CARE Ratings: Valuation and Analysis

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Ratings Industry

Ratings industry has 7 players. However, the market share is dominated by CARE, CRISIL and ICRA which is more than 90%. The rest 4 players, get to have only 10% of the share.

The need for ratings has arisen for a third party view towards granting long term or short term credit by the banks. Hence, it’s an extremely niche market where entry barriers are high with limited competition. This industry also employs skilled labor which constitutes the maximum expenses for the companies. Employee expense to sales is a key ratio to track in this industry. However, geographical location of head offices of companies does play a major role as well. With remote working, will this advantage of a geographical location and its related expenses stay afloat or vanish in thin air is an important aspect every investor should see before they think about entering this sector.

Another thought that arises when we think about limited competition in a given sector is the first mover advantage. This is clearly visible when we see CRISIL having a higher market share than CARE. (Need to put inception dates for both companies). Hence, will it stay the same way or is there a way for other players to catch up and become dominant is a key to generating maximum returns.

A significant driver of growth for Ratings business is the uptick in bank credit cycle. There are periods where banks are more than willing to lend and then there are periods where bad debts catch up. This is a cycle which has been happening since a very long time. Banks like to lend when future looks good. As a result, companies in the ratings business get more work. 

Demonetization has shaken up the MSME sector that used to have different ways of raising capital. Usually termed as off-balance sheet financing, where they would raise money from different market players in lieu of high interest rates. This is a habit which is very difficult to break. For small businesses getting an adequate rating would entail costs and time involved. However, it’s much easier said than done. CRISIL and CARE has been doing it well.

Challenges

The major challenge in this industry usually is related to ethics. Hence, management becomes the most important part of our analysis of companies within this sector. If a large business fails to pay up their loan or goes bankrupt, the first thing that comes under scanner is whether the ratings business had done its job or not.

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There are many instances where a company goes bankrupt, the first eyeballs are always on the rating agencies. It’s fair to believe that investors will rely on ratings agencies to do their job and provide the right and adequate information. At such times, an investor is required to understand whether it’s the problem with competence of the company or some genuine mistake.

IL&FS is the latest case that brought in tons of skepticism in the minds of investors. Four companies had been involved in rating various instruments of IFIN during 2013-2018 — ICRA, CARE, India Ratings and Brickwork Ratings. More than Rs 20,000 crore was invested by provident funds, mutual funds and insurance funds based on the audit reports and credit ratings assigned to different instruments of the company and its units. Yet the failure to anticipate its cash trap left investors wondering – what were the ratings all about then?

This gives birth to a good deal of skepticism in an investor’s mind whether there is more than what meets the eye.

CARE RATINGS -THE BUSINESS

–        Care Ratings is the second largest rating agency in India in terms of volume after CRISIL. 

–        The ratings industry is dominated by 3 major players (CARE, CRISIL, ICRA) (about 90%)

–        Other fringe players like India Ratings, Fitch India, Brickwork Ratings hold a nominal market share

–        The ratings by any of these agencies (especially the top 3) helps companies in lowering interest rates (bank and market) and attract more investors (market)

–        The business usually includes rating of debt instruments for manufacturing and service industries

–        Focus is especially on Infrastructure projects and Environment related projects

–        The instruments include bank borrowing as well as market instruments like debentures, commercial papers (CP) etc

–        As on 2018-19, CARE holds presence in 50%, 42% and 45% share in ET Top 500, BS Top 1000 and FE Top 1000 businesses respectively

–        As per the regulation by SEBI and/or RBI, the rating companies need to reevaluate the rated companies at fixed intervals

–        Usually, CARE enters into the rating agreements for the period of 5 years or length of debt, whichever is lower.

