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Introduction

Dun and Bradstreet India (D&B India) conducted a financial analysis of 39 listed equity broking firms, including some prominent players, to study the dynamics of the broking sector. For the purpose of the study, companies were classified into large, medium and small enterprises to get a better understanding of the sector. Companies having income below Rs 100 million were classified as small-sized firms (11 companies) and those with revenue of above Rs 100 million were considered as large and medium categories. The large and medium companies were further classified on the basis of contribution in total income; thus, companies that accounted for 80% of the total income were classified as large companies (8 companies) and the rest were classified as medium firms (20 companies). The study also includes an analysis of 17 listed companies, chosen from the total 39 firms, whose results were available for the nine months Apr – Dec 2008, to get a better perspective of recent trends.

Income segments

Equity broking firms gradually move towards a diversified product mix

In FY08 the earnings of the companies under study remained strong at Rs 72.18 billion growing by an impressive 95.2% as compared with FY07. During the same year, income from the core broking business grew 70%, but the core business’ share in the total income fell from 83.1% to 72.4% on a y-o-y basis. However, this fall is not unexplained as gradually equity broking firms are adopting a diversified product portfolio to reduce their dependence on equity broking. Even though income from wealth management, portfolio management services (PMS) and advisory fees accounted for a miniscule portion of around 5% of the total income in FY08, these services grew by more than 100% on an annual basis. Likewise, other revenue generating segments like income from trading activities, lending activities and investment banking grew by more than 50%.

In the near future also, the other revenue generating segments collectively, other than core broking business, are estimated to continue playing a larger role.

Medium-sized firms grow faster than peers, but remain more vulnerable in difficult times

During FY07 to FY08, mid-sized companies recorded the steepest increase of more than 100% in total income as compared with large companies’ 93.9% and small-sized companies’ 60%. Medium-sized firms also had a leadership position in terms of the income share from the core broking segment, which was 78% of their total income and grew by more than 100% during FY07-FY08. Moreover, these firms also showed the highest growth in wealth management (by more than 100%), and in PMS and advisory fees and lending activities (by 232.2%).

Nevertheless, the mid-sized companies’ heavy reliance on revenue from core broking activity, around 78% of its total income, is not a comfortable position, especially because revenues almost froze in this segment during FY07 and FY08. On the other hand, large and small-sized companies seem to have lowered their dependence on core broking activities; during FY07 to FY08, the large sized companies’ income from broking operations went down from around 85% to around 70% and that of small-sized companies went down from 60% to 55%. Thus, large and small companies seem to be better insulated than mid-sized firms for facing tough times due to their diversified product mix.

Expenditure component

Interest costs increase by over 140%

Interest cost skyrocketed by 142% in FY08 over FY07 and constituted 8% of the total expenses. Regulatory and stock exchange charges and depreciation increased by 94.0% and 27.2%, respectively, and contributed 4.3% and 3.2% of the total expenditure.

During FY07 to FY08, the income of companies considered for the study grew by 95.2% and its total expenditure, which stood at Rs 49.1 billion in FY08, grew by 79.0%. The other operating expenses, which included administrative, software maintenance, transaction cost etc, surged by 146.8% and constituted 60.1% of the total expenditure. Employee cost was the most significant cost for the equity broking sector, and increased by 68.1% y-o-y; however, the contribution of employee cost in total expenditure decreased from 31.1% to 24.5% during the same time period.

Employee costs highest in small-sized firms

Medium-sized companies not only recorded the fastest growth in total income but also recorded the highest growth in total expenditure during FY07-FY08; their total expenses grew by around 90% as compared with 76.3% and 56.0% for large and small-sized firms, respectively.

Operating and employee costs turned out to be the two significant costs across all the three types of companies. Employee cost, the single highest cost component, accounted for around one fourth of the total expenses for large and medium sized firms; whereas for small firms it accounted for 38%. As in the case of operating costs, midsized firms recorded the highest increase of 88.7% in terms of employee costs.

Operating costs, which include administrative, software maintenance, transaction cost etc, constituted around 60% of the total expenses of large and medium-sized firms, and 43.7% of the total expenses of small-sized firms. Mid-sized firms displayed the highest increase of 89.6% in operating costs.

