India Infoline Ltd

MACROECONOMIC OVERVIEW

Indian economy came out quite unscathed from the global financial turmoil in the year2008-09. It has also emerged resilient and continued its robust growth momentum. Duringthe year under review, the Indian economy posted an impressive growth of 8.6% yoy. Thisgrowth was driven by the rural sector which benefited from good monsoons, increased flowof bank credit and generous funding by the government on various employment and otherschemes. While the growth during FY 2004-08 was driven primarily by accelerated capitalformation, the growth for the last 2 years has been driven by consumption and risingincome. The services sector which has been a dominant part of India’s GDP, also hasmaintained its strong growth momentum. On the flip side, inflation was the major concernfor the policy makers for the year under review. The policy makers responded by tighteningthe monetary policies and increasing the interest rates very aggressively. During the yearunder review, the Central Bank, RBI increased the repo rate by 175 basis points to 6.75%and the reverse repo rate by 225 basis points to 5.75%. The primary causes of inflationhave been:

(i) increase in crude oil and other commodities driven by benign global liquidity aidedby US Central Bank’s Quantitative Easing (QE1 and QE2) and

(ii) Spiraling food prices caused by supply falling short of relatively inelasticdemand.

In the last few quarters however, the gross capital formation has decelerated and thereis apprehension that economic growth will be impacted with a lag. While the private sectorcapital expenditure is marred by high interest rates and lower operating margins with rawmaterial price escalation, the government supported capital expenditure is impacted byfaltering policy making, political uncertainties and delays in decision making. Thegovernment however is trying to get its act together. Recently, government took longpending decision on price hike for petroleum products and the market’s immediateresponse was positive.

Nobody has any doubt in the potential and robust India growth story in the long term.The key variables to watch out for in the short term would be global crude and commodityprices, local inflation and monetary policy stance, government decisions on reforms,policies and infrastructure and monsoon.

Financial Markets

During the year under review, the Indian capital markets showed resilience to a numberof negative news. The key benchmark indices Sensex and Nifty moved up by about 11% yoy.This was primarily driven by FII inflows at a healthy US$ 30 bn during the year. Howeverthe enthusiasm was not matched by local participants in the market namely mutual funds,insurance companies and retail investors. The market sentiment and environment remainedvolatile and choppy. This also led to continued fall in relative share of cash marketturnover and delivery volumes. But there was a huge jump in derivatives (futures andoptions) volumes, where one takes a larger position backed by a small cash margin. Theoverall market volumes went up by stupendous 40% yoy, whereas the cash market volumes fellby 17%. This understandably led to fall in weighted average brokerage yield of mostplayers and operating margins came under a major squeeze. This can lead to a consolidationin the industry. The survivors should emerge stronger and benefit from the long termindustry growth.

Insurance and Mutual Fund industry passed through a transition phase in terms ofregulatory regime. The policy initiatives have been favorable for the customer andtherefore they should benefit the industry in the long term. However significant fall inincome of intermediaries and distributors have impacted the efforts for mobilization offresh money in these sectors. It may take some more time for manufacturers anddistributors to adjust their cost and productivity structure and to tap the opportunityfrom the growing national income and savings. The likely industry consolidation will helpthe larger and well managed players in the medium term.

During the year under review interest cost witnessed a significant increase. Thisimpacted the net interest margin for many NBFC companies like ours. However the creditgrowth continues and by and large NPAs remain under control for the industry. There issignificant latent demand for mortgages, houses and consumer credit. In the short term,demand growth may be subdued as high interest cost will increase the EMI and the abilityof a household to fund a new house. There is significant growth potential in other securedcredit products such as SME, vehicles, gold, health care facilities, educationalinstitituions etc.

IIFL SEGMENT OVERVIEW

In this section, the discussion pertains to the consolidated financials of IndiaInfoline Limited along with all its subsidiaries. As a significant part of theCompany’s business is conducted through its subsidiaries, your Company believes thatthe consolidated accounts provide a more accurate representation of the performance ofyour Company as compared to the stand-alone performance. Therefore management’sdiscussion and analysis pertains to the consolidated results.

The broad composition of consolidated income has been as follows:

Equities broking and related income

It comprises, the income received from broking and related activities in the cash andderivatives segments of equities on BSE and NSE and commodities trading on MCX and NCDEX.The related income includes income derived from wealth management advisory and investmentbanking services.

