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Suresh Krishnamurthy

Mr R. Ravimohan, Managing Director... Likely expansion in corporate debt market augurs well.

SHAREHOLDERS of CRISIL can continue to hold the stock. They, however, will need to nurse a long-term perspective for the stock to deliver returns that are commensurate with risk.

Regulatory shock

For many years now, CRISIL has been a beneficiary of the changes in regulations governing debt securities. Regulations such as mandatory rating for securities helped the company notch steady growth in revenues and profitability. However, in the quarter ended December 2003, regulatory changes became a hurdle for revenue growth. The requirement that banks can invest in only listed debt securities affected activity in the market for private placement of debt securities. The restriction on raising loans from the overseas markets also played a part. Consequently, rating income declined.

The impact on profitability turned out to be quite significant. In the first half of 2003-04, rating revenues rose about 10 per cent; in the third quarter ended December 2003, they declined by about 17 per cent. Importantly, operating profits from rating rose 24 per cent in the first half suggesting that CRISIL was enjoying the benefits of scale. However, the slump in rating revenues led to a 33 per cent fall in operating profits. With ratings accounting for about 90 per cent of profits, net profits too fell by about 43 per cent.

However, the shock to rating revenues is likely to prove temporary. The requirement of listing of debt securities is unlikely to stop triple-A rated companies from participating in the market for private placement. The volume of activity is only likely to improve with the debt issuers likely to take the listing requirement in their stride. The step up in economic activity is another growth driver. Over the long-term, structural changes such as the shift in investor preference for mutual funds vis-à-vis bank term deposits and issuance of complex securities, such as mortgage-backed securities, have the potential to augment ratings revenue growth for CRISIL.

Enhanced risks

However, CRISIL, on an acquisition mode, could enhance risks. Its attempt to explore opportunities at the global level augurs well from the point of profit growth. Similar to IT-enabled services companies, CRISIL is seeking to exploit the arbitrage in labour costs for high-end research. The Rs 15-crore acquisition of a London-based gas advisory and information firm needs to be viewed in this context. Still, acquisitions enhance risk since a failed acquisition can hurt the return on net worth. Further moves on acquisition need to be viewed with caution.

From the shareholder's perspective, continuing acquisitions by CRISIL is negative as it also perpetuates its policy of holding on to free cash flows rather than distributing them as dividends. Cash and equivalents accounted for more than half of CRISIL's net worth as at end-March 2003. CRISIL did step up the dividend rate in 2003; however, the growth in dividends needs to be maintained to ensure that the downside risk to stock price is capped.

Stiffly valued

The valuation of the stock at about 20 times its earnings for the trailing 12 months ended December 2003 is stiff. CRISIL does have the potential to record earnings growth needed to justify the stiff valuation. Factors such as the return on net worth of about 20 per cent, the possibility of improvement in economies of scale and the expectations of steady growth in rating income augur well. However, the risks are high since CRISIL would need to maintain growth for a considerable period to generate reasonable returns for shareholders. In this backdrop, fresh exposures can be avoided now.

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