Description

Care Ratings is India’s second largest credit rating agency. This is a long term play on not just India’s credit growth story but also the structural tailwinds that are in play to develop the bond market in the country. The stock is also trading about ~40% discount to domestic peers, which makes it an attractive long term buying opportunity.

Note: All numbers are in Indian Rupees; Fiscal year end is March 31st

Brief overview of the credit and rating industry in India:

• There are seven RBI-approved Credit Rating Agencies (“CRA”) in India: CRISIL, ICRA, CARE, India Ratings, Brickwork, SMERA and Infomerics. CRISIL is the #1 CRA and is backed by S&P (owns 67% stake) while ICRA is the #3 CRA and is backed by Moody’s (owns ~50% stake).

• CRISIL and CARE have about 31/29% market share (not official data; some research estimates claim that CARE now has slightly more market share than CRISIL) and ICRA has about 22%; combined 3 have about 82% market share which has dropped from 88% in FY12.

• CARE is a pure play ratings company; CRISIL generates ~80% revenues from non-rating businesses and ICRA generates about a third of revenues from non-rating business.

Indian credit market overview:

• Credit rating agencies are dependent on two markets – bank loans and corporate debt. Bank loans form the majority of the credit market while the debt market is still small. Within the bank loans, rating agencies are dependent on industrial and services sector for the credit growth.

• While the overall credit growth in India has been strong, the credit growth has been anaemic in the industrial sector. Credit growth in the industrial sector has been in 1%-2% range in the last 3-4 years. Services sector is another important sector for the ratings agency and here the credit growth has been robust. Most of the public sector banks in India are plagued with bad debts, having lent aggressively to corporates between 2009-2014. Current NPAs of banks stand at ~11.6% (for March 2018 per RBI) and stressed asset ratio was 12.5%. The stressed asset ratio for Industrial segment was highest at ~25%, which has resulted in the banks being extremely cautious in lending to this segment.

• Bond market is underdeveloped in India and represents only a small portion the credit market. Current corporate bonds to GDP is about 17% compared to 40-45% for countries like Russia, Brazil and China and about 115% for UK and US.

• Within the bond market, issuance is currently dominated by financial institutions (making ~75% of the issuers who use the platform to raise money to further lend to corporates) and AAA/AA rated entities (~80-90% of the market). Only the bigger and high rated industrial and services companies have access to the bond markets.

• Commercial paper issuance has been on the rise in the last few years, as yields on the CP have declined due to the excess liquidity with the banks driving yields lower. This has resulted in large corporates with high credit use CPs instead of bank loans. In the last few weeks even this market has come under stress after one of the financial institutions started defaulting on the CPs that were rated AA.  

Why has the bond market not developed so far and what could change this?

The main reason for the shallow bond market is mainly due to the poor bankruptcy laws and low recovery rates (at 25% compared to 80-90% is developed markets like US, UK and Japan) that has resulted in low demand for the paper other than AAA/AA paper. Additionally, pension funds and other institution were only allowed to invest in AA and above paper, resulting in poor demand for AA- and below rated paper.

Currently, the Indian banking sector (especially, the public sector banks) is in bad shape, having lent aggressively to the corporates during the last investment cycle. The public sector banks are saddled with huge amount of bad debts and are not in a position to drive the credit supply for the foreseeable future. Only the well run private banks and NBFCs are able to lend to the corporates but they would rather lend to the retail sector where currently the perceived risk is lower.

The government and the regulatory bodies (RBI and SEBI) have finally understood the importance of improving the bankruptcy process to ensure that investors have a clear path of recovering their capital in the event of a default. In 2016, India set up IBC (Insolvency and Bankruptcy Code) and NCLT (National Company Law Tribunal) benches and in Jan 2017 they gained power, when India’s new bankruptcy laws took effect. Previously, the promoters of the companies raised capital from banks to invest in new ventures and they participated in all of the upside without having to fear insolvency due to the inability of the banks to reclaim their loans. Now, the banks can take the defaulters directly to the NCLT if they cannot come up with a repayment plan within 6 months. Once with NCLT, the case has to be resolved with 180days failing which they will be referred to the bankruptcy courts. The bankruptcy laws are still work in progress with lot of changes taking place as regulators learn and adopt to refine the process. While the progress has been slow, the new laws have instilled caution among promoters of the companies and have started to gain the confidence of the investors. I believe that the IBC and the NCLT will be game changers for the Indian debt market with healthy growth going forward in the next 2-3 years.

Overview of the company:

CARE was set up in 1993, 25 years ago. CRISIL and ICRA, the 2 other major rating companies were set up 6/3 years earlier than CARE. The other CRAs have a much shorter history. S&P and Moody’s acquired stakes in CRISIL and ICRA in 2007 when the Basel II was being implemented. Company ranks #1 in bank loans, #2 in debt (CRISIL is #1) and #3 in SME ratings (ICRA is #1). Company is a pure play ratings provider (with over 98% of revenues from ratings) and generates roughly 50/50% from bank loan/debt ratings.