During the year, our equities broking and related income declined 4.6% yoy to Rs. 6.7bn. This was on account of significant fall in average brokerage yield on the tradedturnover. On the major exchange, NSE, we increased our market share to 4% in the yearunder review as compared to 3.8% in the previous year. The fall in brokerage yield hasbeen an industry wide phenomenon attributed primarily to change in product mix and to someextent to increasing competitive activity. The product mix on the exchange has changed infavour of Futures and Options segment, which accounted for 86% of volumes for the yearunder review as compared to 76% in the previous year, with corresponding fall in relativeshare of cash segment. Within cash segment also, relative share of delivery volumes hasfallen. Brokerage rates, as per industry norms, tend to be significantly higher fordelivery volumes, followed by intra-day and futures & options. The brokerage yield istypically lowest for options contract. To illustrate on an average, brokerage per rupee ofturnover of cash delivery trade can be as high as 8 to 10 times that of a trade in futuresor options segment. Besides, when industry income pie is not growing, like any othercompetitive business, the pricing tends to be cut-throat.

Not deterred by short term cyclical head winds, the Company continued to grow itsdistribution network and client base. During the year, the Company’s client baseincreased to 0.95 mn as against 0.8 mn in the previous year. As on March 31, 2011 theCompany had over 3,000 business locations spread across more than 500 cities and townsacross India.

Our average daily volume in the commodities brokerage business was Rs. 7.4 bn duringfinancial year 2010-11 as compared to Rs. 4.1 bn in financial year 2009-10, registering agrowth of 80% yoy. Our overall market share on both exchanges (MCX and NCDEX) increased to2% from 1.7% in the previous year. Commodities trading is penetrating wider and deeperacross India. The trading volumes in commodities comprise a number of diverse commoditiesfrom Gold, Silver, Wheat to Crude oil and many more. They are relatively less susceptibleto capital market sentiment.

The Company continued to successfully scale up the wealth management business withAssets under Advice crossing the Rs. 200 bn mark. It is one of the industry’sstrongest platforms across various product propositions, which feed into a strong advisorysetup. The Company believes that in medium to long term, the advisory business will havegreater pricing power and stickier relationships with customers.

During the year our Investment Banking team successfully advised and managed tentransactions including IPOs, Qualified Institutional Placements, GDR Offering and Rightsissue. The investment banking business, being deal driven is more erratic and difficult topredict from quarter to quarter basis. For instance, in the previous year, while itstarted off well with a good deal pipeline in the first and second quarter, the momentumsuddenly petered off in the second half of the year.

Financing and investing income

The income from financing and investments stood at Rs. 6.1 bn during the year, up 111%yoy over 2009-10. The Company’s product offerings include margin funding, loanagainst shares, loan to promoters, loan against commercial and residential property, goldloans and financing of healthcare equipment. The Company’s portfolio stood at Rs.32.9 bn as at March 2011, a 102% increase over Rs. 16.3 bn as at March 2010. Predominantlythe Company’s loan book comprises secured lending with collateral of property,securities, gold, equipment, etc. The loan book as at March 31, 2011, comprised Rs. 11.6bn (Rs. 8.4 bn in FY10) of loan against capital market products, Rs. 19.5 bn (Rs. 6.9 bnin FY10) of loan against property and Rs. 1.8 bn (Rs. 1 bn in FY10) being others. Besides,based on available opportunities, the Company also deploys funds in equities, commoditiesor currencies arbitrage activities. The relative contribution of arbitrage activities inthe income of year under review however was not significant. The growth in loan book inthe current year was driven by the Company’s capability to originate retail andwholesale assets against collateral of property through its nationwide distributionnetwork and quick turnaround in the economic and credit environment. The loan againstsecurities book tends to be more volatile depending on capital market sentiment.

Compared to other NBFCs in the peer group, your Company’s balance sheet isrelatively under- leveraged and hence has capacity to meet funds requirement for growth inthe near future without resorting to fresh equity capital.

Distribution and marketing income

Distribution and marketing income comprises commission, brokerage and marketing incomegenerated from distribution of third party products such as insurance, mutual funds andonline marketing activity on the Company’s website. A significant part of this incomeis contributed by commission and brokerage on life insurance premium mobilized as aninsurance broker. The Company sold insurance policies issued by various life insurancecompanies including ICICI Prudential Life Insurance, Reliance Life Insurance, Max New YorkLife and Bajaj Life Insurance. During the year the Company’s income from Distributionand marketing was Rs.1.8 bn, which is an increase of 42.5% yoy.

Costs

The following table sets forth the expenditure that the Company incurred under variousheads:

Direct cost

Direct costs consist of brokerage related charges, exchange and statutory charges,marketing expenses and commissions and direct costs relating to financing business. Directcosts have increased 28.5% on a year-on-year basis to Rs.2.2 bn, in line with growth intotal income. Consequently, direct costs were 15% of revenues in FY2011–level similarto that in the previous year.

