Is Yatirim Menkul Degerler — Update 17 February 2016

In 2015 Turkey’s financial markets were volatile. The Borsa Istanbul 100 equity index declined 16% in local currency terms in 2015 and more than 30% in US dollar terms. Two-year government bond yields rose from c 6.5% at the beginning of the year to around 11% at the end and the Turkish lira fell 20% against the US dollar during year, as we show in the following charts. Turkey’s financial markets share many of the global geopolitical uncertainties that have influenced other countries, including fears of the implications of a rise in US interest rates and concerns over slower global growth. In addition, Turkey’s neighbouring countries Iraq and Syria face serious political and economic turmoil and Russia has imposed trade sanctions on Turkey. Despite all this turmoil, it should be noted that Turkey’s GDP grew c 3% in 2015 (OECD).

Is Investment, ISY’s main trading operation, benefited from the volatile conditions in the Turkish financial markets, which encouraged trading and increased profits by 8% in 2015. However, at a group level, net attributable profit fell by 36% as a result of a number of one-off negatives in its subsidiary operations, as we show in Exhibit 4 below.

Interest and derivative income fell by 8% as the cost of funding its commercial paper programme has now been included in this line; previously it was netted off finance income. This is a more appropriate treatment as the borrowed funds are used in the arbitrage business.

Prop trading includes profits earned from trading in equities, debt securities, equity warrants and mutual funds. In 2015 prop trading from equity warrants was particularly successful as trading benefited from the volatile market conditions. Brokerage revenue comprises revenue from trading in equities, derivatives, fixed income and foreign exchange. In 2015 derivatives brokerage did particularly well, as equity warrant trading increased significantly and foreign exchange trading also performed strongly as clients traded on the decline in the Turkish lira. Corporate finance income held up during the year, with nine M&A transactions executed, compared with eight the previous year, while Is Investment participated in 136 debt issues, raising TRY19.5bn compared with 102 issues in 2014 raising TRY13.8bn. However, in 2015 Is Investment did not participate in any equity IPOs (2014: one), with the volatile equity market causing some potential issues to be postponed. The rise in asset management fees occurred as a result of the higher assets under management of its asset management subsidiary.

Operating expenses rose 16% during the year, ahead of the local inflation rate of c 8%. Part of the increase was due to the depreciation of the Turkish lira as expenses incurred in foreign currencies were reported in Turkish lira, which depreciated by c 20% against the US dollar in 2015, together with increases in stock exchange transaction and registration fees.

The result of a 12% increase in revenue and 16% rise in costs was for operating profits to be flat in 2015 and pre-tax profits to rise by 10% once a higher level of financial income is included.

Subsidiaries: IS Investment has several foreign subsidiaries operating in financial centres abroad, notably Maxis in London and Is Investment Gulf in Dubai, and during the year they collectively made losses of TRY5.7m, with Maxis incurring a loss of TRY4.5m as a result of a decline in brokerage revenues. The Dubai operations are being closed and the loss in 2015 partly reflected the closure costs.

Is Investment Trust had TRY238.2m of total assets at end 2015 (net assets TRY235.5m), of which c 88% was invested in fixed-income securities and cash and equivalents and the remainder mostly in equity investments. The rise in Turkish bond yields in 2015 resulted in mark-to-market declines for Is Investment Trust’s fixed-income portfolio in 2015 and the near 80% fall in attributable profit.

Net profit at Is Private Equity fell from a profit of TRY2.2m in 2014 to a loss of TRY7.3m in 2015. In accordance with IFRS, ISY fully consolidates the investee companies of Is Private Equity and during the year these companies incurred losses, as the increase in their revenue did not keep pace with the rise in their expenses, which arose from their attempts to expand their operations. It should be noted that Is Private Equity accounts for its holdings in investee companies at fair value in its own financial statements and in 2015 it recorded a c 5% decline in their fair value.

