November 29, 2010

BFSI-Stockbrokers
Thematic

Indian Stockbrokers: Awaiting

Analyst contact
Pankaj Agarwal, CFA

Their Turn Tel: +91 22 3043 3206

pankajagarwal@ambitcapital.com

Krishnan ASV
Indian listed brokers have underperformed the broader market for most of the Tel .: +91 22 3043 3205
current rally and they are still trading 50-75% below their peak valuations vkrishnan@ambitcapital.com
from December 2007. This underperformance is driven by the fact that Poonam Saney
revenue and profitability of stockbrokers has been flat between FY08-10 due Tel: +91 22 3043 3216
to lower delivery volumes, lower retail participation and brokers’ inability to poonamsaney@ambitcapital.com
scale up the businesses they started in FY08.
Motilal Oswal- BUY
However, past experience shows that stockbrokers outperform the broader
market significantly in the last leg of the bull market (brokers were up 141% to CMP: Rs161
500% v/s 55% for Sensex between Mar-07 to Dec-07) as retail participation,
Target Price: Rs206
delivery volumes, capital raising and margin financing pick up in this phase.
Upside (%): 28
From this perspective, the recent trends are encouraging because they show EPS (FY11): Rs11.3
that: (i) retail investors are slowly coming back to markets (enthusiastic ADV: Rs20mn/$0.4mn
response to Coal India IPO and Power Grid FPO); (ii) delivery volumes are
Beta: 1.2
increasing (cash delivery volumes are 27% of total cash volumes v/s 17% three
quarters back); and (iii) capital raising and margin financing activities are also
Edelweiss Capital- HOLD
gaining traction. Hence we expect brokers to outperform the markets from
hereon. CMP: Rs50
Even in the longer term we are bullish on the Indian brokerage sector owing Target Price: Rs54
to underpenetration of equities (~9% of household financial savings) in the Upside (%): 8
Indian household savings pie. On the presumption that this ratio will rise as EPS (FY11): Rs3.6
per capita income increases, the opportunity before Indian brokers is huge ADV: Rs143mn/$3.1mn
given that India has one of the highest savings rates in the world at 32% (a
Beta: 1.2
rate that according our Economist, Ritika Mankar, will rise to 39% by 2015).
Motilal Oswal Financial Services (MOFS.IN, BUY, 28% upside) is our top
pick in the sector. MOFS is one of the best broking franchises in India with a Other stocks mentioned in this
strong presence in both retail and institutional broking. Amongst the listed report
brokers, MOFS has the highest contribution (~87%) from broking and other
Company: India Infoline (IIFL.IN)
fee-based businesses in its revenue pie and hence should be the biggest
beneficiary in the climactic phase of a bull market. ADV: Rs239mn/$5.3mn

Edelweiss Capital (EDEL.IN, HOLD, 8% upside): We are initiating coverage

with a HOLD on Edelweiss Capital as the company has the lowest contribution Company: Religare Enterprises (RELG.IN)
from broking and investment banking in its revenue pie (~45%) and hence is ADV: Rs93 mn/$2.1mn
the least likely to benefit from a surge in volumes. Moreover, arbitrage yields
are showing a downward trend and this will likely keep earnings muted.
The biggest risk to our stances on these stocks is the broader market moving
downward. However, this risk is significantly mitigated by the ~10% correction
that the Indian market has undergone from its recent peak with stockbrokers
correcting by 20-25% during the same period and hence trading at the lower
end of their cross cycle PEs.

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit
Capital may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Please refer to disclaimer section on the last page for further important disclaimer.
 BFSI-Stockbrokers

Brokers lagging the broader market

Whilst the broader stockmarket has rallied by 150% since February 2009 and has
nearly touched the previous peak it reached in January 2008, stockbrokers who
should be leverage bets on the broader markets, have languished. Whilst most of
the stockbrokers have performed in line with the broader market in the current
rally (which started in March 2009), their share prices are still ~50% short of the
peak valuations they achieved at the peak of the last bull market in December
2007. This is obviously due to the fact that these brokers have significantly
underperformed the broader market between December 2007 and February 2009
(exhibit 1).

Exhibit 1: Brokers have underperformed the broader market

100

80

60

40

20

0
Dec-07 Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Aug-10

Sensex IIFL MOFS EDEL JM Fin Ibull

Source: Bloomberg

The reason for the brokers’ underperformance in this market is that despite market
volumes rising with the broader stockmarket (market volumes are up 234% and
76% respectively in October 2010 v/s February 2009 and December 2007), the
Exhibit 2: Revenue & profitability
revenues and earnings for brokers have not kept pace with volumes of the broader
growth of major brokers
market.
FY09 FY10 H1FY11
Growth (%) vs vs vs Exhibit 3: Continuous rise in stockbroking volumes
FY08 FY09 H1FY10
Revenues 1400 250%
MOFS -35% 42% -3% 1200 200%
EDEL -14% 2% 17% 1000 150%

IIFL -9% 30% 14% 800 100%

600 50%
400 0%
Net profits
200 -50%
MOFS -47% 91% -13%
0 -100%
EDEL -32% 23% 3%
FY95 FY97 FY99 FY01 FY03 FY05 FY07 FY09 FY11YTD
IIFL -18% 49% -11%
Source: Company fillings, Ambit Capital Average Daily Volume (Rs. bn) (LHS) YoY Growth (%) (RHS)
research
Source: NSE, BSE, Ambit Capital

There are three distinct reasons for the brokers’ inability to grow in line with
market volumes:

 Disproportionate increase in option volumes v/s cash delivery volumes:

Most of the growth in market volumes has come from low yield options
whereas “cash delivery” volumes (which are higher yielding trades) have
remained muted in this rally. This phenomenon has pulled down broking yields
by ~30% (from around ~7bps in FY08 to ~5bps in FY11). Hence despite a

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26% increase in market volumes from the peak of the last bull market (i.e.
2QFY11 v/s 3QFY08), the revenue pie for the sector has shrunk by ~15%.

Exhibit 4: Disproportionate rise in option volumes … Exhibit 5: ... leading to a drop in the brokerage
commission pool despite higher volumes
100%
ADV (Rsbn) Q3FY08 Q2FY11 % change
75%
Cash -delivery 75 48 -35%
50% Cash-intra day 188 133 -29%

25% Futures 608 374 -38%

Options 78 640 718%
0%
Q1FY08 Q3FY08 Q1FY09 Q3FY09 Q1FY10 Q3FY10 Q1FY11 Total volumes 948 1,196 26%
Total brokerage
Cash -Delivery Cash-Intra day Futures Options 34.9 29.7 -15%
commissions (Rsbn)
Source: NSE, BSE, Ambit Capital Source: NSE, BSE, Ambit Capital

Exhibit 6: Revenue breakup of
leading brokers (%)
FY10 (%) MOFS
Equity brokerage &
related income
Invst. banking fee
Net fund based income
incl. financing,
arbitrage, invst &
dividend income
Asset mgmt, 3rd party
distribution; other
income
Total
Source: Company fillings, Ambit Capital
research
Whilst it is difficult to pinpoint the reason for the sudden spurt in option volumes
and the muted growth in cash delivery volumes on Indian exchanges, our
discussions with stockbrokers suggest that lack of faith in the direction of the
IIFL EDEL
market has resulted in market participants executing fewer delivery trades. Once
71 55 27 market participants become more confident of the direction of the market, cash
10 3 9 delivery trades should increase. Moreover, data shows that in most of the leading
developed markets the share of F&O trades as a percentage total equity trades is
9 26 53 in the range 26%-56% (v/s 84% in India), which makes us believe that as Indian
markets mature the share of F&O trades should come down.
9 16 10  Lower retail participation: Another notable feature of this rally has been
the lack of growth in retail participation. Since Indian listed brokers are
100 100 100
predominantly retail brokers, they have been heavily affected by this
phenomenon. Our discussions with industry participants suggest that the lack
of retail participation is the fallout of investors’ memory of the heavy losses
suffered by millions of retail customers in the previous bull market (post being
lured into the market in FY08 by brokers relying on weighty advertising and
hard sales pitches).

