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SECTOR REPORT

PRIVATE CLIENT RESEARCH JUNE 22, 2010

Sarika Lohra sarika.lohra@kotak.com +91 22 6621 6313

India Brokerage Industry


India has witnessed a consistently strong growth of over 7%+ over the past 5 years. This, along with the conducive regulatory environment, has attracted foreign investors to India. The number of FIIs registered in India has increased to 1711 in April 2010 from 513 in 2003. Increasing foreign participation has been significantly positive for capital market intermediaries in India. FY09 remained a lackluster year, with FII being net sellers for ~US$10bn. Retail investors participation also remained low during FY09, which impacted performance of capital market intermediaries. With Indian economy moving on an up cycle during FY10, FIIs infused ~$20bn in Indian capital markets, and retail participation also improved through insurance and mutual fund route. Corporate fund raising activity (through QIPs, IPO, and debt syndication) has also gained momentum during FY10. This has aided capital market intermediaries' fee-income. The secondary capital market volumes clocked a growth of 60% yoy to Rs. 978bn (annual average) during FY10 from Rs609bn in FY09. Presently close to 77% of the capital market volumes comprise of F&O volumes as compared to 61% in FY05. Change in the capital market volume mix has tempered market share of top 10 capital market intermediaries during FY10. Moreover, lower delivery volumes in the cash segment have impacted brokerage yields during FY10. We opine that the market share of most of the capital market intermediaries will remain under pressure going forward. With increased competition, brokerage yields are expected to remain flat despite higher focus of the intermediaries on the cash segment. We have assumed a 15% CAGR over FY11-12 in capital market volumes from current average of Rs 978bn. Operating cost of capital market intermediaries is largely variable in nature. Cost effective distribution model - franchisee and online trading through portals also helps in keeping a check on operating cost. And, thus operating and net profit margins are likely to remain stable. Post recent correction stock prices of capital market intermediaries are trading at significant discount to the benchmark index valuations. The valuations at the current level appear attractive and therefore we are initiating coverage on India Infoline with a BUY recommendation, while valuations for Edelweiss Capital and Motilal Oswal appear rich and therefore we recommend accumulating the stock on declines.

Companies covered

n India Infoline n Edelweiss Capital n Motilal Oswal


x

Brokerage yield (%)

Indian Infoline Motilal Oswal 0.12 0.10 0.08 0.06 0.04 4QFY08 1QFY09 2QFY09 3QFY09 Source: Company 4QFY09 1QFY10 2QFY10 3QFY10 4QFY10 Edelweiss Capital

Investment rationale
q Brokerage revenue growth; largely stable brokerage yield, while market share of the leading players to remain under pressure. Despite diversification into related business - fund management, investment banking etc- Indian capital market intermediaries reap their revenue largely from equity brokerage business. The factors which drive the equity brokerage revenue are secondary capital market volumes and brokerage yield. Secondary market
Valuation Matrix
CMP (Rs) IIFL Motilal Oswal Financial Service Edelweiss Capital Ltd 100 171 504 Target (Rs) 126 177 525 EPS (Rs) FY11E 9.3 13.1 38.9 FY12E 11.0 14.6 45.5 FY11E 10.7 13.1 13.0 PE (x) FY12E 9.1 11.7 11.1 Recommendation BUY ACCUMULATE ACCUMULATE

Source: Kotak Securities - Private Client Research

Registered Office: Kotak Securities Limited, Bakhtawar, 1st floor, 229 Nariman Point, Mumbai 400021 India.

SECTOR REPORT

June 22, 2010

volumes have grown at a CAGR of 55% over FY05-10. Volume share of low brokerage yield Futures & Options (F&O) trading has increased over cash and delivery based volume share. The cash segment delivery volumes have experienced some stabilisation over the past two quarters. This we opine will provide cushion to brokerage yield of capital market intermediaries with higher thrust on cash and delivery based volumes. We are of the view that, pressure on market share may keep the yields stable at ~6bps. q We expect stock market volumes to grow at 15% CAGR over FY10-12. In the wake of global financial market turmoil, Indian stock markets remained subdued during FY09, clocking de-growth in overall volumes of 15% yoy. Revival in economic activity and improving Indian corporate performance has abetted capital market rally during FY10. The overall stock market volumes grew by 61% in FY10. Strong growth in capital market volumes was largely driven by F&O volumes, which comprise of 77% of the total volumes and have grown at 66% CAGR over FY05-10 as compared to overall capital market CAGR of 55%. A strong expected economic growth (nominal) of 14.5% in FY11 and 15% in FY12 is expected to lead to a healthy growth in household financing savings. This, along with an expected rise in FII investments, will be the key driver for capital market volumes. We expect the overall stock market volumes to grow at a CAGR of 15% during FY10-12; the same has been factored in our working for the companies to arrive at the fair price target for the stocks. q Investment banking income to remain buoyant following acceleration in corporate fund raising activity. With the increase in corporate fund raising activity in FY10, capital market intermediaries have witnessed a steady growth in investment banking fees. Investment banking revenue form close to 10% of the total revenue. With benign capital markets and a sanguine investor sentiment, we opine that the growth in the Investment banking business is likely to remain buoyant as the investment banking deal pipeline is expected to remain strong over FY11-12. Increased revenue contribution from investment banking business will likely boost return ratios. q Margins to remain stable- aided by cost effective distribution model; operating expenditure largely variable in nature. In the wake of a healthy growth across all revenue streams coupled with cost effective operating structure and cost control initiatives, we opine that capital market intermediaries will be able to maintain EBITDA and PAT margins. Revenue growth will likely see a healthy growth during FY11-12 following improved capital market volumes, steady investment banking pipeline, and revival in the lending business. Higher impetus is being given to cost effective distribution network of franchisee and sub-brokers and this may aids margin preservation during down turn. We expect firm operating and net profit margins for capital market intermediaries over FY11-12.

Margins (%)
FY09 EBIDTA (%) Edelwiess Motilal Oswal India Infoline Source: Companies 36.7 37.9 30.3 PAT (%) 20.8 19.5 15.0 EBIDTA (%) 34.3 41.1 38.9 FY10 PAT (%) 23.7 27.3 20.6 FY11E EBIDTA (%) 36.4 41.3 38.4 PAT (%) 22.9 27.2 20.5 FY12E EBIDTA (%) 36.9 41.7 39.1 PAT (%) 23.2 27.3 21.2

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q Capital market intermediaries performance largely dependent on capital market volumes; valuations largely appear rich, recommend buying IIFL and accumulating Edelweiss and MOFS on declines. In the wake of improving capital market volumes and largely stable brokerage yields coupled with strong growth in fee based income, we expect healthy growth in earnings for capital market intermediaries in India over FY11 and FY12. Capital market intermediaries have increased thrust on their lending business, which we opine will boost their return ratios going forward. Thus we expect steady improvement in their return ratios for FY11 and FY12 We are valuing IIFL at P/E of 13.5x its FY11 estimated EPS of Rs.9.3, thus assigning a 13% discount to IIFL's median P/E of 15.3x. On a relative basis this translates to a 15% discount to benchmark Sensex P/Ex of 16.5x. We initiate coverage on IIFL with Buy recommendation and a price target of Rs. 126.
We recommend BUY on IIFL and ACCUMULATE on MOFS and ECL

We are valuing Edeweiss Capital Ltd at 14% discount to its Median P/Ex, i.e. 13.5x its FY11 EPS of Rs.38.9; leading to a price target of Rs.525. We have assigned a discount to ECL's historic valuation to factor in shift of capital to newer businesses viz retail broking. Improved capital market outlook is expected to drive earnings growth. We are initaiating coverage on Edelweiss capital with a price target of Rs. 525. However, at the current levels valuation apperas rich and despite a positive business growth outlook we recommend accumulating the stock on declines given the limited upside of 4% from current levels. We are valuing MOFS at its Median P/Ex of 13.5x its FY11 estimated EPS of Rs. 9.3. At 13.5x P/Ex of FY11E EPS, the fair price target for MOFS will be Rs.177, which offers limited upside of 3.2% from current levels. Hence, recommend accumulating the stock at declines with price target of Rs.177 Risk and concerns to our call q Businesses significantly correlated to capital markets- Business diversification notwithstanding, all business verticals of the stock broking companies like the securities business, investment banking, private equity, asset management, venture capital etc are directly correlated to performance of the capital markets. In the event of any severe downturn in capital market, stock broking companies' profitability may adversely get impacted. q Increasing competition- Brokerage industry has been highly fragmented in nature has relatively lower entry barriers. Hence, it has seen an increase in participation of foreign and domestic brokerage houses. Besides impacting the overall market share, it may further impact pricing power and profitability of the stock broking companies. q Brokerage yields may witness pressure- Of late stock broking companies have witnessed slippage in the brokerage yield. This is mainly on the back of change in the market volume mix, which is now more skewed towards options, where yields are relatively lower. Only those players who are able to maintain some consistency in margins will be better off and will be able to stay put even during the turbulent market scenario.

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INDUSTRY OUTLOOK
Steady economic growth supporting improvement in stock market volumes; positive for capital market intermediaries
n Indian capital markets have witnessed steady growth in volumes over the past 5 years following increased participation from institutional (both foreign and domestic) as well as retail investors. The strong GDP growth at 7%+ has attracted investors to the capital markets. n Liberaisation has opened up Indian economy and conducive regulatory environment has attracted foreign participation in India. FII registration over the past 10 years has increased significantly from 517 in 2003 to 1711 in April 2010. Moreover, individual investor participation in capital markets has also increased. India's household financial savings in share & debentures, mutual funds and insurance has also seen an uptick. n Capital market volumes were impacted during FY08-09, in the backdrop of global financial turmoil. Improved economic activity and strong corporate earnings growth has revived trading volumes in the Indian capital markets during FY10. Going forward, we opine that the extension of trading session by another hour is less likely to aid improvement in volumes; however, a largely stable brokerage yield and steady fee based income growth will boost revenue growth for capital market intermediaries.
Segment wise improvement in volumes
25000 20000 15000 10000 5000 0 Apr-03 Aug-03 Dec-03 Apr-04 Aug-04 Dec-04 Apr-05 Aug-05 Dec-05 Apr-06 Aug-06 Dec-06 Apr-07 Aug-07 Dec-07 Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09 25500 0 NSE (LHS) BSE (LHS) F&O (RHS) 51000 102000 76500

Overall improvement in volume


140,000 105,000 70,000 35,000 Oct-03 Oct-04 Oct-05 Oct-06 Oct-07 Oct-08 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Oct-09 4

Source: NSE, complied by Kotak Securities - Private Client Research

Source: NSE, complied by Kotak Securities - Private Client Research

Increase in FII participation n Improving global macroeconomic scenario and revival in Indian economic growth has allured foreign investors to India. The number of foreign institutional investors (FIIs) registered in India has gone up materially over the last five years from 517 in 2003 to 1711 in April 2010. n The global financial meltdown of FY09 impacted fund inflow to India also. FII were net sellers to the tune of $10bn with cumulative investments of $50bn in FY09.
Growing FII registration in India, FII inflow remain strong

n Nonetheless, foreign investments saw significant improvement during FY10 following revival in economic activity and healthy corporate earnings growth. FII were net buyers to the tune of $20bn during FY10 with cumulative investment of $78bn. n Foreign Direct Investments (FDI) in India has also clocked an uptick during FY10, up by 4% yoy to Rs.1178bn (as on February 2010) from Rs. 1130bn. Increased foreign institutions participation in India offers immense opportunity to capital market intermediaries with improved volumes in investment banking activity.

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Revival in foreign capital inflow in India


120 80 35.9 10.2 25.8 9.9 15.2 1.8 15.8 0.6 40 0 2008-09 -10.3 Cumulative Net Investment (US $ bn) 68.0 57.7 78.0 Net Investment (US $ Net) 45.3 52.0

Increase in number of FIIs registered in India


1800

1350

16.0

20.3

9.3

6.7

900

450 2009-10

-40 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08

0 2003 Source: SEBI 2004 2005 2006 2007 2008 2009

Source: SEBI

Increase in DII inflows In the wake of global financial turmoil during FY09, Indian Mutual Funds (MFs) witnessed significantly higher withdrawals, as the asset under management (AUM) also declined due to stock market correction. MFs saw a net redemption of Rs. 283bn which pulled the total AUM down to Rs. 4173bn in FY09. FY10 saw a revival in investor confidence amidst improvement in economic activity in India. Resultantly, MFs saw a net inflow of Rs. 1,416bn increasing the total AUM to Rs.6,651bn.
Growing mutual fund participation
8000 6000 4000 2000 0 -2000 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 5 Net inflow Total AUM

Source: AMFI INDIA

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Increasing household financial savings will led to increasing retail participation; and thus higher retail penetration Indian equity markets have relatively lower penetration levels. The same is reflective in the proportion of investment to financial saving of Indian household. Investment in equities as a percentage of total investments has witnessed an increase over period of time as compared to small saving instruments like NSC's and post office deposits to Mutual Funds (Equity), ULIPs etc, from less than 2% to ~10% in FY2008. Secondly with the rising interest rates, major part of the public savings has also moved to fixed deposits with banks.
Financial saving of the household sector (gross)
(Rs Crore) Financial Saving (Gross) Financial saving % of GDP Currency % of total financial savings Deposits % of total financial savings Share and Debentures % of total financial savings Of whichi) Private Corporate Business % of total financial savings ii) Mutual Funds (Other than UTI) % of total financial savings Claims on Government % of total financial savings Insurance Funds % of total financial savings Provident and Pension Funds % of total financial savings GDP at Current Market Prices Source: RBI P: Provisional. #: Preliminary Estimates. 23,755 3.7 34,709 5.3 19,198 3.0 1,14,851 17.7 72,106 11.1 4,129,173.0 31,565 4.4 56,799 7.9 -28,315 (4.0) 1,28,930 18.0 70,878 9.9 4,723,400.0 31,124 4.2 -10,478 (1.4) -23,479 (3.1) 150337 20.1 70,891 9.5 5,321,753.0 2006-07 650412 15.8 66,274 10.2 3,19,385 49.1 58,598 9.0 2007-08 (P) 715994 15.2 81,278 11.4 3,74,088 52.2 89,134 12.4 2008-09 # 746865 14.0 93,056 12.5 436710 58.5 19,349 2.6