Fees are generated from the initial rating provided and subsequent annual surveillance fees until maturity. RBI guidelines have set floor on fee rates; initial rating fees of 4bps of the notional amount subject to minimum of Rupees 40k; an additional surveillance fee is subject to minimum of Rupees 30k. The fee on rated debt is typically higher at 10bps of notional versus 3-5bps for bank loans, but in practice the blended fees are close to 2bps due to competition.

Company has also started to diversify its business. While staying within the ratings business, it has started subsidiaries in Nepal (owns 51%) and Africa (owns 78%). It has also entered into the advisory business with CARE Advisory, Research and Training Services Limited (CART) and CARE risk solutions. These businesses are very small part of the overall business; but most importantly not losing money for the company.

Why I like the company:

• Well established reputed credit ratings companies are amazing businesses to hold for the long term – high entry barrier, low capex, high operating leverage, high ROE/low debt and cash generating machines. In India, there is a duopoly between CRISIL and CARE (ICRA being a smaller player). The only disadvantage being that currently in India the CRAs do not have pricing power.   

• The financial service industry is in the early stages of development (industry is still very small at less than 5% of GDP versus over 15% for US). The credit growth for developed countries should be around 1.5-2.0x GDP. With India expected to grow at about 7% for the next decade, this would imply credit growth in the 10-15% range.

• Outside the general credit growth, the government and the regulatory bodies are focused on developing the bond market. A major recent initiative included the promotion of the Commercial Paper market. In early 2017, RBI made it easier for companies to raise capital using CPs by reducing the minimum ticket size of the loans and also lowering the minimum credit rating to A3 from A2 (1-notch lower). The RBI also mandated that the CPs should be rated by minimum of 2 CRAs which benefited CARE.

• There are a number of newer regulations in the works to develop the bond market both from the supply as well as the demand side. New proposed regulations include:

• Incremental borrowing from the bond market: SEBI has proposed new regulations that requires large listed companies (having debt of over Rs. 1.0billion (approx. $15mn) and minimum AA rating) will have to source 25% of incremental borrowings from the bond market. This will be implemented from March 2019; there is some levy for corporate to bypass this for the first 1-2 years but will be compulsory from March 2021. The government had initially proposed this for companies with single A and above rating, but SEBI decided to be conservative when coming up with the rule. I believe eventually the rule will be modified to include Single A and above companies.

o  Institutional investors will be allowed to invest in single A paper: Current investment regulations do not allow institutional investors like pension funds, insurance companies and mutual funds from investing in below AA rated paper. In the recent budget, the government has proposed that the regulators allow single A rated paper to be allowed. If the proposal is accepted, it will definitely go miles to deepen the bond market by increasing the demand for A paper (currently 2% of the market)

• There are also few incremental opportunities that the company can capitalize on in the near term:

• Dual rating requirement under the IBC proceeding: IBC framework now requires 2 ratings from CRAs for those cases which are referred to NCLT (also includes those that are not yet referred but sitting in joint lenders forum).

• Dual rating requirement for NPA resolution: Under RBI’s current framework (revised Feb 2018) of the resolution plan which involves restructuring of the NPAs, the residual debt will have to be independently be rated by 2 approved CRAs (CARE is one of the CRAs that can rate the loans).  With current NPAs at 11% of the total bank debt and the big accounts going through the NPA resolution, the dual rating requirement should provide revenue upside.

• I believe that current valuation is very cheap if we take a long-term view on the company. Also on a relative basis, the stock is currently cheaper than its peers. The Company is currently trading at ~20.5x LTM earnings and so the stock is not particularly a bargain stock; but 5 and 10-year average trading PE has been 27/26x. Company is sitting on a lot of cash (Rs 5 billion equivalent to 83% of total assets) and has no debt. CRISIL and ICRA on the other hand are trading at 36x and 33x LTM earnings.

CARE’s topline growth is linked to India’s credit growth (especially industrials and services sector). While it is difficult to project credit growth for the next 1-2 years, over longer time frame I expect the credit growth should be about 10-15% range. The bond market should grow at a faster rate due to the low base and governments push to drive this industry. For CARE, this should imply growth at least in line with the bond market growth. As India’s bond market matures and we see more of Single A and below paper, the blended fee realisation for CARE should also increase, implying top line growth much faster than credit growth. The bottomline should increase at a faster rate given the high operating leverage of the business.

• Good shareholder list with a professionally run management and no promoter holding. Understanding promoter holding is very important while investing in Indian stocks. In this context, there are no promoters and the company is professionally run. CRISIL owns ~9% of CARE – CRISIL started by shares of CARE earlier this year (probably with the intention of acquiring the company). Soon after the shareholding was made public, SEBI put a 10% cross-shareholding cap for rating agencies, effectively thwarting any intentions of acquiring CARE. Other top investors include Monish Pabrai who recently started investing in the company and currently owns over 7.5% stake (per latest disclosure).

Catalyst

no immediate catalyst given long term structural nature of the idea. New regulations that will boost the bond market in India when implemented will act as catalyst that will drive long term growth