Description

Executive Summary – Long Recommendation: I recommend buying ISEC’s shares at Rs 840 / share with a price target of Rs ~1200 / share. At this price, the stock has a 50% margin of safety with a maximum potential downside of 16%. I believe that, even in the event of a merger, the shareholders of ISEC will be able to extract a fair value. 

Variant Perception: ISEC’s insider’s (ICICI Bank, the “Parent” bank, which owns 75% and controls the distribution) are keen to acquire the remaining ~25% of the business at effectively Rs 665 / share. This is a clear bargain to the benefit of the Parent, at the expense of the subsidiary’s shareholders. The market believes that the transaction will take place (evident in the share price). However, many of the large minority shareholders (whose approval is needed) and their advisors have expressed their dissatisfaction with the current terms and are likely to block the transaction.

As a result of the Parent owning 75% of the shares outstanding, ISEC is an illiquid security, with only 500k shares traded a day (around US$ 2 Mn) and few institutional investors. To build even a US$ 10 Mn position would take someone 25 trading days / 5 weeks at least during which time they run the risk of moving the share price.

The market has missed the transformation that has taken place at one of India’s leading integrated financial services firm; ISEC has evolved from a volatile broking business to a more stable financial “supermarket”. Most of the sell-side questions on earnings calls revolve around market share in derivatives, equity broking, and the cost of funds for margin trade funding (MTF). While these are large, fast-growing, and very profitable lines (MTF is a ~30% RoE business), they are unlikely to continue to grow at the same historical pace as because these activities (derivative and margin trading) are injurious to customer’s financial health (9/10 of Indian traders lose money in derivates). Management has, rightly, been more focused on building a full-service wealth platform with sticky flows, which the market has completely missed – this is not the brokerage it was a decade ago!

It also has a better brand and a strong right-to-win in India’s burgeoning towns and cities – where the unit economics and customer psychology will make it difficult for other players (incl. digital platforms) to build a sticky customer base. ISEC’s parent is one of the most trusted brands in India (a country with low levels of “generalized trust”) and through their thousands of branches, ISEC is able to serve customers without incurring fixed staff and office costs.

Valuation: An extremely conservative valuation for ISEC is around Rs 800 / share based on a multiple of 23x FY23 EPS. The multiple is calculated using a cost of equity of 12% (the long-term historical average) and growth rate of 7.4%, in line with the risk-free rate (note that the difference applied in the Gordon-growth model is effectively the equity risk premium). The assets advised by, and subsequently the earnings of ISEC, should grow at least at the Indian risk-free rate which is currently at ~7.4% and compares to the long-term reported rate of inflation of ~6%. Achieving a risk-free rate of return on their client’s assets should be easily managed by ISEC, which deploys the advised AuM into diversified equity funds. The risk of customer assets leaving in a down market is effectively mitigated by ISEC’s “new” operating model which benefits from automatic investing and dollar-cost-averaging: ~60% of the revenue in FY23 is derived from such sticky sources versus 11% in FY14 and 18% FY18, when the business listed (more details in appendix).

A downside case (i.e. loss of principal) could occur if the proposed delisting (and effective merger) occurs, which requires ISEC shareholder approval (bank shareholder approval is a given), regulatory approval (from two independent regulators, RBI and SEBI) and a sudden re-rating of ICICI Bank (currently over-valued at 3.1x book, effectively a PAT yield equivalent to the risk-free rate). Indian regulation requires that two-thirds of the minority shareholders approve the transaction. Many of the large minority shareholders and their advisors are aware of the obvious bargain being given away and have made their displeasure known publicly (several news agencies, stock forums and Twitter threads have also picked up the topic). I believe that the domestic mutual funds and large number of retail shareholders will vote with the loud, smart money. Failing that, the cumulative probability of all four events taking place is extremely small.

A more reasonable multiple would be between 30x to 40x EPS: Rs 1,000 (20% upside) to Rs 1,400 (70% upside) / share – its most comparable peer (360One WAM, see appendix) trades at nearly 30x LTM EPS. In summation, at the current price, there is a single digit chance of a 16% loss and a moderate chance of a 25-50% profit.