Exhibit 7: Retail participation yet to pick up significantly

100%

75%

50%

25%

0%
Q1FY08 Q3FY08 Q1FY09 Q3FY09 Q1FY10 Q3FY10 Q1FY11
Retail Prop FII DII

Source: NSE, BSE, Ambit Capital

 Inability to scale up other businesses: In the final phase of the last bull
run, many brokers had entered other capital market businesses such as
financing, third party distribution, asset management and wealth
management. The dream of building a large diversified financial services
business was and is an attractive dream for the promoters of most brokerages
who crave for a more stable, more robust revenue stream versus that which is
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driven entirely by the yo-yoing stock market. However, due to various reasons
most brokers have been unable to scale up the intended non-broking
businesses:
1. The scrapping of entry load on mutual funds in August 2007 by the
Securities and Exchange Board of India (SEBI) and the capping of charges
on ULIPs in December 2009 by the Insurance Regulatory Authority of India
(IRDA) affected brokers’ third party distribution businesses and wealth
management businesses. For instance, India Infoline’s third party
distribution income has fallen 25% between FY08 and FY10 and Edelweiss
has had to reduce headcount in its wealth management venture.
2. The liquidity scarcity post the Lehman debacle in September 2008 and the
higher loan losses affected brokers’ ability to scale up their financing
businesses. For instance higher loan losses on the retail book led to India
Infoline discontinuing the unsecured loan segment while liquidity scarcity
and risk concerns forced Edelweiss to sharply reduce its promoter financing
portfolio to Rs5bn in FY09 from Rs10bn in FY08.
3. Margin financing was an attractive business in the FY07-08 bull run.
However, in this bull run, lack of retail participation has constrained
brokers’ ability to provide margin financing. For instance, despite the fact
that total market volumes are up 30% in FY10 v/s FY08, Motilal Oswal’s
margin financing book has shrunk 40% over the stated period.

However, long term story is very much intact …

Despite the short term headwinds for the sector owing to higher option volumes,
the lack of retail participation and regulatory and economic changes impacting the
non-brokerage businesses, we are bullish on the long-term prospects of the Indian
brokerage sector on the following counts:

 GDP growth and liquidity to drive volumes: Market volumes are a function
of total market cap and stock specific liquidity. Over the last decade the total
market cap of Indian exchanges has grown by ~7.8x v/s a 3.1x increase in
GDP. Given expected nominal GDP growth rate of ~14% over the next
decade, it would be safe to expect that the total market cap on Indian
exchanges will grow by at least a CAGR of ~20% over the next decade.
Whilst the trading volumes on Indian exchanges have increased at twice the
pace of market cap over the last decade, the trading velocity (i.e. total traded
volumes as a percentage of total market cap) on Indian exchanges is still much
lower versus other developed and developing markets (exhibit 8). The reason
for the low trading velocity is the low free float in Indian companies (59% of
the outstanding stock in Indian companies is held by promoters) as well as the
relatively low retail participation. However, as Indian corporates (including
PSUs) issue more capital to grow their businesses, promoters (including Indian
government) will have to dilute their holdings. That in turn will increase the
free float in the market.

Exhibit 8: Turnover velocity in India is one of the lowest

Country Exchange Turnover velocity*
BSE 20%
India
NSE 58%
Shanghai SE 182%
China
Shenzhen SE 378%
Taiwan Taiwan SE 164%
Korea Korea Exchange 162%
NASDAQ OMX 332.5%
US
NYSE Euronext 125.8%
Source: Nilsen Indian Equity investors survey-2010, Ambit Capital research. Turnover velocity here is defined
as monthly trading volumes as a % of total market on the exchange.

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 Mobilization of retail financial savings into equities: The share of equities

in financial savings at ~9% is dismally low in India and far lower than the
corresponding ratios in other developing and developed countries. Only 1.4%
of Indians invest in equities versus 5%-10% in other major developed and
developing countries. On the presumption that this ratio will rise as the country
gets richer, there is a huge untapped opportunity for Indian brokers given that
India has one of the highest savings rates in the world at 32% (a rate that
according our economist, Ritika Mankar, will rise to 39% by 2015).

Exhibit 9: Equities form a relatively lower share

Exhibit 10: Lower retail participation in Indian stock markets
in Indian customer’s financial savings wallet.*
Demat Accounts Population Demat/
Stocks Other financial assets in Million in Million Population (in %)
Korea 32% 68% India 16.8 1,173 1.4%
China 31% 69% China 125 1,330 9.4%
US 34% 66% Russia 3 139 2.2%
Japan 22% 78% South Korea 3.55 48 7.4%
UK 38% 62% UK 10 61 16.4%
India* 9% 95% USA 14.54 310 4.7%
Source: World Bank, Ambit Capital research. *For India the Source: Nielsen India Investors Survey-2010, Ambit Capital research
data represents percentage of incremental financial savings by
Indian households over last 60 years.

 Consolidation is on the cards: The Indian broking industry is one of the

most fragmented in the world (9,640 registered brokers v/s 63 in Korea and
285 in China). The top 10 brokers contribute only ~25% of the total volumes
in India versus more than 45% in China and Korea. The fragmentation is more
prominent in retail broking where there are more than 300 active brokers with
sizeable operations. However, we think that consolidation is imminent in the
Indian retail broking space owing to reasons stated below:
1. Growing need for heavy investments: Most of the retail brokers have
survived because of their personalized services to their clients. However,
due to the spread of financial education and increase in income levels,
clients are increasingly demanding more products and services such as
research, internet trading portals, wealth management advice etc. This will
require significant investments from the brokers (both in terms of
expensive hires and systems and controls); and the scale of the investment
required will likely force many brokers out of business.
2. Falling broking yields: Over the last decade, brokerage yields (cash and
F&O) in India have decreased from ~100bps to ~5bps. At such low yields
and given the scale of investment required, smaller brokers will be unable
to stay in the game.

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… in the short term the scenario is not that bad

Whilst we are bullish on the long-term prospects of the sector, we believe even in
short term, the trends are encouraging. Given that stockbroking volumes have a
strong correlation with the direction of the broader market (Sensex grew at 38%
CAGR between FY03-08 whilst market volumes grew at a CAGR of 68% during the
same period), we expect stockbroking volumes to move with the Sensex.

Exhibit 11: Volumes rise along with the broader market

1,400 22,000
1,200 20,000
1,000 18,000
800 16,000
600 14,000
400 12,000
200 10,000
- 8,000
Q4FY07 Q2FY08 Q4FY08 Q2FY09 Q4FY09 Q2FY10 Q4FY10 Q2FY11

Average Daily stockbroking volumes (Rs. Bn) (LHS) BSE Sensex (RHS)

Source: Ambit Capital research

We note more encouragingly, apart from broking volumes rising with the stock
market, historical trends show that cash delivery volumes and retail equity
participation increases with the level of the stock market:

 Increase in cash delivery volumes: Cash delivery volumes are the most
lucrative trades for brokers generating ~20bps in commission v/s ~4bps-5bps
for non-delivery cash trades and F&O trades. The past trends (table 10) show
that cash delivery volumes have a strong correlation with broader markets and
their percentage share in total volumes increases with the level of the stock
market. The last three quarters’ data is already showing such a pick-up in
delivery volumes.