Overall capital market volumes are more skewed towards futures and options segments The overall stock market volumes over FY04-09 witnessed a CAGR of ~43%. This was largely driven by increased volume in the Futures & Options (F&O) segment, which has witnessed a CAGR of 52% over FY04-09. F&O segment comprise of 74% of the total stock market volumes. F&O segment carries a relatively lower yield than cash segment and thus leads to a lower blended brokerage yield.
Avg Daily Turnover
FY04 FY05 21 12 45 27 101 61 167 13.4 FY06 32 11 63 22 193 67 288 72.6 FY07 39 9 78 19 298 72 415 44.2 FY08 63 9 138 19 519 72 720 73.4 FY09 46 8 115 19 452 74 609 -15.4 FY10 56 6 166 17 762 77 984 61.6

F&O segment forms majority of capital market volume

BSE (cash) % of total volumes NSE (cash) % of total volumes F&O (NSE) % of total volumes Total % Chg

20 13 43 29 84 57 147

Source: NSE India, BSE, Kotak Securities - Private Client Research

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Moreover, over the period, the mix of F&O volumes has also changed. The share of low yield -Options (largely index options) has increased materially, comprising of close to 50% of the total F&O volumes. This is one of the major reasons which have impacted the overall brokerage yield for these capital market intermediaries.
Investorwise market share (%)
Institutional investors 100% 80% 60% 40% 20% 0% Apr-07 Jun-07 AugOct-07 DecFeb-08 Apr-08 Jun-08 AugOct-08 DecFeb-09 Apr-09 Jun-09 AugOct-09 DecFeb-10 Apr-10 Retail Proprietary

Cat wise F&O turnover


Stock Futures Index Futures Stock Options Index Options

100% 80% 60% 40% 20% 0% Apr-03 Aug-03 Dec-03 Apr-04 Aug-04 Dec-04 Apr-05 Aug-05 Dec-05 Apr-06 Aug-06 Dec-06 Apr-07 Aug-07 Dec-07 Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Source: NSE India Jul-06 Jul-07 Jul-08 Jan-07 Jan-08 Jan-09 Jul-09 Apr-06 Apr-07 Apr-08 Apr-09
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Source: NSE India

Cash segment deliverable volumes relatively lower; appear to be stabilizing subsequent to improving economic growth Over the past 3-4 quarters, brokerage firms are experiencing pressure on their brokerage yields. As mentioned above, the southward trend had been largely at the back of change in the volume mix (increasing share of low yield index and stock options). Moreover, this is also due to a decline in deliverable volume (cash segment) which is relatively more profitable for stock broking companies as compared to future and options segment. However, over the past 4-5 months improvement in retail participation and some improvement in retail investor sentiments led to an improvement in the overall deliverable volumes; it stood at 23.1% duringDec-09. Further, a polynomial trend line indicates improvement in the overall deliverable volumes. We are of the view that improved deliverable volumes will aid brokerage yields of capital market intermediaries.
% of delivery to value of shares traded
35 30 25 20 15 Jul-05 Jan-06 Apr-05 Jan-10 7 Oct-05 Oct-06 Oct-07 Oct-08 Oct-09

Cash segment deliverable volumes showing signs of improvment

Source: NSE India

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We expect stock market volumes to grow at 15% CAGR over FY10-12 In the wake of global financial market turmoil, Indian stock markets remained subdued during FY09, clocking de-growth in overall volumes of 15% yoy. Revival in economic activity and improving Indian corporate performance has abetted capital market rally during FY10. The overall stock market volumes grew by 61% in FY10. Strong growth in capital market volumes was largely driven by F&O volumes, which comprise of 77% of the total volumes and have grown at 66% CAGR over FY05-10 as compared to overall capital market CAGR of 55%. Considering a strong economic growth (nominal) of 14.5% in FY11 and 15% in FY12 leading to a healthy growth in household financing saving will be the key driver for capital market volumes. We expect the overall stock market volumes to growth at a CAGR of 15% during FY10-12; the same has been factored in our working for the companies to arrive at the fair price target for the stocks.
Capital market volume estimate
FY08 GDP % chg Household Financial Savings % chg Financial savings/ GDP Share & Debenture of Financial Savings % chg Share & Debenture/Household savings (%) Share & Debenture/GDP (%) Capital Mkt Volume % chg CAGR (%) 4,540,987 13 715,994 10 16 89,134 52 12 2 5,660,392 74 FY09 5,228,650 15 746,865 4 14 19,349 -78 3 0 14,861,665 163 FY10E 5,868,332 12 747,612 10 13 38,698 100 5 1 23,177,844 56 FY11 6,719,240 15 748,546 13 11 48,373 25 6 1 25,869,075 12 FY12 7,727,126 15 749,669 15 10 62,884 30 8 1 30,908,505 19 15

We expect capital market volume to grow at 15% CAGR over FY10-12

Source: RBI, MOSPI, NSE India, BSE, Kotak Securities - Private Client Research

Increased thrust on developing retail clientele; aim for steady margins going forward Retail investors contribute close to 50% of the total capital market volumes and also provides cross selling opportunities for higher fee income. Therefore, with the improved capital market volumes and stock broking companies have increased focus on developing retail business segment. Domestic stock broking companies are expanding their pan India presence by increasing the network of branches and franchisees. Franchisee structure has been a relatively low fixed cost structure and is more preferred. However, owned branches generate higher volumes and are relatively more profitable. We are of the view that domestic strong broking companies with vast branch network are relatively immune to rising competition and will continue to hold sizeable market share.
Retail comprised of over 50% market volumes
Institutional investors 100% 80% 60% 40% 20% 0% Feb-08 Feb-09 Jun-07 Jun-08 Dec-07 Dec-08 Jun-09 Aug-07 Aug-08 Aug-09 Dec-09 Oct-07 Oct-08 Apr-07 Apr-08 Apr-09 Oct-09 Retail Proprietary

Source: NSE India

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Market share of leading players likely to moderate going forward Increased participation of foreign capital market intermediaries in India has intensified competition in the brokerage industry. Some of the major capital market intermediaries have lost market share largely in the institutional segment. The top ten stock brokers' share declined over FY09 in FY10, which now stands close to 28%; however, the industry remains largely fragmented. We have assumed a 15% growth in overall capital market volumes while capital market intermediaries (under coverage) we expect an average growth of 14% in volumes during FY11 - Edelweiss - 16% yoy (following acquisition of anagram and diversification into retail broking business), IIFL-13.5% (lower than average), MOFS-11.3% (lower than average). A lower than average growth rate of capital market intermediaries will result in reduction in the market share of capital market intermediaries to persist during FY11-12. However higher impetus on higher brokerage yield cash segment will help stabilize brokerage yield. This, we opine will be the key revenue growth driver for well diversified (agency based and capital market intermediaries.
Market share of leading brokers
Indian Infoline 63 60 40 20 0 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 55 45 42 31 25 27 33 28 50% 2.4 25% 1.2 0% FY05 FY06 FY07 FY08 FY09 FY10 1.9 2.4 3.4 3.8 3.8 3.5 4.1 4.7 4.2 3.3 100% 75% 3.3 4.8 5.0 5.9 6.4 6.5 Motilal Oswal Edelweiss

Market share to remain under pressure following increased competition

Market share of top 10 brokers


80 73

Source: NSE, complied by Kotak Securities - Private Client Research

Source: NSE, complied by Kotak Securities - Private Client Research

Brokerage yields of the capital market intermediaries under pressure; expected to stabilise going forward Stock market volumes have undergone significant change over FY05-10. Stock market volumes are more skewed towards low brokerage yield F&O segment than cash and delivery segment (which is relatively higher brokerage yield segments), thus, tempering overall brokerage yields of most of the capital market intermediaries. The average yields in the stock broking business hover around 0.07%.
Brokerage yields impacted following change in volume mix

Further, we are of the view that despite increased competition in the stock broking industry, leading players with a well established institutional as well as retail business will be able to maintain steady brokerage yields. IIFL, which hold a competitive position with one of the highest brokerage yields of around 8bps, following its strong foothold in the retails business is expected to witness marginal tempering which is largely build in the stock valuation. However, players like MOFS and Edelweiss Capital are expected to maintain stable brokerage yield going forward. Edelweiss capital's brokerage yield is expected to be supported by its retail foray while brokerage yield of MOFS are likely to remain firm given its impetus on high yield cash and delivery segment.

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Industry diversifying revenue streams; diversification through inorganic growth route likely - industry ripe for consolidation Indian stock broking companies have diversified into fee based capital market related business like investment banking, private equity and asset management. Although overall stock market volumes have improved significantly during the last decade, market share of top 10 brokers has slipped to 27% from a high of 92% in FY97. Most of the large broking houses with strong balance sheet, sizeable market share are now looking at expanding their market share in both - institutional as well as retail segment. Capital market intermediaries who have significant presence in the institutional segment are looking at expanding in the retail segment and vice versa. We opine that consolidation in the stock broking industry is likely. Acquisition of Anagram capital (well known retail brokerage house) by Edelweiss Capital (prominent institutional brokerage house and investment banker) is an initiation of consolidations in the industry. In contrast to this, Reliance capital, which has a well established retail broking arm Reliance money, has acquired an institutional investment advisory firm Quant capital. We opine that diversification will benefit companies, by balancing their revenue streams, brokerage & commissions and higher contribution from fee based income.
Valuations
Companies FY10 Indian Infoline Motilal Oswal Edelweiss Capital 11,239 6,453 9,690 Revenue (Rsmn) FY11E 12,969 7,096 12,710 FY12E 14,772 7,881 14,679 FY10 2,320 1,704 2,205 PAT (Rs mn) FY11E 2,661 1,857 2,816 FY12E 3,139 2,070 3,307 FY10 8.1 12.0 30.6 EPS (Rs) FY11E 9.3 13.1 38.9 FY12E 11.0 14.6 45.5

Source: Companies, Kotak Securities - Private Client Research

Capital market intermediaries' performance largely dependent on capital market volumes; valuations largely appear attractive for IIFL, we recommend buying; while we recommend accumulating Edelweiss and MOFS on declines following rich valuations.
Capital market intermediary performance linked to market volume, recommend to BUY IIFL, ACCUMULATE MOFS and ECL

n In the wake of improving capital market volumes and largely flat brokerage yields coupled with strong growth in fee based income, we expect healthy growth in earnings for capital market intermediaries in India over FY11 and FY12. Capital market intermediaries have increased thrust on their lending business, which we opine will boost their return ratios going forward. Thus we expect steady improvement in their return ratios for FY11 and FY12 n We are valuing Edeweiss Capital Ltd at 14% discount to its Median P/Ex, i.e. 13.5x its FY11 EPS of Rs.38.9; leading to a price target of Rs.525. We have assigned a discount to ECL's historic valuation to factor in shift of capital to newer businesses viz retail broking. Improved capital market outlook is expected to drive earnings growth. We are initaiating coverage on Edelweiss capital with a price target of Rs. 525. However, at the current levels valuation apperas rich and despite a positive business growth outlook we recommend accumulating the stock on declines given the limited upside of 4% from current levels.

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n We are valuing IIFL at P/E of 13.5x its FY11 estimated EPS of Rs.9.3, thus assigning a 13% discount to IIFL's median P/E of 15.3x . On a relative basis this translates to a 15% discount of benchmark Sensex P/Ex of 16.5x. We initiate coverage on IIFL with Buy recommendation and a price target of Rs. 126. n We are valuing MOFS at its Median P/Ex of 13.5x its FY11 estimated EPS of Rs. 9.3. At 13.5x P/Ex of FY11E EPS, the fair price target for MOFS will be Rs. 171, which offers limited upside of 3.7% from current levels. Hence, recommend accumulating the stock at declines with price target of Rs.177
Relative to Sensex
80 60 40 20 0 May-06 May-07 May-08 May-09 May-10 Jan-06 Jan-07 Jan-08 Jan-09 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Jan-10 IIFL PE Sensex ECL PE MOFS PE

Source: Bloomberg, Kotak Securities - Private Client Research

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COMPANIES

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Sarika Lohra sarika.lohra@kotak.com +91 22 6621 6313

INDIA INFOLINE LTD


PRICE : RS.100 TARGET PRICE : RS.126 RECOMMENDATION : BUY FY11E PE: 10.7X

Stock details
BSE code NSE code Market cap (Rs bn) Free float (%) 52-wk Hi/Lo (Rs) Avg. daily volume BSE Avg. daily volume NSE Shares o/s (mn) Source: Capitaline : : : : : : : : 532636 INDIAINFO 28.5 66 173/45 1041167 3212007 283.4

Summary table
(Rs mn) FY10 FY11E 12,958 11 12,969 4,986 2,661 38.4 20.5 61.6 28.3 9.3 63 15.7 7.9 10.7 1.6 FY12E 14,760 12 14,772 5,776 3,139 39.1 21.2 60.9 28.3 11.0 69 16.6 8.2 9.1 1.4

Income from opns 11,229 Other income Total income EBITDA PAT PAT Margins (%) Operating Exp/ Total Income Employee Cost/ Total Income EPS Book Value RoE RoA P/E P/BV 28.3 8.1 56 14.7 9.2 12.3 1.8 61.1 10 11,239 4,373 2,320 20.6

India Infoline (IIFL) is one of the leading brokerage houses in India offering a spectrum of investment related services to institutional and retails customers. With a well established retail branch network of over 2000 outlets and expansion into institutional equity business, IIFL is expected to maintain its market share at around 4%, while its brokerage yields are likely to remain largely stable at close to 0.07-0.08%. We are of the view that, growth in other businesses including investment banking, insurance distribution, wealth management and lending business is expected to remain steady. Higher thrust on lending and investment banking business is expected to boost IIFL's return ratios. We expect a net profit of Rs.2.6bn and Rs.3.1bn for FY11 and FY12 respectively, with an EPS of Rs.9.3 and Rs. 11.0. Strengthening return ratios are expected to support premium valuation. The stock is currently trading at P/Ex of 10.7x based on FY11 estimates and 9.1x its FY12 earnings estimates. At the current levels, stock valuations appear attractive. Therefore, we are initiating coverage on India Infoline Ltd with accumulate recommendation and 12-month price target of Rs. 126

EBIDTA Margins (%) 38.9

Investment Rationale
q Brokerage income likely to remain significant part of the total operating income. IIFL's strong retail presence and a foray into institutional business have aided healthy brokerage income growth over FY06-10. IIFL's brokerage income contributed close to 54% of the operating income in FY10 as compared to 70% in FY05, witnessing a CAGR of 44% over FY05-10. With stable market share of 3.8% (FY10) and brokerage yield of close to 8bps, we expect a healthy CAGR of 14% in IIFL's brokerage revenue over FY10-12. We expect the secondary capital market volumes to witness a CAGR of 15% over FY10-12 and the IIFL's brokerage revenue to total income will continue to form close to 50-55% of the total revenue during FY11 and FY12. IIFL has a healthy mix of fund based and fee income. While brokerage revenue will continue to have significant contribution to the overall earnings, we opine that increased thrust on both fund-based (interest income from lending business -26% of the revenue) and fee- based (life insurance distribution, asset management and investment banking etc) business will boost return ratios for IIFL going forward. q Retail broking & distribution- robust branch network offers opportunity to cross sell; well developed online trading platform offers cost effectiveness. IIFL follows a multi-channel delivery model for its retail broking and distribution business. It has rapidly enhanced its retail broking business over the past 5-year, increasing the branch network from 80 in FY05 to over 2300 outlets in FY10. This includes close to 500 owned branches and over 1800 franchisees. Additionally it has efficiently developed the online broking platform through its websites www.indiainfoline.com and www.5paisa.com to enhance its reach to the customers and offer service through this cost effective distribution platform. . We opine that although the franchisee model is beneficial during the downturn due to its cost effectiveness; however, in the long run strong network of owned branches aid higher trading volumes support firm brokerage yields.

