By now, it is very likely for you to think that my views might be biased and I am just backing up some big investor. Reading through this post may not surprise you at all. My strategy is to find convicted ideas of investors I admire and research them to find hidden gems if I get lucky. Nevertheless, I have tried my best to put out there my own research to help me stick with my conviction. So this is another pick by Mohnish Pabrai. He recently invested 180 Cr and bought around 5% stake in the CARERatings Ltd (Pabrai Stake). Before you read any further, you should watch him explaining businesses that have deep moats and can be run by idiots. Watch this video from about 20 – 27 min. Also, you can hear Rakesh Jhunjhunwala speaking about one of his multi-baggers here. Now that you know how and why I choose CARE Ratings to study, let’s get started.
CARE Ratings is the 2nd largest credit rating agency in India established in 1993 that enjoys a 30% market share. The company rates creditworthiness of bank loans and corporate debt i.e. bonds and other financial instruments. Credit rating agencies help big institutional investors and banks to measure the risk against their lending. Their ratings directly affect the interest rates that are being charged on bank loans or issued bonds. These ratings differ from AAA to BBB and even lower which directly affect the implied interest rates anywhere from 6 to 10 %. ‘AAA’ means a borrower can sufficiently repay its debt whereas ‘BBB’ means the company can barely make their timely payments. Better the rating – lower the interest rate on borrowings and vice versa. Being a full-service rating agency, CARE has developed various products apart from debt ratings such as Infra ratings, MFI Grading, Real Estate Star Rating, Edu-Grade, REIT Rating, RESCO Grading, ESCO Grading, IPO Grading, ITI Grading, Shipyard Grading etc.
Credit rating business has a fantastic economics that attracted my attention. They enjoy robust operating margins at 65% consistent and return on equity of about 30%. Return on capital employed is at an average of 30%. The business requires no debt. The only expense on their books is qualified personnel. Moreover, the company has been paying out half of their earnings through dividends with an average dividend payout ratio close to 50%. There are very few businesses on the planet that enjoy such a good economics.
As you can see, the sales growth has been low in recent years. The main driver for this business to grow is the credit growth or credit offtake i.e. increment in borrowed money. There are two major ways credit growth takes place – increased borrowing from banks and corporate debt i.e. issued bonds. Credit growth is also related to the GDP growth of the country. Statistics show that credit offtake is 1.5-1.7 times the GDP of the country. At the current GDP of 7.5%, we are looking at 11-12% growth in the overall corporate debt issued in India. I think this is a conservative estimate considering the transformation shift happening in the Indian bond market describe further below.
An interesting caveat of this business is contractual nature of rating assignments. Clients are required to continuously cooperate with the same rating agency for carrying out a review of ratings. Thus, they are required to pay surveillance fee on an annual basis. Credit rating assigned correlates with the risk weightage to the bank loan and/or bonds issued. Higher the risk weightage – higher the interest rate and vice versa. In case of an unrated borrower, RBI had earlier stipulated a risk weightage of 100%, however for BB or lower rating, risk weightage was 150%. Hence many borrowers whose rating deteriorated from BBB to BB did not share information with rating agency due to which their rating got suspended. Thus, they were classified as unrated and got better risk weightage of 100% as against 150%. Under the new rule from RBI – the corporates which got rating suspended would immediately carry risk weightage of 150-200% depending on the last rating. Hence there would be no incentive for the borrower to get the rating suspended. if anything, unrated borrowers will try to get rated to have lower interest and better incentives on their debt. Thus, recurring revenue is going nowhere!
CARE Rating earns 98% of its revenue from rating business and has recently launched risk solutions and research subsidiaries to create organic growth. CARE Kalypto Risk technologies provide risk management solutions which are a niche financial area where the bank needs to spend significant funds to purchase the solution. CARE Advisory Research and Training Ltd works in research that supplements their rating business. People who register in CARE Advisory have to go through an established course which later assures them a job as well as quality personnel for CARE.
