CARE Ratings- Deep value or value trap?

Disclaimer: This is not a recommendation and is written purely as an educational exercise. Please conduct your own diligence or consult a investment advisor for your investment decisions.

About the Author: The post is written by our EZPP partner Manu Jindal. Manu is a graduate from IIM Calcutta, currently working with Airtel Labs. He writes about Payments & New Tech at ZappChai.

With the advent of IL&FS crisis in 2018 and the increasing vigil on rating business, the stock prices of CARE ratings crashed. This piece tries to explain what CARE ratings does, what makes ratings businesses attractive, the demand and supply levers in the industry, how the financials have looked like for the last couple of years and the risks the business entails and a take on the valuations.

What does CARE Ratings do?

CARE primarily generates revenue from the rating business. This means that they rate corporate debt instruments like bonds and bank loans. This vertical contributes 95% of the revenue. Remaining 5% corresponds to advisory services given to the corporates in the form of structured products, impaired asset resolution etc.

They have two types of fee from the ratings: Rating fee which is charged first time and then the surveillance fee which is charged on annual basis on recurring mode.

What makes rating business attractive?

  1. This business is highly human intelligence driven. So it has a high amount of operating leverage -meaning a small % increase in top-line would result in a sharp improvement in bottom line

  2. Since the primary asset is human intelligence, it is a high ROCE (to the range of 35%-50%), high ROE, high NFAT and low working capital business.

  3. This forms the backbone of money markets. Every corporation has to get their instruments rated by at least 2 agencies. The highly oligopolistic nature of the market with 96%+ being carried out by CRISIL, CARE, India Ratings, Brickwork and ICRA

  4. There are high entries to barrier. No one can just start this business and get the clients. Huge approval process is needed and these approvals are given based on the track record of the company/individual driving the company

  5. This is a highly cyclical business, the prospects of which improve on picking up of capex cycle/MF’s penetration in the country

Supply & Demand side factors - What drives business?

For the rating business, supply and demand side factors are equivalent to what is present in money market:

  1. Supply Side Factors:

  • Penetration of debt mutual funds and alternate investment instruments for the people

  • Banks willing to lend their money to corporations

2. Demand Side Factors:

  • Corporate Capex since corporates want to raise the money via debt and issuing bonds#

While demand has remained muted as capex plans get pushed back, supply has been mixed with debt MFs seeing outflows on one hand while successful private banks focus more heavily on their corporate loan books.

Financial snapshot

For the detailed financials, I have prepared a small spreadsheet which can be accessed here:

Probably one of the first things you'll notice is the decline in revenue over the last two years, with an especially sharp drop in FY20. The next thing that'll probably grab your attention is the consequent precipitous drop in net margins, which while still healthy at 34%+ have dropped significantly from their once 50%+ levels.

While the drop in revenue can be attributed to a lower level of capex in the industry and the reputational blow post the IL&FS crisis, with the mix also being worsened by more PSU capex (which is typically capped in terms of rating agency fees) a largely fixed and growing employee cost base led to a drop in margins.

Risks involved in the business:

  • Supply side risk factors: People have moved away from the traditional saving instruments of real estate and gold. This can be gauged from the fact that AUM of these funds have increased by 25% in the past 3 years. However there is one caveat: banks willingness to lend money due to their stressed balance sheet. India has experience one of the most severe twin balance sheet problem in the recent times and given that most of the debt is raised through banks, this poses as one of the risk factors.

  • Demand Side Risk factors: Given the muted capex since 2008, it was widely believed that capex cycle would start improving from 2020 onwards. However Covid has dealt the blow to capex cycle. And it is widely believed that capex would remain muted and even decline by 25%

  • Reputation Risk: This business is highly relationship driven and one blow to reputation, can cast the eternal blow to the company in terms of getting new clients. The same happened with CARE when IL&FS default was unearthed. As a result, the future clientele can be affected due to this blow.

  • Business Model: This is one of the most controversial factors at play from ratings perspective. In India, the model used is “Issuer Pays”. Consider this scenario: if you want to borrow the money by issuing some instruments, you would have to get yourself rated from CRA’s. Now herein lies the conflict of interest where CRA’s want to play merry with their rating fee and the business wants to get themselves rated as AAA so that they can easily access the debt. This was one of the major Lehmann moment of 2008 financial crisis where CRA’s rated CDO’s as AAA even through they were junk

  • Concentration of ratings in net revenue: For CARE, diversification has not happened yet. Hence, 95% of their revenues come through ratings. Given the muted debt markets, this poses a high risk factor

Strength and key risk mitigation:

  • Highest OPM amongst the competitors: CARE has the highest operating profit margins since they keep the employee cost under control. Employees are paid through exercise of ESOP’s as well which is clearly evident in 2016 statement where NPM felt on the account of employees exercising their options

  • Competent Management in the form of Ajay Mahajan: CARE had the consortium of PSU banks in early 2012 as their major clients. Also their rating process was not robust. The recent appointment of Ajay bodes well given his 20+ years of experience in the marquee firms as BOA which is expected to bring the best practices from the global rating firms

  • Diversification by CARE: Given the muted debt market, the major focus has shifted to the following:

  • Bigger share of ancillary services like securitization, impaired asset resolution etc. which might not be good for OPM but would strengthen the P&L for CARE

  • AI & ML capability in rating process which would be the first of its kind in India on account of their recent acquisition

  • Close monitoring of SEBI: Post the IL&FS, SEBI’s close monitoring of the rating is expected to bring best practices out of the CRA’s and avoid any kind of trust deficit.

  • CRISIL investment in CARE: This is one of the best fact for the bulls in CRA’s when the leader has invested at 1600 per share in CRISIL in 2016 and bought 9% equity. This is further expected to bring synergies in the rating processes.

  • Clean Books: There are no contingent liabilities or related party transactions since there are no promoters involved. Considering the ownership pattern, it is jointly owned by consortium of mutual funds and other DII’s (including CRISIL).

Valuation perspective: Although this is not an investment advise, it helps to look at how the firm is being valued. At the current market value of 1070 cr, cash reserves of 440 cr and 0 debt, the enterprise value comes out to be 630 crores. At an average CFO of 740 crores in the past 9 years, it comes out to be ~80 crores per annum. The substantial cash reserve and low investment intensity demonstrate capacity to weather the storm and fund any future growth with internal accruals. Around 1000 cr has been paid as a dividend in the last 9 years which is again a good sign and demonstrates management intent to share free cash with shareholders.

The firm can effectively be a good proxy play on economic recovery. Similar scenario occurred post 2008 when Moody’s & S&P prices hammered and then reached 10x (from $35 to current price of $270 for moody). However their earnings rebounded to pre-2008 level only in 2013. But given the high profitability of the industry, prices can rebound on the economy bouncing back

GSN Invest++: At GSN Invest++ we analyze 70 market leading firms across parameters of growth, longevity and stability. You could subscribe for the same here.

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