Source: Company, Kotak Securities - Private Client Research

Shareholding pattern

Public & others 14% Corporate 4% Foreign 28%

Promoters 34%
Source: Capitaline

Institutions 20%

1 year performance (Rel to sensex)


Sensex

India Infoline

Source: Capitaline

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June 22, 2010

q Strong and well recognized research team. Revenue from broking business has witnessed significant uptick post incorporation of its institutional business during FY07-08, which grew by 150% to Rs.24.3bn from Rs.9.7bn in FY07. We expect that institutional broking revenue will continue to be key growth driver given expected increase in FII inflow in India going forward. IIFL's analysts have won awards at several forums & have been among the top ranked analysts in several surveys. It has also received the BQ1 Broker Rating from CRISIL. CRISIL broker's rating reflects its opinion on the quality of operation and services provided by the stock broker. As per CRISIL's grading system brokers are graded on a 5 point scale ranging from BQ1 to BQ5 where BQ1 is the highest. q Lending growth to pick up. IIFL, though its consumer finance subsidiary offers - personal loans, mortgage loans margin funding, loan against share (LAS) and debentures. Its advances book has grown over two-fold; from Rs.3.29bn in FY08 to Rs10.17bn in FY09. IIFL has been maintaining adequate risk cover on its lending book. It has a 2.5-3x collateral coverage on its financing book. This has aided in maintaining healthy asset quality performance. Its NNPA in FY10 stood at close to 1%. It has received approval from RBI for setting of a housing finance company. Low leverage on loan book offers attractive opportunity to expand lending business, given that it has a prudent risk management system in place. Going forward, we expect steady growth in IIFL's corporate and retail loan book in the backdrop of improving macroeconomic scenario. q Growing contribution from wealth management businesses. The Indian wealth management industry is gearing up to meet the expanding market opportunities. According to a McKinsey report India's household disposable income, which grew at 3.6% during 1985-2005 is expected to grow at the rate of 5.3% over 2005-2025 to Rs.3,20,000. The robust business network coupled with strong macroeconomic factors offers IIFL an opportunity to rapidly scale up its asset management business. IIFL, through its offshore fund management business, (operating with a brand name of 'IIFL Capital') is planning to raise close to $500mn from overseas financial institutions to set up a fund of funds. It will raise funds from institutions across Asia, West-Asia, Europe and the US for the Resilient India Growth Fund which will invest in Indian mutual funds. q Insurance brokerage business to grow at a relatively slower pace over FY11-FY12. IIFL had been the leading life insurance distributor for ICICI Prudential life insurance. The company has also entered into tie-up with other insurance companies, which includes Max New York Life, MetLife, Kotak Life, Birla Sunlife and Reliance etc. We opine that, with a relatively slower growth in new business premium in the overall life insurance industry, the contribution from insurance brokerage business will continue to witness a moderate growth trend going forward. We expect a 11% CAGR over FY10-12 to Rs.664mn, which forms around 4.5% of the total revenue. q Higher impetus to investment banking; expected to boost return ratios going forward. Improvement in global macroeconomic scenario post May 2009 has led to an increase in deal flow in the investment banking business during the FY10 which aided a 16 fold growth in its investment banking income to Rs.388mn as compared to Rs 23bn in FY09. The share of investment banking revenue stood at 10% of the total revenue. During FY10 IIFL has completed close to 10 investment banking transactions including 7 ECM (IPOs and QIPs) transactions of the total 140 deals concluded during FY10. This indicates a market share of 5% in investment banking (ECM) segment) With benign capital markets and a sanguine investor sentiment, we opine that the growth in the Investment banking business is likely to remain buoyant as the investment banking deal pipeline is expected to remain strong over FY11-12.

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Valuation and recommendation


We initiate coverage on IIFL with BUY recommendation and a price target of Rs. 126.

q In the wake of improving capital market volumes and strong growth in fee based income, we expect strong growth in earnings for IIFL for FY11 and FY12. We expect the share of lending business related income to increase; this is also expected to boost IIFL's return ratios going forward. We expect RoE to improve to 16% in FY11 and 17% for FY12. Improving return ratios will act as key rerating catalyst for the stock. q We are valuing IIFL at P/E of 13.5x its FY11 estimated EPS of Rs.9.3 to arrive at a fair price target of Rs. 126. At current market price that stock is trading at 10.9x its FY11 P/E, which is an attractive upside of 26% from current levels. Hence, we initiate coverage on IIFL with Buy recommendation and a price target of Rs. 126.

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COMPANY BACKGROUND
India Infoline Ltd. (IIFL) is one of the leading financial services company engaged in the stock broking and financial services business. The company provides equity and debt related products and services like equity broking to retail and institutional clients, investment management (wealth management), insurance distribution, and consumer financing. IIFL broadly operates in six business segments, through its subsidiaries which include stock broking, investment banking, asset management & wealth management, consumer finance, and insurance distribution. Brokerage income likely to remain significant part of the total operating income n In the wake of global financial market turmoil stock market volumes witnessed de-growth during FY09. However, with a revival in economic activity and a positive outlook on the India's corporate earnings growth, outlook for capital market intermediaries appears positive going forward. IIFL's strong retail presence and a foray into institutional business have aided healthy brokerage income growth over FY06-10. IIFL's brokerage income contributed close to 54% of the operating income in FY10 as compared to 70% in FY05, witnessing a CAGR of 44% over FY05-10.
Brokerage income will continue to form signifncant part of total revenue

n With stable market share of 3.8% (FY10) and brokerage yield of close to 8bps (expected to witness pressure due to increasing pressure on institutional brokerage yield), we expect a healthy CAGR of 14% in IIFL's brokerage revenue over FY10-12. We expect the secondary capital market volumes to witness a CAGR of 15% over FY10-12 and the IIFL's brokerage revenue to total income will continue to form close to 50-55% of the total revenue during FY11 and FY12. n IIFL has a healthy mix of fund based and fee income. While brokerage revenue will continue to have significant contribution to the overall earnings, we opine that increased thrust on both fund-based (interest income from lending business -26% of the revenue) and fee- based (life insurance distribution, asset management and investment banking etc) business will boost return ratios for IIFL going forward. n Institutional business drives market share while retail segment aids brokerage yield- IIFL ventured into institutional brokerage business during FY2007 after the competitive management team from CLSA joined in. This led to strong growth in its brokerage revenues over FY07-08. At its institutional equities arm, IIFL has been able to scale up its research capabilities along with client base significantly. IIFL's client list embraces practically all large domestic as well as global institutional investors active in India.

Equity brokerage Income & market share


Equity brokerage income (Rs mn - LHS) 2500 2000 1500 1000 500 0 Q1FY07 Q2FY07 Q3FY07 Q4FY07 Q1FY08 Q2FY08 Q3FY08 Q4FY08 Q1FY09 Q2FY09 Q3FY09 Q4FY09 Q1FY10 Q2FY10 Q3FY10 Q4FY10 Market share (% - RHS) 5 4 3 2 1 0

Brokerage yield (%)


0.12 0.09 0.06 0.03 0.00 FY07 FY08 FY09 FY10E FY11E FY12E 0.11 0.11 0.10 0.07 0.08 0.08

Source: Company

Source: Company, Kotak Securities - Private Client Research

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n Its average daily volume clocked a CAGR of 53%, from Rs.9.7bn in FY07 to Rs.35.0bn in FY10 as compared to a 22% CAGR in overall stock market volumes. Its market share improved to 3.8% in FY10, along with healthy brokerage yields of close to 8-9bps, which is one of the best in the brokerage industry. From current levels, we expect marginal pressure on IIFL's brokerage yield, which is expected to be maintain at around ~8bps, coupled with firm market share of ~3.8% over FY11-12. We expect a CAGR of 15% in its brokerage revenue over FY09 - FY12. . Retail broking & distribution- robust branch network offers opportunity to cross sell; well developed online trading platform offers cost effectiveness n IIFL follows a multi-channel delivery model for its retail broking and distribution business. It has rapidly enhanced its retail broking business over the past 5-year, increasing the branch network from 80 in FY05 to over 2300 outlets in FY10. This includes close to 500 owned branches and over 1800 franchisees. We opine that although the franchisee model is beneficial during the downturn due to its cost effectiveness; however, in the long run strong network of owned branches aid higher trading volumes support firm brokerage yields.
Higher thrust on retail broking business, strong network provides an edge

n Additionally it has efficiently developed the online broking platform through its websites www.indiainfoline.com and www.5paisa.com to enhance its reach to the customers and offer service through this cost effective distribution platform. n A strong branch network has not only facilitated in building a larger customers base of over 6-lakh customers, but has also aided in cross selling various financial products and services like life insurance and mutual funds to retail customers. n Moreover, its pan-India presence has offered IIFL a business edge in extremely competitive retail broking business. It has aided in developing other related businesses such as financing, wealth and asset management etc. n IIFL has also started international operation through its offices in key locations, which are -New York, Singapore, Dubai, Brazil, Russia and UK. This augments accessing non-resident Indians and large institutional investors, through which it offers advisory and investment services to its customers.
Retail clients, branches & average daily volumes
2,400 1,800 1,200 600 0 FY05 FY06 FY07 FY08 FY09 FY10 Retail client ('000 - LHS) Branches (Nos - LHS) Average Daily volume (Rs mn - RHS) 40,000 30,000 20,000 10,000 -

Source: Company

Kotak Securities - Private Client Research

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June 22, 2010

Strong and well recognized research team n IIFL initiated its institutional brokerage business in 2007-08 and strengthened it by bringing on board a well equipped institutional team from CLSA. It is empanelled with close to 200 active foreign institutional investors and domestic mutual funds, which will continue to aid in expanding its institutional broking business. n IIFL has ramped up its institutional business swiftly, having a team of close to 25 analyst and coverage on over 150 stocks. Research based advisory system create significant value for brokerage business and also helps in building a strong brand in the long-run. We expect IIFL to benefit from that. n Revenue from brokering business has witness significant uptick post incorporation of its institutional business during FY07-08, which grew by 150% to Rs.24.3bn from Rs.9.7bn in FY07. We expect that institutional broking revenue will continue to be key growth driver given expected increase in FII inflow in India going forward. n IIFL's analysts have won awards at several forums & have been among the top ranked analysts in several surveys. It has also received the BQ1 Broker Rating from CRISIL. CRISIL broker's rating reflects its opinion on the quality of operation and services provided by the stock broker. As per CRISIL's grading system brokers are graded on a 5 point scale ranging from BQ1 to BQ5 where BQ1 is the highest. Diversification into related business n IIFL has a well diversified business model, with its brokerage revenue comprising of close to 55% of the total income. The Balance non-brokerage revenue includes income from lending business, marketing and online media, life insurance brokerage, wealth management and investment banking. n IIFL has increased its thrust on ramping up asset management business which will aid its fee- based income. Although all the related businesses are linked to capital market, it provides some buffer to the operating income in the event of lackluster stock market volumes, which directly impacts the brokerage revenues. Lending growth to pick up n IIFL, though its consumer finance subsidiary (100%; post -acquisition of Orient Global's 22% stake in the business), offers - personal loans, mortgage loans margin funding, loan against share (LAS) and debentures. Its advances book has grown over two-fold; from Rs.3.29bn in FY08 to Rs10.17bn in FY09.
Higher impetus on lending business, expect healthy growth in interest income stream

n During FY10 its financing book stood at Rs 16.3bn up by 61% yoy, comprising mainly of secured mortgaged loans (42%) and margin funding (36%). While exposure to personal loans and loan against shares (LAS) remain relatively lower. This is mainly on account of lower business risk and attractive yields of close to 16%-17% on mortgage loans and margin funding segments. n IIFL has been maintaining adequate risk cover on its lending book. It has a 2.53x collateral coverage on its financing book. This has aided in maintaining healthy asset quality performance. It's NNPA in FY10 stood lower than 1%. n Going forward, we opine that, with its strong risk management capabilities and appropriate risk cover will support asset quality. We expect net NPA of less than 1% over FY11 and FY12. n It has received approval from RBI for setting of a housing finance company. Low leverage on loan book offers attractive opportunity to expand lending business, given that it has a prudent risk management system in place. Going forward, we expect steady growth in IIFL's corporate and retail loan book in the backdrop of improving macroeconomic scenario.