Exhibit 12: Delivery volumes rise with market levels

40% 21,000

35% 18,000
15,000
30%
12,000
25%
9,000
20% 6,000
15% 3,000
FY03 FY06 Q2FY08 Q1FY09 Q4FY09 Q3FY10 Q2FY11

Delivery volumes as % of cash volumes (%) (LHS) BSE Sensex (RHS)

Source: Ambit Capital research

 Increased retail participation: Unlike the last bull market, retail investors
have not been active in this bull market. Even fund flows into equity mutual
funds and the subscription of the retail portion of the IPOs shows lack of retail
investor activity in the market. Previous market cycles show that normally retail
investors become super active in the later stages of a bull market. Once retail
investors become active, this will not only increase trading velocity, it will also
help Indian listed brokers disproportionately as most of them are
predominantly retail brokers. The enthusiastic retail response for the Coal

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 BFSI-Stockbrokers

India IPO and the Power Grid FPO indicates that retail investors have slowly
started returning to the market.

Exhibit 13: An uptick in retail volumes is already visible

700 65%
600
62%
500
400 59%
300 56%
200
53%
100
0 50%
Q1FY08 Q3FY08 Q1FY09 Q3FY09 Q1FY10 Q3FY10 Q1FY11

F&O Retail Volumes ADV (Rs bn) Cash retail volumes (Rs. Bn)
Retail volumes as a % of total volumes
Source: Ambit Capital research

 Increased investment banking and margin financing opportunities:

Data at the market regulator, SEBI’s website, shows that more than 40
companies are lined up to raise fresh capital of between US$8-US$10bn from
the markets in the next six months. This will not only increase investment
banking opportunities for the brokers but will likely also help increase their
financing income by providing margin funding opportunities during IPOs
(many retail and HNI investors tend to subscribe to IPOs using margin
funding).

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Valuation
Since stockbrokers are leveraged bets on the Indian economy, they should trade at
a similar multiple to the broader market. Indian brokers do not have a long
trading history as most of them were listed in the last phase of the FY08 bull
market. However, historic data shows that stockbrokers outperform the
broader market the most in the final phases of a bull market when retail
activity is highest, delivery volumes are at their peak and the market is
full of equity capital raisings providing investment banking and financing
opportunities to brokers.
In the current rally, Indian brokers have traded at a discount to the broader stock
market due to their earnings not growing with the broader stock market. However,
as discussed above, as we enter the more advanced phase of this bull market, we
expect history to repeat itself with stockbrokers’ earnings growing at a rapid pace.
This should lead to the valuation multiple of brokers converging towards the
broader markets and thereby market outperformance of the brokers. At present,
the broader India market is trading at a forward earnings multiple of ~18x versus
a band of 11-14x for listed Indian brokers. This gap should narrow if the Sensex
continues to rise. Moreover, Indian brokers are trading at a 30% discount on
forward P/E to their eastern Asian peers despite having better ROEs. All of this
suggests that Indian brokers are not getting the valuation multiples they deserve.
The relative valuation of three brokers (see table on next page) shows that based
on FY11 P/E Edelweiss Capital appears the most expensive while India Infoline
looks to be the cheapest among these three brokers.

Exhibit 14: Indian stockbrokers appear inexpensive on relative valuation

Price Market Asset
ROE (%) ROA (%) P/BV(x) P/E (x)
(local cap size
currency) ($ mn) (US$ mn) FY11E FY12E FY11E FY12E FY11E FY12E FY11E FY12E
Indian peers
India Infoline Ltd 81 508 1,021 13.8 15.4 4.3 4.7 1.3 1.2 10.8 8.9
Indiabulls Securities Ltd 22 110 221 NA NA NA NA NA NA NA NA
JM Financial Ltd 30 486 937 NA NA NA NA NA NA NA NA
Motilal Oswal Financial Services Ltd 161 501 397 15.2 15.8 NA NA 2.1 2.1 13.7 11.2
Religare Enterprises Ltd 490 1,414 2,095 NA NA NA NA NA NA NA NA
Edelweiss Capital Ltd 49 801 1,272 11.8 12.1 NA NA 1.4 1.3 13.9 12.0
Average for Indian brokers - - - 13.6 14.4 4.3 4.7 1.6 1.5 12.8 10.7
Asian peers

Nomura Holdings, Inc. $5 18,001 322,304 1.6 4.2 NA NA 0.8 0.8 NA 18.3

Haitong Securities Co., Ltd. $1 11,860 17,247 8.1 8.6 2.8 2.9 1.8 1.6 35.0 16.4

Daiwa Securities Group Inc. $4 6,648 171,554 0.3 2.1 0.1 0.2 0.7 0.7 318.8 36.9

Samsung Securities Co., Ltd. $51 3,418 10,333 NA NA NA NA NA NA NA NA

CITIC Securities $2 18,982 29,544 13.8 11.4 7.9 3.2 1.9 1.8 24.3 17.6

Hyundai Securities Co., Ltd. $10 1,673 9,290 NA NA NA NA NA NA NA NA

Mizuho Securities Co., Ltd. $2 3,221 209,510 NA NA NA NA NA NA NA NA

Northeast Securities Co., Ltd. $3 2,200 2,683 17.8 20.6 2.8 3.1 4.5 3.8 33.0 20.3

Mirae Asset Securities Co., Ltd. $42 1,771 6,193 NA NA 2.2 2.8 NA NA NA NA

Sinolink Securities Co., Ltd $2 2,365 1,574 NA NA NA NA 6.1 5.0 47.3 30.2

Average - - - 8.3 9.4 3.1 2.4 2.6 2.3 91.7 23.3

Source: Bloomberg

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Catalysts that could push brokers’ multiples upward

Traditionally, Indian stockbrokers have been happy to focus on corporates’ equity
capital needs and most of the listed brokers generate around 5-10% of their
topline from ECM. However, as Kotak has shown over the past twenty years and as
Standard Chartered and Deutsche Bank are showing now, there is a bigger
opportunity for capital raising intermediaries who approach corporates with both
debt and equity capital raising propositions. With the Axis Bank-Enam deal (dated
November 17, 2010) now lighting the touch paper, more Indian brokers will look
to tie up with domestic or foreign partners in the months ahead.
Even more pertinently, the valuation at which at Axis Bank has acquired Enam (21x
FY11 earnings) has highlighted we believe the strategic value inherent in the
boardroom and investor relationships that the better Indian stockbrokers possess.
Hence the Axis-Enam deal and similar deals in the months ahead have set the
scene for a bout of re-rating for the Indian stockbroking sector.

Company-specific summaries
Motilal Oswal (MOFS.IN, BUY, 28% upside): Arguably one of the best-run
listed Indian brokerage houses with a large (1,500 outlets in 600 cities) branch
network, one of the better equity research teams in India and a sensible promoter-
led management team with 20 years of experience in the industry. The company
has maintained its focus on non-capital intensive fee-based businesses like
broking, investment banking and asset management and has stayed away from
capital intensive businesses like retail financing, insurance etc. where stockbrokers
have no visible competitive advantage. However, the lack of retail activity and
higher option volumes in this bull has meant that MOFS’ earnings have remained
muted between FY08 an FY11YTD. As the bull market matures, the entry of retail
investors, increased cash delivery volumes and higher investment banking and
margin trading activity should benefit MOFS disproportionately.
Edelweiss Capital (EDEL.IN, HOLD, 8% upside): India’s biggest derivatives
broker with sizable financing and arbitrage operations. The company grew at a
phenomenal CAGR of 133% between FY05-08. However, following its successful
IPO in December 2007 the company failed to live up to expectations, partly due to
a decrease in arbitrage opportunities (as a brutal bear market kicked in) and partly
due to its reduced market share in institutional broking and inability to scale up
the businesses inaugurated at the fag end of FY08. This has led to the stock
underperforming peers and the stock market for the most part of the current rally.
However, the company has shown signs of a recovery in the past five quarters. It
has maintained its market share in institutional broking whilst scaling up its (i)
investment banking business (revenues up 5x in last five quarters); and (ii)
promoter financing book 6x over the last six quarters. At the same time it acquired
retail broker Anagram Capital in January 2010 for Rs1.6bn and thereby added
Rs1.1bn to its topline. This has led to the stock outperforming its peers and the
broader markets in FY11YTD. However, the current valuations appear to be
factoring in these positives and we expect modest upside in the stock from here.
India Infoline (IIFL.IN, NOT RATED): Arguably, India Infoline is the only
successful new entrant in institutional broking in India over the last five years
partly due to the company attracting top talent from the then (May 2007) market
leader, CLSA. The company has a well established retail broking franchisee and its
stature in institutional broking has increased multifold over the last three years.
However, after the spectacular outperformance of the stock in the first three
months of the current rally (February 2009 to May 2009), the stock has
significantly underperformed the broader market and peers. Over the past 15
months IIFL has failed to meet the market’s expectations with static market share
in broking, loan losses on its unsecured loan book and a dip in its third party
distribution income (post SEBI and IRDA lowering intermediation costs).

