will act as further growth levers.

*Well positioned for local manufacturing thrust:* India has the world's second-largest military and is the third-largest defense spender globally. It is also the second-largest importer of defense equipment (60% of its requirements). The policy push is now towards local production and exports of defense equipment. Further, the defense ministry has come up with a list of over 300 items that will progressively be banned from import, creating a localization opportunity of Rs5.6trn over F20-28. HAL has transformed from a repair & overhaul organization to acquiring and internally developing strong manufacturing, design and development capabilities, and developing the ability to provide complete product lifecycle management services.

*lndia – a large opportunity for the aerospace industry:* Our analysis suggests that India will become the second-largest market for aircraft manufacturers as it looks to upgrade its aging fleet and add more advanced aircraft over the next two decades. HAL's F22 revenue was US$3.1bn. Based on our bottom-up analysis, HAL's existing products could see orders worth over US$60bn in the manufacturing segment alone (F22: 30% of revenues). Beyond this pipeline, upgrades, engine replacements, repair and overhaul (F22: 60% of revenue), and exports would add to top-line growth.

*HAL stacks up reasonably well against peers:* HAL is the market leader in aerospace and is also the largest company by revenue in India's defense sector. Globally HAL occupied the 41st position on revenue (US$3.1bn) and aims to be in the top 25 by the end of the decade. HAL has strong revenue growth, high margins, high R&D spending, and reasonable net working capital when compared to its global defense peers. Although the stock is up 78% YTD, we believe the market is not fully pricing in the strong growth runway. HAL trades at discounts of 19% on F24 PER and 50% on F24 EV/EBITDA (on consensus estimates) to its global peers despite strong growth prospects. HAL also trades at a 32% discount to BEL (on forward consensus PER), India's second-largest defense company, despite having a similar growth profile (based on consensus estimates) over the next three years. Currently only seven sell-side analysts cover HAL, compared with 30 for BEL, despite similar market capitalizations.

*Initiate at Overweight, PT of Rs2,655 (23% upside):* We project F22-24/F24-27 CAGRs of 6%/14% for revenue, 9%/14% for EBITDA, and 5%/14% for net profit. We believe there are upside risks to our net profit CAGR of 14% over F24-27 if the pipeline opportunity and engine orders come through quicker than our base case forecasts. We value HAL using a residual income model that assumes a 12% earnings CAGR for F27-42 (three stage growth model), cost of equity of 12.5% (risk-free rate of 7.4% and adj. beta of 0.86x), rising dividend payout (average 55%), terminal ROE of 24%, and terminal growth of 4%.

*Key risks:* 1) Some of HAL's supplies are niche products and are capital-intensive, hence suppliers prefer to prioritize higher volume contracts. HAL thus needs to carry more inventory, so as to manage the execution timeline of its contracts. 2) The armed forces delay new aircraft orders. 3) Possible delays in receivables and/or in the receipt of advances would increase working capital. However, the trend has been steadily improving over the past few years.