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Lending breakup (FY09)


LAS/Deben tures 16%

Lending breakup (FY10)


LAS/Deben tures 16% Personal loans 6%

Personal loans 18%

Margin funding 12%

Mortgage loan 54%

Margin funding 36%

Mortgage loan 42%

Source: Company

Source: Company

Growing contribution from wealth management businesses n The Indian wealth management industry is gearing up to meet the expanding market opportunities. According to a McKinsey report India's household disposable income, which grew at 3.6% during 1985-2005 is expected to grow at the rate of 5.3% over 2005-2025 to Rs.3,20,000. The robust business network coupled with strong macroeconomic factors offers IIFL an opportunity to rapidly scale up its asset management business. n During FY09, IIFL received approval from the monetary authority of Singapore to carry out corporate advisory and dealing in securities. Its Singapore arm offers brokerage, asset management and investment banking services to institutional and individual investors in Singapore. n IIFL started its wealth management business in 2006, and it has witnessed a strong growth in its asset under management, which for FY10 stands at Rs. 52.5bn, and contributes over 3% of the total revenue. Its wealth management team offers advisory and investment services to high net worth individuals operating under the brand name of 'IIFL Wealth'. India Infoline recently got approval from capital market regulator SEBI and is expects to start mutual fund operations by the first quarter of the next financial year. n IIFL, through its offshore fund management business, (operating with a brand name of 'IIFL Capital') is planning to raise close to $500mn from overseas financial institutions to set up a fund of funds. It will raise funds from institutions across Asia, West-Asia, Europe and the US for the Resilient India Growth Fund which will invest in Indian mutual funds.
Wealth management income & percentage of total revenue
250 200 150 6.0 100 50 0 Q1FY07 Q2FY07 Q3FY07 Q4FY07 Q1FY08 Q2FY08 Q3FY08 Q4FY08 Q1FY09 Q2FY09 Q3FY09 Q4FY09 Q1FY10 Q2FY10 Q3FY10 Q4FY10 3.0 0.0 Wealth mangement (Rs mn) (LHS) % of total revenue (RHS) 12.0 9.0

Source: Company

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Insurance brokerage business to grow at a relatively slower pace over FY11-FY12 n IIFL had been the leading life insurance distributor for ICICI Prudential life insurance. The company has also entered into tie-up with other insurance companies, which includes Max New York Life, MetLife, Kotak Life, Birla Sunlife and Reliance etc. n IIFL's insurance distribution business contributed close to 14% of its total revenue in FY07 and 10% in FY08 following a strong growth in first year premium income in the backdrop of upbeat capital market. However, during FY09 life insurance distribution income dropped significantly by 52% to Rs.481bn forming 5% of total income. n Improvement in overall sentiments and During FY10, IIFL's life insurance distribution income has witnessed a healthy growth of 11% yoy forming 5% of the total income. Going forward, the outlook of the business is largely linked with the industry fortunes, IIFL's position as a broker is expected to consolidate.
Share of insurance distribution income expected to remain lower

n We opine that, with a relatively slower growth in new business premium in the overall life insurance industry, the contribution from insurance brokerage business will continue to witness a moderate growth trend going forward. We expect a 11% CAGR over FY10-12 to Rs.664mn, which forms around 4.5% of the total revenue.
Declining share of life insurance distribution income
Life insurance distribution (Rs mn - LHS) 1200 900 600 300 0 FY06 FY07 FY08 FY09 FY10 10.1 14.1 9.9 % of total Revenue (RHS) 16 12 5.0 8 4 0

4.8

Source: Company

Higher impetus to investment banking; expected to boost return ratios going forward n IIFL, which initiated the investment banking business in 2005, witnessed a slowdown in the merchant banking revenue during FY09 following drying up of the primary market. Its investment banking revenue de-grew significantly to Rs.230mn as compared to Rs.1.6bn in FY08.
Strong investment banking team in place, strong deal pipeline to drive growth

n Nonetheless, improvement in global macroeconomic scenario post May 2009 has led to an increase in deal flow in the investment banking business during the FY10 which aided a 16 fold growth in its investment banking income to Rs.388mn as compared to Rs 23mn in FY09. The share of investment banking revenue stood at 10% of the total revenue. During FY10 IIFL has completed close to 10 investment banking transactions including 7 ECM (IPOs and QIPs) transactions of the total 140 deals concluded during FY10. This indicates a market share of 5% in investment banking (ECM) segment) n With benign capital markets and a sanguine investor sentiment, we opine that the growth in the Investment banking business is likely to remain buoyant as the investment banking deal pipeline is expected to remain strong over FY1112. Increased revenue contribution from its investment banking business will be boosting its return ratios.

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Media and online businesses n IIFL's media and online business comprise of revenue from advertisement on its websites www.indiainfoline.com and www.5paisa.com by way of website banner, micro-sites, and other marketing and promotional activities. This also includes revenue from sale of research reports to customers. Revenue from this stream has witnessed a CAGR of close to 30% over FY05-10. n The media and online business contributed close to 6% to IIFL's topline during FY10 to Rs.659mn. This income stream de-grew during FY09 following unfavorable capital market conditions. However with the re-launch of a revised version during 3QFY10, IIFL has witnessed an uptick in the revenue from this income stream during 2HFY10. Given the improving advertisement spend by Indian corporate; we expect healthy revenue growth going forward.
Media and online business revenue to pick up
350 280 210 140 70 0 Q1FY08 Q2FY08 Q3FY08 Q4FY08 Q1FY09 Q2FY09 Q3FY09 Q4FY09 Q1FY10 Q2FY10 Q3FY10 Q4FY10 Media and online income (LHS) % of total (RHS) 15.0 12.0 9.0 6.0 3.0 0.0

Source: Company

Financials
Healthy growth in revenue supported by improved brokerage volumes and higher growth in advances; related businesses contribution to improve n Indian capital markets have seen increase in institutional inflows- both domestic and foreign. FII have invested close to $20bn during FY10 as compared to a net outflow of $10bn during FY09. Moreover, Indian stock market has also seen revival in retail participation reflective in the NSE data and opening of new DP accounts with NSDL. n The stock markets have seen improvement in average traded volumes post a significant plunge in FY09 in the wake of global financial turmoil. We are of the view that, in the backdrop of healthy stock market volumes and firm brokerage yields, IIFLs revenue growth during FY11-12 will continue to remain steady. n Moreover, improved growth in newer businesses such as investment banking (which has a strong pipeline), financing business and growing asset management business will lead to higher contribution from these businesses going forward. n We expect an overall revenue growth of 15% yoy to Rs.12.9bn for FY11 and 14% yoy to Rs.14.7bn for FY12. Revenue from brokerage and financing business (55% of the total revenue) will continue to contribute material share of the total revenue.

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Revenue breakup (Rs mn)


14000 10500 7000 3500 0 FY10E FY11E FY05 FY06 FY07 FY08 FY09 Merchant Banker Wealth and Mutual fund advisory Commodities brokerage & related Life insurance distribution Marketing and online media Financing and investments Equity brokerage and related

Source: Company; Kotak Securities - Private Client Research

Financing business to gain traction, we expect loan book of Rs.19.6bn in FY11 and Rs 22.5bn FY12 n Advances book grew by 61% yoy in FY10 to Rs.16.3bn as compared to Rs.10.2bn in FY09. The strong growth is attributable to higher growth in mortgage loans and margin funding business. Its income was however impacted by softening of interest rates during FY10 as compared to interest rate levels prevailing in FY09. Interest income from financing business grew by a moderate 10% yoy to Rs.2.9bn in FY10 as compared to Rs.2.6bn in FY09 n IIFL's lending book, which largely comprises of mortgage loans and margin funding, is expected to witness a strong growth going forward. This is mainly because these two segments (mortgage loans and margins funding) will continue to be key focus areas for the company as it offers attractive yields of around 16%-17%. n We maintain our positive outlook for IIFL's financing business, on the back of steady growth in its loan book, while income from financing business will continue to remain key contributor to IIFL's top-line. n We expect a 20% yoy growth in IIFL's loan book during FY11 to Rs. 19.6bn and 15% yoy in FY12 to Rs.22.5bn. Going forward, in the wake of benign interest rate scenario; we expect strong growth of 23% yoy to Rs. 3.4bn and 18% yoy to Rs.3.9bn in IIFL's income from financing business during FY11 and FY12 respectively. Stable margins- both at the operating and net levels; we expect a net profit growth of 12% yoy and 15% yoy for FY11 and FY12 respectively n In the light of improved stock market volumes and steady brokerage yields at around 8-9bps, we expect that IIFL will be able to maintain stable operating profit margin and net profit margin going forward. Its FY09 margins, both at the operating as well as net level, were lower due to lower stock market volumes which also impacted income from related business viz investment banking, asset management, life insurance distribution etc. n The improvement in stock market volumes and improvement in investor sentiments has aided growth in its top-line during FY10. IIFL's competitive market share of around ~3.9% and healthy brokerage yield at 8-9bps has aided in improving operating margins to ~38% and net profit margins to 20% during the FY10, which is a commendable improvement over 30% Operating margins and 15% PAT margins for FY09.

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n The notable improvement in operating efficiency is also supported by the measures adopted towards cost optimization, IIFL commissioned a state-of-the-art facility in Chennai for its back office and call center operations. We opine that this has aided in controlling its operating cost. This will also be significantly beneficial for the company in the long run. n Importantly. IIFL's employee cost ratio largely remained stable in FY10 to 28% as compared to 28.4% in FY09 despite a 16% increase in employee cost. Going forward, in the wake of high attrition nature of the stock broking industry, we opine that talent retention measure will lead to its employee cost. We have factored in a 15% and a 14% increase in employee cost over FY11 and FY12 respectively. n Therefore, going forward, we expect a stable operating margin of 38% over FY11 and 39% in FY12 and net profit margin of 20% during FY11 and 21% in FY12. This we opine that this will translate to a healthy growth in bottom-line to Rs.2.6bn and Rs 3.1bn over FY11 and FY12 respectively.
EBIDTA & PAT margins (%)
45 38 31 24 17 10 FY05 FY06 FY07 FY08 FY09 FY10 FY11E FY12E Source: Company, Kotak Securities - Private Client Research EBITDA (%) PAT Margin (%)

Operating efficiency (%)


Operting cost/Income 80 60 40 20 0 FY05 FY06 FY07 FY08 FY09 FY10 FY11E FY12E
Source: Company, Kotak Securities - Private Client Research

Employee cost/Income 70 61 61 62 61

62

60

67

25 13 17

24

28

28

28

28

We expect healthy earnings growth trend over FY11-FY12 n We expect healthy growth in earnings for IIFL on the back of improve macroeconomic scenario which led to revival in stock market volumes and thus the brokerage revenue. In addition to this, strong investment banking deal pipeline and a fast ramping up of asset management business would support IIFL's fee based income which will also boost its return ratios. n We opine that, in the wake of buoyant capital markets and pickup in fresh disbursements in the consumer finance business, IIFL is expected to witness steady growth in its bottom-line. Going forward, IIFL's net profit is expected to growth by 15% yoy during FY11 to Rs. 2.6bn and by 18% yoy to Rs. 3.1bn in FY12.

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June 22, 2010

Trading at 10.9x FY11 P/Ex, recommend buy with a price target of Rs. 126. n In the wake of improving capital market volumes and strong growth in fee based income, we expect strong growth in earnings for IIFL for FY11 and FY12. We expect the share of lending business related income to increase; this is also expected boost IIFL's return ratios going forward. We expect RoE for FY11 to improve to 16% and to 17% in FY12. Improving return ratios will act as key rerating catalyst for the stock.
We initiate coverage on IIFL with BUY recommendation and a price target of Rs. 126.

n IIFL at current levels appear attractive post the significant correction. At 10.9x FY11 P/Es compared to its historic median P/Ex of 13.5x and the stock also offer attractive upside from current levels. IIFL's one-year forward rolling P/E chart also indicated that the stock is presently trading at discount to its peer, hence, based on attractive valuations we prefer IIFL over its peer. n We are valuing IIFL at P/E of 13.5x its FY11 estimated EPS of Rs.9.3 to arrive at a fair price target of Rs. 126. At current market price that stock is trading at 10.9x its FY11 P/E, which is an attractive upside of 26% from current levels. Hence, we initiate coverage on IIFL with Buy recommendation and a price target of Rs. 126.

Relative to Sensex
80 60 40 Sensex P/E IIFL P/E

PE Band
500 400 300 200 IIFL 10 15 20 25 30

20 0 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10

100 0 May-06 May-07 May-08 May-09 May-10 24 Jan-06 Jan-07 Jan-08 Jan-09 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Jan-10

Source: Bloomber, Kotak Securities - Private Client Research

Source: Capitaline, Kotak Securities - Private Client Research

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June 22, 2010

FINANCIALS
Profit and Loss Statement (Rs mn)
(Year-end March) Income from operations Other income Total income Operating expenses Employee cost Direct Cost Other operating expenses EBITDA Interest Depreciation PBT Taxes Profit before MI Minority interest PAT FY09 9,607 24 9,631 6,708 2,737 2,068 1,904 2,923 332 396 2,195 622 1,573 125 1,448 FY10 11,229 10 11,239 6,866 3,179 1,676 2,011 4,373 291 535 3,547 1,207 2,340 21 2,320 FY11E 12,958 11 7,982 3,668 2,002 2,312 4,986 364 615 4,007 1,322 2,685 24 2,661 FY12E 14,760 12 8,997 4,178 2,159 2,659 5,776 373 676 4,726 1,560 3,166 28 3,139

Balance sheet (Rs mn)


(Year-end March) Equity Capital Reserves and Surplus Networth Borrowings Minority interest Total liabilties Application of funds Fixed Assets Investments Deferred Tax assets Loans and advances Current assets Current liabilities Net current assets Total Assets 2,853 3,150 120 13,618 8,748 9,398 12,968 19,090 4,374 4,820 157 23,130 14,847 15,919 22,058 31,408 5,168 5,543 157 25,443 15,756 15,919 25,280 5,020 6,374 157 28,114 16,726 15,919 28,921 FY09 567 14,880 15,447 518 3,125 19,090 FY10 570 15,479 16,049 15,177 182 31,408 FY11E 570 17,341 17,912 18,030 206 FY12E 570 19,225 19,795 20,444 234

12,969 14,772

36,148 40,472

36,148 40,472

Source: Company, Kotak Securities - Private Client Research

Source: Company, Kotak Securities - Private Client Research

Key data
FY09 EPS (Rs) Book Value (Rs) P/E (x) P/BV (x) Efficiency ratio (%) Operating Exp/ Total Income Operating Exp/ Avg Assets Employee Cost/Total Income Employee Cost/ Avg Assets 69.7 30.8 28.4 12.6 61.1 27.2 28.3 12.6 61.6 23.6 28.3 10.9 60.9 23.5 28.3 10.9 5.1 55 19.6 1.8 FY10 8.1 56 12.3 1.8 FY11E 9.3 63 10.7 1.6 FY12E 11.0 69 9.1 1.4

Ratio Analysis
FY09 EBIDTA Margins (%) PAT Margins (%) EBITDA/Branch (Rs mn) PAT/Branch (Rs mn) Return Ratios (%) RoE RoA 9.5 6.6 14.7 9.2 15.7 7.9 16.6 8.2 30.3 15.0 1.9 1.0 FY10 38.9 20.6 1.9 1.0 FY11E 38.4 20.5 2.1 1.1 FY12E 39.1 21.2 2.3 1.3

Source: Company, Kotak Securities - Private Client Research

Source: Company, Kotak Securities - Private Client Research

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SECTOR REPORT Sarika Lohra sarika.lohra@kotak.com +91 22 6621 6313