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Given that 60% of its revenues arise from the broking business and given its
sizeable retail presence, India Infoline could be one of the beneficiaries from the
entry of retail investors into the market in the climactic phases of this bull market.
However, a further drop in third party revenues and persistent NPAs on its lending
book could be the major negatives for the stock.
Religare Enterprises (RELG.IN, NOT RATED): Religare has significant presence
in retail broking (40% of revenues) and asset financing (~32% of revenues) and is
trying to build multinational investment banking and asset management business
with a focus on Emerging markets. The company has been acquiring boutique
asset managers and brokerage firms across the globe for its asset management
and investment banking businesses and has made some very senior hires over the
past year from bulge bracket firms to run these businesses. Right now only
brokerage and financing businesses are cash flow positive for the company and
hence upside for the stock is entirely dependent on the company’s success in its
new businesses.

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Motilal Oswal Fin. Serv.

Bloomberg: MOFS IN EQUITY
Reuters: MOFS.BO BUY

India’s most direct broking play

Analyst contacts
Pankaj Agarwal, CFA
Tel: +91 22 3043 3206
Motilal Oswal Financial Services Ltd. (MOFS) is one of the best broking pankajagarwal@ambitcapital.com
franchises in India with a strong presence in both retail and institutional
Krishnan ASV
broking. However, lack of retail activity and higher option volumes in this bull
run (as opposed to higher cash delivery volumes) has meant that MOFS’ Tel.: +91 22 3043 3205
vkrishnan@ambitcapital.com
earnings have remained muted between FY08 and FY10 (flat between FY08-
10 v/s 67% CAGR between FY06-08). As the bull market matures, the entry of Poonam Saney
retail investors, increased cash delivery volumes and higher investment Tel: +91 22 3043 3216
banking and margin trading activity should benefit MOFS disproportionately. poonamsaney@ambitcapital.com

Moreover, we believe MOFS is one of the best-run broking franchises in India

with a large (1,500 outlets in 600 cities) branch network, among the better
equity research teams, and a sensible promoter-led management team with
20 years of industry experience. Furthermore, MOFS’ business model should Recommendation
help the firm manage its profitability better versus peers on a cross-cycle basis
CMP: Rs161
on the following counts:
Target Price: Rs206
 A focus on non-capital intensive businesses: MOFS has maintained its
Upside (%): 28%
focus on non-capital intensive fee-based businesses such as broking,
investment banking and asset management and has stayed away from EPS (FY11): Rs 11.3
capital intensive businesses such as retail financing, insurance etc. wherein
stockbrokers have no visible competitive advantages. Stock Information

 Flexible cost structure model: MOFS has successfully built a franchisee- Mkt cap: Rs24bn/US$517mn
based retail broking model which is non-capital intensive and helps MOFS 52-wk H/L: Rs232/135
manage its cost structure better (even in a bear market) as all the fixed and
3M Avg. daily vol.: Rs.20mn/$0.4mn
operating costs are borne by the franchisee in lieu of a cut from total
brokerage commissions. For example, in the FY09 bear market, whilst Beta: 1.2x
volumes in the market fell by 15%, MOFS’ revenues were down 35% but its BSE Sensex: 19,136
operating margin was flat at 36% (v/s fall of 6% for EDEL and 7% for IIFL).
Nifty: 5,752
Valuation
Stock Performance (%)
Assuming revenue CAGR of 19% between FY10-15 (FY06-10 CAGR was 24%) 1M 3M 12M YTD
and an average operating margin of 38% between FY10-15 (FY06-10 average
-17.6 4.8 -3.2 -7.2
was 38%), a cost of equity of 15%, our DCF model values MOFS at Rs206 per Absolute
share, 28% upside from current levels. This implies an earnings multiple of Rel. to Sensex -13.4 -1.4 -13.8 -16.1
14.5x on FY12EPS and P/B multiple of 2.2x on FY12 BVPS. The P/E multiple is
broadly in line with the marketwide multiple. Consensus EPS estimates imply Performance (%)
that MOFS is currently trading at FY12 P/E of 11.4 x, which is a 5% premium to 25,000 230
Indian peers. 20,000
210
190
15,000 170
150
Exhibit 1: Key financials 10,000 130
Year to March (Rsmn) FY09A FY10A FY11E FY12E FY13E No v-09 A pr-10 Sep-10
Sensex M o tilal Oswal
Total income 4,482 6,367 6,680 8,478 10,328
Operating profit 1,627 2,673 2,590 3,222 3,893 Source: Bloomberg, Ambit Capital research
Net profit 895 1,707 1,611 2,020 2,465
EPS (Rs) 6.3 11.9 11.3 14.1 17.2
BVPS (Rs) 56 66 78 92 109
P/E (x) 25.5 13.5 14.3 11.4 9.3
P/B (x) 2.9 2.4 2.1 1.8 1.5
Source: Company, Ambit Capital research

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit
Capital may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Please refer to disclaimer section on the last page for further important disclaimer.
 Motilal Oswal Fin. Serv.

Company Financial Snapshot

Profit and Loss (consolidated) Company Background

FY10 FY11E FY12E
Total Income 6,367 6,680 8,478 Motilal Oswal is among the largest stockbrokers in India with
Operating expenses 3,683 4,091 5,255 significant presence in both retail and institutional stock
Operating Profit 2,673 2,590 3,222 broking. The company was started by promoters Ramdeo
PBT 2,534 2,456 3,074 Agarwal and Motilal Oswal in 1987 as a sub-brokerage firm
Net Profit 1,707 1,611 2,020 that subsequently got a broking license in 1990. The company
EPS (Rs)-Basic 11.9 11.3 14.1 launched its institutional broking business in 1994 and
EPS (Rs)-Diluted 11.9 11.3 14.1 expanded its retail broking business by acquiring some
regional stock brokers in 2005-06 and starting an internet
Profit and Loss Ratios trading portal in 2005. The company started offering portfolio
management services in 2003, followed by its entry into
Operating Margin % 42 39 38
investment banking in 2006 and mutual fund management in
PAT Margin % 27 24 24
FY10. The company went public in 2007 and raised Rs2.5bn
P/E (X) 13.1 13.9 11.0
by offering a 10.5% stake in the company.

Balance Sheet (consolidated) Operating Metrics (consolidated)

FY10 FY11E FY12E FY10 FY11E FY12E
Total Assets 10,552 13,075 14,534 Broking Market Share (%) 3.2 3.0 3.0
Net Fixed Assets 2,400 2,629 2,629 Broking Yield (bps) 6.1 5.2 5.4
Current Assets 1,600 4,320 5,184 Loan portfolio 1,600 4,320 5,184
Other Assets 6,552 6,126 6,721 Total AUM (Rsbn) 16.9 25.3 30.3
Total Liabilities 10,552 13,075 14,534
Networth 9,460 11,094 13,115
Borrowings 1 1,083 1,982
Others 1,091 897 -563
Balance Sheet Ratios
ROA 18.4% 13.6% 14.6%
ROE 19.6% 15.7% 16.7%
Debt/Equity 0.0% 9.8% 15.1%
P/BV (X) 2.4 2.1 1.8

Revenue Breakdown Consistent operating margins

45% 40%
Segment FY10 Revenues 35%
Equity brokerage &
71% 30%
related income 40%
25%
Net Interest Income 9%
20%
Investment banking fees 10% 35% 15%
Asset Management Fees 6%
10%
Other income 3%
30% 5%
Total 100%
FY06 FY07 FY08 FY09 FY10
Rs6.4bn
Operating Margin (LHS) ROE (%) (RHS)

Source: Company; Ambit Capital research

Ambit Capital Pvt Ltd 2

 Motilal Oswal Fin. Serv.