CARE Ratings (Africa) Private Limited (CRAF) is a subsidiary of CARE now operational and has also completed a few rating assignments. This venture aims to leverage opportunities in the African continent. CRAF has also got the recognition from Bank of Mauritius (BoM) as an External Credit Assessment Institution (ECAI) for all market segments w.e.f. May 9, 2016. Further, The African Development Bank has taken up close to 10% stake in CRAF
In 2017, CARE Ratings signed a MoU with Vishal Group Limited and Emerging Nepal Limited to start a credit rating agency in Nepal to be called CARE Ratings (Nepal) Limited with CARE as majority stakeholder. CARE owns a 10% stake in Malaysia’s leading credit rating agency, MARC. CARE also owns 10% stake in ARC Ratings, a credit rating agency based out of Europe.
CARE has also entered into a technical tie-up with Japan Rating Company. The main purpose of JV is to develop a mutually beneficial relationship. CARE now has an alternative for the client who wants an international rating and does not want to go to two established players. Similarly, JRC would assist CARE in getting business from the investment happening through Japanese investors. CARE has consistently increased their market share for the last 10 years that can be seen below.
Warren Buffet and other value investors often encourage to find a business that has deep moats. Rating business is certainly one of them that imposes a high entry barrier which is the reputation of the established players. In India, there are only 3 main players CRISIL, CARE & ICRA that hold 85% market share. Not long ago, CARE has become the 2nd largest player surpassing ICRA. There are 3 more agencies that are formed recently but it will take a lot of time for them to gain such a big market share. You can see below that CARE has the best margins among industry which is due to low employee costs and higher productivity per employee.
Global rating agencies
Globally, credit rating is a high niche business where only 3 companies dominate 90% of the market share. They are S&P (40%), Moody’s (40%) & Fitch (10%). All 3 of them are based out of U.S and have enjoyed deep moats for almost a century. These agencies also rate the sovereign debt issued by all the countries i.e government bonds. Here’s a really good video to understand more about global rating agencies.
The business for credit rating agencies is robust because they are not liable for providing wrong rating against any company or country and their obvious excuse is – ‘things change’. In simple terms, it’s like asking ‘how do I look ?’ after dressing up. Moody’s gets paid to say ‘good or could be better!’ Later if the makeup runs off and you look ugly – Not Moody’s business anymore. Such was the case during the subprime bubble in 2007 where high-risk mortgage-backed securities by Lehman brothers were AAA rated only until they filed for bankruptcy. The ratings were immediately and conveniently reduced to Default grade. There were many allegations against these credit rating agencies due to wrong ratings and lack of research and everybody thought that this business is gone for long. Even Warren Buffet who was the largest shareholder at the time with 13% stake in the company was subpoenaed to give his opinion about Moodys and you can watch his videos on youtube where he agrees that they did some mistakes but thinks that business is robust. Turns out, Moody’s got away with paying only $864 Millon for causing such a catastrophe after 10 years in 2017. Read here. As for the investors, Moody’s stock tanked from $72 in 2007 to $18 in 2009, only to rise up to $183 today. A small note – CARE does not evaluate sovereign debt for countries. Only S&P, Fitch and Moodys are able to do that.
This monopoly has continued its way in Indian markets as well. S&P has a majority stake in CRISIL whereas Moody’s is a parent holder of ICRA and India ratings is owned by Fitch. These global parent companies help their babies with global tools, processes and offshore revenue to grow themselves. CARE, however, is a non-promotor owned company and thus becomes hostile for acquisition. Last year, CRISIL bought 9% stake in CARE Ratings as an investment after which SEBI issued a guidance that a rating agency cannot be a major stakeholder for a competitive rating agency and cannot get a board seat – Read here. This event shows that CRISIL thinks CARE is a better business to buy than buying back their own shares. An interesting video speaks about the history of consolidation in global rating business – watch here
CARE’s moat is very deep and has lots of alligators to defend their castle.
- Monopoly – This is a high entry barrier business due to the reputation of existing established players as explained earlier.
- Robust nature of business – Rating agencies are not legally liable for their opinions and can change their ratings conveniently.
- Higher switching costs – Switching to other rating agency is a time-consuming process & costs additional money. An existing rating agency would have a thorough understanding of the business along with a detailed database of the company. This would save precious time/ effort for existing rating agency
- Network effect – Established players that provide quality service enjoy brand recognition and a strong industry network which attracts new borrowers.
- Consistency and credibility – Most corporate borrowers would desire consistency and comparability in credit opinions. Also, investors preference for CRA’s with a long-standing track record would ensure that newer players would take substantial time to gain investor confidence
The growth of credit rating agencies is tied to credit offtake i.e. loans issued by banks and corporate debt (bond) issuances. Thus, it is important to know about macros of the Indian economy and developments around corporate debt to gauge the future growth for credit rating agencies.