June 22, 2010

MOTILAL OSWAL FINANCIAL SERVICES


PRICE : RS.171 TARGET PRICE : RS.177 RECOMMENDATION : ACCUMULATE FY11E PE: 13.1X

Stock details
BSE code NSE code Market cap (Rs bn) Free float (%) 52-wk Hi/Lo (Rs) Avg. daily volume BSE Avg. daily volume NSE Shares o/s (mn) Source: Capitaline : : : : : : : : 532832 MOTILALOFS 24.282 30.16 190/55 41965 74148 143.07

Summary table
(Rs mn) Income from opns Other income Total income EBITDA PAT PAT Margins (%) Operating Expenses/ Total Income Employee Cost/ Total Income EPS Book Value RoE (%) RoA (%) P/E P/BV 21.9 12.0 65.5 19.8 19.6 14.3 2.6 22.5 13.1 76.0 18.5 18.1 13.1 2.3 22.8 14.6 87.6 17.8 17.3 11.7 2.0 58.9 58.7 58.3 FY10 6,250 203 6,453 2,567 1,704 27.3 FY11E 6,837 259 7,096 2,826 1,857 41.3 27.2 FY12E 7,576 305 7,881 3,162 2,070 41.7 27.3

Motilal Oswal Financial Services is one of the leading capital market intermediaries, offering a bouquet of services to institutional and retail investors. Equity brokerage business contributes over 70% of its total revenue, while asset management business (including wealth management), and financing business forms the rest. MOFS lays impetus on high brokerage yield cash segment than low yield futures and option business, which forms over 50% of the total stock market volumes. This strategy has helped MOFS in delivering a strong growth in its operating income. Additionally, its franchisee based distribution network coupled with thrust on online trading has aided improved operating efficiency. We expect healthy operating margins and net profit margins going forward. We expect a net profit of Rs.1.8bn for FY11 and Rs.2.1bn in FY12 leading to an EPS of Rs.13.1 and Rs 14.6 for FY11 and FY12 respectively. At the current market price, the stock is trading at P/Ex of 13.1x its FY11 earnings estimates. We opine that the stock is trading close to its historic median P/Ex of 13.5x. We are valuing MOFS at P/Ex of 13.5x (at median P/ Ex) to arrive at a fair price target of Rs. 177. Our price target offers a limited upside of 3% from current levels and therefore we recommend investors to Accumulate the stock at declines.

EBIDTA Margins (%) 41.1

Investment Rationale
q Steady capital market volume to aid top-line growth. MOFS's brokerage business (under is 100% subsidiary- Motilal Oswal Securities (MOS)), akin to other brokerage house, is expected to remain the key revenue contributor for MOFSL. The equity brokerage business has witnessed a strong revival during FY10. We opine that this revenue stream will remain the key contributor to the top-line going forward. Its brokerage revenue comprises of close to 74% of the total revenue and has grown by 32.5% yoy during FY10 in the wake of steady brokerage yield and improved stock market volumes. We expect a 10% CAGR in its top-line over FY10-12, which will be largely driven by a strong growth fee based businesses- particularly asset management and investment banking. We are of the view that the diversification in to other businesses notwithstanding, brokerage will continue to be the key revenue contributor at ~70% over FY1112. q Healthy growth in brokerage revenues; courtesy higher impetus on brokerage yields, while market share may witness pressure. Secondary market average daily volumes have improved during FY10 to Rs.973.9bn as compared to Rs. 608.9bn in FY09. However, average daily volumes have remained largely stagnant over 3QFY10 (Rs. 954.9bn) and 4QFY10 (Rs.943.3bn). MOFSL's market share has declined to 2.9% in FY10 from 4.2% in FY09. Since, high yield cash segment is MOFS's key focus area, lower cash segment delivery based volumes has impacted its market share during FY10. While company remains relatively less active in the low yield F&O segment, which forms close to 77% of the total capital market volume. We are of the view that, with the company, continuing to focus on high yield cash segment its brokerage yield is expected to remain largely stable going forward. We have factored in a 15% CAGR in capital market volumes in our model. Since, brokerage revenue stream contributes a sizeable 74% to its total revenue; we expect a moderate growth of 6% yoy and 5% yoy during FY11 and FY12, which we opine will be largely driven by stable brokerage yields despite pressure on market share.

Source: Company, Kotak Securities - Private Client Research

Shareholding pattern

Public & others 11.98% Corporate holding 0.44%

Foreign 7.80% Institutions 9.94%

Promoters 69.84%
Source: Capitaline

1 year performance (Rel to sensex)


Motilal Oswal

Sensex

Source: Capitaline

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SECTOR REPORT

June 22, 2010

q Expanding distribution network for greater penetration- higher thrust on franchisee based model. India has lower retail penetration level (reflective in household financial saving in capital markets). The share of household financial saving invested in private corporate business stood at 2.6% in FY2008-09 following de-growth in Mutual funds. MOFSL has enhanced its reach with a robust pan-India network at 1293 locations; of which 61 are owned branches, while 1232 are franchisee. MOFS is placing higher impetus on increasing its retail client base. Currently, it has presence in 581 cities through its vast network of branches and franchisees. MOFS's franchisee and sub-brokers model has helped MOFS in maintain strong operating margins compared to its peers. However, we are of the view that with the revenue sharing being in favor of franchisee (generally a 60:40 ratio), may to impacts the cash inflows over the longer term. q Swiftly ramping up asset management businesses- MOFS is providing personalized investment management service through wealth management to its high networth individuals and corporate clients. The company is looking forward to swiftly ramp up its wealth management business, with the launch of a dedicated private client group brand "Purple". MOFS is laying higher focus on portfolio management services, and we expect a 20% CAGR over FY11-12 in MOFS's asset management fee income. Motilal Oswal Asset Management Company has also received the final approval from SEBI to set up its mutual fund business. With a strong team in place, MOFS is expected to launch its first mutual fund scheme and target to swiftly ramp-up its AUM over FY11-12. On the private equity (Motilal Oswal Private Equity - MOPE) front, MOFS's domestic real estate fund i.e. India Realty Excellence Fund ("IREF") has done its final closing at about Rs1.5 billion of commitments. q Scaling up financing business - margin funding: MoFS provides ancillary services to its customers like loan against share and margin funding. The company had made a conscious effort to trim down its advances book during FY08 and FY09. To draw on the excess liquidity, MOFS incorporated Principal Strategies Group (PSG), which deployed the excess liquidity in risk free arbitrage strategies and aided its fund based revenue. Its interest income forms close to ~10% of the MOFS's total income at Rs.6.5bn. During FY10 its margin funding book remained flattish at Rs 1.6bn as compared to Rs. 1.5bn in FY09. Going forward, MOFS is looking at scaling up its fund based business, for which, it will shift the funds deployed in low return principal strategy group to high yield margin funding and loan against share book. q Expect healthy growth in earnings; operating margins to remain stable. MOS's franchisee retail-distribution model helps keeping a check on its operating cost with all the franchisee operating expenses born by the partner. Its operating cost being largely linked to capital market performance is variable in nature and therefore, helps maintain steady margins. Given the strong capital market performance and steady growth in the fee based income (investment banking and asset management), MOFS operating margins improved during FY10 to 41% from 34% in FY09. Earnings growth is expected to remain healthy during FY11 and FY12; however we expect a flattish trend in operating (EBITDA) margins of 41% over FY11 and FY12. MOFS's net profit margins improved during FY10 to 27% as compared to 21% in FY09. We expect a similar net profit margin trend going forward; PAT margins of 27% over FY11 and FY12 respectively q Steady brokerage yield to support earnings growth, we recommend accumulating the stock. Improved capital market volumes have aided improvement in brokerage revenue during FY10, along with strong growth in fee based income; we expect healthy growth in earnings during FY11 and FY12. Moreover, enhanced return ratios in the wake of strong earnings growth will support higher valuation for the stock. At 13.1x FY11E EPS, the fair price target for MOFS will be Rs. 171, which offers limited upside of 3.7% from current levels. Hence, we initiate coverage on MOFS with accumulate recommendation and 12-month price target of Rs.177

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June 22, 2010

COMPANY BACKGROUND
Motilal Oswal Financial Services (MOFSL) is an integrated financial service player offering a large spectrum of investment services to institutions and retail customers. In a bid to expand fee based income streams it initiated its Investment Banking venture during 2006-07 and asset management business during FY2008. It is leveraging upon its strong research skill to further diversify into asset management business, with addition of AMC, wealth management, Private Equity and principal strategies group to its large spectrum of services. MOFS has a well established network of 1300 branches and franchisee, through which it serves a vast customer base of 6-lacs. The company lays higher thrust on a franchisee model, which is relatively cost effective and offers higher profitability. Healthy capital market volume to aid top-line growth n The Indian stock market has seen improvement in average traded volumes post a significant plunge in FY09 in the wake of global financial turmoil. MOFS's brokerage business (under is 100% subsidiary- Motilal Oswal Securities (MOS)), akin to other brokerage house, is expected to remain the key revenue contributor for MOFSL. MOS provides equity investment and advisory services to institutional and individual clients. n We opine that, MOFS's vast and cost effective network of ~1300 branches and franchisee, which provides a pan-India presence to MOFSL; along with its strong research based investment advice, gives MOS a competitive edge over its peers. n Post a subdued FY09, the equity brokerage business has witnessed a strong revival during FY10. We opine that this revenue stream will remain the key contributor to the top-line going forward. Its brokerage revenue comprises of close to 74% of the total revenue and has grown by 32.5% yoy during FY10 in the wake of steady brokerage yield and improved stock market volumes. n Going forward, buoyant capital market conditions are expected to boost investment banking and asset management business. We expect a 10% CAGR in its top-line over FY10-12, which will be largely driven by a strong growth fee based businesses- particularly asset management and investment banking. We are of the view that the diversification in to other businesses notwithstanding, brokerage will continue to be the key revenue contributor at ~70% over FY1112.
Revenue breakup (Rs mn)
Brokerage Income Asset management 8000 6000 4000 38 2000 0 FY08 FY09 FY10 FY11E FY12E 36 34 Investment Banking EBITDA (% - RHS) Fund based income 44 42 40

Healthy capital maket volume to support revenue growth

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SECTOR REPORT

June 22, 2010

Healthy growth in brokerage revenues; courtesy higher impetus on brokerage yields, while market share remains stablen Market share of top 10 brokers as per NSE volumes stood at 28% (33% in FY09) for FY10. Secondary market volumes have improved during FY10 to Rs.973.9bn in FY10 as compared to Rs. 608.9bn in FY09. However it has remained almost stagnant over 3QFY10 (Rs. 954.9bn) and 4QFY10 (Rs.943.3bn). Going by the trend in the capital market volumes, coupled with increased competition, we opine that the market share of the leading players is likely to witness some pressure.
Higher impetus on brokerage yield, market share remain under pressure

n MOFSL's market share has declined to 2.9% in FY10 from 4.2% in FY09. Since, high yield cash segment is MOFS's key focus area, lower cash segment delivery based volumes has impacted its market share during FY10. While company remains relatively less active in the low yield F&O segment, which forms close to 77% of the total capital market volume. n We are of the view that, with the company continuing to focus on high yield cash segment its brokerage yield are expected to remain steady going forward. We view this as one of MOFS's key strength area which will drive its broking related income going forward. n We have factored in a 15% CAGR in capital market volumes in our model. Since, brokerage revenue stream contributes a sizeable 74% to its total revenue; we expect a moderate growth of 6% yoy and 5% yoy during FY11 and FY12, which we opine will be largely driven by steady brokerage yields. Going forward, we also believe that share of brokerage revenue to total income will decline gradually in the wake of increase in thrust on fee based income.

Average daily volume


Avg. Volumes (Rs bn - LHS) 35 28 21 14 7 0 FY04 FY05 FY06 FY07 FY08 FY09 FY10 Marekt share (% - RHS) 5.0 4.0 3.0 2.0 1.0 0.0

Market share on brokerage yield


5.0% 4.0% 3.0% 2.0% Market share (% - LHS) 1.0% 0.0% 4QFY08 Source: Company 2QFY09 4QFY10 2QFY10 4QFY10 Brokerage yield (bps - RHS) 3.0 2.0 7.0 6.0 5.0 4.0

Source: Company.

Strong research based advisory and execution skills, key to strong brokerage business n MOSL has an experienced team of 27 research analysts covering close over 236 companies in 27 sectors and close to 23 commodities. In order to expand its institutional market share MOFS has placed material thrust on research based investment advice. For this MOFS is supported by an extremely strong sales trading team comprising of experienced and qualified professional.
Strong research capabilities and trade execution skills

n Over the period, MOSL has been able to develop a strong relationship with its institutional and well as individual investors, who are supported by strong research based advisory and dexterous trade execution capabilities. n Owing to its strong research capabilities and trade execution skills, MOFS has been consistently receiving awards and recognitions as top brokerage house in India. We opine that this has also aided in building a strong brand value for MOFS and will also lead to healthy business growth going forward.