Key assumptions & estimates

Exhibit 2: Key assumptions and estimates for MOFS (all figures in Rsmn unless otherwise mentioned)
Assumptions FY09 FY10 FY11E FY12E FY13E Comments
Growth in overall Although market volumes have grown at a CAGR of 40% over
stock market -17% 56% 28% 20% 20% FY05-10, we are taking a conservative estimate of 22% growth in
volumes market volumes between FY10-13.
Brokerage market MOFS maintains its market share on the back of its strong
4.20% 3.20% 2.96% 3.00% 3.00%
share (%) distribution channel and strong advisory capabilities.
We do not see broking yields falling from current levels given
Broking yield (bps) 5.17 6.14 5.15 5.5 5.5
they are already 40% lower than yields in developed markets.
We expect financing, asset management and investment banking
Growth in non- revenues to pick up because of increased capital raising by
-2% 50% 10% 26% 26%
brokerage income Indian corporates, which will help both the i-banking and margin
financing businesses.
We expect operating margins to fall slightly going forward due to
Operating margin
36.3% 42.1% 38.8% 38.0% 37.7% higher payroll expenses.

Key output
FY09 FY10 FY11E FY12E FY13E Comments
(YoY growth)
Expect revenues to grow at 27% in FY12 v/s FY11 on the back of
Net revenues -42% 42% 5% 27% 22% rising market volumes and slightly higher yields due to the
increase in cash delivey volumes with rising markets.
Operating profit to grow in line with revenues in FY12 because of
Operating profit -36% 65% -3% 24% 21%
the variable cost structure of the company.
Profit after tax -47% 87% -5% 25% 22% As explained above.
Source: Ambit Capital research

Ambit Versus Consensus

Bloomberg provides estimates on MOFS from only three other brokers. Hence
consensus estimates on MOFS contain limited data. Our revenue estimates appear
to be slightly higher than consensus. We believe this is largely because brokers are
extrapolating current trends and assuming lower market volume growth (in line
with recent experience). However our EPS estimates are in line with consensus as
we are factoring higher employee to bring down profit margins.

Exhibit 3: Ambit v/s consensus

(Rsmn) Consensus Ambit % change
Total income
FY11E 6,651 6,680 0%
FY12E 7,518 8,478 13%
EPS (Rs)
FY11E 11.3 11.3 0%
FY12E 14.2 14.1 -1%
Source: Ambit Capital research, Bloomberg

Ambit Capital Pvt Ltd 3

 Motilal Oswal Fin. Serv.
Exhibit 4: SWOT analysis of MOFS
Strengths
 Stable operating margins across the cycle because
of the franchisee-based business model which
allows MOFS to operate with low overheads (since
the franchisee bears the overheads).
 Strong distribution channel with 1,500 branches in
600 cities countrywide.
 Experienced and conservative management team
with more than two decades of experience in the
Indian stock market.
Opportunities
 Opportunity to act as a consolidator in the Indian
broking market as this market heads towards
consolidation.
 To use its strong institutional and retail distribution
to grow its ECM business. The ECM business
accounted for 10% of MOFS’ revenues in FY10.
 To leverage its retail distribution platform to sell
third party products such as insurance and mutual
funds.
Source: Ambit Capital research
Ambit Capital Pvt Ltd
Weaknesses
 Low diversification as ~70% of revenues come from
broking and all of the company’s businesses are
highly dependent on general capital market
activities.
 Low operating leverage because of the franchisee-
based business model (which keeps MOFS’ fixed
costs low but also means that MOFS has to share its
brokerage income with franchisees).
Threats
 Entry of new players such as Religare, Reliance into
the both institutional and retail broking market.
 The larger franchisees tend to push for higher
commission share with the implicit threat that if
such concessions are not granted, they will move
their franchise elsewhere.
4
 Motilal Oswal Fin. Serv.

Valuation
We have valued MOFS using free cash flow to equity (FCFE) model. Our FCFE
metric is cash profits - increase in working capital. Our FCFE model has three
distinct phases:
 FY10-FY15: We model each year in detail and broadly assume that (i) revenue
will grow at 29% and (ii) operating margins would fade down to 37% by FY15.
 FY15-20: We fade the revenue growth gradually so that by FY20 the revenue
growth is 5% and operating margins fade to 35%.
 From FY20 FCFE grows at a CAGR of 5%.
Based on these assumptions and assuming a cost of equity of 15% and a terminal
growth rate of 5%, our FCFE model values MOFS at Rs206 per share (implied
valuation of 14.5x FY12 EPS). MOFS is currently trading at an FY12 P/E of 11.4x,
which is at slight premium of 5% to its Indian peers but at a discount to broader
stockmarket which is on ~15 FY12 EPS. However, MOFS is currently trading at an
FY12 P/B multiple of 2.1x, which is a ~30% premium to peers. Given MOFS’
higher return ratios (ROE of 20% in FY10 v/s 15% for IIFL and 11% and EDEL), we
believe MOFS deserves a higher P/B multiple versus peers.

Exhibit 5: Valuation sensitivity to key assumptions

High Case Base Case Low Case
Total market volumes growing Total market volumes growing at
Growth in stock Total market volumes growing at
at CAGR of 30% between CAGR of 21% between FY10-15
market volumes CAGR of 15% between FY10-15
FY10-15 (FY05-10 CAGR of 40%)
MOFS’ market MOFS’ market share in equity MOFS’ maintaining its current market MOFS’ market share in equity
share (equity volumes goes up to 3.5% in share in equity volumes at 2.96% volumes falls to 2.5% between
volumes) FY12. until FY12. (FY09=4.2%, FY10=3.2%) FY10-12.
Other income growing at a Other income growing at a CAGR of
Other income growing at a CAGR
Other income CAGR of 30% between FY10- 21% between FY10-15 (FY06-10
of 15% between FY10-12
15 CAGR of 64%)
An average operating margin Operating margin fading down to 37% An average operating margin of
Operating margins
of 38% between FY10-15. by FY15 (FY09=38%), FY10=42%) 35% between FY10-15 .
FCFE valuation (Rs) Rs333 Rs. 206 Rs167
Upside Upside of 107% Upside of 28% Upside of 4%
Source: Company filings; Ambit Capital research

The key downside risks to our Positive stance are:

 Lower-than-expected growth in stock market volumes,
 Lower-than-expected increase in MOFS’ market share in broking

Cross Cycle Valuation

MOFS is trading at a forward PE of 13.7x (on consensus estimates) which is at a
11% discount to its long term average forward PE of 15.4x (calculated based on
the period from September 2007 to November 2010).

Ambit Capital Pvt Ltd 5

 Motilal Oswal Fin. Serv.

Exhibit 6: MOFS is trading at the lower end of its historical PE multiple

500

400 MOFS stock price

30x
300
20x
200

100 10x

Sep-07

Mar-08
Nov-07
Jan-08

May-08
Jul-08
Sep-08
Nov-08
Jan-09
Mar-09
May-09
Jul-09
Sep-09
Nov-09
Jan-10
Mar-10
May-10
Jul-10
Sep-10
Nov-10
Source: Bloomberg

Ambit Capital Pvt Ltd 6

 Motilal Oswal Fin. Serv.

