Is Yatirim Menkul Degerler — Update 18 November 2015

Is Investment (ISY) is Turkey’s leading investment bank and part of the Isbank group, which is the largest private bank in Turkey and with its affiliates owns c 71% of its shares. ISY benefits from Isbank’s large distribution network and high standing among the Turkish business community. ISY was established in 1996 and has leading market shares in all aspects of investment banking in Turkey including equity, bond, derivatives and FX trading. It is also active in equity IPOs, bond issue, asset management and private equity.

There are no large investment banks in Europe or Turkey with which to compare ISY, but we believe some consideration of value can be derived from comparing ISY’s valuation with those European banks with large investment banking operations such as CS, UBS BNP Paribas and Deutsche Bank, among others. By comparison, ISY looks good value as it is trading on a P/E c 30% lower on average for 2015 and 2016, while its yield is 4x higher in 2015 and more than 3x higher in 2016 on the basis that ISY does not cut its dividend. ISY’s ROE is 20% higher than the others in 2015 and 40% higher in 2016, yet its P/BV is 20% lower, further suggesting that ISY represents good value. While ISY, and Turkey, may face many current economic and geopolitical problems, the country’s long term economic potential might be considered to warrant a premium valuation in the course of time.

ISY’s financial performance is heavily dependent on the Turkish financial markets. In the first nine months of 2015 its brokerage activities performed strongly and benefited from volatile markets, which encouraged trading, although there were a number of negatives, not least the mark-to-market losses incurred by its investment trust activities as a result of rising bond yields. We have lowered our attributable profit forecasts by 29% for 2015 following the publication of the nine-month results and by 19% for 2016. We tentatively maintain the DPS at Kr13.2, even though it will not be covered by 2015 earnings, as ISY has a strong capital position and seeks to reward investors with a high dividend.

ISY’s fortunes are sensitive to the following:

ISY is the investment banking subsidiary of Isbank, Turkey’s largest bank, which owns 65.7% of its shares directly and another 5% through connected companies. ISY is the leading investment bank in Turkey with strong positions in equity and debt trading, corporate finance and FX trading and through its subsidiaries it has significant exposure to asset management and private equity. ISY benefits from Isbank’s large distribution network and high standing among the Turkish business community. At 30 September 2015 ISY employed 388 people and at 30 September had equity, excluding minority interests of TRY542m. ISY aims to maintain its leading positions in its Turkish investment bank and asset management industries, but also maintain profitability. It also seeks to expand its role of investment banking and asset management in the Turkish economy.

The following exhibit shows the components of ISY’s group activities by segment/corporate entity. It should be noted that ISY consolidates companies in which it has less than a 50% holding because of the significant influence it has in the company’s activities.

This is the main operating entity in the group, with significant market share in Turkish investment banking, as shown in the following exhibits.

ISY also earns revenue from equity and debt issues and is a leading participant in those markets. The Turkish equity IPO market has been relatively subdued in the last couple of years as a result of economic uncertainty, but the debt IPO market has shown continued growth, as shown in Exhibits 4 and 5 below. ISY managed one IPO in 2014, giving it a 24% market share of the amount raised. It has fully participated in the growth in debt issue and in 2014 led 102 issues giving it a market share of 21% of the amount raised.

Is Investment Trust (ISYAT): ISYAT is a closed-end fund. It was created in 1995 and listed on the Istanbul Stock Exchange in 1996. It is the largest investment trust in Turkey, with net assets of TRY230m at 30 September 2015, 80% of which were invested in debt securities and 6% in equities.

Is Private Equity (Is Girisim, ISGSY): ISGSY is a listed private equity fund, of which ISY owns 29.1%. It invests directly in Turkey’s growing mid-cap private companies. At 30 September 2015 its assets in ISY’s group accounts amounted to TRY457m, before minority interests (FY14: TRY 426m) and comprised investments in five companies and a large portfolio of cash and liquid assets. ISY fully consolidates the investee companies and values them at historic costs, whereas in the accounts of ISGSY they are valued at fair value. ISGSY’s five investee companies were active in the consumer services, healthcare, telecoms & IT and services/outsourcing sectors, with a sixth company active in tourism added in November. It also has a large portfolio of cash and liquid investments, which in its own accounts amounted to around 43% of its total assets at 30 September 2015, showing that it has considerable potential to increase private equity investments. Since its inception in 2004, the trust has completed 11 exits at an average IRR of 26.5% and a cash exit multiple of 2.3x in US dollar terms.

Is Asset Management: offers discretionary and non-discretionary asset management services and is 70% owned by ISY. Pension funds are growing in Turkey, with the recovery in 2015 in the equity market and as wealthier individuals seek to provide for their retirement. Turkish pension fund assets under management (AuMs) rose 38% in the year to 30 September 2015 to TRY44.1bn and ISY’s asset management subsidiary had an 18.4% share in this market at 30 September 2015. The mutual fund industry in Turkey is also showing good growth, 24.8% in the year to 30 September 2015 to TRY39.7bn and in this market ISY’s asset manager had a 23.4% market share.