The above image shows India’s domestic credit growth inclusive of corporate debt and bank loans on a YoY basis. The credit offtake has been slowing down since 2011 and hit a multi-year low in 2017 due to transformational changes in the last couple of years such as demonetization & GST. These are actually beneficial changes for the long-term prospects of the economy and credit offtake is likely to pick up from here.
The bank loan growth was subdued due to NPA issues for majority public-sector banks in India. The rating business in the last few years has been somewhat challenging considering that, as the market matures the volumes are dependent on what comes on the borrowing floor. When the economy does not grow at the desired rate, the level of borrowing slows down which then impacts the rating industry canvas. In the past, there was space to be sought on the bank loan rating piece when the Basel II approach was implemented in 2008. It was easy to grow business as there were many unrated companies. Progressively with time, as the backlog of unrated bank loans reduces, the overall mass of the ratable universe becomes dependent on growth in credit.
Currently corporate debt market in India is only 15% as compared to 40-45% of developed countries. The bond market in India is still developing and there has been a substantial growth noticed in recent years. Thanks to the Modi Government. It is showing signs of a higher growth trajectory with issuances being steady.
RBI in May 2016 issued new guidelines for banks whose exposures of specified borrowers over a specified limit would attract a higher capital risk weight than before. This would encourage such borrowers to approach the bond market for lower interest rates. Banks can subscribe to bonds (issued by corporates who have reached the NPLL.) and may help such issuers. This is likely to be in effect in March 2019.
The latest regulatory framework for banks – Basel III allows banks to have their internal rating for loans. There was much news about this implementation taking away the rating agency’s business. However, RBI has clearly encouraged banks to use external ratings to measure the credit risks. Moreover, With the NPA issues in hand, banks will not want to be held accountable if a large loan goes bad.
Small & Medium Enterprises (SME) is a highly untapped market in India. The penetration level is less than 5% in this market. Although, CRISIL is the major shareholder of this market. CARE is all set to get more business from this growing sector. Also, Care’s approach to the SME business is based not just on getting more assignments but works on the assumption that they would become larger with time and be potential borrowers in the debt market. This strategy has helped the company to continuously increase their client base from 5,263 in FY13 to 15,908 in FY17.
Challenges in the Indian bond market
One of the reasons why investors are not willing to participate in the bond market is the mismatch between the price of the bonds and the actual risk they carry. To create a more attractive environment for investments, the credit rating industry must be transparent and adhere to international best practices. By doing so, investors can take advantage of an international standardized rating, which will, in turn, make the market more transparent and reliable. This will attract both domestic and foreign investors. CARE, although does not have any international MNC backing, has laid out their rating process on their website for various instruments and is transparent with its credit ratings business.
Overall, there is a transformation shift in the capital market in India which is likely augur well for CARE and other rating agencies going forward. Corporates will have to borrow money if India is to grow at 7-8% GDP rate.
Even though the business is very robust, it does not make it bulletproof. Some of the key risks that arise are a conflict of interest, fraud vigilance, & reputational risk.
Conflict of interest – There is a conflict of interest since companies who wish to get rated for their creditworthiness pay the fees to these credit rating agencies. Moreover, credit rating agencies assist in compiling complex financial instruments for big institutions to invest into and rate them. During 2008 subprime bubble in the U.S, Moody’s rated the complex mortgage-backed securities by Lehman Brothers as AAA which had gone bankrupt. This has been a topic of long discussion, but no major changes have happened globally except that there is a formation of INCRA which is a nonprofit credit rating agency formed to rate the sovereign debt.
Fraud vigilance and accountability – CARE’s reputation could be adversely affected by fraud or breach in confidentiality that it owes towards its clients committed by employees, clients or third parties. To mitigate the same, CARE has adopted a comprehensive code of conduct and takes annual declarations from employees, directors and rating committee members as stipulated in the code. CARE has adopted a Whistle Blower Policy as a necessary mechanism for employees to report to the management, concerns about unethical behavior or actual or suspected fraud or violation of the Company’s Code of Conduct. Further, no member of staff has been denied access to the Audit Committee
Reputational risk – CARE’s business is largely dependent on its brand recognition. CARE has separated the analytics function and the business development function, and analyst’s compensation is not linked to business generated. On April 01, 2017, CARE has moved to an Internal Rating Committee system where all ratings are assigned by senior personnel of the company. As per SEBI guidelines, MD & CEO is not a part of such Rating Committees. CARE, on its website, discloses the rating process that it adopts for rating any instrument or facility. The website also gives a comprehensive insight into the various methodologies adopted by CARE for rating different financial instruments.