Company Overview: ICICI securities is one of the leading financial-service firms in India with ~10% market share (number of customers). It was founded in 1995 as a subsidiary of ICICI Bank, India’s second-largest bank, which continues to be the 75% owner. It provides ~9 million Indians with financial advice and earns commissions and fees on the assets advised (in mutual funds, proprietary funds, and private equity / venture capital funds), brokerage on equities and derivatives traded, commissions on insurance and loan sales. It does this though several online platforms, 140 of its own branches and 4500+ branches of ICICI Bank in 2700+ towns and cities in India. It also has an institutional broking business and an investment bank. It is a leading (top 5 / top 10) player in every business line and benefits immensely from the reach of its Parent as well as the experience of its management team. 

Industry Overview: The Indian wealth management industry is nascent, despite > 1 billion bank accounts (versus 1.4 billion Indians), only ~75 million Indians filed taxes of which only ~60 million are investors in mutual funds, versus ~100 million stock market investors (many Indians fall below the minimum tax threshold). Only ~40% of individual’s assets are in financial products, which in turn is predominantly (60%) deployed in low-return fixed income products (bank deposits, insurance, government savings programs). The non-financial and fixed income assets do not deliver a return greater than the rate of inflation faced by the holders of those assets; while the reported inflation rate is 6%, this is heavily (40%) weighted towards food, which correctly reflects the spending pattern of 90% of low-income Indians. However, the Indians (the ~10%) who hold those assets experience a rate of inflation closer to ~10%, given a higher proportion of healthcare and education spending (the prices of which are currently inflating at ~14% pa). There is therefore a huge imperative for those Indians to invest more in higher-yielding products and to get more Indians to invest. The wealth management industry helps to make that happen by opening branches near those Indians (most Indians are scattered in countless small towns and villages) and introducing them to equity markets, guiding them through the associated volatility (I’m simplifying greatly, the actual process takes several decades). For this, they earn an annual commission based on the nature and size of the assets advised or a brokerage fee (typically a flat rate) on stock market transactions. Over the last 2 decades, the industry’s Assets under Advice (AuA) has grown at a ~20% CAGR, ~ 12% of which can be attributed to mark-to-market. While there is a long-tail of players and no single player enjoys a substantial scale advantage over all the rest, players like ISEC have the benefit of many (essentially free) branches in small towns, the financial size of which would not support a standalone wealth manager. Captive distribution, in the form of bank branches, has thus allowed some players to increase their share, especially in markets with the highest growth.

Company Strategy: When it listed in 2018, ISEC was predominantly a brokerage house (~60% of revenue) with a large amount of exposure to capital market volatility in its other major line, investment banking. Since then, it has expanded its product offering, built out digital platforms and started developing its own products to create a stickier flow of AuM, revenues and profits. Today the brokerage business contributes only ~20% to the total (see appendix), while the “sticky” revenue has increased from 11% of total in FY14 to 18% in FY18 to 61% in FY23. Especially interesting is management’s steadfast focus on this singular aim during unprecedented growth in the broking industry - the number of new broking accounts being opened tripled and then doubled in two consecutive years. Although ISEC did benefit from this tailwind, especially in its MTF business, it has actively deprioritized this business in favor of other business lines; the net revenue of it’s broking business is actually smaller than it was 9 years ago. It has instead focused more heavily on growing the mutual fund distribution business and the private wealth management business. These two lines differ from broking in two key ways; 1) the investment funds are automatically debited from the client’s bank accounts every month under what is called a Systematic Investment Plan (SIP, known as dollar-cost-averaging in the U.S), reducing the impact of human psychology and 2) the fees earned are not on the traded quantity (i.e. the “flow”), but the invested assets under management (the “stock”) and thereby benefit from the marked-to-market returns of the underlying assets. The launch of it’s private wealth management offering in 2019 was especially instrumental in ISEC’s strategy. 

Value proposition to customers: Through its exclusive partnerships with ICICI and IDFC banks, ISEC allows new customers to open three, fully integrated bank, DEMAT and online trading accounts instantly. This has the added benefit of allowing customers to instantly transfer funds between accounts (instead of waiting for T+2), pledge shares, or borrow against various holdings. ISEC also offers a comprehensive array of investment, protection, and borrowing options for its customers so that their financial needs can be managed holistically by a single advisor and are made available in a comprehensive report. Furthermore, many Indians are new to financial markets and there have been several instances of brokerages and advisors using client money for their own needs or otherwise mismanaging them. ICICI is a household name in most parts of the country and is trusted to behave responsibly (failure to do so could damage faith in the bank, which would be entirely disastrous). 

