Rising competition and costs are likely to keep profitability of brokerage firms under pressure, leading to consolidation.
The Axis Bank-Enam deal sparked a rally in brokerage stocks and also fuelled murmurs of possible consolidation in the industry. Currently, while the number of pan-India brokerages (medium to large players) is over 25, there are many stand-alone players.
Industry experts feel consolidation is surely on the cards and expect the stand-alone players to have a tough time surviving in this low profitability business amidst intensifying competition as the bigger players aggressively expand their reach.
While the consolidation would pan out over the medium to long-term, the near-term prospects of brokerage firms are not very bright, suggesting that their stocks would at best move in line with the broader markets.
There are quite a few triggers that could lead to consolidation (mergers and acquisitions) in the industry. Among key reasons is the intensifying competition and rising costs, which are putting pressure on the margins.
"Consolidation is a definite possibility in this sector. However, each player has its own credentials with expertise in different domains like investment banking, commodities, etc.
The next deal could possibly be some foreign player buying out an Indian brokerage for its distribution skills. In the next 5-10 years, the industry will shrink to around 10 large players and some region-specific small brokers," says Jagannadham Thunuguntla , strategist and head of research, SMC Global.
Among other factors, says Karthik Srinivasan, senior VP, Co-head, financial sector ratings-ICRA, "The RBI draft laying down guidelines for new banking licences, expected to come out at the end of January 2011, can act as a trigger for consolidation in this space."
While players with a strong parentage (MNCs, big Indian corporate houses) are better placed to withstand tough times, brokerage outfits owned by banks will aim to achieve a higher growth trajectory.
Industry sources suggest smaller banks are also eyeing deals with domestic brokerages as it adds to the former's offering. Similarly, they do not rule out the possibility of an NBFC buying out a brokerage firm in a bid to diversify their operations.
However, consolidation among standalone brokerages seems unlikely due to the large business overlap.
The key behind identifying the buyout candidates lies in understanding their profiles and the synergies they can bring to their acquirers. A reasonable market share coupled with a strong relationship with corporates is the most crucial factor influencing a takeover or merger decision. The need to fuel growth could be another strong reason for the same.
Compared to the drubbing the brokerage companies received during the meltdown days, the revival of the capital markets has breathed life into these companies.
However, the September quarter results of the larger players did not enthuse, while it was a mixed bag for smaller players. The quarterly numbers reveal that the pressure on profitability remains and is largely due to lower yields (rates).
The consolidated performance was largely driven by higher funding books, IPO and M&A transactions. The broking business is changing in favour of options volumes, which have low brokerage rates. Though the equity markets are looking better, the brokerage rates are likely to remain under downward pressure, believes Srinivasan.
A higher number of retail participants and cash transactions would allow the brokerages to protect these rates. Experts believe the strength in M&A transactions and equity capital markets will continue for this financial year.
The September quarter performance is, thus, expected to be sustained in FY11. Also, while brokerage firms try to expand their reach, higher recruitments and performance bonuses will also impact margins.
Interestingly, companies that have varied business interests like investment banking, asset management and lending (margin funding, mortgage) are managing to stay adrift of higher volatility in earnings.
The enthusiasm over the Axis-Enam deal was shortlived as the brokerage stocks fell soon. Though the brokerage stocks are expected to move in tandem with the broader indices, improving capital markets and the financial profile of some companies will lead to case-specific upgrades.
For many of the bigger firms which have diversified into areas like AMCs, life insurance, etc, performance in these businesses will also influence their stock valuations.
Among individual stocks, analysts prefer Motilal Oswal Financial Services and Edelweiss Capital in this space owing to their better retail reach and wider bouquet of services.
While JM Financial does not have any presence in the brokerage space, analysts are positive on the stock due to its presence in the investment banking and financing space.
