Edelweiss Capital: Invest at cut-off

Investors can bid for the initial public offering from Edelweiss Capital at the cut-off price. A good track record of growth, a balanced business model with a focus on institutional clients, and a superior margin profile make Edelweiss Capital a quality exposure to the Indian financial services sector, which is in the take-off phase. The offer, which is being made in the price band of Rs 725-825, values the company at 34-38 times the likely earnings for FY-08. This assumes that Edelweiss will sustain its income growth of the first five months for the full year and manage an operating profit margin in line with its three year trend.

At the higher end of the price band, the asking price values Edelweiss at a premium to Motilal Oswal Financial Services and Religare Enterprises (based on its offer price), but at a discount to firms such as IndiaInfoline. Though these valuations appear expensive on an absolute basis, they are justified by the scorching pace of growth managed by Edelweiss since inception, its less risky business mix and the scalability offered by businesses such as wealth management, financing and asset management, which are recent additions to its portfolio.

Different business mix

Edelweiss Capital's core operations are investment banking, asset management and portfolio management services, which are housed in the parent company. However, like other financial services companies, Edelweiss Capital too has a range of subsidiaries engaged in private client and institutional broking, advisory and wealth management services (all housed in Edelweiss Securities, a 100 per cent arm), as well as insurance broking and financing businesses. Most of these, save for the insurance broking arm, are 100 per cent subsidiaries, whose financials reflect in the company's consolidated numbers.

Fee-based income arising from investment banking services and brokerage from advisory/trading services for institutional clients, have accounted for between 55 and 63 per cent of the company's total income over the past three years, while trading/arbitrage and treasury income have accounted for much of the rest. Edelweiss' reliance on investment banking and institutional advisory services for its income makes its business less volume-driven than that of peers such as Religare — which are more focused on retail equity broking services.

The growth in fee income for Edelweiss would hinge indirectly on buoyant equity market conditions and healthy levels of M&A and fund-raising activity by Indian companies. But unlike equity broking targeted at retail clients, the business is not vulnerable to blips in transaction volumes in the equity markets caused by short-term market volatility. Regulatory risks would also be relatively lower in engagements with institutional investors as compared to retail investors.

The different business mix also appears responsible for Edelweiss enjoying a superior operating profit margin compared to similar sized peers in the financial services space. The company's OPM has consistently hovered above 50 per cent for the past four years, while the best performers within its peer group have only managed 30-35 per cent. This superior margin profile has allowed the company greater cushion to handle a spike in financing costs in recent times.

Edelweiss has managed to bag mandates for a reasonable number of mid-sized IPOs over the past year (Cinemax, Meghmani Organics, Orbit Corporation), has dabbled in private equity and real estate advisory, and has a portfolio of 150 clients for its institutional equities business. While competition in the investment banking business is intense with large international firms and a host of boutique investment banks vying for a share of the pie, the buoyancy in fund raising by mid and small sized firms through the equities and convertibles route offer potential for an entrenched player such as Edelweiss to scale up fee-based income.

That fee and brokerage income for Edelweiss has risen over four-fold from Rs 42 crore in FY-05 to over Rs 137 crore, in the first five months of FY-08, with steady growth from year to year, suggests that it has been successful in bagging a steady stream of mandates for its investment banking business. Contributions from the investment banking business however, may be lumpy and may make for considerable variation in performance between quarters.

Treasury gains

The substantial contribution made by treasury operations, however, appears to be a weak spot in the company's financials. Treasury gains over the past three years have been driven by a steady expansion in the company's surplus funds, which have contributed to a swelling investment book. However, these surplus funds may have to be ploughed back into the business as the company scales up its nascent businesses and expands its presence in more capital-intensive segments such as wholesale financing.

This would substantially shrink the treasury income from current levels. Profit contributions from Edelweiss' recent forays such as wealth management and asset management, as well as a rise in fee-based income, could make up for the reduced treasury contributions. That the company's treasury has been conservatively managed, relying more on arbitrage and debt returns, rather than the stock markets, is a comforting factor on this score.

Financials

Overall, Edelweiss' consolidated operations are comparable in scale to companies such as Motilal Oswal, Indiainfoline and Religare, with a total income of Rs 371 crore in FY-07. Like its peers, Edelweiss has seen a substantial scaling up of revenues this fiscal, with a total income of Rs 284 crore in the first five months of FY-08 alone. With net profits (after minority interests) of Rs 109 crore and Rs 80.9 crore in FY-07 and FY-08 (five months to August) respectively, the company ranks higher than the others on profitability. The company's profits for FY-07 would translate into per share earnings of Rs.15 on the post-offer equity base. Our earnings estimate for FY-08 suggests a likely per share earnings of Rs.20-22 for the year.

Offer details: Edelweiss Capital is offering 83.8 lakh shares at a price band of Rs 725-825 (face value of Rs.5) through this book-built initial public offering. The promoter holding will stand at 34.98 per cent of the post-offer capital, while institutional investors and employees (through ESOPs) will hold another 54.7 per cent.

The offer proceeds will be deployed mainly towards enhancing margin limits to be maintained with the exchanges, opening of additional offices, IT investments and prepayment of loans.