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June 22, 2010

Business diversification will trim down vulnerability to volatile capital markets n Close to 73% of MOFS's revenue is contributed by broking business, while the balance 26% non-broking revenue is divided into - investment banking (10%), financing (10%)(loan against shares and margins funding), asset management and private equity (6%) etc. n Although, all of MOFS's businesses are linked to capital markets, diversification into ancillary businesses will not only aid a healthy top-line growth but will also act as cushion to volatile stock market volumes. n We view business diversification as significantly beneficial for MOFS. Revenue diversification in to fee based businesses such as investment banking, asset management private equity etc will help mitigating risk of revenue concentration in its revenue mix; with a blend of commission based and fee based income. Increased thrust on investment banking; improved fee-based income is expected to boost return ratios n MOFS established its investment banking business in 2006 to offer financial advisory, capital raising and other related services to its corporate clients, financial sponsors and other institutions. It has a strong team of close to 28 experienced professional based out of Delhi, Mumbai, and Hyderabad. n MOFS's investment banking business is in nascent stage with a team of close to 29 professionals and has concluded around 45 deals (including debt and ECM). Of the total 140 deals in equity and capital market (ECM) segment during FY10, MOFS has concluded around 5 deals, which accounts for close to 3.6% market share. n Improved macroeconomic scenario over FY10 has led to a significant uptick in corporate fund raising activity in India. Investment banking business contributed close to 10% of its FY10 revenues to Rs.649mn, materially up by 43% yoy as compared to Rs 452mn in FY09.
Improvement in macroeconomic conditions will foster strong investment banking deal pipeline

n Going forward, we opine that the improvement in macroeconomic conditions and recovery in capital market activity will foster strong investment banking deal pipeline. Therefore we expect 25% CAGR in MOFS's revenue from investment banking vertical over FY11-12, and the share of these segments is likely to improve from 10% presently to close to 14% in FY12.
Investment banking revenue / total revenue
Investment Banking (Rs mn - LHS) Investment banking/Total Income (% - RHS)

1000 750 500 250 0

15 12 9 6 3

FY08

FY09

FY10

FY11E

FY12E

Source: Company, Kotak Securities - Private Client Research

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SECTOR REPORT

June 22, 2010

Swiftly ramping up asset management businessesn Personalized investment management service through wealth management - MOFS commenced its wealth management business in 2002 to provide personalized portfolio management services to its high networth individuals and corporate clients. This included investment planning, advisory, execution and monitoring of various investment products. The company is looking forward to swiftly ramp up its wealth management business, with the launch of a dedicated private client group brand "Purple".
Contribution from asset management fee income to aid healthy top-line growth

n It currently has a customer base of 3700 with an AUM base of ~ Rs. 17bn of which Rs9.8bn is in PMS. Contribution from asset management fee remained steady at around 6% of the total income during FY10 to Rs. 401mn. MOFS is laying higher focus on portfolio management services, and we expect a 20% CAGR over FY11-12 in MOFS's asset management fee. n Asset Management Company- Motilal Oswal Asset Management Company has also received the final approval from SEBI to set up its mutual fund business. With a strong team in place, MOFS is expected to launch its first mutual fund scheme and target to swiftly ramp-up its AUM over FY11-12. With increased focus on scaling up asset management business MOFS's fee income is expected to witness steady improvement going forward. n Private Equity- On the private equity (Motilal Oswal Private Equity - MOPE) front, MOFS's domestic real estate fund i.e. India Realty Excellence Fund ("IREF") has done its final closing at about Rs1.5 billion of commitments. MOPE has built a strong deal pipeline for IREF and is evaluating several investment opportunities.

PMS AUM (Rs bn)


12 9

Asset management & Fee income


700 525 Asset management (Rs mn - LHS) AMC fee income (% - RHS) 8.0 6.0 4.0 2.0 FY08 FY09 FY10 FY11E FY12E 10.0

6 350 3 175 0 Q2FY09 Q3FY09 Q4FY09 Q1FY10 Q2FY10 Q3FY10 Q4FY10 0

Source: Company

Source: Company. Kotak securities - Private Client Research

Scaling up financing business - margin funding n MoFS provides ancillary services to its customers like loan against share and margin funding. The company had made a conscious effort to trim down its advances book during FY08 and FY09 following the global financial turmoil. Therefore, during FY09, to draw on the excess liquidity, MOFS incorporate Principal Strategies Group (PSG), which deployed the excess liquidity in risk free arbitrage strategies and aided its fund based revenue. n Its interest income stood at Rs 6.5bn in FY10, a flattish growth over Rs 6.4bn in FY09. This forms close to ~10% of the MOFS's total income. Its fund based income also includes income from principal strategies group, which manage short term liquidity in the business. n Going forward, MOFS is looking at scaling up its fund based business, for which, it will shift the funds deployed in low return principal strategy group to high yield margin funding and loan against share book, which we believe is materially positive and will boost its return ratios. During FY10 its margin funding book remained flattish at Rs 1.6bn as compared to Rs. 1.5bn in FY09. We expect loan book growth of
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June 22, 2010

Margin funding book (Rs bn)


4.0 3.0 2.0

Interest income from financing business


Fund based income (Rs bn - LHS) Fund based income/total income (% - RHS) 800 600 400 28 21 14 7 0 FY11E 4QFY08 1QFY09 2QFY09 3QFY09 4QFY09 1QFY10 2QFY10 3QFY10 4QFY10 FY12E

1.0 0.0 4QFY08 1QFY09 2QFY09 3QFY09 4QFY09 1QFY10 2QFY10 3QFY10 4QFY10

200 0

Source: Company

Source: Company. Kotak securities - Private Client Research

Expanding distribution network for greater penetration- higher thrust on franchisee based model n India has lower retail penetration level (reflective in household financial saving in capital markets). The share of household financial saving invested in private corporate business stood at 2.6% in FY2008-09 following de-growth in Mutual funds. MOFSL has enhanced its reach with a robust pan-India network at 1293 locations; of which 61 are owned branches, while 1232 are franchisee.
Franchisee distribution model is beneficial in checking operating costs

n MOFS is placing higher impetus on increasing its retail client base. Currently, it has presence in 581 cities through its vast network of branches and franchisees. MOFSL has strategic alliance with State Bank of India (SBI), IDBI Bank and Axis Bank to offer online broker services to their retail banking clients. n MOFS's franchisee and sub-brokers network provides advantage of lower establishment expenses coupled with wider presence. This has also helped the company in maintain strong operating margins compared to its peers. However, we are of the view that with the revenue sharing being in favor of franchisee (generally a 60:40 ratio), is expected to impacts the cash inflows over the longer term. Online trading- key to cost effective penetration the retail segment n Online trading platform offered to retail customers' aid in curtailing employee cost as well as operating cost. With an online trading platform, retail investor can directly invest in stock market independently on their own trading portals offered by the brokerage companies. We opine that this has helped MOFS in expanding its customer base and maintain steady operating performance. n MOFS has entered into alliance with SBI, Axis and IDBI bank to offer online brokerage platform to their customers. Going forward, we opine that this will aid healthy growth in its retail brokerage business. n The key predicament and reason as for a poor penetration of the online trading platform in India is lack of awareness and the knowledge of a hi-tech online trading platform. We opine that in the longer run it will be significantly beneficial for the capital market intermediaries as it will aid in containing its operating cost and contend with the rising competition.

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Pan india presence growing client base


Branches (LHS) 1600 1200 800 400 0 FY04 FY05 FY06 FY07 FY08 FY09 FY10 Source: Company Client base ('000 - RHS) 700

Operating Efficiency (%)


68.0

51.0 525 350 175 0 34.0 Employee/Income Operating/Income

17.0

0.0 FY06 FY07 FY08 FY09 FY10 FY11E FY12E

Source: Company, Kotak Securities - Private Client Research

Financials
Steady revenue growth likely, in line with strong over all capital market performance n Institutional inflows from both - domestic and foreign - have remained relatively steady during FY10. FII have invested close to $20bn during FY10 as compared to a net outflow of $10bn during FY09. In additional to this, stock markets have also seen some revival in retail participation, which is evident from the NSE data and opening of new DP accounts with NSDL. Going forward in the wake of firm brokerage yields and improved fee based income, we expect healthy growth in MOFS's revenue over FY11 and FY12. n Further, strong investment banking pipeline and a rapid fund mobilization in the asset management business will aid superior earnings growth. With revenue from brokerage contribution significant share of total revenue, we expect a revenue growth of 9% yoy to Rs.6.8bn for FY11 and 11% yoy to Rs. 7.5bn during FY12.
Total revenue (Rs mn)
8000 6000
18.2% CAGR

4000 2000 0 FY08 FY09 FY10 FY11E FY12E

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SECTOR REPORT

June 22, 2010

Increased thrust on asset management and investment banking business to boost fee income n We expect a strong growth in MOFS's non-brokerage related income, which we opine will be the key revenue growth driver over FY11-12. We expect a CAGR of 22% over FY10-12 in MOFS's fee income investment banking business and asset management fee. n MOFS's Investment banking (IB) business, which contributes around 10% to the total revenue and asset management business, which contribute about 6% to its total revenue, are expected to witness healthy growth during FY11 and FY12. n With MOFS's increased thrust on fund mobilization and strong investment banking deal pipeline we expect a 20% CGAR over FY10-12 in asset management fee income and a 22% CAGR in MOFS's investment banking fee. Expect healthy growth in earnings; operating margins to remain stable n MOS's franchisee retail-distribution model helps keeping a check on its operating cost with all the franchisee operating expenses born by the partner. Its operating cost being largely linked to capital market performance is variable in nature and therefore, helps maintain steady margins. Operating margins during FY08 were impacted mainly due to change in the accounting norms for STT being treated as expenditure then set-off against income tax. n Given the strong capital market performance and steady growth in the fee based income (investment banking and asset management), MOFS operating margins improved during FY10 to 41% in FY10 from 34% in FY09. Earnings growth is expected to remain healthy during FY11 and FY12; however we expect a flattish trend in operating (EBITDA) margins of 41% over FY11 and FY12. n MOFS's net profit margins improved during FY10 to 27% as compared to 21% in FY09 We expect a similar trend in its net profit margins, PAT margins (%), which is expected at 27% over FY11 and FY12 respectively.
Profitability ratios
80 Operating margins Net profit margin 60

EBITDA & PAT margins - Quarterly


45 40 35 30 25 EBITDA (% - LHS) PAT (% - RHS) Q4FY07 Q1FY08 Q2FY08 Q3FY08 Q4FY08 Q1FY09 Q2FY09 Q3FY09 Q4FY09 Q1FY10 Q2FY10 Q3FY10 Q4FY10 34 35 28 21 14 7 0

40

20

20

0 FY06 FY07 FY08 FY09 FY10E FY11E FY12E

Source: Company, Kotak Securities - Private Client Research

Source: Company

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SECTOR REPORT

June 22, 2010

Steady brokerage yield to support earnings growth; trading at 13.1x FY11 earnings estimate we recommend accumulating the stock at declines with a price target of Rs. 177 n Improved capital market volumes have aided improvement in brokerage revenue during FY10, along with strong growth in fee based income; we expect healthy growth in earnings during FY11 and FY12. Moreover, enhanced return ratios in the wake of strong earnings growth will support higher valuation for the stock. n At current market price, the stock is trading at a P/E of 12.6x its FY11 earnings estimate and 11.3x its FY12 earnings estimates. The stock currently trading close to its historic median P/Ex of 13.5x, and the stock currently appears richly valued. n We are valuing MOFS at P/E of 13.1x its FY11 estimated EPS of Rs.10.4, to arrive at fair price target for MOFS at Rs.177, which offers limited upside of 3.7% from current levels. Hence, we initiate coverage on MOFS with accumulate recommendation and 12-month price target of Rs.177

PE band (x)
500 400 300 200 100 0 Jul-08 Mar-08 Mar-09 Jul-09 May-08 May-09 Nov-07 Nov-08 Nov-09 Sep-08 Sep-09 Mar-10 Jan-08 Jan-09 Jan-10 10 17.5 12.5 20 15 MOFS

Relative to Sensex
50 40 30 20 10 0 Jul-08 Mar-08 Mar-09 Jul-09 May-08 May-09 Nov-07 Nov-08 Nov-09 Sep-08 Sep-09 Mar-10 35 Jan-08 Jan-09 Jan-10
MOFS P/E Sensex P/E

Source: Capitaline, Kotak Securities - Private Client Research

Source: Bloomber, Kotak Securities - Private Client Research

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June 22, 2010

FINANCIALS
Profit and Loss Statement (Rs mn)
(Year-end March) Income from operations `-Brokerage Income `-Advisory fee Other Income Total Income Operating Expenditure EBIDTA Depreciation Interest PBT Provision for Taxation Extraoridnary items Minority Interest PAT % chg FY09 4,340 3,268 452 321 4,661 2,854 1,486 203 178 1,426 462 30 38 896 FY10 6,250 4,551 649 203 6,453 3,683 2,567 142 96 2,532 788 40 1,704 90.1 FY11E 6,837 4,861 792 259 7,096 4,011 2,826 138 103 2,843 948 38 1,857 9.0 FY12E 7,576 5,276 966 305 7,881 4,414 3,162 136 111 3,219 1,056 50 43 2,070 11.5

Balance sheet (Rs mn)


(Year-end March) Sources of Funds Equity Capital Reserves & Surplus Networth Borrowings Minority interest Total Liabilities Application of Funds Fixed Assets Investments Deffered Tax Assets Current Assets Current Liabilites Net current Assets Total assets 745 492 12 12,885 6,154 6,731 7,980 782 566 12 14,045 5,989 8,056 9,416 821 665 12 15,401 5,836 9,566 861 782 13 16,889 5,693 11,196 142 7,797 7,939 1 40 7,979 142 9,160 9,302 64 50 9,416 142 10,645 10,787 212 65 142 12,302 12,444 338 70 FY09 FY10 FY11E FY12E

11,064 12,852

11,064 12,852

Source: Company, Kotak Securities - Private Client Research

Source: Company, Kotak Securities - Private Client Research

Key data
FY09 EPS (Rs) Book Value (Rs) P/E (x) P/BV (x) Efficiency ratio (%) Operating Exp/ Total Income Operating Exp/ Avg Assets Employee Cost/Total Income Employee Cost/ Avg Assets 62.1 11.7 26.2 14.5 58.9 18.7 21.9 15.7 58.7 17.1 22.5 15.0 58.3 16.1 22.8 14.5 6.3 55.9 27.1 3.1 FY10 12.0 65.5 14.3 2.6 FY11E 13.1 76.0 13.1 2.3 FY12E 14.6 87.6 11.7 2.0

Ratio Analysis
FY09 EBIDTA Margins (%) PAT Margins (%) EBITDA/Branch (Rs mn) PAT/Branch (Rs mn) Return Ratios (%) RoE RoA 11.9 10.8 19.8 19.6 18.5 18.1 17.8 17.3 34.2 20.6 1.3 0.7 FY10 41.1 27.3 1.7 1.1 FY11E 41.3 27.2 1.7 1.1 FY12E 41.7 27.3 1.7 1.1

Source: Company, Kotak Securities - Private Client Research

Source: Company, Kotak Securities - Private Client Research

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Sarika Lohra sarika.lohra@kotak.com +91 22 6621 6313

EDELWEISS CAPITAL LTD (ECL)


PRICE : RS.504 TARGET PRICE : RS.525 RECOMMENDATION : ACCUMULATE FY11E PE: 13.0X

Stock details
BSE Code NSE Code Market Cap (Rs bn) Free float (%) 52 wk- hi/lo (Rs) : : : : : 532922 EDELWEISS 37.8 61.93 542/241 53780 71240 75.0

Avg. daily volume (BSE) : Avg. Daily volume (NSE) : Shares o/s (mn) Source: Capitaline :

Summary table
(Rs mn) Income from opns Other income Total income EBITDA PAT EBIDTA Margins (%) PAT Margins (%) Operating Expenses/ Total Income Employee Cost/ Total Income EPS Book Value RoE RoA P/E P/BV FY10 FY11E FY12E

