CRISIL, CARE, ICRA. Raters are ripe for an upgrade

In India, the fortunes of rating agencies depend on the underlying economy and the capital market conditions. Sluggish investment activity and fewer bond issuances have impacted the revenues of these companies in recent times.

If the economy were to recover from here, rating agencies will stand to benefit both from the first round of fund-raising as well as refinancing activity.

Three rating agencies — CRISIL, ICRA and CARE — command 82 per cent share of ratings revenue in India. Of these, CRISIL and ICRA trade at a higher premium compared to CARE, thanks to their diversified revenue streams and additional business from international partners — S&P in the case of CRISIL and Moody’s for ICRA.

CRISIL will continue to command premium valuations and is likely to see an earnings upgrade. ICRA, on the other hand, has limited upsides from current levels, owing to the sharp move in the stock in the last two months, after Moody’s announcement to up its stake in the company through an open offer. On the other hand, comfortable valuations and growing interest from foreign investors can lead to notable upsides in CARE.

Investors with a two-three year horizon can buy into CRISIL and CARE and pare some of their gains in ICRA.

In India, rating revenues broadly comprise bank loan ratings, corporate bond ratings and SME ratings. While bank loan and bond ratings account for a significant portion of rating revenues, SME rating has been a more recent opportunity.

Sluggish economic activity and high interest rates have not been conducive to the high-margin bond market. Corporate bond issuances were down 24 per cent in 2013-14.

Over the medium term, growth will return as investment activity picks up. Peaking of domestic interest rates will also provide a fillip to bond issuances. Sluggishness in bond ratings is offset by growth in bank loans and SME ratings. A pick up in credit growth, which has fallen to 14 per cent in the last two years from 17-20 per cent in previous years, will drive growth in bank loan ratings over the next two years.

SME ratings is a growing opportunity, but the ticket size is small here with low margins. This will continue to be in focus as long as other segments remain lacklustre.

CRISIL, a subsidiary of S&P (67.7 per cent stake) that pioneered credit ratings in the country, was the first to diversify into research services. This has opened up ample growth opportunities. The work that CRISIL does for its parent S&P is about a third of its ratings revenues. CRISIL was the first to foray into SME ratings, which has helped it offset the slack in bond ratings.

Within the research segment, the company caters to both the domestic as well as global finance markets. CRISIL has built its research business through the inorganic route by acquiring IREVNA in 2005 and Pipal Research in 2010. The company also acquired Coalition — a business intelligence provider — in 2012.

While domestic research remained subdued, the global research and analytics (GR&A) division has done well, thanks to addition of new clients. Rupee depreciation has also helped revenues grow 22 per cent in 2013-14. Despite exposure to the low-margin SME segment, the company has maintained its margins in the 32-34 per cent range in the last five years.

Pick-up in economic activity and bond issuances can result in earnings growth of 16-17 per cent for CRISIL. At the current price, CRISIL trades at 24 times its one-year forward earnings. While this is above its historical average of 22 times, an earnings upgrade is likely. CRISIL, a market leader, will continue to command premium valuation.

CARE is a pure Indian rating agency which has only recently started to expand internationally. It has also started expanding into research, but is still at a nascent stage.

CARE has been expanding its international presence. Recently, it co-promoted a rating agency called ARC Ratings, in which it has 20 per cent stake. This will help strenghten its overseas footing.

The company commands the highest margins compared to both CRISIL and ICRA. However, increasing exposure to the SME segment has impacted the company’s operating profit margin (OPM), which is now at 68 per cent, down from 71 per cent last year. Sustainability of its superior margins will need to be watched. CARE has a cash kitty of ₹441 crore, which it will use for its inorganic initiatives.

CARE will witness marginally lower earnings growth of 10-12 per cent due to lower billing rates for SME ratings.

The stock of CARE also moved sharply in the last two months, after its four principal shareholders — holding 45 per cent stake— made public their intention to offload their holdings.

The stock has been re-rated significantly from 14 times to 17 times one-year forward earnings. CARE has a healthy share in rating revenues, and sports OPM of about 68 per cent vis-à-vis 23-33 per cent margin of others. With foreign rating agencies as well as PE investors taking an active interest in Indian rating agencies, this pure Indian player may see some re-rating.

While the company’s earnings will grow at a slower pace vis-à-vis its peers, valuations offer enough leg-room for an upside.

ICRA has four main business segments — rating, consulting, outsourced services, and IT-related services. Recently, the company has also been exploring opportunities in SME ratings.

However, the volume of debt rating grew at a modest 5 per cent annually in the last four years, while volumes in bank loan ratings declined 10 per cent.

Thus, ICRA’s ratings revenues grew at a slower pace than CARE and ranks third in terms of market share.

ICRA’s consulting services segment has also remained sluggish, owing to over-capacity in the consulting space. The outsourced service segment mainly comprises work outsourced by Moody’s, which forms 9 per cent of revenues. While the company has attempted to diversify its business, consulting and IT-related services are not very profitable. And hence a pick up in ratings and outsourcing business will remain key drivers for earnings. ICRA will witness an earnings growth of 14-15 per cent over the next two years.

After the recent announcement by Moody’s to up its stake in ICRA, the stock shot up 20 per cent in the last two months. ICRA, which traded at a discount of 18-20 per cent to CRISIL in the past, now trades at par with it. While a higher stake by Moody’s is expected to open more revenue opportunities, significant upsides are limited.

ICRA has been lagging its peers in ratings growth. ICRA’s open offer, priced at ₹2,000, is 6 per cent higher than its current market price. Investors can partially book profits by tendering shares through the open offer, which closes on May 8.

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