Efes NPL Asset Management: (non-performing loans): the subsidiary was established in early 2011 with the purpose of buying and selling non-performing loans (NPLs) from Turkish banks at a discount to face value. Local rules prevent banks lowering interest rates for distressed borrowers and any provisions they make are not deductible for corporate tax purposes. Selling the loans allows the interest rates to be amended and the crystallised loss is allowable for tax purposes. This motivates the banks to sell their NPLs.

ISY has an experienced management team with many members having worked at the company since its formation. There is a board of directors comprising nine individuals under the chairmanship of Ilhami Koç. He was appointed chairman in February 2013, having previously worked at ISY for many years, including a period as CEO from 2002 to January 2013. The executive board consists of seven individuals: general manager Ali Erdal Aral and six assistant general managers, each of whom has different areas of responsibility. Mr Aral graduated from the Economics Department of Marmara University in 1989 and received his Master’s degree in international banking from Loughborough University of Technology. Since starting his career at Isbank in 1989, he has served in various units and branches, before being appointed head of treasury in 2002. He was later promoted to corporate branch manager of Isbank–Kozyatağı corporate branch in 2008 and deputy chief executive at Isbank in 2011.

The Turkish economy has been strong over the last 10 years, which has had a beneficial effect on Turkish capital markets, on which ISY is heavily dependent as its revenues are correlated to Turkish financial market activity and the level of the Borsa Istanbul. Over the last 10 years Turkey’s annual GDP growth was 4.3% according to OECD statistics, higher than the world average of 3.8%, the OECD average of 1.5% and two of the BRICs, Brazil (3.4%) and Russia (3.5%). However, that growth has slowed over the last couple of years and fell to 2.9% in 2014, although for the year to 30 June 2015 it was 3.8%. In the short term, Turkey is facing many challenges, including the following:

Turkey shares borders with many countries facing serious political and economic turmoil, notably Syria and Iraq to the south, but also Greece to the west and Ukraine to the north. While the EU remains Turkey’s main trading partner, these countries are also important. A particularly disturbing development is that Turkey has become involved in the fight against terrorism, which undermines international investor confidence.

Turkey has just concluded parliamentary elections, where the ruling party, which has been in power for the last 13 years, won a decisive majority. An election in June resulted in a hung parliament, which unsettled investors. The margin of victory was not enough to give the ruling party the “super majority” it required to alter the constitution in favour of a presidency rather than a parliament, so further political disputes cannot be ruled out. However, the November election has given Turkey clear political leadership at a time when the country faces many economic and political challenges, so the victory has been well received by investors.

Turkey’s finance minister, Mehmet Simsek, has said that the new four-year mandate won by the ruling party will allow it to pursue economic reforms including expanding the number of citizens who have formal pension plans and deepening local capital markets by changing tax laws to encourage Turkish companies to borrow locally and use equity rather than loans to fund expansion. As the largest Turkish investment bank and its largest asset manager, ISY can be expect to benefit from these initiatives if they are enacted.

New capital markets regulations were implemented in Turkey on 1 July 2015 and there was a general expectation that they would result in the smaller, less well-capitalised participants leaving the industry to the benefit of larger companies like ISY, which would win market share. That has not yet happened as many of the smaller players have increased their capital, probably to undertake FX business, which was strong over the summer. However, ISY did sign a contract to transact brokerage transactions for smaller financial firms in 2015 that will enable it to process increased volumes through its brokerage network, which in turn will enable it to gain increased efficiencies.

There are no large investment banks in Europe or Turkey with which to compare ISY, but we believe that some guidance for the appropriate valuation of ISY can be obtained by considering the market multiples of the European banks with significant investment banking activities, as shown in Exhibit 5 below.

ISY’s P/E is 81% of the European average in 2015 and 58% in 2016, while its yield is 4x higher for 2015 and more than 3x for 2016, suggesting ISY is good value assuming the dividend is sustainable. ISY’s ROE is 1.2x that of the European banks for 2015 and 1.4x for 2016, yet its P/BV is around 20% lower, which also suggests that its share price represents good value, especially considering the long-term potential of the Turkish economy.

Another valuation metric that we can use to assess the value of ISY is to estimate the cost of equity that investors are using in their valuation of ISY and compare it with the other banks. The cost of equity can be estimated by rearranging the well-known Gordon’s growth model for the banks to give the following formula:

Cost of equity= ROE - growth rateP/BV+growth rate

Using a 5% long-term growth rate, the cost of equity for the broader bank group in Exhibit 6 above, based on an ROE of 7.7% and P/BV of 0.8x, is 8.4%. This compares with an estimated cost of equity for ISY of 14.7%, a difference of 6%. While this additional risk premium could be considered high bearing in mind that ISY is mostly operating in a long-term growth market, it should be noted that the difference between Turkish and US government 10-year bond yields is 7.43%, so the market seems to be applying a slightly lower risk premium to ISY than it does to Turkish bonds.

