Defence Sector: Kotak Turns Bullish on Drones, Electronics, and Exports; But Risks Remain

Synopsis: Kotak Institutional Equities remains structurally bullish on India’s defence sector, expecting capital expenditure to grow around 11 percent annually over the next four to five years, but flags that stock valuations, already at a 50 percent premium to global peers, leave limited room for broad-based upside, with drones, electronics, and exports emerging as the more interesting opportunities within the space.

Sometimes a bullish sector call and a valuation warning arrive in the same breath, and this is one of those moments. India’s defence sector has been a genuine market darling over the past few years, and the latest brokerage view neither disputes that story nor endorses buying it indiscriminately at current prices.

The Growth Story Remains Intact

Kotak expects India’s defence capital expenditure to grow at an annual rate of around 11 percent over the next four to five years, following what the brokerage describes as a sharp jump in FY27. That growth case rests on genuinely durable pillars rather than a temporary spending cycle: continued government focus on military modernisation, a deliberate push toward import substitution, and geopolitical uncertainty that shows no sign of easing globally.

Deepak Krishnan, the analyst behind the note, framed the structural case plainly, pointing to domestic optionality alongside export potential as European nations increase defence spending toward 5 percent of GDP under NATO commitments, with drones and counter-drone systems singled out as a particularly important growth driver going forward. 

That’s a notably specific reference point, since a shift in European defence budgets of that magnitude would represent a genuinely large addressable market for any supplier positioned to capture even a modest share.

Valuations Are Becoming a Concern

Here’s where the note turns more cautious. Kotak expects the historical pattern of 25 to 30 percent annual EBITDA growth across Indian defence companies to broadly continue, which on its own would be a strong case for continued investor interest. The complication is that Indian defence stocks currently trade at roughly a 50 percent valuation premium to their global peers, a gap wide enough that even genuinely strong earnings growth may already be priced in rather than representing fresh upside.

This is worth sitting with for a moment. A 50 percent premium to global peers means investors buying into this sector today are paying meaningfully more per unit of earnings than someone buying an equivalent defence company listed anywhere else in the world. 

That premium can be justified by India’s unique domestic order visibility and import substitution tailwind, but it also means the margin for disappointment is thinner than the headline growth numbers might suggest. Kotak’s own framing, remaining positive on long-term fundamentals while explicitly cautious on valuations, captures this tension precisely: the story is real, the price already reflects a lot of it.

Private Players to Benefit From Emerging Technologies

One of the more actionable distinctions in this note is between public- and private-sector opportunities within defence. Kotak expects private companies to capture a disproportionate share of future opportunities, particularly in newer segments such as drones, counter-drone systems, defence electronics, and other advanced technologies, while public sector companies are expected to retain their dominance in areas where they already have established manufacturing capabilities and decades-long government relationships.

This isn’t a call that private players will displace PSU defence names broadly; it’s a more nuanced read that the newer, technology-intensive segments of the industry favour companies with product innovation speed and specialised engineering talent, areas where nimbler private firms have historically had an edge over larger, more process-driven public sector manufacturers.

Electronics and Exports Emerge as Key Drivers

Electronics is becoming an increasingly significant share of value across naval, land, and air defence platforms, according to the brokerage, creating genuine opportunities for specialised component and systems suppliers rather than just prime contractors assembling final platforms. 

Missile replenishment programmes, the ongoing need to restock munitions consumed during actual military operations and training, alongside growing export demand, particularly from Europe, are cited as factors that could support sustained order inflows for these specialised suppliers over multiple years rather than a single procurement cycle.

This matters for how investors should think about which companies within the sector carry more durable growth visibility. A company supplying electronics or components across multiple platform types has more diversified revenue exposure than one dependent on a single large weapons system contract, and is arguably better positioned to benefit from this broader electronics content trend regardless of which specific platforms win individual tenders.

Drone Opportunities Split Between Commodity and Advanced Platforms

Within the drone segment specifically, Kotak draws a useful distinction. Lower-end drone products are likely to face intense competition and commoditisation, limiting pricing power and margins for companies operating purely in that segment. 

Advanced platforms, specifically medium-altitude and high-altitude long-endurance drones, offer considerably better opportunities for companies with genuine technology depth, since these platforms require sustained R&D investment that’s harder for new entrants to replicate quickly. Upcoming government procurement programmes in this space could help establish early market leaders, making the identity of early winners in these advanced categories worth tracking closely as tenders are awarded.

Shipbuilding and Aerospace Offer Long-Term Opportunities

Shipbuilding stands out as another area with genuine long-term growth potential, with commercial shipbuilding emerging as an additional opportunity layered on top of traditional defence orders for domestic yards. Government-backed procurement plans and financial assistance schemes are expected to provide multi-year revenue visibility, while partnerships with overseas manufacturers could further strengthen technical capabilities at Indian shipyards.

Commercial aerospace supply is a separate but related opportunity, supported by strong order backlogs at global aircraft manufacturers. Indian component suppliers stand to benefit from increasing outsourcing by these global players, though it’s worth noting that most Indian companies in this space currently operate as tier-one or tier-two vendors supplying components and sub-assemblies, rather than as full aircraft manufacturers, a distinction that matters for sizing the realistic revenue opportunity available to any single supplier.

What This Means for Investors

The overarching message from this note is one of selective optimism rather than blanket enthusiasm for the sector. The structural growth case for Indian defence spending is genuinely intact, and the segments highlighted here, electronics, advanced drones, exports, and shipbuilding, represent areas where specific companies could meaningfully outgrow the broader sector average. 

But with valuations already running well ahead of global peers, the more useful exercise for investors is distinguishing between companies positioned in these genuinely differentiated growth pockets versus those simply riding the sector’s overall re-rating, since the latter group carries considerably less margin of safety at current prices.

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