Will IIFL Wealth stock mirror the smooth shift in business model?

While the market opportunity is huge and likely to grow in sync with India’s economic growth and rising income/wealth levels in the economy, there are more reasons to consider IIFL Wealth.

Highlights
-Wealth management industry on a growth path
-IIFL Wealth enjoys strong market position
-Business model has transformed for better; moved to an advisory model from the broker model
-Focus on annual recurring revenue (ARR) is encouraging
-Profitability has improved
-Strong earnings visibility though linkage to capital markets can add to volatility
-Valuations fair: being the only listed wealth player makes it a worthy long-term bet

The business of managing wealth is looking up, thanks to the buoyancy in equities and the large but under-penetrated market. India, after all, is one of the fastest growing wealth market globally both in terms of the number of ultra-high net worth individuals (UHNI) and the wealth levels.

The wealth space is mostly dominated by private banks, but the contribution of wealth business to these banks’ total profits remains minuscule. For instance, Kotak Mahindra Bank is the largest wealth manager in the country, but the giant share of its profits (more than 60 per cent) is contributed by the banking operations. Hence, the best way to play wealth space is through pure play wealth manager IIFL Wealth the largest non-bank wealth manager, which offers an exciting opportunity.
 
While the market opportunity is huge and likely to grow in sync with India’s economic growth and rising income/wealth levels in the economy, there are more reasons to consider IIFL Wealth.

Unlike lending and other financial services businesses, wealth management is largely a fee-based business and hence is relatively low-risk with limited exposure to credit events. Moreover, wealth business requires limited capital for growth and can potentially generate non-linear profit growth and high return on equity (ROE). The biggest reason for our enthusiasm, however, is the high proportion of annual recurring revenue (ARR) earned by IIFL Wealth, which makes its revenues relatively more stable, predictable and non-cyclical.

Business in brief

Founded in 2008, IIFL Wealth has catapulted itself to the position of the third-largest private wealth management firm in India with an assets under advisory (AUA) of Rs 2.35 lakh crore as on June 30, 2021. The firm offers a full suite of services to its clients, including distribution, advisory, asset management, broking, and lending.
Under wealth management, the company has an advisory platform named “IIFL One” that offers investment solutions to UHNIs under a transparent single-fee structure. The company does not earn any commission from the manufacturer (the fund house) but earns a contracted fee from a client. The fee charged in this model is based on a percentage of the AUM depending on the nature of mandate (discretionary/non-discretionary). IIFL One is the leading model within the industry that best aligns the client’s interest to that of the wealth manager, leaving no motivation for relationship managers to push a particular product/offering with high commissions.

In the asset management business (AMC), the primary focus is on alternative investments, which include private equity, structured credit and real estate, and portfolio management services (PMS). Mutual funds (MF) form a very small proportion of its total assets under management (AUM).  IIFL Wealth is among the largest managers of alternate investment funds (AIFs) in India, with an AUM of Rs 27,090 crore as of June.

Its wholly owned non-banking financial company (NBFC), IIFL Wealth Prime, had a loan book of Rs 3,350 crore as of June, mainly consisting of loans against securities. The NBFC largely supports the wealth management business by providing loans to clients as a temporary bridge for their liquidity requirements.

As on March 31, 2021, IIFL had around 250 relationship managers (RMs) across 29 offices. The company is likely to maintain its leading position in the wealth management business over the medium term.

IIFL Wealth is backed by marquee investors (General Atlantic, Fairfax), which gives it an advantage to raise funds. The capital requirement, however, is small and limited for the NBFC, sponsor-commitment in AIFs and the working capital required to cover interim operating expenses.

In the past, it has utilised capital raised for inorganic growth and acquired a couple of smaller wealth firms and an NBFC. IIFL Wealth purchased the wealth business of L&T Finance in April 2020, which added Rs 9,919 crore to the AUM.
 
Revenue drivers

IIFL Wealth’s revenue is in the form of commission and trail income from distribution of financial products, brokerage, interest income on the NBFC book, advisory fees, and management fees. As on June 30, 2021, the wealth management segment accounted for 81 per cent of the AUM and asset management formed 19 per cent.
Wealth management contributed to 75 per cent of revenues (excluding other income), out of which 58 per cent was recurring and 42 per cent was transactional. Asset management formed 25 per cent of revenue, which was completely recurring in nature.
 
In the past couple of years, IIFL Wealth’s profitability was impacted on account of a change in the revenue recognition model and the mark-to-market (MTM) losses on its AIFs. SEBI’s decision to ban upfront commissions on distribution of MF and to cap total expense ratio (TER), the fee that a fund house charges from investors every year to manage their money, adversely impacted the revenues of IIFL Wealth as most fund houses passed the cut by reducing distributors’ commissions.

What we like about IIFL Wealth?

Proactive transition to advisory model
IIFL Wealth’s business model underwent a transition following big regulatory changes.  Revenues are now recognised on a trail basis even for the PMS and the AIFs.
The transformation in the business model is visible as it now earns revenues through fee-paying clients under it advisory platform (IIFL One). The two-year old platform has seen a healthy growth in assets and has crossed the Rs 30,000-crore-mark in June. The advisory model continues to gain acceptance across clients and the broader industry, and can help to reduce the regulatory uncertainties associated with the distribution fees from the manufacturer.

Focus on ARR

The management’s strategy of focusing on increasing the share of annual recurring revenue (ARR), as opposed to the transaction/brokerage revenue, is encouraging, and has helped to reduce the volatility in revenue.
The share of ARR in overall revenue has improved to 67 per cent in Q1 FY22 and the company is well on track of reaching the targeted level of 70-75 per cent by end FY22.
The recurring AUM share in the total AUM has increased from 22 per cent in FY15 to 40 per cent in Q1 FY21 and further improved to 50 per cent in Q1 FY22. Over the last five quarters, Rs 36,000 crores or 96 per cent of net flows have been annual recurring in nature and the momentum is likely to continue.

Rising net inflows and stabilising retention rates

IIFL Wealth received the highest quarterly net flows ever in Q1 FY22. Also, the overall retention rate (revenue earned/average AUM), which declined to 0.57 per cent in FY21 from 0.74 per cent in FY19 due to the transition in the business model, is stabilising with a slight uptick in the retention rates for IIFL One.

Upbeat management guidance & high dividend payout

The management expects a compounded annual growth rate (CAGR) of 12-15 per cent in AUM and a profit CAGR of 18-25 per cent over FY21-26. With the increase in the share of ARR assets (with comparatively higher yields) and cost rationalisation, the ROE has already improved from 7 per cent in FY20 to 16 per cent in Q1 FY22. The management expects to reach an ROE of 20 per cent going into FY23.  Moreover, it maintains its guidance of paying 75-80 per cent of its net profit as dividend.
 
Key business risks

The company’s revenues are exposed to fluctuations in the capital markets and regulatory changes. Technology can be disruptive as AI-based/robo wealth advisors are gaining popularity.

Valuation and view

We see IIFL Wealth’s business to be on a sustained growth path, driven by more millionaires seeking wealth advice. Earnings are likely to be strong in the near to medium term, which will drive the stock up.
At the current market price of Rs 1,518, IIFL Wealth is trading at 26 times FY23 estimated earnings, which is reasonable considering the improved business fundamentals and the visibility of earnings growth. Long-term investors should start accumulating the stock.
 

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Moneycontrol