Employee cost

Employee costs were Rs. 3.92 bn for FY2011, which is up 23.5% on a year-on-year basis.This increase in employee cost is primarily on account of rise in average salary levelsowing to inflation, competitive pressures as job market recovered from its slumber in theprevious two years and relative strengthening of senior management team.

Administrative cost

Our administrative costs comprise expenses incurred on rent, electricity, telecommunication, technology, infrastructure, printing and stationery, travel, courier,advertisement, legal and professional etc. Administrative expenses during the year stoodat Rs. 2.6 bn, a rise of 29% as compared to 2009-10. The increase in administrative costis mainly due to increase in infrastructure for supporting long term growth of thebusiness.

Depreciation expense

Depreciation in FY2011 was Rs. 581.7 mn compared to Rs. 534.6 mn in FY2010 an increaseof 9%. This increase has primarily been on account of ongoing capital expenditure onexpanding our overall infrastructure.

Share capital

Your Company’s share capital has increased from Rs. 570.4 mn last year to Rs.572.8 mn, as a net result of exercise and allotment of 14,194,925 equity shares of Rs. 2each to employees under the Company’s employee stock options schemes and buy back of12,998,877 shares.

Reserves and surplus

The Company’s net worth (excluding minority interest) grew from Rs.16.1 bn in2009-10 to Rs.16.6 bn in 2010-11. Your Company’s book value per share rose from Rs.56.27 per share to Rs. 58.11 per share (excluding minority interest). The increase innetworth is on account of retained profits, partly negated by buy-back which was at aprice, higher than the then book value. Summary of reserves and surplus is provided in thetable below.

Securities Premium

Loans

Secured loans outstanding as on March 31, 2011 were Rs. 15.7 bn compared to Rs. 3.6 bnas at the previous year end. The Company availed of long term secured loans from banks andmutual funds primarily to fund the medium to long term requirements of its lendingbusiness. These loans are mainly secured against the receivables of the Company.

Your Company’s unsecured loans as on March 31, 2011 were Rs. 13.6 bn compared toRs. 11.6 bn as at the previous year end. The unsecured loans were taken mainly from mutualfunds to finance the Company’s short term requirements of its lending business.

Fixed Assets

During the year, the Company’s gross block rose by 14% to Rs. 5.6 bn from Rs. 4.9bn in the previous year. The new addition to fixed assets included the Company’s newhead office at Thane, where the Company has invested in the state-of-the-art technology tosupport inter alia its backoffice, customer service and call center operations. TheCompany continued to invest in technology, call center infrastructure, upgradation ofexisting offices as well as new regional offices in the country.

A statement of movement in fixed assets is given below:

Investments

Your Company’s investment portfolio stood at Rs. 3.4 bn as of March 31, 2011, ascompared to Rs. 4.8 bn as at the previous year end. Of this Rs. 2.98 bn were deployed infixed income schemes of various mutual funds and Rs. 178 mn in equity of variouscompanies. Your Company also holds private equity investment of Rs. 247.7 mn (Rs. 100.2 mnas on March 31, 2010) besides Rs. 16.8 mn in 130,000 shares in The Bombay Stock ExchangeLtd. (Rs. 16.8 mn as on March 31, 2010)

Deferred tax assets and liabilities

Deferred tax assets and liabilities have been computed as per the provisions of theIncome Tax Act, 1961. Deferred tax assets are Rs. 284.3 mn as on March 31, 2011. Some ofthe Company’s international subsdiaries are in investment phase and are expected tobe profitable in three to five years’ time.

Working capital

As on March 31, 2011, the Company’s working capital stood at Rs. 37.8 bn ascompared to Rs. 22.0 bn last year. There has been a significant growth in the loan bookresulting in Loans and Advances increasing to Rs. 39.3 bn in the current year from Rs.20.2 bn in the previous year. Cash and bank balances were marginally higher at Rs. 8.3 bnas compared to Rs. 8.1 bn in the previous year. Of this Rs. 3.5 bn (Rs. 3.0 bn in theprevious year) was kept in fixed deposits with banks as margin for bank guarantees for ourbroking business. Sundry debtors balance as at year end stood at Rs. 4.9 bn as compared toRs. 6.1 bn as at the previous year end, reflecting lower velocity particularly in the cashmarket towards the end of year under review as compared to the same in the previous year.Stock on hand mainly comprises fully hedged arbitrage position as on March 31, 2011 andcertain bonds stock as at year end.