ISY’s financial results are dependent on activity levels and the direction of the Turkish financial markets.

Turkish equity markets started 2015 in optimistic mood as falling oil prices were expected to lower inflation, which would allow interest rates to fall and boost economic activity, so the Borsa Istanbul rose to over 91,000 by the end of January, 45% higher than the year before. However, since that date, negative global and local economic and political developments including negative sentiment towards emerging markets, have resulted in a decline in the index. There was a rebound in the index after September, which has continued after the decisive outcome of the general election. However, sentiment remains fragile.

Turkish bond yields have risen for most of 2015 and the Turkish lira has depreciated against the US$ over concerns about Turkey’s economy and geopolitical and local political uncertainties. However, even before the outcome of the Turkish elections was announced in November, there was a recovery the lira and a fall in Turkish bond yields, as investors increased their risk appetite for Turkish assets.

Q315 results for ISY were a continuation of the performance achieved earlier in the year, with the investment bank performing relatively well in its core activities, but a number of one-off negatives, especially in the subsidiaries, resulting in group net profit falling by 30% y-o-y, as shown in Exhibit 9 below.

Is Investment (parent) posted a 12% y-o-y increase in attributable profits in the nine months to 30 September 2015, as shown in Exhibit 11.

Interest and derivative income fell 26% in the nine months to 30 September 2015 compared with the previous year, as in 2015 the cost of funding its commercial paper programme has now been included in this line; it was previously netted off finance income. This is a more appropriate treatment as the borrowed funds are used in the arbitrage business.

Prop book trading consists of trading in equities, debt instruments, mutual funds and warrants. In aggregate there was a 16% increase y-o-y, with equity warrant trading doing particularly well. In aggregate, brokerage revenues rose 25% y-o-y, primarily because of 28% growth in derivative brokerage and a 36% rise in FX brokerage, as ISY’s investors traded actively in the volatile market conditions. Equity brokerage revenues rose around 9%. ISY has lost some market share in trading equities, derivative and FX as the company has been reluctant to chase market share with discounted prices like some of its rivals.

ISY’s corporate finance team was active in the first nine months of 2015, with revenue rising 49%
y-o-y. It closed five M&A transactions in the period despite the adverse market headwinds. Asset management revenues increased as a result of the higher AuMs being managed.

Operating expenses at Is Investment (parent) increased by 11% y-o-y in 9M15, more than inflation of around 8%. ISY normally keeps a close control over operating expenses, but in this instance the depreciation of the Turkish lira meant it was unable to do so in 2015.

The rise in net finance income in 9M15 occurred as the cost of funding its commercial paper activities was reclassified to the interest and derivative income line in the profit and loss account.

The foreign-based subsidiaries incurred a loss of TRY4.1m in 9M15, considerably higher than in the comparable period of the previous year. Usually the foreign subsidiaries more or less break even in aggregate, but ISY is in the process of closing its Dubai subsidiary and its London operation, Maxis Investments, has suffered from GBP costs and revenues linked to the depreciating Turkish lira.

The lower profit contribution from Is Investment Trust was due to unrealised losses in its bond portfolio following the rise in Turkish lira interest rates during the year. Is Private Equity losses were the result of operating losses at its investee companies, which were adversely affected by political headwinds in Turkey. It should be remembered that ISY fully consolidates the results of Is Private Equity in its accounts, even though IS Private Equity values its holdings at fair value in its accounts.

The rise in profit contribution of 38% from Is Asset Management was due to the rise in its AuMs as a result of the strength of the Turkish equity compared to 2014. Efes NPL Asset Management profits fell 12% y-o-y in 9M15, which should be considered a good performance given the rise in bond markets during the year and the uncertain economic and political situation.

We have revised down our 2015 and 2016 attributable profit expectations, the former by 29% and the latter by 19% to reflect a cautious economic and financial outlook.

We have left our DPS forecasts for 2015 and 2016 unchanged. ISY increased its DPS by over 90% in 2014 as it believes that shareholders are more likely to be rewarded by dividend income than by capital gains from a rising ISY share price. ISY has a comparatively strong balance sheet with tangible equity equal to 15% of total assets, which compares with 9% at Goldman Sachs, so the company could pay out more than its earnings on a temporary basis. We estimate that if ISY maintains its dividend in 2015 at Kr 13.2, the dividend will be slightly uncovered by attributable profits in 2015, but we anticipate that it will be covered again in 2016. The dividend payment is a board matter, which will be decided in spring 2016 when the economic and political outlook may be clearer. Our dividend forecasts remain tentative.