Is Asset Management increased profits by 16% in 2015. Despite the weak financial markets, assets under management (AUM) rose to TRY20.7bn by year end from TRY18.4bn the year before, an increase of 12.5%. New pension fund regulations are encouraging growth in pension assets and there was a particularly strong increase of 28% in pension fund assets during the year. At the end of 2015, they accounted for 42% of AUM, from 37% at the end of 2014.

Efes NPL Asset Management invests in non-performing loans (NPLs) from Turkish banks, which it acquires at a discount to their assessed value. Banks are motivated to sell loans because it enables them to crystallise loan losses for tax purposes faster than they could do otherwise. After a couple of years of strong performance, Efes NPL Asset Management’s profits in 2015 declined by 22% as the difficult financial markets in 2015 restricted its ability to realise gains from the portfolio that it acquired.

We have lowered our 2016 forecasts for ISY to reflect what we now expect to be more difficult financial markets. On the basis that market conditions remain similar, we expect that in 2016 Is Investment (parent) will earn comparable net profits to those it earned in 2015. We anticipate that there will be reduced losses at Is Investment Trust compared with 2015 on the assumption that Turkish bond yields in 2016 are in line with those at the end of 2015. We also anticipate a slightly lower level of losses at the foreign subsidiaries, with Dubai closure costs having been mainly booked in 2015. However, we continue to expect losses at Is Private Equity and Efes NPL Asset Management to maintain its reduced level of profits, as we do not expect a significant turnaround in their operating environments in 2016. The net result is that we have lowered our 2016 net attributable profit for the group by 22% to TRY49m, although this is a 21% increase on the 2015 outcome. We tentatively forecast 2017 net profits for the group at TRY56.7m, 16% higher than in 2016, with most of the improvement arsing at Is Investment (parent) from increased market activity.

We have currently left our 2015 and 2016 DPS forecasts unchanged and have tentatively forecast that the dividend for 2017 is in line with that for 2016. For 2014 ISY increased its DPS by more than 90% as it anticipated that shareholders would be more likely to be rewarded by dividend income than capital gains, given the many uncertainties in the Turkish equity market. Its dividend policy has been to pay dividends equal to at least 30% of profits; the dividend for 2014 was equal to around 75% of profits for that year. If the company does pay a dividend of Kr13.2 per share for 2015, the payout will be around 116% and, if it maintains the dividend at a comparable level in 2016 and 2017, we estimate the payout will be 96% and 83% of net profits respectively. ISY has a comparatively strong balance sheet with tangible equity of 15% to total assets at the end of 2015, falling to 14% at the end of 2017, which compares with a figure of 8% for Goldman Sachs at the end of 2015. ISY also has the potential support of its parent, Is Bank, should it need capital support. ISY could therefore afford to pay a high dividend for the period to 2017 if it wishes. The dividend payment is a board matter and will be decided next in March 2016 for the FY15.

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 7 below. Since our last note on ISY in November 2015, there have been significant falls in the prices of our sample of European banks (c 30%) reflecting a number of concerns, including the possibility of a global economic slowdown, reduced likelihood of persistently rising US interest rates boosting their interest income, plus the poor financial performance of European and US investment banks in Q415, especially in their fixed income, currencies and commodities (FICC) business. By contrast, ISY’s share price has been broadly constant over that period so that the stock market ratings of the European banks have moved down towards that of ISY in this period.

The average P/E for ISY for the current and following years is broadly comparable to that of the European average, but ISY offers investors a yield that is considerably higher, assuming the payout is maintained, of course. ISY’s P/BV for the current and following years is c 18% higher than the European sample, which is less than its ROE premiums to these banks over that period of c 42%.

Another valuation metric 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 7 above, based on an ROE of 7.5% and P/BV of 0.6x, is 9.2%. This compares with an estimated cost of equity for ISY of 12.4%, a difference of 3%. 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 8.9%, so the market seems to be applying a lower risk premium to ISY than it does to Turkish bonds.