Exhibit 7: Income statement

Y/E Mar (Rsmn) FY09A FY10A FY11E FY12E FY13E
Brokerage income 3,268 4,551 4,681 5,960 7,152
Net interest income 461 553 574 778 1,150
Other fee income 753 1,263 1,426 1,739 2,025
Total Income 4,482 6,367 6,680 8,478 10,328
Operating expenses 2,854 3,683 4,091 5,255 6,435
Direct costs 971 1,630 1,552 1,991 2,408
Employee costs 1,203 1,367 1,685 2,159 2,656
Admin expenses 681 687 854 1,105 1,372
Operating profit 1,627 2,673 2,590 3,222 3,893
Depreciation 203 149 133 149 149
Exceptional items -30 0 0 0 0
PBT 1,395 2,534 2,456 3,074 3,744
Less:tax 462 788 796 996 1,213
PAT 933 1,744 1,660 2,077 2,530
Extraordinary items, minority interest etc. (38) (40) (49) (57) (65)
Net Profit 895 1,707 1,611 2,020 2,465

EPS (Rs)- basic 6.3 11.9 11.3 14.1 17.2

EPS (Rs)- diluted 6.3 11.9 11.3 14.1 17.2
Dividend per share(Rs) 0.8 1.2 1.1 1.4 1.7
Source: Company, Ambit Capital research

Exhibit 8: Balance sheet

Y/E Mar (Rsmn) FY09A FY10A FY11E FY12E FY13E
Sources of funds
Net worth 7,939 9,460 11,094 13,115 15,579
Minority interest 80 40 41 46 46
Borrowings 1,455 1 1,083 1,982 1,421
Net deferred taxes 13 -12 -31 -48 -48
Total sources of funds 7,968 10,552 13,075 14,534 16,792

Application of funds
Cash 5,428 4,333 4,452 6,473 8,937
Investments 492 514 613 613 613
Fixed assets 745 2,400 2,629 2,629 2,629
Loan book 1,500 1,600 4,320 5,184 6,221
Net working capital -197 1,705 1,060 -365 -1,608
Total application of funds 7,968 10,552 13,075 14,534 16,792

BVPS 56 66 78 92 109
Source: Company, Ambit Capital research

Ambit Capital Pvt Ltd 7

 Motilal Oswal Fin. Serv.

Exhibit 9: Key metrics

(%) FY09A FY10A FY11E FY12E FY13E
Broking market share (%) 4.2% 3.2% 3.0% 3.0% 3.0%
Brokerage yield 5.2 6.1 5.2 5.5 5.5
Operating cost/income 63.7% 57.9% 61.2% 62.0% 62.3%
Debt to equity 18.3% 0.0% 9.8% 15.1% 9.1%
Revenue growth -34.5% 42.1% 4.9% 26.9% 21.8%
PAT growth -47.1% 90.7% -5.6% 25.4% 22.0%
Source: Company, Ambit Capital research

Exhibit 10: Valuation and return ratios

(%) FY09A FY10A FY11E FY12E FY13E
P/E 25.5 13.5 14.3 11.4 9.3
P/BV 2.9 2.4 2.1 1.8 1.5
ROA 10.8% 18.4% 13.6% 14.6% 15.7%
ROE 11.9% 19.6% 15.7% 16.7% 17.2%
Source: Company, Ambit Capital research

Ambit Capital Pvt Ltd 8

BFSI-Stockbrokers November 29, 2010

Edelweiss Capital
Bloomberg: EDEL IN EQUITY
Reuters: EDEL.BO HOLD

Thriving Once Again Analyst contact

Pankaj Agarwal, CFA
Tel: +91 22 3043 3206
After muted growth between FY08-10, Edelweiss has shown signs of recovery pankajagarwal@ambitcapital.com
in the last five quarters by: (i) maintaining market share in broking; (ii)
Krishnan ASV
growing its investment banking business; (iii) deploying excess capital to grow
Tel.:+91 22 3043 3205
its financing book; and buying mid-sized retail broker, Anagram Capital in
vkrishnan@ambitcapital.com
2010. However the current valuation of 1.5x FY11 BV and 14x FY11 EPS
already largely factors in these positives and we expect limited upside from Poonam Saney
current levels. Hence initiating with a HOLD recommendation. Tel: +91 22 3043 3216
poonamsaney@ambitcapital.com
Despite our positive stance on the brokerage sector our HOLD
recommendation is driven by three factors:
 Low contribution from broking and fee-based businesses: Amongst
Recommendation
the main listed brokers, Edelweiss has the lowest contribution from fee-
based businesses such as broking and investment banking (45% v/s 80% CMP: Rs50
for MOFS and ~60% for IIFL). These fee-based income streams, we
Target Price: Rs54
believe, have the best growth potential in the long term, the highest ROE
and the most direct correlation with market levels. Upside (%): 8
EPS (FY10): Rs3.6
 Arbitrage yields are falling: The arbitrage desk at Edelweiss contributes
37% to its topline. However, the arbitrage yields are trending downward
(from ~18% in FY08 to ~14% in FY11) as new players are entering the Stock Information
market coupled with the introduction of algorithmic trading software in the
Indian market. Hence we do not foresee the arbitrage business as being Mkt cap: Rs37bn/US$787mn
sustainable on its own in the long run as yields are expected to decrease 52-wk H/L: Rs68/39
further with Indian markets becoming more efficient.
3M Avg. daily vol.: Rs143mn/$3.1mn
 Stability and scalability in financing business: Edelweiss is a leading
Beta: 1.2x
player in the promoter financing and IPO financing business. However, the
business in the current form is not scalable as the promoter financing BSE Sensex: 19,137
market is relatively small and IPO financing opportunities are sporadic. We Nifty: 5,752
do not foresee visible competitive advantages in the other mainstream
lending businesses it is planning to get enter (eg. mortgages, SME and Stock Performance (%)
infra financing).
1M 3M 12M YTD

Valuation Absolute -18.0 -4.0 10.0 7.2

Rel. to Sensex -15.0 -9.6 -3.2 -3.8
Our sum-of-the-parts valuation (SOTP) model values Edelweiss at Rs54 (8%
upside). We value the broking and other fee-based businesses at Rs36 based Performance (%)
on an FCFE model. Given the unpredictable nature of the arbitrage business
25,000 75
and the scalability issues of the financing business and the lower ROEs (~8%)
65
in both these businesses, we have valued these businesses at 1x the net assets 20,000
employed in these businesses (Rs18 per share). 15,000
55
45
10,000 35
No v-09 A pr-10 Sep-10
Exhibit 1: Key financials
Sensex Edelwiess Capital
Year to March (Rsmn) FY09 FY10 FY11E FY12E FY13E
Total income 7,668 7,835 9,975 11,582 13,226 Source: Bloomberg, Ambit Capital research
Operating income 3,467 3,450 4,102 5,198 5,869
Net profit 1,864 2,292 2,673 3,432 3,897
EPS (Rs) 2.5 3.1 3.6 4.6 5.2
BVPS (Rs) 28 30 32 36 41
P/E (x) 20.4 16.9 13.9 10.9 9.6
P/B (x) 1.8 1.6 1.6 1.4 1.2
Source: Company, Ambit Capital research

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit
Capital may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Please refer to disclaimer section on the last page for further important disclaimer.
 Edelweiss Capital

Company Financial Snapshot

Profit and Loss (consolidated) Company Background

FY10 FY11E FY12E
Total Income 7,835 9,975 11,582 Edelweiss is amongst the Top 10 institutional brokers in India
Operating expenses 4,385 5,874 6,384 and one of the largest domestic brokers (~5% market share in
Operating Profit 3,450 4,102 5,198 institutional broking) with a sizeable financing book along
PBT 3,328 3,957 5,046 with one of the largest arbitrage trading desks in India. The
Net Profit 2,292 2,673 3,432 company was started by investment bankers Rashesh Shah
EPS (Rs)-Diluted 3.1 3.6 4.6 and Venkat Ramaswamy in 1996 as an advisory house
focused on private equity and M&A deals. In subsequent years
the company entered institutional broking, investment
Profit and Loss Ratios banking, asset management and wholesale financing
Operating Margin % 44% 41% 45% businesses. It has recently entered retail broking by acquiring
PAT Margin % 29% 27% 30% Anagram Capital along with launching its online trading
P/E (X) 16.9 13.9 10.9 portal. Edelweiss is starting its life insurance business in FY12
in a joint venture with Japanese insurance giant Tokio Marine.

