Over the long term, the under-penetrated debt market offers significant scope for growth in revenues.

Investors can consider subscribing to the public issue of Credit Analysis and Research (CARE Ratings). CARE Ratings is India’s second largest rating agency in terms of rating revenues.

In this offer, existing shareholders are selling their shares to the public as the company has no debt and has high cash and liquid investments on its books. The company enjoys better margins than its peers in ratings business.

CARE offers corporate bond, bank loan, commercial paper and securitisation ratings. A fall in interest rates may give a fillip to debt fund raising.

But, CARE’s revenues in its rating business may grow at lower rates than in the past (41 per cent compounded annually during the period 2007-08 and 2011-12), given the rising competition and the likely fall in ticket sizes on bank loan ratings.

At the upper end of the price band Rs 750, the stock would discount its FY12 earnings by 18.5 times.

In comparison, ICRA is trading at 26 times the same earnings CRISIL’s price earnings multiple is 35 times. Relatively, CARE is priced at a discount to other rating agencies despite a higher proportion of its business coming from the high-margin ratings business.

Ratings segment accounts for around 86.4 per cent of the total income for CARE. CRISIL and ICRA, on the other hand, derived 39.3 per cent and 61 per cent from ratings segment during the six months ended September 2012. But rather high reliance on bank loan ratings, which may begin to taper off after 2014, does create uncertainties for CARE.

Corporate debt market offers huge scope: Over long-term, the under-penetrated debt market offers significant scope for growth in the revenues.

According to the RBI, the corporate bond market in India, as a per cent of GDP, was 11.8 per cent compared to 17.2 per cent in Emerging East Asia and 19.8 per cent in Japan.

The size of the corporate debt market as of September 2012 is just a fourth of the bank loan market. Large non-financial companies have been raising only about 4 per cent of their requirements through the debt market.

The setting of a minimum base rate for bank lending, relaxations in the ceiling and taxes for FIIs investing in debt, may help revive the debt market.

A moderation in interest rates and a revival in the rating upgrade cycle, may help the corporate debt market. The latter may help mutual funds and insurers, who don’t invest in below AA instruments participate actively in debt markets. Falling rates may also make domestic debt more competitive in relation to foreign borrowings, after including hedging costs.

Bank loan rating aids growth: Basel II norms mandated banks to rate their wholesale loans and allocate capital based on credit risk. Credit rating agencies made hay from this move with revenues from bank loan ratings soaring even while corporate debt activity declined.

CARE Ratings was a significant beneficiary of this, given that it has promoter backing in the form of banks. Around 72 per cent of the value of debt rated by CARE in 2011-12 was for bank loan ratings. If this is mainly from Basel II ratings, the business could face challenges, post 2014, when banks can have in-house ratings on loans.

The RBI has allowed banks to migrate to internal rating-based approach and approved banks can use their own internal estimates to determine the capital requirement for a given credit exposure.

If banks migrate to internal ratings, then the borrowing companies need not approach rating agencies for the ratings.

The RBI plans to have 18 months of parallel runs of the systems and plans to give final approval starting March 2014.

Given higher reliance of CARE Ratings to bank loan rating business, this may turn out to be a significant risk.

Profitability: The net profit of CARE grew at 44 per cent compounded annually from 2007-08 to 2011-12. The return on equity for the year ended March 2012 was 30.7 per cent.

The company’s operating margin from its rating business was 65 per cent for the first half the current fiscal as compared to 38.5 per cent in the case of CRISIL and ICRA.

While CARE Ratings’ margin is high, it has been on a decline from 79 per cent in 2009-10. Despite the rating business being dominated by the top three players, the new entrants are giving tough competition to the existing agencies. There is severe pricing pressure on older players.

To counter this, CARE Ratings, for instance, has introduced a fixed fee cap model, wherein the client pays fixed fee for a certain period and once the fee is exhausted it may not charge additional fee for incremental issuances based on the terms of contract.

While this strategy may help retain clients, profitability may come under pressure. Further, forays into new areas such as SME ratings where CARE is a relatively recent player will also have impact on its margins.

Cash balances and diversification: CARE has Rs 370 crore of cash and investments on its books. This accounts for 17 per cent of the company’s market cap at the upper end of the price band. These balances may help company scout for acquisitions in other domains such as research and risk solutions.

The company has already acquired 75 per cent stake in Kalypto, a firm which specialises in risk management software.

It is also in exclusive talks with a Nigerian risk management company. With strong free cash flows ratings, cash balances will continue to soar.

In the absence of acquisitions, higher dividend payout can be expected from the company. The risk to diversification is that such an exercise is a long-gestation one.

For instance, even as more than a third of revenues of ICRA come from non-rating businesses, their contribution to operating profits is still at 7.5 per cent.

(This article was published on December 8, 2012)
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