Management strategy continues to be in the direction of enhancing the rating business by widening the client base and deepening relationships. The number of clients is very important because even if the business procured is of a smaller magnitude, it has the potential to grow in the future. Management is vigilant about enhancing their presence in the country. Their website can show you all the interactions that company’s directors have on a monthly basis with business challenges in India such as ET now & CNBC. You can simply do a quick youtube search and find out multiple interviews of CEO Rajesh Mokashi.
As per sources, the attrition rate in CARE is very high at entry level. The stable middle and top management kind of provide stability to the operations, however, given the importance of manpower, the company may face problem in case attrition rate continues to remain high. In that case, if the company increases salary to align pay at entry level with its peer, then the operating margins which are highest among the credit rating players would likely to decline. CARE has a training center in Ahmedabad which should help them hire better quality employees moving forward.
The operating margins have been sustained between 65-70% for the last 5 years. I suspect them to drop further by at least 5% by end of next decade considering CARE has started to invest in research & international rating business. Average taxation to remain at 24%. Overall, I anticipate 12-15% growth in the rating business. Any other inorganic growth from international rating business & research solutions will be icing on the cake. Thus, DCF calculation with an assumption of selling the business at 15 times its 10 year’s earnings gives an intrinsic value in the range of Rs 1041 to Rs 1665.
An interesting thing that I noticed is that ICRA & CRISIL both have P/E ratios of 40 & 30 respectively, whereas CARE is at 23 times its earnings. Surprisingly, their (ICRA & CRISIL’s) growth has been mediocre than that of CARE in the last 10 years ranging between 7-10%. The only logical reasoning I could find is the parent holding of S&P and Moody’s.
Some tailwinds for rating business
- RBI – (Jan’ 17) mandated dual ratings for commercial paper growing forward which will help CARE reap larger revenue.
- Rating revenue in India is less than 1% of the entire credit market vs 5-6% in the US. Increasing funding in mutual funds, debt markets, and infrastructure development will augur well for rating industry.
- Rating agencies role per RBI’s guidelines for large corporate borrowers and will provide a basis for rating agency moving forward.
- Basel III liquidity guidelines will allow banks to invest up to 40% in bonds and CP’s as against 10% which would encourage borrowers to issue bonds and thus get rated.
- New instruments such as REIT’s, Infrastructure bonds, Hybrids for insurance sector will help the bond market development.
- The new NPA resolution under Implementation of bankruptcy code (IBC) has a specific role for rating agencies and CARE is expected to gain more business in this area.
Credit rating is a very indispensable and robust business that has high entry barriers. It is an asset-light model that requires no debt. The business enjoys high ROE, ROCE & free cash flows that have made its way back to shareholders through dividends. Indian bond market is not developed yet. However, there is only one side things can go from here and that is up. This is highly possible with recent transformational events such as demonetization and GST. If India’s GDP has to grow at 7-8 %, then companies will have to borrow money. Banks facing NPA issues, corporates are going to shift towards the bond market for better interest rates. All this augurs well for rating agencies where clients show up on your doorstep every single day asking for a better rating to borrow more money. What’s more is they pay you an annual fee just to maintain their rating. It is important to be one of the established companies in this business since reputation is everything. And that is the case for CARE Ratings Ltd in India with 30% growing market share. The management seems focussed on their core business as well as developing other revenue streams. I think CARE Ratings will be a compounder 10 years down the line.
Personally, I like this business to invest 5-10% of my portfolio but the valuation does not attract me at the moment. I have taken a tracking position with 3% of my portfolio and will add more if the stock price falls below Rs 1050/-. The stock price of Rs 1280/- seems fairly equivalent with the intrinsic value of the company at the moment. At the end, I would like to quote Warren Buffet here – “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Disclaimer: This is not a stock tip. These are my personal opinions for educational purposes only. Anyone who invests in any company needs to do their own due diligence and are themselves fully responsible for the outcome.