The regulatory and stock exchange expenses grew the most in large companies at 96.1% as compared with medium and small companies, whose related expenses grew by 87.2% and 38.0%, respectively. The highest increase in interest costs was recorded by mid-sized companies at around 180%.;

Profitability

Net cash flow from operating activities generated positive figures in FY08

The operating profit margin of the companies covered in the study decreased by around 600 bps at 39.5% in FY08 as compared with 45.4% in FY07 owing to an increase in administrative and operating expenses. The net profit margins, however, did not deviate much from FY07; in FY08, the net profit margin was 21.6%, almost in line with FY07’s 21%.

Interest coverage ratio stood at 6.9% in FY08 which decreased from the FY07 figure of 8.1%. Debt to equity ratio for FY08 stood at 1.25 which increased from 0.6 recorded in FY07; this clearly shows that the sector has increased its reliance on debt financing. Interest cost as a component of total expenditure is likely to increase further in the future considering the difficult business environment. The cash and bank balance increased by 275.4% in FY08. Companies covered in the study also generated positive net cash flow from operating activities for FY08 compared to negative cash flows in FY07.

Large companies show better margins

Large companies dominated the sector in terms of operating profit margins as well as in terms of growth; the operating profit margin of large companies improved to 42.1% in FY08 as compared with 35.7% in FY07.

The net profit margins of large companies at 23.4%, was in line with FY07’s margins. Mid-sized companies and small-sized companies registered a net profit margin of 15.2% and 3.17%, respectively. However, the small companies also included three loss-making companies — if these companies are excluded from the analysis, the margin for this group of companies improves to 22.9%.

The return on net worth of large companies in FY08 was 38.9% as compared with 36.4% in FY07. The return on net worth of mid-sized companies showed maximum improvement at 17.3% in FY08 as compared with 10.6% in FY07. Small companies recorded a return on net worth of 1.6% and if the loss-making companies are excluded, their net worth improved to 11.4%.

The increase in debt-equity ratio of large companies from 0.7 times in FY07 to 1.6 FY08 denotes the increasing dependence of large companies on debt to finance their business activities. On the other hand, medium and small-sized companies’ debt-equity ratio stood at a much more comfortable level of 0.4 and 0.1 respectively as compared to large companies.

The growth in large companies’ cash and bank balance also surpassed that of other categories; the cash and bank balance of large companies jumped by 325% while that of medium-sized companies’ grew by 121.4%. Moreover, large companies reported a positive net cash flow from operating activities as compared with a negative cash flow in FY07. While medium companies’ net cash flow grew by 170.4%, small companies’ cash flows was negative.

Performance in FY09

The plunge in stock markets during the first nine months of FY09 dried up share volumes on stock exchanges and further pressurised revenues of stock broking companies. During the first nine months of FY09, the y-o-y total income for the 17 listed equity-broking companies decreased by 18.4% at Rs 11,501.3 million as compared with the same period last year.

However the bottomline had a much worse tale to tell. A large share of the operating expenditure of the retail broking industry is fixed, and that has now begun to have an impact. While revenues fell sharply, expenditure fell by just 4% - resulting in a major impact on profitability. Profits have halved and the pressure on profits is immense as companies are finding it difficult to adjust costs amid declining revenues. In the first nine months of FY09, the PAT margin of the 17 listed companies was 16.7% as compared with 29.1% during the same period of FY08.

Interest expenses prove to be a drag

The interest expenses accounted for close to 3% of net sales for the 17 companies. As profitability deteriorated, the burden of interest expense on earnings (EBIT) increased leading to deterioration of the interest-coverage ratio. Before the start of FY09, it was plausible for the equity broking companies to believe that related businesses such as margin financing, wealth management and advisory services, investment banking, distribution of financial products, etc would lead to diversified revenue streams and would augment growth opportunities, besides providing a cushion to the cyclical business of equity broking. However, as investment appetite has decreased, revenue from most of the related businesses has collapsed. The distribution of financial products has also been hurt as there are hardly any IPO offerings in the markets and the appetite for other financial products including mutual funds has dipped.

The equity markets seem to be showing signs of revival, as the Sensex jumped from a low of 8,160 on Mar 9, 2008 to 12,134 on May 4, 2009, gaining around 50% in a span of two months on the back of strong volumes. Even though there is a glimmer of hope that lies ahead, it is too early to assume that the worst is behind. Whether this is the start of a new upward cycle, only time will tell.