–        Rating fee is collected in advance, however, the reevaluation fee is only received after the company completes the process (at every interval)

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–        The company is trying to break into the MSME/NSIC segment as a future prospect

–        The subsidiaries include CARE Nepal and CARE Africa (Mauritius) (for geographical expansion)

–        Other WOS include CARE Risk Solutions and CARE Advisory for diversifying the business

–        The proportion of all subsidiaries taken together as on 2018-19 is less than 5%

–        A MoU has also been signed with Russian Rating agency for knowledge sharing

FACTS AND OBSERVATIONS

o   CARE has captured close to 11% market share in CPs in terms of volume (INR)

o   CARE has a total of 2,94,61,214 shares outstanding of Rs. 10 each. There is no promoter holding, highest number of shares are held by FIIs/FPIs at 46.65% followed by retail and insurance companies

o   Since this is a service industry, employees (due to knowledge, network and experience) are the assets of the company. 

o   The excess cash is invested in various listed and unlisted securities. CRISIL has book value of almost twice that of CARE yet the investments made by both companies are similar in terms of value

o   The volume (INR) of debt rated increased, the number of assignments ALONG WITH Turnover decreased. This means that the rating fees is a fixed based fee and not a percentage based fee.

NEGATIVES

o   Faces pricing pressure from competitors

o   Risk of non-payment of fees in the event of a downward revision

o   Both, the MD/CEO Rajesh Mokashi and Chairman SB Mainak were sent on indefinite leave and subsequently stepped down post the IL&FS / DHFL rating issue

o   RBI has approved Internal Rating Based (IRB) approach through which some banks can rate internally. This could impact the business 

o   The number of assignments rated by CARE decreased by 8.42% to 9380 assignments in FY2018-19

o   Highly inconsistent FCFE

o   Debtors Turnover (number of times debtors pay in a year) increased from 6.75 to 8.22 times

o   As on December 2019:

Company name Turnover NPAT
CRISIL -0.90% -5.00%
ICRA -4.50% -22.80%
CARE -22.60% -34.70%

 POSITIVES

o   The company has an operating margin of 56.60% (best in industry)

o   Other income (income from investments mostly) forms almost 10% of the total revenue (return on average investment = 6.35%. Mostly invested in debt securities)

o   Dividend yield of 7.50%

o   The analytics / rating function is separate from business development. This reduces conflict of interest for getting more business v/s giving independent rating

o   The company has terminated the services of both, MD/CEO and Chairman and replaced by Ajay Mahajan and Neeru Saggi respectively. It needs to be seen how well the management performs under the new MD/CEO and Chairman.

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o   Ajay Mahajan is said to be energetic and has a lot of focus on automation

o   Trying to serve the MSME segment with customized requirements and bringing them into the customer ambit

o   We can expect a lot of issues coming in H2FY21 once the businesses gain normalcy after the COVID-19 impact

o   Lowering of interest rates by RBI can also act as a catalyst for more number of bond issues

o   Rating of insolvency resolution plans has helped generate a lot of business in FY2018-19

o   The volume (INR) of debt instruments in the Indian economy grew by only 7%, whereas the volume of instruments rated by CARE grew by 21%. It is safe to say that CARE is capturing more business in the market.

MOAT

o   Business runs on Brand recognition

o   Indirect barriers to entry in the form of recognition by SEBI / RBI

o   Care Ratings is the second largest rating agency in India in terms of volume after CRISIL. 

o   The ratings industry is dominated by 3 major players (CARE, CRISIL, ICRA) (about 90%)

o   Recognized by RBI for Basel II implementation

VALUATION

–        As per our proprietary intrinsic value calculation (up to FY 2018-19) of the business, the comparison is as follows:

 Intrinsic value per share             1437.78
CMP (21.07.2020) 445.30
Undervalued / (Overvalued) 69.03%

POINTS TO CONSIDER

–        With the results just around the corner, we need to wait to get the latest figures as we expect the results to be significantly lower than previous year due to the performance in the first three quarters and due to COVID-19 impact and lockdown from end of March 2020.

–        We also need to see how the company has responded during the lockdown like:

o   Assignments completed

o   New assignments generated

o   Handling of fixed costs and salaries

–        We also need to check how company responds in the challenges that lie ahead especially in terms of drop in debt issues due to the long lockdown and overall impact on economy due to COVID-19

Please note: That this analysis is purely for educational purposes only. Please contact your broker, fund manager or wealth manager before making any investment related decisions.



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Jinay Savla
Wealth Manager I Personal CFO I Finance Blogger I 10x in 10 Years I Podcast
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