Edelweiss IPO Analysis

Edelweiss Capital's IPO may appear slightly expensive but it has high margins to boot.

It's raining IPOs from Indian broking firms. After IPOs of Motilal Oswal and Religare Enterprises in August and October respectively, there is yet another player Edelweiss Capital tapping the primary market.

And it's a bonanza time for investors as they can rake in profits not only by following the broking firms' investment advice but also investing in their companies, whose stock prices are soaring on the bourses.

For example, stock price of Motilal Oswal has appreciated by more than 50 per cent in less than three months and Religare too is expected to be a big gainer on listing.

Edelweiss Capital, a holding company of nine subsidiaries, plans to raise about Rs 609-693 crore from the primary market by issuing 8.4 million equity shares (including employee reservation of 0.2 million) in the price band of Rs 725-825.

The company plans to spend about Rs 435 crore over the next two years, most of which will be spent by March 2008.

The IPO proceeds will mainly be invested in its 100 per cent subsidiary, Edelweiss Securities (ESL)—which is into institutional equities, private client broking and wealth management for maintaining higher margin balances with the stock exchanges, prepaying loans, expanding office network and infrastructure, and enhancing existing technological capacity.

Same products… Like its peers, Edelweiss also wants to offer more than just equity broking and expand its product basket to position itself as a diversified financial services player.

The company, which started as an investment bank in 1996, has grown its businesses rapidly in last four to five years to include various high growth businesses like institutional equities, private client broking (for high net worth individuals), asset management, wealth management, insurance broking, treasury and wholesale financing.

The company has classified the last two businesses (treasury and wholesale financing) as capital businesses, and they form about 38 per cent of total revenues. It groups the remaining segments as agency businesses, which contribute about 58 per cent.

The company has indicated that it will achieve a balance between these two businesses.

...but a different strategy There are certain factors, which merit attention before investing in Edelweiss' IPO. First, the company is a dominant player in the institutional and high net worth individuals (HNI) segments with almost negligible presence in retail.

This is in contrast with other major players which are expanding their footprint in retail.

This could however be a blessing in disguise in the sense that it has helped the company enjoy higher margins – operating profit margin and net profit margin of about 48 per cent and 29 per cent respectively - than its comparable peers.

Says Arun Kejriwal, director, Kejriwal Research and Investment Services, "The company's forte in institutional and HNI segment has helped as retail business means low brokerages and small volumes." However, the company has not closed doors for retail customers and will evaluate the opportunity.

Second, financial services, being a high growth industry, companies have to grapple with retaining good talent and rein in attrition.

Edelweiss Capital has tackled this problem by issuing shares and ESOPs to employees, which will account for just under 20 per cent of the company's post-issue capital. Moreover, most of the senior management has been with the company for over five years.

Third, global financial players like Greater Pacific, Galleon Group, Sequoia Capital, Shuaa Capital and Lehman Brothers will be holding 37 per cent in the post-IPO capital, which instills confidence about the company's reputation and skills.

Some of these investors are also represented on the board, half of which is made of independent directors.

The only thing, retail investors need to keep in mind is the fact that the industry, in which the company operates, is highly working capital intensive as margin requirements increase if business increases.

So, constant capital infusion (equity or debt) is required from time to time which could lead to dilution (in case of equity).

High margins… The issue has been assigned IPO Grade 4/5 by Crisil indicating that the fundamentals of the company are above industry average. This follows strong growth reported in the past few years without much contribution of low margin high volumes retail business unlike its peers.

The company's consolidated net sales zoomed at 119 per cent a year between FY05 and FY07, thanks to the introduction of new high growth businesses mentioned above.

Despite substantial jump in employee and other operating expenses, the company managed to clock a higher operating profit growth of 123 per cent CAGR in the same period due to high margin institutional and HNI business. Net profit growth was capped at 120 per cent (still robust) due to jump in interest costs.

Going forward, the growth is expected to be higher as many of its subsidiaries covering various businesses like wealth management, asset management and advisory services have been formed in FY06, which are yet to achieve scale.

Further, increasing foreign money, rising market turnover and growing HNI population provides immense potential to the company.

Despite short term hiccups, the long term trend of the Indian market is upwards thus providing long term visibility. Moreover margins are likely to be maintained.

"Our focus is on profitable growth with risk managed return on equity," says Rashesh Shah, chairman and managing director of the company.

…bring premium valuation At Rs 725-825, the issue is priced at about 27 times and 30 times for FY08 estimated earnings respectively. This is much higher than its closest peers Motilal Oswal and Religare which trade at 21 times and 15 times for estimated FY08 earnings respectively.

The company commands high valuations because it enjoys superior margins than others and has reported strong financial performance without too much presence into the retail business.

Also, the growth in FY09 is going to be robust. For estimated FY09 earnings, the company's is valued at 13 - 15 times (assuming 100 per cent growth in earnings ) and 17-20 times (assuming 50 per cent).

Short term investors would get decent returns depending on market conditions post listing. Long term investors can select from a wide range of listed broking firms depending on factors like the extent of diversification, broader network and choice between HNI or retail growth. Issue opens: November 15 Issue closes: November 20