'Sell these defence stocks' is the word from Goldman Sachs - Three key reasons behind the bearish call

Global investment banking firm Goldman Sachs has initiated coverage on two shipbuilding companies - Mazagon Dock Shipbuilders Ltd. and Garden Reach Shipbuilders Ltd. on Thursday, October 22 with a "sell" rating.

Goldman Sachs has ascribed a price target of ₹1,855 for Mazagon Dock, which indicates a downside of 7% from current levels, while for Garden Reach, it has a target of ₹1,515, which indicates a downside potential of 24% from current levels.

The firm has highlighted three key reasons behind its "sell" recommendation:

First, both the companies do not have any meaningful presence in white spaces.

Second, Goldman Sachs expects the Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) to decline at a 19.3% Compounded Annual Growth Rate (CAGR) through financial year 2029, compared to a 26% CAGR growth for the rest of the aerospace and defence companies under their coverage.

Lastly, both the companies are trading at higher valuations with smaller order books and lower growth outlooks compared to global shipbuilders.

Goldman Sachs wrote in its note that India accounts for less than 1% of the global shipbuilding market, with defence and military vessels accounting for nearly 75% of the domestic market, compared to 22% globally. As a result, the firm termed Indian shipbuilding as a lumpy, cyclical, concentrated and a long-gestation business.

Additionally, defence orders operate on fixed-price and cost-plus models with front loaded customer advances, leading to the margins of these companies being prone to cost variations, the note said.

Both Mazagon Dock and Garden Reach Shipbuilders are now at the tail end of delivery on major programs and as a result, their trailing book-to-bill has fallen to cyclical lows, signaling that the current record revenue reflect peak billing on depleting backlogs, instead of sustainable momentum, Goldman Sachs observed.

The trailing book-to-bill ratio for Mazagon Dock has dropped to 1.37x, while for Garden Reach, it has dropped to 1.81x.

11 analysts have coverage on Garden Reach, of which seven analysts have a "buy" rating on the stock, while two others have a "hold" and "sell" recommendation each. The consensus estimates of price targets implies an upside potential of 47% from current levels.

16 analysts have coverage on Mazagon Dock, of which eight have a "buy" rating, three have a "hold" rating, while five others have a "sell" recommendation. The consensus estimate of price targets implies an upside potential of 32% from current levels.

Shares of Garden Reach Shipbuilders are down 5.2% on Thursday at ₹1,917.9. The stock is down 42% from its 52-week high.

Shares of Mazagon Dock Shipbuilders are also trading 5.1% lower at ₹1,896.1. The stock is down 34% from its 52-week high of ₹2,881.