Edelweiss Capital is one of the leading boutique investment banking and institutional brokerage company, which is now extending its equity broking services to individual investors with its acquisition of Anagram Capital. We expect ECL's brokerage yield to improve going forward from current levels of ~5bps to 6bps over FY11-12 with its foray into high brokerage yield individual broking business. We opine that an uptick in its low leverage financing book coupled with improving yield on advances will boost interest income going forward. Asset management fee income growth will remain steady following higher impetus on fund mobilization. ECL is looking forward to have an AUM of close to $500mn during FY11. We expect a CAGR of 15% in its revenues over FY10-12, with healthy operating margin of 36% and net profit margin of 23% over FY11-12. We are valuing Edeweiss Capital Ltd at 14% discount to its Median P/ Ex,(15.0x) i.e. 13.5x its FY11 EPS of Rs.38.9; leading to a price target of Rs.525. We have assigned a discount to ECL's historic valuation to factor in shift of capital to newer businesses viz retail broking. Improved capital market outlook is expected to drive earnings growth. We are initaiating coverage on Edelweiss capital with a price target of Rs. 525. However, at the current levels valuation apperas rich and despite a positive business growth outlook we recommend accumulating the stock on declines given the limited upside of 4% from current levels

9,690 12,710 14,679 88 95 105 9,778 12,805 14,784 5,306 7,879 9,504 2,205 2,816 3,307 34.3 23.7 59.2 8.5 30.6 301.2 10.5 5.8 16.5 1.7 36.4 22.9 57.1 7.1 38.9 325.4 12.4 5.5 13.0 1.5 36.9 23.2 56.7 6.4 45.5 356.3 13.4 5.6 11.1 1.4

Investment Rationale
q Strong market share in the institutional broking; retail broking foray will aid stable market share and improvement in brokerage yield going forward. Edelweiss has a strong presence in the institutional brokerage segment. It has a client base has of close to 500 active institutions. The strong research support has facilitated in building a strong relationship with institutional clients. Its strong research team which covers close to 160 stocks across 18 sectors coupled with excellent trade execution skill has provided ECL a competitive edge over its peers. Currently ECL's market share is at around 4.8%. Since retail segment forms a significant 50% of the total stock market volume the company has forayed into retail broking business by acquisition on Anagram Capital. ECL has been able to add close to 3000 customer monthly. Since the brokerage yield in the retail segment is relatively higher we expect improvement in brokerage yield also. We expect improvement in ECL market share and brokerage yield going forward to 6% and 6bps respectively. q Investment banking business: strong pipeline to boost fee income. Improved capital market scenario and a strong team of 40 investment bankers have benefited ECLs' investment banking business as it had been able to conclude a total of 31 deals during FY10. Its strong relations with large corporate as well as emerging and mid market companies has helped in maintaining traction in its IB fee income. As per the details available from prime data base- of the total 140 equity capital market (ECM) deals during FY10, ECL had a market share of close to 12% with 17 deals and stood at 3rd rank. The company has concluded close to 33 investment banking deals including both ECM and DCM during FY10 as compared to 9 deals in FY09. This indicates strong revival in the investment banking business. Going forward, with its strong deal pipeline, we expect continued traction in its investment banking revenue.

Source: Company, Kotak Securities - Private Client Research

Shareholding pattern

Public & others 20%

Foreign 37%

Promoters 39%

Institutions 3% Corporate holding 1%

Source: Capitaline

1 year performance (Rel to sensex)


Sensex

Edelweiss Cap

Source: Capitaline

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q Income from treasury operation remained significant part of the revenue; likely to wane going forward. ECL deploys the surplus cash in the balance sheet in low risk arbitrage opportunities to optimise returns. Its treasury income (trading and arbitrage) comprised of significant portion of ECL's operating income. Since arbitrage strategies yield attractive returns during high volatility and directional trends; ECL's liquidity management strategies have aided superior return ratios over FY07-09. The consistent share of trading income reflects ECL's efficiency to perform during weak markets. Arbitrage yields witnessed pressure due to range bound stock market movement and ECL's capital preservation strategy. This also impacted its return ratios, which were relatively subdued. We are of the view that the share of trading income will remain prominent in ECL's total income over FY10-11. However, going forward, with the shifting of surplus fund in the balance sheet to relatively high yield and less leveraged lending business, the share is expected to recede. We expect ECL's return ratios to rebound during FY12 to ~12%. q Alternate asset management business- fresh fund mobilization gaining traction; asset management fee income to improve. ECL's alternate asset management business focuses on offshore institutional investors and has recently achieved the first closure of $105mn in Edelweiss Special Opportunities Fund. Going forward, in the wake of improved macroeconomic conditions the fund mobilization activity is expected to gain momentum; and ECL is targeting to increase its AUM to $ 500 mn during FY11. On the domestic asset management business front, Edelweiss Mutual Fund is running nine schemes and has a total AUM of Rs 1.14bn. q Scaling up lending business- loan book leverage to increase to 2-2.5x during FY11. Edelweiss runs its lending business through its NBFC subsidiaryECL Finance. ECL Finance's lending business largely comprise of Promoter financing, Loan against shares (LAS), loan against ESOPs and IPO financing. ECL Finance's loan book is not at all leveraged on a standalone basis. At the group level, ECL is leveraged 1.2x. ECL is swiftly scaling up its lending business, its loan book during FY10 stood at Rs 18bn as compared to Rs.5.5 bn in FY09. Going forward, the company targets loan book size of over Rs 25 bn (equity leverage of 2x) by FY11. However, we expect a loan book of over Rs 20.5bn for FY11 and Rs 22.5bn for FY12. q Strong balance sheet to augment business growth. ECL has a compelling balance sheet with a debt to equity ratio of 0.4x, which we believe will be significantly helpful in incubating new business expansion plans. We consider this as ECL's major strength as this will also help ECL in expanding its existing businesses, such as - executing larger orders for its institutional clients and meeting margin calls whenever needed. We opine that this will help ECL in garner significant share of institutional broking business,

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Trading at 13.0x FY11 EPS, valuations at current level appear rich; we recommend investors to accumulate the stock on declines with a price target of Rs. 525. q At the current market price the stock is trading at one year forward P/Ex of 11.7x, which indicats signifincat discount to the benchmark index Sensex (trading at an median P/E of 19.9x). This is largely due to company's capital preservation strategy during FY09 and H1FY10 , which led to a decline in income from its leding business and also lower yield on arbitrage and trading business. With ECL ramping up all its business stream, we expect net profit growth of 26% yoy in FY10 and 20% yoy in FY11.
We are initaiating coverage on Edelweiss capital with ACCUMULATE recommendation and a price target of Rs.525.

q We are valuing Edeweiss Capital Ltd at 14% discount to its Median P/Ex, i.e. 13.5x its FY11 EPS of Rs.38.9; leading to a price target of Rs.525. We have assigned a discount to ECL's historic valuation to factor in shift of capital to newer businesses viz retail broking. Improved capital market outlook is expected to drive earnings growth. We are initaiating coverage on Edelweiss capital with a price target of Rs. 525. However, at the current levels valuation apperas rich and despite a positive business growth outlook we recommend accumulating the stock on declines given the limited upside of 4% from current levels.

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COMPANY BACKGROUND
Edelweiss Capital Ltd (ECL) commenced its business in 1995 as a boutique investment bank and has diversified into providing financial services varying from investment banking, institutional equities, private client broking, asset management and investment advisory services, wealth management, insurance broking and wholesale financing to corporate, institutional and high networth individual clients. ECL has endeavored to remained ahead of competitors with its innovative product ideas e.g. indigenously developed derivatives trading model and techniques, liquidity management through arbitrage strategies, etc. With intent to enter into retail broking business, Edelweiss has recently acquired Anagram Capital, which has healthy branch network and client base. The company conducts its operations along with its subsidiaries and associates. With its proficient management and strong business model in place, we opine that Edelweiss is well placed to take advantage of the growing Indian capital market.

Business Model
ECL has classified its business model into two segments- Agency business and Capital business. Its Agency business includes- Investment banking, brokerage services- Institutional and retail customers, asset management and financial product distribution, while its capital based business includes- Treasury, and Wholesale financing. Agency businesses n Investment Banking. The investment banking business provides a broad range of services, including equity capital markets transaction execution, mergers and acquisitions advisory, structured finance advisory, private equity advisory, real estate advisory and infrastructure advisory. n Institutional Equities. ECL's institutional equities business provides sales-trading, distribution and research to institutional investors, both FIIs and domestic institutional investors. For FY10, ECL had over 500 foreign and close to100 domestic institutional investors actively doing business with it. ECL has close to 145 professionals in its institutional equities business who serve these customers. Retail Equities n Private Client Brokerage: ECL's private client brokerage services are targeted at high net worth and other individuals who actively invest and trade in equity markets and seek priority service with customized research and advisory support. As on December 2009, ECL provided private client brokerage services to more than 35,000 customers, and continues to add close to 3500-4000 customers a month. Acquisition of Anagram will further expand its customer base. n Wealth Management: While it entered into serving high networth individual in 2005-07, it added wealth management services to its bouquet in 2008-09. It provides investment advisory and planning and financial management services to high networth individuals families, family offices or corporates. n Asset management business: Edelweiss asset management business includes domestic asset management and alternative asset management businesses. During FY09, in line with the global financial crisis Edelweiss experienced erosion in its off shore assets under management. This was largely due to combined impact of a sharp decline in NAVs and material increase in redemptions from investors. ECL is now looking at ramping up this business at a steady pace.

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n Insurance Brokerage: ECL provides brokerage services for non-life insurance products of major insurance companies in India. Its insurance brokerage professionals are experienced in distributing fire and fleet insurance products, particularly in niche areas of insurance such as transport fleet insurance. n Capital Business: Edelweiss's capital based business largely includes lending business and treasury operations. It carries out its lending business through its fully capitalized NBFC ECL Finance, which is largely engaged in the business of promoter funding, ESOP funding, and loan against shares. The outstanding loan book stoods at Rs. 6.3bn at the end of FY09 which increased to Rs 18bn in FY10. n Treasury book operations: Over the period ECL's treasury operations have helped in generating superior return ratios. It helps ECL in managing surplus liquidity of the group on a short-term basis. It follows a multi strategy approach with an aim to achieve absolute returns and optimise its yields. Nonetheless during FY09 the arbitrage opportunities reduced due to lower market volumes.

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INVESTMENT RATIONALE
Strong market share in the institutional broking; retail broking foray will aid stable market share, despite rising competition. n Edelweiss has a strong presence in the institutional brokerage segment. Its client base has close to 500 active clients. The strong research support has facilitated in building a strong relationship with institutional clients. Its strong research team, which covers close to 160 stocks in 18, sectors coupled with excellent trade execution skill has provided ECL a competitive edge over its peers.
Brokeratge yield and market share to remain largely stable following retail foray

n ECL's market share (mainly in institutional segment) stood at 6.4% in FY09; however, change in stock market volume mix along with increased competition has impacted its market share, which is presently hovering in the range of 4.54.8% (excluding Anagram Capital). Going ahead, we expect overall secondary market volumes to witness a CAGR of 15-17% and with ECL foraying into retail broking, we expect that it will be able to maintain steady overall market share at 4.8-5% (consolidating Anagram Capital over FY11-12). n Since the retail segment forms a significant part of the total stock market volume ECL has forayed into retail broking business through inorganic route. It is also laying significant thrust on building its private client servicing business with addition of close to 3000 retail customers monthly.

Growing avg daily volume and stable market share


Avg Daily Volume (Rs bn - LHS) Market share (% - RHS)

Stable market share from brokerage


Market share (% - LHS) Brokerage yield (% - RHS) 7.0 0.06 6.0 5.0 4.0 0.04 3.0 2.0 FY07 FY08 FY09 FY10 FY11E FY12E 0.03 0.05

8.0 8 6 4

0.07

50 40 30 20 10 0 4QFY08 1QFY09 2QFY09 3QFY09 4QFY09 1QFY10 2QFY10 3QFY10 4QFY10

2 0

Source: Company

Source: Company, Kotak Securities - Private Client Research

Striking a right balance by foraying into retail segment n With intent to foray into retail broking business, Edelweiss capital has acquired Anagram Capital for Rs. 1640 mn from Lalbhai group (Arvind Mills). Anagram capital is one of the retail broking houses with a client base of 180,000 and has strong geographic spread through its network of 137 branches and over 1300 sub-brokers. n The retail segment comprises of over 50% of the stock market volumes. Moreover, this business segment also enjoys relatively higher brokerage yields then the institutional business. Therefore, we opine that ECL's foray in retail broking business by inorganic route is a step in the right direction of business expansion. Going forward, we opine that the retail brokerage segment will help maintain steady market share. Secondly, since, retail segment enjoys higher brokerage yields; it will also aid ECL in maintaining largely stable brokerage yields.

Retail initiative to inorgonic route to aid brokerage yield

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Brokerage yield likely to improve going forward - supported by retail foray n ECL has faced pressure on its brokerage yield in the wake of increased competition. Brokerage yields were also impacted in the backdrop of lower cash segment delivery volumes and increased F&O trading volumes. ECL's average brokerage yield hovered around 6-7 bps during FY08-09, which was broadly in line with industry average of 7 bps. However, its brokerage yield slipped to 5.5 bps (0.055%) during 1QFY10, and remained steady at 5.5 bps during FY10.
Brokerage yield is likely to improve to 0.06% (6bps) during FY11-12

n Going forward, we opine that with the inclusion of a ready retail client base along with healthy branch network following its acquisition of Anagram Capital, brokerage yield is likely to improve to 0.06% (6bps) during FY11-12. Hence, we expect a healthy growth in earnings aided by improved brokerage yields.
Brokerage yield (%)
8.0 6.9 7.0 6.0 5.0 4.0 4QFY08 1QFY09 2QFY09 3QFY09 4QFY09 1QFY10 2QFY10 3QFY10 4QFY10 6.8 6.8

6.5 6.0 5.5 5.3 5.9 5.5

Source: Company

Investment banking business: strong pipeline to boost fee income n Investment banking fee comprised of close to 18 % of its total agency fee and commission income in FY08 and 8 % in FY09 to Rs. 0.8 bn and Rs 0.2 bn respectively. During FY10, markets have witnessed an increase in corporate fund raising activity, particularly in the equity capital market (ECM) segment (IPOs/ FPOs and QIPs). The improved capital market scenario and a strong team of 40 investment bankers have benefited ECLs' investment banking business as it had been able to close 14 deals during 4QFY10. The company has conclude over 30 investment banking deals during FY10 including both ECM and DCM.
Strong relations with large corporate as well as emerging and mid market companies to aid traction in its IB fee income

n ECL drives major part of its investment banking revenue from non-public market capital. Its strong relations with large corporate as well as emerging and mid market companies has helped in maintaining traction in its IB fee income. As per the details available from prime data base- of the total 140 equity capital market deals (including QIPs, IPO/FPO, and Rights Issue) during FY10, ECL has a market share of close to 12% with 17 deals ( 12- QIPs, 3- IP/FPO,2-Right Issues) and is ranked third. Going forward, in the wake of strong deal pipeline, we expect healthy growth in ECL's investment banking fee.

