- Deal Digest (Aug 20)
Broking firm Motilal Oswal Financial Services [MOFS] could be getting its IPO out just in the nick of time. With dark clouds hovering over global capital markets, the fairy tail run of broking firms could be close to getting over, at least for a few quarters. This could adversely affect the fund raising plans of dozens of smaller broking firms which are lined up in both public and private equity markets.
In recent times, broking firms have commanded premium valuations. The three key listed firms – India Infoline, IL&FS Investmart and Geojit, all quote at a P/E of more than 40x based on FY07 profits. This has whetted the appetite of smaller broking firms, at least 15-20 of which now want to raise money at high premiums.
MOFS’s IPO, which intends to raise Rs 240 crore or so from retail investors, is opened on August 21st. This is a blue chip firm, and the pricing is reasonable compared to its peers. MOFS appears to be asking a P/E of 31x on FY07 net profit. This could see investors lining up to subscribe. But other broking firms, which haven’t yet got cash in the bank may not be so lucky, since the market scenario appears to have changed.
Six months ago, if you asked the question – ‘What is the probability of a bear market?’ – most investors would have said 10% or less. Now things have changed. US economy is looking shaky, RBI doing its best to slow demand, rising rupee, slowing exports, yen carry trade under threat – the list of negatives far outweighs the positives.
The ET-NCAER Business Confidence Index had its sharpest fall since the start of the bull markets in its last read. So now if you the same question, investors will rate the probability of a bear market as high as 40-50%.
A change in market outlook can have dramatic consequences on valuations of broking firms. In the last 3-4 years investors seem to have overlooked the downside in broking firms, but the fact remains that broking is one of the most risky businesses around. It is about as risky as steel – the only difference being you have a brand here, unlike steel. However, the business parameters can be equally, if not more volatile.
To understand risk in investing in a broking firm, it is important to understand the affect a falling market can have on revenues, and operating profits. At this point, most listed broking firms have PBDIT margin of around 30-35%. Broking is a peculiar business. When the market falls 10%, revenues can immediately fall 10%, even if you are executing exactly the same number of trades for exactly the same number of customers.
The impact often is far more severe. The number of trades falls as well. So for a 10% fall in indices, trading volumes can fall far more. Average daily turnover was more than 50% lower in 2002 as compared to 2001, while the market on an average was down only around 10% or so.
So given the way the broking business is, profits of broking firms can fall sharply in a bear market. Say indices correct 10-15% and stay there, broking firms can easily have 25-30% drop in net profit.
The market has looked extremely shaky in 2007. The traded amount gives the impression of having gone up, since indices have risen. But the trading volumes have stayed almost flat since 2006. The fact that mutual funds have been net sellers in 2007 also shows that retail investors have moved away from equities.
When fixed deposit rates are 9.5%, an ordinary investor should stay away from equities. In fact, for MOFS, its amount under management under portfolio management has shrunk marginally in FY07 over FY06. Even high net worth individuals aren’t committing more to the markets in recent months.
So the probability of the bull market taking a halt is rather high at this point. This means there is good chance of broking firms delivering lower profits in FY08 as compared to FY07.
This brings us back to our key point – broking firms that haven’t raised money yet could have a very small window left in which to do so. Any investor – whether a private equity player, or a retail investor – would ideally give a lesser price to a broking firm now, compared to six months ago.
In this 4 year bull rally, there have been two occasions when the market has seen severe falls. It has rallied both times after that. Will the market be a third time lucky? The odds are less this time.