Balance Sheet (consolidated) Operating Metrics (consolidated)

FY10 FY11E FY12E FY10 FY11E FY12E
Total Assets 51,844 96,095 107,716 Broking Market Share (%) 1.7% 2.2% 2.4%
Net Fixed Assets 589 4,361 4,361 Broking Yield 5.5 4.4 4.7
Loan Book 18,373 46,290 53,710 Loan Portfolio 18,373 46,290 53,710
Other Assets 32,882 45,444 49,645 Yield on advances ~15.70% 15.0% 15.0%
Total Liabilities 51,844 96,095 107,716 Cost of funds ~8.0% 8.4% 9.0%
Networth 22,574 23,757 27,189 Arbitrage portfolio ~16,000 13,000 13,000
Minority interest 2,132 5,736 5,736 Gross arbitrage yield ~15.3% 15.4% 14.4%
Borrowings 27,138 66,601 74,791

Balance Sheet Ratios

ROA 5.5% 3.6% 3.4%
ROE % 10.5% 11.5% 13.5%
Debt/Equity 120% 280% 275%
P/BV (X) 1.6 1.6 1.4

Revenue Breakdown Falling ROEs and margins

FY10 Revenues
Segment 55% 40%
(%)
35%
52%
Net Interest Income 18% 30%
49% 25%
Broking Income 27%
46% 20%
Other Fee Income 18% 15%
43%
Treasury, Arbitrage and 10%
37%
other fund based income 40% 5%
Total 100% FY05 FY06 FY07 FY08 FY09 FY10
Operating Margin (LHS) ROE (%) (RHS)
Rs7.8bn

Ambit Capital Pvt Ltd 2

 Edelweiss Capital

Key assumptions & estimates

Exhibit 2: Key assumptions and estimates for EDEL (all figures in Rsmn unless otherwise mentioned)
FY09 FY10 FY11E FY12E FY13E Comments
Assumptions
Although market volumes have grown at a CAGR of 40% over
Growth in overall
-17% 56% 28% 20% 20% FY05-10, we are taking a conservative estimate of 22% growth in
stock market volumes
market volumes between FY10-13.
Brokerage market
EDEL increases its market share after acquisition of Anagram
share (%) NA 1.7% 2.2% 2.4% 2.4%
Capital.

We do not see broking yields falling from current levels given

Broking yield (bps) NA 5.5 4.5 4.5 4.5 that they are already 40% lower than yields in developed
markets.
Growth in other fee We expect asset management and investment banking revenues
-51% 80% 68% 15% 15%
income to pick up with the market
Whilst Edelweiss is rapidly growing its financing portfolio, falling
Grwoth in net fund arbitrage yields and lower incremental yields in the financing
17% -18% 5% 4% 9%
based income portfolio result in 7% CAGR between FY10-13 in fund based
income.
We expect operating margins to fall slightly in FY11 v/s FY10 due
to higher payroll expenses in the current year. However we
Operating margin 45% 44% 41% 45% 44% expect it to increase in FY12 as a result of cost savings on lease
rentals once the company moves its operations in its owned
premises.
Key outputs (YoY growth)

Expect revenues to grow at 19% CAGR between FY10-13 on the

Net revenues -14% 2% 27% 16% 14% back of the Anagram acquistion, rising market volumes and
higher investment banking and financing revenues offset by
lower arbitrage income.

Operating profit -24% 0% 19% 27% 13% Operating profit to grow higher than revenues in FY12 due to
increase in operating margins as explianed above.

Profit after tax -32% 23% 17% 28% 14% As explained above.
Source: Ambit Capital research

Ambit versus consensus

Bloomberg provides estimates on Edelweiss from only four other brokers. Hence
consensus estimates on Edelweiss contain limited data. Whilst our FY11 revenue
and EPS estimates are in line with consensus, our FY12 EPS estimates are around
11% above consensus. Whist we do not have access to the breakdown of
consensus’ revenue forecast, our view is that consensus is not factoring in cost
savings on lease rentals once the company moves to its owned premises in FY12.

Exhibit 3: Ambit v/s consensus

(Rsmn) Consensus Ambit % change
Total income
FY11E 9,965 9,975 1%
FY12E 11,101 11,582 4%
EPS (Rs)
FY11E 3.6 3.6 1%
FY12E 4.1 4.6 11%
Source: Bloomberg, Ambit Capital research

Ambit Capital Pvt Ltd 3

 Edelweiss Capital
Exhibit 4: SWOT Analysis
Strengths
 A strong management team which has repeatedly
spotted new business opportunities ahead of its
competitors e.g. derivatives broking in 2001 and
fixed income desk in 2008.
 Derivatives broking desk is the largest in India and
the overall institutional broking business
(~US$45mn in revenues in FY10) is now amongst
the largest in India (if we look outside the top
MNC brokers)
Opportunities
 Opportunity to use its retail and institutional
distribution to scale up its investment banking
business. Already, in FY10 Edelweiss’ ECM
business has made substantial progress with
revenues growing by ~250%.
 Edelweiss acquired Anagram (FY10 revenues
Rs1.1bn) for Rs1.7bn. Now it has opportunity to
scale up the Anagram retail business using parent
company’s balance sheet strength (which will now
allow Anagram to provide margin financing to its
clients) and advisory capabilities.
Source: Ambit Capital research
Ambit Capital Pvt Ltd
Weaknesses
 A major portion of company’s current revenues are
not scalable (.i.e. arbitrage and promoter financing)
because of limited opportunities in these segments
and higher capital requirements.
 Edelweiss’ retail broking franchise – Anagram - has
been recently acquired and needs to be turned
around and invested in to make it of a similar
quality to its other businesses.
Threats
 Inability to successfully integrate Anagram Capital
with the parent company.
 Entry of new players such as Jefferies and Barclays
Capital into the institutional broking market pulling
down yields and EDEL’s market share.
4
 Edelweiss Capital

Valuation
We have valued Edelweiss using a sum-of-the-parts (SOTP) model with a free cash
flow to equity (FCFE) valuation for its brokerage segment and fee income
businesses and a book value multiple for its book-based businesses.
Our FCFE metric is “cash profits less increase in working capital”. Our FCFE model
has three distinct phases:
 FY11-FY15: We model each year discretely and broadly assume that fee-
based revenue will grow at 20% CAGR and operating margins should average
at 43%.
 FY15-20: We fade the revenue growth gradually so that by FY20 the revenue
growth is 5% and operating margins fade to 41%.
 From FY20 FCFE grows at a CAGR of 5%.
Based on the assumptions shown above and assuming; a) cost of equity at 15%;
and b) terminal growth at 5%, our FCFE model values Edelweiss’ fee-based
business at Rs36 per share.
Due to the low ROE in its financing businesses and lack of scalability and
predictability in the financing and arbitrage businesses, we have valued these two
businesses at 1x the net assets employed in the stated businesses. This translates
to Rs18 per share for these businesses.
Hence we arrive at a total valuation for the company at Rs54 per share (implied
FY11 P/E of 15.1x and FY11 P/BV of 1.7x), implying 8% upside from current levels.

