Brokerage to bank? ?Edelweiss Capital?s (EDEL) revenue bias has tilted more towards interest income over recent quarters (44% in Q1FY11 vs. 31% a year ago), as the management focuses on expanding the lending portfolio, and growth in broking and arbitrage segments remains sluggish.
The management is keen on a banking licence?deems it to be a longer-term necessity for customer franchise, asset growth and funding mix. If made available, this could alter its growth and margin profile.
Broking: EDEL estimates retail commission pool at nearly 3x institutional commissions. It is seeing some early signs of a pickup in retail volumes and aims to double its own retail commissions in the next 18 months. Recent Anagram acquisition is a strong platform to build the retail business.
Financing: The company?s credit book (loan against shares) has grown rapidly since Q2FY10 and the management targets a Rs50-bn loan book in three years (from Rs30 bn now). In addition, it is starting new products (loan against property/mortgages), which are likely to add to the book. Moreover, it is also open to exploring inorganic opportunities to further growth in this segment.
Asset management: EDEL is not expecting to grow its AUMs (assets under management) meaningfully near term, as demand remains sluggish. While it recently raised some offshore funds ($250m), domestic flows remain weak, with no momentum visible near term. Medium-term plans are to keep introducing new products and establish a performance track record, while keeping expenses low.
In the investment mode: EDEL will need to invest capital for: (i) growing the lending business; (ii) planned life Insurance foray; and (iii) building the retail brokerage. We believe these will pay off as these businesses achieve scale, but near term, will likely be a drag on profitability.
We rate Edelweiss Sell/Medium Risk. Edelweiss is among the largest institutional brokerages in India and enjoys a favourable market positioning and a strong management team. In a rising equity market this should create strong leverage in its operating revenues. Moreover, it has a large capital base, which can be leveraged quickly to be deployed in its market leading arbitrage business.
However, capital market volumes in India have continued to be fragmented due to a changing product mix and increasing competitive intensity and have pressured profitability for leading players.
Moreover, Edelweiss has a relatively smaller retail franchise, which we believe will likely be the next upside leg for market turnover (as institutional turnover has already been strong) and can impact Edelweiss? competitive positioning. Edelweiss? arbitrage trading business has also continued to attract lower turnover and profitability which is expected to remain a drag on overall profitability. Moreover, we expect cost pressures to increase going forward, leading to possible declines in profit margins.
Valuation: Our target price of Rs 50 is based on a price-to-earnings approach. We value brokerages/related businesses at a slight discount to broader market earnings multiples in the current environment. We believe that such cyclical businesses should trade at a discount to the market during a strong market environment and vice-versa. In the current market environment, we use 15x 1yr forward PE (price-to-earnings) to value Edelweiss? overall business (in line with our multiples for other players in the sector). Our target multiple is at a 10-15% discount to the broader Sensex multiple (we argue that brokerages should trade at discounts in a strong market and vice-versa). This values Edelweiss at Rs 50 per share.
Risks: We rate Edelweiss Medium Risk, though our quantitative risk-rating system, which tracks 260-day historical share-price volatility, suggests Low Risk. We prefer Medium Risk to Low Risk because Edelweiss? revenues continue to be closely linked to capital market growth and volatility. Upside risks to our target price include: (i) higher than expected growth in brokerage volumes; (ii) better than expected returns on the treasury portfolio; and (iii) higher than anticipated upsides on the launch/amalgamation of new retail brokerage platform.