IIFL Securities: 3rd Largest Indian Broker with ~25% ROCE at 1x EV/FCF

My Top Pick for 2021

IIFL Securities (part of the India Infoline Group) is India’s 3rd largest securities broker, and set to benefit from the increasing retail participation in Indian securities markets. IIFL is also a leading securities research house and investment bank, and also has an insurance brokerage segment. It recently acquired Karvy’s trading and brokerage accounts, and there was a brief 35% rise in the stock price in 2 days before it crashed back to its previous price levels. This is the rare stock where you have both a good business and a good investment, which is why it is my top pick for 2021.

A Little Background

IIFL Securities was spun out of IIFL Holdings around 2017-2018 because the market was assigning the stock a significant holdco discount. I and many other observers, along with management believed that the spin-off would be the catalyst for unlocking a lot of value, and it did for the two other arms of IIFL (Finance and Wealth Management). However, IIFL Securities continued to trade at a massive discount to its intrinsic value. The company initiated a buyback and bought back 5.31% of its float, however this too was not big enough a catalyst for the market to price the company at its intrinsic value.

The company was one of the first Internet-native brokers, and captured a lot of market share due to the ease of trading on its platform. It was one of the market leaders until zero brokerage platforms arrived on the scene. Now, with the recent acquisition of Karvy’s demat accounts, it has become the 3rd largest broker in the country, second only to discount brokerages Zerodha and Upstox.

Its investment banking and equity sales houses are elite and lead their respective markets. Its insurance business is relatively new but growing rapidly.

The Moat

1. Brand Power

IIFL was the first online brokerage, as mentioned above, and you may remember accessing its website in the Internet’s early days in India. Even if you did not open an account at the time, the IIFL brand became known to you. Many people went on to open accounts, as evidenced by the 4% market share of Average Daily Turnover (quite high for a fragmented market).

This is anecdotal but I believe IIFL has one of the best customer experiences compared to other Indian brokerages. I have tried many platforms and find it to be one of the best. It has a modern website and application, good execution & customer service. Its user experience and account opening process is on the same level as many new discount brokers and far better than most full service brokers, slightly lagging Zerodha and some others but not by too much (.3 - .5 stars on Play Store). Downloads are almost in the same range, with the top 3 having 5 million + each on the Play Store.

I believe IIFL combines the best of discount and full service brokers. It has impressive applications & customer service, as well as easy account opening procedures, just like many discount brokers. It has the reliability, trust and brand loyalty full service brokers enjoy. IIFL is certainly leading the fully priced brokerage market and challenging the discount brokers, it could become the No. 2 in its sector within a couple of years.

The investment banking and equity research operations are certainly the best in the country. IIFL Securities is an elite boutique bank, which has underwritten a significant amount of deal flow in the country. In prestige it is second only to Equirus and foreign banks. IIFL Securities is like the Centerview or Moelis of India.

Management adds to the brand power too. Founder Nirmal Jain and director Sanjeev Bhasin are highly respected on the Street, as is the CEO R Venkatraman. Their presence attracts and helps retain valuable customers and employees.

2. Switching Costs

Many investors in India are infrequent traders. Switching to the broker with the lowest transaction costs on the Street is impractical and would require lots of time and effort. This is of course not applicable to day traders, but most of them are not long-term users and not the type of customer who can be retained.

IIFL offers trading APIs free of charge to its registered customers. This adds another layer of stickiness, as it is tough to change trading systems once they are set up.

Institutional customers will most certainly not change brokers frequently, if they ever do. Most institutions have accounts with multiple brokers, so they can just choose to divert order flow to their other accounts. However, Zerodha and others cannot yet handle the massive order flow such customers bring, and full service brokers can handle their orders but with multiple institutional clients there is a limit on how many they can serve.

The only competition for IIFL on the institutional front is from small family-owned brokerages and foreign banks. The one who wins here will have to offer the best execution, post-trade services and customer service.

3. Barriers to Entry

The Indian brokerage market is very fragmented, with multiple small brokers capturing a significant percentage of the market share. In such a setup, to enter and gain market share you have to capitalize on a major technological change. The zero charges business model is very new, and before realizing they could sell order flow and data to market makers, most of these discount brokers were cannibalizing themselves.

With crypto (and as a consequence DeFi) set to be prohibited in India, I don’t see a big technological change coming in the securities markets in the near future. Most brokers, including IIFL, have already realized economies of scale and harnessed network effects to their benefit, and toppling them will be highly difficult.

End Market Analysis

The Indian securities market is growing rapidly, with a lot more people from previously underdeveloped regions opening trading accounts. Many states have logged 100% growth in 1H 2020, with a cumulative 6.3 million demat accounts opened in the country. I have seen a lot of interest in the stock market in places where 2-3 years ago people wouldn’t trust even government owned banks with their money. If you know India you know this is a big paradigm shift.

While retail participation is increasing, new institutional investors are also entering the picture. New funds are being chartered domestically and an increasing number of new foreign investors are entering the market.

The number of retail accounts in India is 44 million, which is a penetration rate of 3.5%. That is an abysmally low figure, however, there are a million new accounts being opened every month (source). A comparable economy is China, where there are 180 million retail accounts, a penetration rate of 14%.

Comparables

It is obvious that IIFL is undervalued compared to its returns on capital. The median EV/FCF multiple sems to be 13x, which seems reasonable to me.

Valuation

The current valuation offers a lot of upside and should be taken advantage of. For those who wonder why I assign a relatively high multiple to a company with declining revenue, I believe this year will be the turnaround year where revenues rise after 3 years of decline. My analytics platform annualizes the quarterly data for me automatically and I see at least 10% revenue growth in the base case. We should remember that the revenues from the purchased Karvy accounts are yet to be realized.

Catalysts

1. The firm has a lot of cash on hand, equal to 80% of its market cap. Another buyback could be highly value accretive.

2. The firm can also acquire a smaller brokerage. There are about 8-10 listed which are smaller than the company.

3. Annual results show FCF and profit growth and the market rerates the stock.

4. The customers who came on board due to the acquired Karvy accounts retain their business with IIFL.

Free Optionality

I have not yet included the insurance business in this thesis, because I don’t understand it yet. Very little information is available, I look forward to the annual report when more numbers are revealed.

IIFL can start cross-selling market data, connectivity, post-trade solutions, custodianship among other high-margin services to its existing customers. Many brokers in foreign countries sell these services with great results (eg: Interactive Brokers, JP Morgan, Wedbush etc.)

That’s all the analysis I have for my top pick of 2021. I am materially invested in this stock, so take my advice with a grain of salt.