Exhibit 5: Valuation sensitivity to key assumptions

High Case
Fee based businesses
Total market volumes grow
Growth in stock market
at CAGR of 35 % between
volumes
FY10-15
Edelweiss’ market share in
EDEL’s market share equity volumes going up to
(equity volumes) its previous high of 3% in
FY15 from 2.4% in 2QFY11.
Other fee income growing at
Investment banking and other
a CAGR of 25% between
fee income
FY10-15.
Core FCFE valuation Rs51
Financing, cash and
1.2X net assets = Rs22
investments and arbitrage book
SOTP valuation Rs73
Upside Upside of 46%
Source: Company filings; Ambit Capital research
Base Case
Total market volumes grow at
CAGR of 22% between FY10-
15 (FY05-10 CAGR of 40%)
Edelweiss’ maintaining its
market share in equity volumes
at 2.4% between FY10-15
(~1.8% in FY09 and FY10)
Other fee income growing at a
CAGR of 15% between FY01-15
(FY05-10 CAGR of 54%)
Rs36
1.0X net assets = Rs18
Rs54
Upside of 8%
Low Case
Total market volumes grow at
CAGR of 15% between FY10-
15
Edelweiss’ market share in
equity volumes falling to 2%
between FY10 and FY15.
Other fee Income growing at a
CAGR of 10% between FY10-14.
Rs29
0.8X net assets = Rs15
Rs44
Downside of 12%

The key downside risk to our HOLD stance are:

 Lower-than-expected growth in stock market volumes,
 Lower-than-expected increase in market share.

Ambit Capital Pvt Ltd 5

 Edelweiss Capital

Cross Cycle Valuation

EDEL is trading at a forward PE of 14.0x (on consensus estimates) which is at a
12% discount to its long term average forward PE of 15.9x (calculated based on
the period from September 2007 to November 2010).

Exhibit 6: Edelweiss is trading at a discount to its long term average PE

180
150 EDEL stock price
120 35x

90
20x
60
30 10x

0
Dec-07

Mar-08

Jun-08

Sep-08

Dec-08

Mar-09

Jun-09

Sep-09

Dec-09

Mar-10

Jun-10

Sep-10
Source: Bloomberg

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 Edelweiss Capital

Exhibit 7: Income statement

Y/E March (Rsmn) FY09A FY10A FY11E FY12E FY13E
Fee based income 2,441 3,504 5,456 6,903 8,145
Equity broking 1,648 2,079 3,063 4,150 4,980
Other fee based income 793 1,425 2,393 2,752 3,165
Net fund based income 5,187 4,243 4,439 4,596 4,993
Interest income 3,315 3,389 6,966 8,896 10,413
Arbitrage income 2,512 2,455 2,008 1,878 1,748
Investment and dividend income 697 342 175 184 193
Less interest expense 1,337 1,943 4,710 6,363 7,362
Total income 7,668 7,835 9,975 11,582 13,226
Operating expenses 4,201 4,385 5,874 6,384 7,357
Operating costs 2,542 2,763 3,492 3,590 4,133
Employee costs 1,659 1,622 2,381 2,794 3,224
Operating profit 3,467 3,450 4,102 5,198 5,869
Depreciation 177 122 145 152 160
PBT 3,290 3,328 3,957 5,046 5,710
Less:tax 1,199 879 1,161 1,514 1,713
PAT 2,091 2,449 2,795 3,532 3,997
Minority interest (227) (157) (122) (100) (100)
Net profit 1,864 2,292 2,673 3,432 3,897
Basic-EPS (Rs) 2.5 3.1 3.6 4.6 5.2
Diluted EPS (Rs) 2.4 2.9 3.6 4.6 5.2
Source: Company, Ambit Capital research

Exhibit 8: Balance sheet

Y/E March (Rsmn) FY09A FY10A FY11E FY12E FY13E
Sources of funds
Net worth 21,154 22,574 23,757 27,189 31,086
Minority interest 2,149 2,132 5,736 5,736 5,736
Borrowings 7,624 27,138 66,601 74,791 84,393
Total sources of funds 30,926 51,844 96,095 107,716 121,215

Application of funds
Cash and bank FDs 19,441 16,945 15,734 19,166 23,063
Investments 1,073 1,560 5,073 5,073 5,073
Loan book 6,295 18,373 46,290 53,710 62,614
Fixed assets 527 589 4,361 4,361 4,361
Net working capital 3,590 14,377 24,637 25,406 26,104
Total application of funds 30,926 51,844 96,095 107,716 121,215
Source: Company, Ambit Capital research

Ambit Capital Pvt Ltd 7

 Edelweiss Capital

Exhibit 9: Key metrics

(%) FY09A FY10A FY11E FY12E FY13E
Brokerage market share NA 1.7% 2.2% 2.4% 2.4%
Broking yields NA 5.5 4.4 4.5 4.5
Operating cost/income 55% 56% 59% 55% 56%
Debt to equity 36% 120% 280% 275% 271%
Source: Company, Ambit Capital research

Exhibit 10: Valuation and return ratios

(%) FY09A FY10A FY11E FY12E FY13E
P/E 20.4 16.9 13.9 10.9 9.6
P/BV 1.8 1.6 1.6 1.4 1.2
ROA 5.3% 5.5% 3.6% 3.4% 3.4%
ROE 9.4% 10.5% 11.5% 13.5% 13.4%
Source: Company, Ambit Capital research

Ambit Capital Pvt Ltd 8

 Edelweiss Capital

Institutional Equities Team

Saurabh Mukherjea Managing Director - Institutional Equities – (022) 30433174 saurabhmukherjea@ambitcapital.com

Research

Analysts Industry Sectors Desk-Phone E-mail

Amit Ahire Telecom / Media & Entertainment (022) 30433202 amitahire@ambitcapital.com
Ankur Rudra IT/Education Services (022) 30433211 ankurrudra@ambitcapital.com
Ashish Shroff Technical Analysis (022) 30433209/3221 ashishshroff@ambitcapital.com
Ashvin Shetty Consumer (022) 30433285 ashvinshetty@ambitcapital.com
Bhargav Buddhadev Power/Capital Goods (022) 30433252 bhargavbuddhadev@ambitcapital.com
Chandrani De Metals & Mining (022) 30433210 chandranide@ambitcapital.com
Chhavi Agarwal Infrastructure (022) 30433203 chhaviagarwal@ambitcapital.com
Gaurav Mehta Derivatives Analysis (022) 30433255 gauravmehta@ambitcapital.com
Krishnan ASV Banking (022) 30433205 vkrishnan@ambitcapital.com
Nitin Bhasin Infrastructure (022) 30433241 nitinbhasin@ambitcapital.com
Pankaj Agarwal NBFCs (022) 30433206 pankajagarwal@ambitcapital.com
Parikshit Kandpal Construction / Real estate (022) 30433201 parikshitkandpal@ambitcapital.com
Poonam Saney BFSI (022) 30433216 poonamsaney@ambitcapital.com
Puneet Bambha Power/Capital Goods (022) 30433259 puneetbambha@ambitcapital.com
Rajesh Kumar Ravi Cement (022) 30433274 rajeshravi@ambitcapital.com
Ritika Mankar Economy (022) 30433175 ritikamankar@ambitcapital.com
Ritu Modi Metals & Mining (022) 30433292 ritumodi@ambitcapital.com
Subhashini Gurumurty IT/Education Services (022) 30433264 subhashinig@ambitcapital.com
Vijay Chugh Consumer (incl FMCG, Retail, Automobiles) (022) 30433054 vijaychugh@ambitcapital.com

Sales

Alok Doshi Manager Sales (022) 30433229 alokdhoshi@ambitcapital.com

Deepak Sawhney VP - Ins Equity (022) 30433295 deepaksawhney@ambitcapital.com
Dharmen Shah VP - Ins Equity (022) 30433289 dharmenshah@ambitcapital.com
Dipti Mehta Senior Manager Equities (022) 30433053 diptimehta@ambitcapital.com

Ambit Capital Pvt Ltd 9

 Edelweiss Capital

Explanation of Investment Rating

Investment Rating Expected return

(over 12-month period from date of initial rating)

Buy >15%

Hold 5% to 15%

Sell <5%

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