Supply chain: ISEC has partnerships with all major mutual funds, insurance companies, private wealth managers and lenders. It also has an in-house research team that covers 300+ Indian stocks and funds.

Management: Vijay Chandok has been CEO of ISEC since 2019 (with ICICI group for ~30 years) and Vinod Dhall has been the Chairman of the Board since 2014. Anupam Guha heads the private wealth business (which he set up) and has worked at ISEC for ~15 years. Ajay Saraf has run the institutional business for 8 years and joined the group 17 years ago. They are compensated by salary, performance bonus and, in a very large part by ESOPs (~80% of total comp).

Risks: 

• Prolonged market downturn: Such an event would eventually shake even the customers who have signed up for SIPs. While this risk does remain, the benefit to ISEC is that banking will be needed even in such an environment and therefore the tangible capital of the business remains intact, ready to be put to use when the market eventually picks up again. 

• Banking crisis: A widespread or ICICI-driven banking crisis could damage the long-term potential of ISEC. However, the Indian regulator has stepped in to rescue failed banks (Yes bank, for example) which have gone on to grow their securities and banking franchises thereafter.

• Transaction consummation: Entirely possible but would require two-thirds of the minority shareholders to ignore the obvious fact that the business listed at the almost the same price it is now being purchased back at. Many retail investors have cottoned onto this fact and are vocal on Twitter and investment forums. The largest risk is that the retail investors follow the direction of LIC, who own 2.6% of ISEC and 7.6% of ICICI Bank. It would also require the regulator to allow ICICI Bank to use a newly created loophole (the merger was announced the week after the loophole was created), which is supposed to apply to companies in the same line of business. Aside from the question of whether wealth management is truly in the same field as banking, in the circular wherein the loophole was created, SEBI mentioned that this exemption is given only “at it’s discretion”.

  • I suspect that ICICI Bank is aware that the odds its merger will go through are slim and is therefore not serious (management’s tone on the delisting of their business has been casual to say the least – “what are you expecting me to say about the topic”) but is rather using this mechanism to draw institutional attention towards the business in hopes of getting a fair valuation.

Pre-Mortem: A severe banking crisis would not only damage the distribution capabilities (and therefore the profits) of ISEC, but also likely lead to an increase in the equity risk premium. The risk-premia for non-US countries (including India), broadly tracks the US premium. We can see that, during banking crises, the risk premium does indeed increase dramatically, which would lead to not only depressed earnings but also depressed multiples for ISEC for around a decade or longer. 

Follow-Up work: I would want to speak with some of the large minority shareholders and their advisors, many of whom are known to me, being careful to not inadvertently get ahold of any non-public price sensitive information. I’d also like to speak branch and relationship managers at ICICI securities to get a better feel for the customer stickiness and the broad portfolio construction. Finally, I’d like to speak with the management to understand if / how they are building a platform for the eventual churn in their independent financial advisors (IFA) / branch staff; in the US, Charles Schwab continues it relationships with registered investment advisers (RIA) who leave to start their own, smaller, RIA businesses by providing them with a custodial services, a technology platform and back-office support.

Disclaimer: I have a significant interest in the companies mentioned in this report and take no responsibility for the factual accuracy of the information provided. Investors are encouraged to do to their diligence before investing.

Appendices

Appendix 1: US Equity Risk Premium has risen during financial crises but otherwise remained between 3%  to 5%

Appendix 2: ISEC changed from a volatile brokerage-led business to a “sticky” flow and recurring fee business

Appendix 3: Despite better prospects, ISEC trades at a discount relative to peers

Note: Angel One is largely a broking business (~70% of revenue), its nascent mutual fund distribution business is a pure “direct” (i.e. no commission) platform and earns 0 fees. Broking-derived profits are greater to much more fluctuation and can be thought of as having a “double-beta” risk in adddition to operating leverage. 

IIFL securities is currently fighting a legal case with the Indian regulator, SEBI, regarding claims that it mismanaged client funds during 2014-17. If it is unsuccessful, it could be barred from onboarding new clients for 2 years.

Financial Statements of ICICI Securities

Catalyst

There is a key vote on the 27th of March on the delisting of the business. I believe that the delisting is not in the interest of the minority shareholders and therefore if the minority shareholders vote against the deal the price will advance shortly after.