Current liabilities as on March 31, 2011 were Rs. 15.5 bn as compared to Rs. 12.9 bn inthe previous year. Current liabilities include amounts payable to the stock exchangestowards pay in which fluctuate on a day-to-day basis. Provisions, including provisions fortaxation, gratuity and leave encashment stood at Rs. 26.8 mn as compared to Rs. 105.4 mnin the previous year. Provisions for gratuity and leave encashment are made based onactuarial valuation.

Human resources

Your Company’s business critically depends on quality of manpower. YourCompany’s philosophy has been to hire the best talent and then give them autonomy totake decisions and implement. The Company has over the years, developed a work culturewhich is unique and can be summarized as people with ‘Owner Mindset’. All theemployees are aligned to the culture; they think, act and behave like owners as if it weretheir own business. This alone has enabled the Company to grow from a small startup to oneof the leading companies in financial services, in a span of a decade and in the face ofcompetition from bulge bracket institutions and corporate houses. The Company’srecruitment, re-training, rewarding and retention policies are developed to protect andfortify the core culture. Today, the Company offers a strong brand, a challenging workenvironment conducive for independent decision making and competitive compensationincluding stock ownership. This allows the Company to attract and retain extremelyqualified professionals with impeccable professional track records

The total employee strength of the Company and its subsidiaries was 10,924 as on March31, 2011.

Risk management

Risk management is integrated seamlessly into business strategy at your Company. Theobjective of our risk management process is to insulate the Company from the risksassociated with the business while simultaneously creating an environment conducive forits growth. It entails a comprehensive estimation, control and review of risk to protectorganizational value. The top management has a "hands – on" approach at astrategic level, at the same time delegating and decentralizing operations. RiskManagement also forms a critical part of our training module across all levels so that allemployees are trained on risk management and implications thereof.

At the Company, a governance process has been institutionalised, which ensures thatrisk management concepts are applied to all business and risk types. Decision makinglevels are based on the Company’s objectives and risk tolerance limits. Strategies,policies and limits are designed to ensure that risks are prudently diversified. Riskmitigating activities are reviewed periodically by senior management and further at theBoard.

Our experienced compliance and risk management team also plays a vital role in ensuringthat the rules and regulations are followed, not just in letter but also in spirit. Therisk management discipline is centrally initiated but prudently decentralized; percolatingto the line managers and helping them mitigate risks at the transactional level, the mosteffective form of risk management.

Market risk

The financial services sector is affected by a variety of factors linked to economicdevelopment in India and rest of the world global fund flows and politics. Any economicevent across the globe can have a direct or indirect impact on your Company. To mitigatethis we have diversified our revenue streams across multiple product lines and businesses.

Reputation risk

Over the years, your Company has built systems, processes, checks and balances whichensures that operating managers say ‘No’ to poor quality in pursuit of instantresults, short cuts, stop-gap alternatives, unfair / ad hoc policies and cutting corners,among others. Also, it has in place stringent employee trading guidelines and policies.The Company’s policy ensures strict disciplinary actions against those deviating fromthe same.

The Company has institutionalised a number of measures to secure customer interests.Trader terminals provide real-time data and ledger balances of the stocks and fundsposition enabling customers of their online positions. The Company transfers clientfunds/securities to the customers designated banks/demat accounts. All receipts andpayments from/to customers are done through account payee cheques/DDs with Client Ids andno cash acceptance is permitted. The Company makes a constant and concerted effort toeducate customers of the Do’s and Don’t’s.

Credit and Finance risk

For credit and finance business, we have a multi level Credit & InvestmentCommittees consisting of directors of the board / HODs to consider credit and investmentproposals. The major credit proposals are formally evaluated and approved by variouscommittees. We have in place the Risk Management Committee and Asset Liability ManagementCommittee (ALCO) consisting of directors and senior officials which regularly meets andreviews the policies, systems, controls and positions of credit and finance business.

The risk committee reviews the risk management processes covering credit andunderwriting controls, operations, technology, compliance risks, etc. The ALCO committeeinvolves in balance sheet planning from risk return perspective including the strategicmanagement of interest rate and liquidity risk. Towards this end, the ALCO committeereviews product pricing for various loans and advances, desired maturity profile and mixof the incremental asset and liabilities. It reviews the funding policies of the Companyin the light of interest rate movements and desired fund mixes particularly fixed /floating rate funds, wholesale / retail funds, money market funding etc. from time totime.

Technology risk

Over the years, the Company has invested in cutting-edge technologies with asingle-minded objective: to enrich end-user experience and better controls.