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Income from treasury operation have remained significant part of the revenue; likely to wane going forward n ECL deploys the surplus cash in the balance sheet in low risk arbitrage opportunities to optimise returns. Its treasury income (trading and arbitrage) comprised of significant portion of ECL's operating income. During FY09 around 28-30% of total operating income was arbitrage and trading income. ECL's treasury operations absorb short term liquidity available in the group as also regenerate liquidity for use of other group businesses whenever required at a short notice with minimal impact cost. n Since arbitrage strategies yield attractive returns during high volatility and directional trends; ECL's liquidity management strategies have aided superior return ratios over FY07-09. The consistent share of trading income reflects ECL's efficiency to perform during weak markets.
Shifting of surplus fund to high yield lending business will lead to decline in share of arbitrage income

n During FY10 treasury operation contributed 25% to its total income. Arbitrage yields witnessed pressure due to range bound stock market movement in 2HFY10 and ECL's capital preservation strategy. This has also impacted its return ratios, which were relatively subdued. We are of the view that the share of trading income will remain prominent in ECL's total income over FY10-11. However, going forward, with the shifting of surplus fund in the balance sheet to relatively high yield and less leveraged lending business, the share of trading and arbitrage gains will recede. We expect ECL's return ratios to rebound during FY12 to ~12%.
Trading and arbitrage income
1600 1200 800 400 0 1QFY08 2QFY08 3QFY08 4QFY08 1QFY09 2QFY09 3QFY09 4QFY09 1QFY10 2QFY10 3QFY10 4QFY10 31 35 29 17 32 26 18 57 Trading and arbitrage income (Rs mn - LHS) % of Total income (RHS) 44 32 23 15 15 0 45 30 60

Source: Company

Alternate asset management business- fresh fund mobilization gaining traction; asset management fee income to improve n ECL's alternate asset management business focuses on offshore institutional investors and has recently achieved the first closure of $105mn in Edelweiss Special Opportunities Fund. On the domestic asset management business front, Edelweiss Mutual Fund is running 10 schemes including the Edelweiss Income Advantage Fund and has a total AUM of Rs 1.2bn. n On the back of improved macroeconomic conditions the fund mobilization activity has gained momentum during FY10, ECL's AUM improved to US$208mn as compared to US$108mn in FY09. Going forward, ECL is targeting to enhance its AUM to $ 500 mn during FY11-12.

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Scaling up lending business- loan book leverage to increase to 22.5x during FY11-12 n Edelweiss runs its lending business through its NBFC subsidiary- ECL Finance. ECL Finance's lending business largely comprise of Promoter financing, Loan against shares (LAS), loan against ESOPs and IPO financing. ECL Finance's loan book is not at all leveraged on a standalone basis, as its loans outstanding are about Rs.18bn and a networth of ~Rs.12bn for FY10. At the group level, ECL is leveraged 1.2x. n Since loan against share form a significant part of ECL finance's loan book. it has been maintaining adequate collateral (loan to value multiple or LTV) so as to mitigate impact of (stock) price fluctuations. Its loan book is collateralised close to 3x of the value of loan. n ECL is swiftly scaling up its lending business, its loan book during FY10 stood at Rs 18.4bn as compared to Rs. 5.5bn in FY09. Going forward, the company targets to have loan book size of over Rs 25 bn (equity leverage of 2x) by FY11. However, we have build in loan book of Rs 22.5bn for FY11 and Rs 26.2bn in.
Loan book (Rs bn)
21.0 18.0 15.0 12.0 9.0 6.0 3.0 0.0 Q4FY08 Q1FY09 Q2FY09 Q3FY09 Q4FY09 Q1FY10 Q2FY10 Q3FY10 Q4FY10 9.2 9.2 10.0 7.0 5.5 4.5 6.9 10.0 18.4

Source: Company

New business ventures ECL has grown from an investment banking firm to a diversified financial services organization. Edelweiss continues to look to invest in long term business opportunities in adjacent markets in financial services. Of late, it has entered into two new business segments: - Alternate asset management business and Life insurance venture (ECL has formed a joint venture with Tokio Marine for a life insurance venture). These business are at nascent stage and do not contribute to top-line.

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FINANCIALS
Strong balance sheet to augment business growth ECL has a strong balance sheet with a debt to equity ratio of 0.4x, which we believe will be significantly helpful in incubating new business expansion plans. We consider this as ECL's major strength as this will also help ECL in expanding its existing businesses, such as - executing larger orders for its institutional clients and meeting margin calls whenever needed. We opine that this will help ECL in garner significant share of institutional broking business,
Debt - Equity
1.8 1.5 1.2 0.9 0.6 0.3 0.0 FY11E FY12E FY06 FY07 FY08 FY09 FY10

Brokerage and fee revenue to form 33%; share of interest income to increase n ECL's operating income is largely driven by institutional broking and treasury operations, which comprises around 45% of the total income. Owing to favorable market conditions, the core brokerage income grew by 36% yoy to Rs.3.5bn during FY10, i.e. 36% of the total revenue. However, with the acquisition of Anagram Capital, we expect improved contribution from this segment. Impetus on scaling up the lending business will also aid steady top-line growth for the company. We expect a 17% yoy growth in total revenue during FY11 to Rs.12.7bn and Rs.14.6bn in FY12. n On the brokerage and fee income front, we expect an 18% yoy growth in FY11 to Rs.4.1bn and 14% yoy growth in FY12 to Rs.4.7bn. We expect the contribution from brokerage business and fee income to be maintained at 33% over FY11 and FY12 respectively. n On the lending business front we expect steady growth in its interest income as it prepares to divert funds from arbitrage and trading business. We expect a 44% yoy growth in interest income to Rs.5.6bn in FY11 and 47% yoy in FY12 to Rs.6.9bn.
Diversified business mix (%)
Fee income Investment and dividend income 100% 80% 60% 40% 20% 0% FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10E FY11E FY12E Trading and arbitrage income Interest income

Source: Company

Source: Company, Kotak Securities - Private Client Research

Steady operating performance n With healthy growth across revenue streams, ECL has made serious efforts to check its operating cost and maintain greater operating efficiencies. ECL largely focuses on low cost operating structure to serve its customers and is laying higher emphasis on online trading platform. It also offers call and trade services to its customers which is outsourced through call centers located at three key locations in India. The recently acquired Anagram Capital also largely operates through a sub-broker structure, which is relatively cost effective.

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n Given the enhanced growth in ECL's revenue streams along with check on operating cost, it has one of the best operating ratios as compared to its peers. Going forward, we expect ECL to maintain stable EBITDA margins at 36% in FY11 and at 37% in FY12. Its net profit margin is also expected to remain firm at 23% (23% in FY10) over FY11 and FY12. n In the wake of stable operating performance, we expect healthy growth in ECL's bottom-line at 28% yoy to Rs.2.8bn for FY11 and 17% yoy in FY12 to Rs.3.3bn. This translates to an EPS of Rs.39 and Rs 45 for FY11 and FY12 respectively
EBIDTA & PAT margins
80.0 60.0 40.0 20.0 0.0 FY06
Source: Company

EBITDA margin (%)

PAT margin (%)

FY07

FY08

FY09

FY10E

FY11E

FY12E

Trading at 13.0x FY11 EPS, valuations at current level appear rich; we recommend investors to accumulate the stock on declines with a price target of Rs. 525. n ECL, primarily an institutional broker has forayed into individual brokerage services thorugh inorganic route (aquired Anagram Capital). It is expected to witness healthy growth in earnings over FY11-12. We expect overall stock market volumes to grow by 15% over FY11-12. ECL has diversified its revenue stream. The share of trading and arbitrage income as percentage to total income, although remains prominent during FY11-12; however, it is likely to decline gradually as the funds will be shifted to high yield lending business. Asset management fee income growth is expected to remain steady going forward. n With ECL ramping up all its business stream, we expect net profit growth of 28% yoy in FY11 and 17% yoy in FY12. Following a healthy earnings growth outlook we are positive on ECLs future performance. However, at the current market price the stock is trading at one year forward P/Ex of 13.0x and therefore appears richly valued.
We are initaiating coverage on Edelweiss capital with ACCUMULATE recommendation and a price target of Rs.525

n We are valuing Edeweiss Capital Ltd at 14% discount to its Median P/Ex,(15.0x) i.e. 13.5x its FY11 EPS of Rs.38.9; leading to a price target of Rs.525. We have assigned a discount to ECL's historic valuation to factor in shift of capital to newer businesses viz retail broking. Improved capital market outlook is expected to drive earnings growth. We are initaiating coverage on Edelweiss capital with a price target of Rs.525. However, at the current levels valuation apperas rich and despite a positive business growth outlook we recommend accumulating the stock on declines given the limited upside of 4% from current levels..

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Relative to Sensex
40 30 20 10 0 Feb-08 Feb-09 Dec-08 Aug-08 Aug-09 Dec-09 Feb-10 Jun-08 Jun-09 Oct-08 Apr-08 Apr-09 Oct-09 Apr-10 ECL P/E Sensex P/E

One-year forward PE band


900 675 450 225 0 Jul-08 Mar-09 Jul-09 May-09 Mar-10 May-10 48 Jan-09 Nov-08 Nov-09 Sep-08 Sep-09 Jan-10 ECL 15 10 17.5 12.5 20

Source: Bloomber, Kotak Securities - Private Client Research

Source: Capitaline, Kotak Securities - Private Client Research

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FINANCIALS
Profit and Loss Statement (Rs mn)
(Year-end March) Income from operations Fee and commission Trading and arbitrage Interest income Other income Operating expense `-Employee Cost EBITDA Financial expenses Depreciation and Amort PBT Provision for taxes Profit after tax Minority Interest PAT FY09 8,965 2,441 3,209 3,315 40 4,201 1,659 4,764 1337 176.6 3,250.3 1,199 2,051 227 1,824 FY10 9,690 3,504 2,797 3,389 88 4,384 1,621 5,306 1943 122.5 3,240.9 879 2,362 157 2,205 FY11E 12,710 4,140 2,954 5,616 95 4,831 1,756 7,879 3,235 116 4,527 1,548 2,979 162 2,816 FY12E 14,679 4,714 3,056 6,909 105 5,176 1,824 9,504 4,081 111 5,312 1,815 3,497 190 3,307 Application of funds Fixed Assets Investments Current Assets Current Liabilities Net current assets Total Assets 527 2,698 34,711 5,176 29,535 32,760 913 5,769 50,592 5,435 45,157 51,840 1,005 6,779 57,469 6,250 51,219 1,155 8,135 67,761 7,187 60,574

Balance sheet (Rs mn)


(Year-end March) Sources of funds Share capital Reserves and Surplus Total Networth Borrowings Minority interest Total Liabilities 375 20,779 21,154 7,624 3,983 32,761 375 22,195 22,570 27,140 2,130 51,840 375 24,011 24,385 32,487 2,130 375 26,327 26,702 41,032 2,130 FY09 FY10 FY11E FY12E

59,003 69,864

59,003 69,864

Source: Company, Kotak Securities - Private Client Research

Source: Company, Kotak Securities - Private Client Research

Key data
FY09 EPS (Rs) Book Value (Rs) P/E (x) P/BV (x) Efficiency ratio (%) Operating Exp/Total Income Operating Exp/Avg Assets Employee Cost/Total Income Employee Cost/Avg Assets 38.8 9.7 18.5 4.6 59.2 8.5 16.7 3.8 57.1 7.1 13.8 3.2 56.7 6.4 12.4 2.8 24.88 282.13 20.26 1.79 FY10 30.59 301.20 16.48 1.67 FY11E 38.85 325.43 12.97 1.55 FY12E 45.53 356.34 11.07 1.41

Ratio Analysis
FY09 EBIDTA margin (%) PAT Margins (%) EBITDA growth (%) PAT growth (%) Return Ratios (%) RoE RoA 9.4 5.8 10.5 5.8 12.4 5.5 13.4 5.6 36.7 20.8 (27.1) -32.7 FY10 34.3 23.7 11.4 20.8 FY11E 36.4 22.9 48.5 27.8 FY12E 36.9 23.2 20.6 17.4

Source: Company, Kotak Securities - Private Client Research

Source: Company, Kotak Securities - Private Client Research

Kotak Securities - Private Client Research

Please see the disclaimer on the last page

For Private Circulation

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SECTOR REPORT

June 22, 2010

Research Team
Dipen Shah IT, Media dipen.shah@kotak.com +91 22 6621 6301 Sanjeev Zarbade Capital Goods, Engineering sanjeev.zarbade@kotak.com +91 22 6621 6305 Teena Virmani Construction, Cement, Mid Cap teena.virmani@kotak.com +91 22 6621 6302 Apurva Doshi Logistics, Textiles, Mid Cap doshi.apurva@kotak.com +91 22 6621 6308 Saurabh Gurnurkar Media, IT saurabh.gurnurkar@kotak.com +91 22 6621 6310 Saurabh Agrawal Metals, Mining agrawal.saurabh@kotak.com +91 22 6621 6309 Saday Sinha Banking, Economy saday.sinha@kotak.com +91 22 6621 6312 Sarika Lohra NBFCs sarika.lohra@kotak.com +91 22 6621 6313 Arun Agarwal Automobiles arun.agarwal@kotak.com +91 22 6621 6143 Ruchir Khare Capital Goods, Engineering ruchir.khare@kotak.com +91 22 6621 6448 Huzaifa Suratwala A Pharmaceuticals huzaifa.a@kotak.com +91 22 6621 6306 Jayesh Kumar Economy kumar.jayesh@kotak.com +91 22 6652 9172 Shrikant Chouhan Technical analyst shrikant.chouhan@kotak.com +91 22 6621 6360 K. Kathirvelu Production k.kathirvelu@kotak.com +91 22 6621 6311

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