As a policy, the Company has consistently overprovided for business volumes at everypoint in its IT network. The Company’s servers have been provided with built-inredundancy, auto switch-over capability and stand-by servers. Besides, the Companycontinuously monitors infrastructure performance, ensuring optimum utilization. Ourbusiness is intensively linked to technology and hence to mitigate risk of technologyfailure we have multiple options for internet bandwidth and internet connectivity and backend service providers. We have sophisticated firewalls to protect our IT infrastructureand have also invested in disaster recovery centers. Recently your Company has entrusted amulti-year contract with IBM to manage all its IT infrastructure and facilities. The dealis unique in that it is contracted on outcomes rather than resources, and willdramatically improve security, reliability and availability against measured service levelcommitments. The agreement covers IIFL’s 700 branches. IBM will set up a centralisedhelpdesk, a pan-India services desk, applications and infrastructure in branches, anddeploy service management processes to cover assets. IT security, capacity, network,storage, incident/problem/change and technology among others.

Compliance risk

Your Company operates primarily in financial services space. Each of these businessesis regulated by a different regulator and as such compliance forms a critical part ofoperations of the group. We are registered and regulated by SEBI for merchant banking,stock broking, depository participants and portfolio management businesses. India InfolineInvestment Services Ltd and Moneyline Credit Ltd are NBFCs registered by Reserve Bank ofIndia and housing finance subsidiary namely India Infoline Housing Finance Ltd isregistered with National Housing Bank. Our commodities broking subsidiary is regulated byForward Markets Commission and our insurance broking subsidiary is registered with IRDA.Besides, our foreign subsidiaries are registered with respective overseas regulatoryauthorities. Your Company has a full-fledged compliance department, headed by a ChiefCompliance Officer, which ensures all the regulatory compliances and reportings of thegroup.

At your Company, the compliance discipline extends across the entire transaction cycle:KYC process, transaction execution, transaction settlement involving securities, fundtransfer, customer reporting’s etc. The compliance requirements across the variousservice points have been communicated comprehensively to all through compliance manualsand circulars. To ensure complete involvement in the compliance process, heads of theevery business/zones/area offices and departments submit quarterly compliance reports, thecompilations of which are reviewed by the Audit Committee/Board and also submitted toregulatory bodies as per requirement.

Human resources risk

Over the years, your Company has put in place the following initiatives to retain itspeople capital:

> Created an environment which is conducive for the overall growth and progress ofour employees

> Empowered employees to take decisions. With the fundamental ethos of ‘OwnerMindset’ people are treated more like ‘co-owners’ than employees

> Goal setting in consultation with key business executives, enhancing a sense ofownership

> Rolling out an attractive ESOP scheme, where-in ‘Owner Minset’ does notjust remain as an esoteric proposition but it actually makes owners out of employees

> Encouraged growth from within as a strategy to plug vacancies.

Internal controls

The Company has invested in ensuring that its internal audit and control systems areadequate and commensurate with the nature of our business and the size of our operations.The Company has retained a reputed global firm Ernst & Young as its Group InternalAuditor. The Company also retains a few specialized Audit firms to carry out specific /concurrent audit of some critical functions such as Half yearly internal audit of brokingbusiness mandated by SEBI/Exchanges, KYC process, demat transfers, pay-outs, systemsaudit, branches & sub brokers audits etc. The Company also has an internal team ofprofessionals at head office in Mumbai, supported by regional teams at zonal offices. Theinternal team undertakes some special situation audits and follows up on implementation ofInternal Auditors’ recommendations. The Auditors’ reports and recommendationsand rectifications / implementations are reviewed by the top management and AuditCommittee at regular intervals.

The internal processes have been designed to ensure adequate checks and balances atevery stage. The processes are reviewed periodically by Internal Auditors as well as AuditCommittee and amended as required. Your Company also has to comply with several specificaudits that are required by regulatory authorities such as SEBI / Exchanges / Depositoriesand the reports are submitted to the regulators periodically.

Outlook

Your Company is well placed to seize the long term opportunity in financial servicesspace in India. India’s national income is expected to grow at an annual rate of over8% in real terms, which will be close to 14-15% p.a. in monetary or nominal terms.Invariably, a developing economy passing through such rapid growth phase, witnesses itsfinancial services sector to grow at 1.5 to 2 times the national income growth. The sectorwhile has tremendous long term potential to grow, has a distinct characteristic of beingcyclical. Therefore we see a sort of roller coaster ride. Long term players like yourCompany, see this as an opportunity rather than an obstacle. Invariably when head windsare strong, the weaker players fall off the roller coaster, paving way for the long termplayers to emerge strong.