Credit Rating - Sector Initiation - Centrum 05062014

Centrum Equity Research is available on Bloomberg, Thomson Reuters and FactSet

A credit-able proposition We initiate coverage on Credit Rating Agencies (CRA) with a positive bias CARE (Buy) and CRISIL (Hold). Elevated interest rates, policy lapses and moderation in GDP growth impacted the investment cycle during FY11-14 and in turn the ratings business. With stable government, prospects have emerged of policy reforms across core sectors of growth which will push corporate capex plans. This, in addition to initiatives on reviving the corporate bond market will result in a surge in the rating business and lead to improved profitability for CRAs. CRISIL and CARE stand to gain given their leadership positions and superior returns profile.

Green shoots emerging; but it will be a gradual process: The period betweenFY11-14 was characterised by weak investment activities following policy lapses,sticky interest rates and moderation in GDP growth. This, in addition to excessleveraging by the corporates and higher levels of delinquencies (NPAs) led tomoderation in funds raised by corporates to 15.2% CAGR vs 21.4% CAGR in thepreceding period (FY08-11). Green shoots have emerged following early signs ofprogress in reforms across core growth sectors. With a stable government and theneed to accelerate growth, leading corporates, lenders and associations expectgradual recovery beginning H2FY15.

Efforts to revive corporate bond market; SME, the next business opportunity:The Indian corporate bond market remains under-penetrated (~3% of GDP),partially due to the financial structures and regulatory intervention in the past.Efforts have been made towards reviving the corporate bond market byencouraging participation of various investors. With huge capex pipeline andconstrains on bank funding, the growth in corporate bond market though gradual,will improve steadily. SME is the backbone of large industries (contributing 45% tomanufacturing) and with immense benefits of rating, is the next businessopportunity for rating agencies.

Asset light model; credibility of utmost importance: CRAs deal with the capitalrequirement of corporates and reflect the health of investment activities in theeconomy. These agencies operate on asset light models that generate healthyEBIDTA margins and superior return ratios. Judicious utilisation of cash is vital fromthe shareholders perspective and hence these agencies have resorted to paybackor taken up in-organic growth. Default study / stability reports play a vital role inassessing the health of corporates and quality of ratings by the agencies, but it canaffect their credibility if they fail to recognise early signs of stress. Though CRISILand ICRA have done well, CAREs performance was equally good. (exhibit 36-39).

Outlook and recommendation: CRISIL commands premium to its peers given itsstrong parentage, well diversified revenue mix and superior return ratio profile.Valuations at 31.1x CY15E EPS is on the higher band and limits upside. Initiate withHOLD (TP of Rs1,340). CARE trades at 34% / 48% discount to ICRA and CRISILrespectively. While the discount to CRISIL is justified given the superior profile ofthe latter, we believe the valuation gap to ICRA is on the higher side and shouldnarrow as CARE scores well on all ratios when compared to ICRA. Initiate with Buyand target price at Rs1,150.

Stock Price Performance (%) *

Company Name 1 M 3M 6 M 1 Yr

CARE Ratings 17.5 25.8 27.8 30.0

CRISIL 8.5 21.3 32.0 16.4

ICRA 25.2 25.2 54.0 43.5

Nifty 10.6 17.5 20.1 17.4

Source: Bloomberg; *as on 04 June 2014

Aalok Shah, [email protected]; 91 22 4215 9075

Company Name

Rating Target

Price (Rs) Upside /

Downside (%)

EPS P/E (x) RoCE (%) RoE (%) Dividend yield (%)

FY14 FY15E FY16E FY14 FY15E FY16E FY14 FY15E FY16E FY14 FY15E FY16E FY14 FY15E FY16E

CARE Buy 1,150 22.3 44.4 48.7 57.6 21.2 19.3 16.3 39.2 38.9 41.9 28.3 28.0 30.2 3.0 3.2 3.4

CRISIL Hold 1,340 (3.7) 33.2 38.1 44.7 41.9 36.5 31.1 34.0 33.3 33.4 39.0 36.6 36.7 1.4 1.3 1.6

Source: Company, Centrum Research Estimates

Financials

Initiating Coverage 05 June 2014

INDIA

Credit Rating Agencies

2 Credit Rating Agencies

Table of content

Executive Summary ............................................................................................................................. 3

Slowdown in investment cycle impacts rating business; expect gradual recovery. ....................... 5

Weak investment activities see growth rates moderate ......................................................................................... 5

Green shoots emerging, policy reforms to aid revival in investment activities ............................................. 6

Current situation more of re-adjustment after a long period of lower growth ............................................. 6

Efforts underway to revive corporate bond market .......................................................................... 7

Corporate India has relied on external source of funding; more under the equity route: ........................ 7

FY14 saw slower corporate bond activities; expect gradual improvement. ................................................... 8

Efforts underway to develop the corporate bond market ..................................................................................... 9

SME segment: The next big market opportunity ..................................................................................................... 10

Credit rating agencies - Asset light model; credibility plays a vital role ........................................ 11

Rating agencies: Business model and sector dynamics: ....................................................................................... 11

BLR business enabled huge surge in rating revenues: .......................................................................................... 11

Default study plays a vital role in assessing the health of corporates ............................................................. 13

Consolidation: Can it be the next big wave? ............................................................................................................. 14

Valuation, view and key risks ............................................................................................................ 15

Recommendation................................................................................................................................................................. 15

Key threats .............................................................................................................................................................................. 16

Company Section

CARE ....................................................................................................................................................................................... 17

CRISIL ...................................................................................................................................................................................... 30

Annexure ........................................................................................................................................... 41

ICRA ......................................................................................................................................................................................... 42

India Ratings and Research ............................................................................................................................................ 43

Brickwork Rating ............................................................................................................................................................... 44

SMERA .................................................................................................................................................................................... 45


Executive Summary

Policy lapses, elevated interest rates and delay in project implementation had impacted the corporate investment cycle during FY11-14. This in-turn resulted in moderation in funds raised by corporates under the bank credit and corporate bond issue to 15.2% CAGR (cumulative) over FY11-14 vs 21.4% CAGR in FY08-11. The two large CRAs saw mere 12% CAGR in their rating revenues over FY11-14 vis--vis 36% CAGR in the preceding period. Stable government and the need for accelerated growth through reforms across core sectors have raised the prospect of a revival in corporate investment cycle. Efforts to revive the corporate bond market and the increased emphasis on bank loan rating will see credit rating agencies notching up gains. CRISIL and CARE with dominant positions will be initial beneficiaries.

Recent policy measures have created a basis for revival in investment activities. Assessment of some indicators industrial outlook survey, quarterly order book, capacity utilization survey and institutional assistance by corporates has pointed at early signs of green shoots emerging. India remains in the early stages of the adjustment phase and hence can be vulnerable to shocks both internally and externally. The government will have to respond quickly to the deteriorating macro environment while containing fiscal deficit, delinquencies in the banking system and importantly taking appropriate policy measures towards distressed sectors. Leading corporates, lenders and associations have talked about recovery beginning in H2FY15 due to the stable government, easing interest rates (real interest rate turning positive) and reforms.

Unlike the Indian government bond market that is highly penetrated (40% of GDP), the Indian corporate bond market remains under-penetrated (~3% of GDP) and is partially due to the structure of the Indian financial system and regulatory interventions.

Considerable efforts have been made in reviving the corporate bond market in the recent past by providing incentives to retail investors (reduced the trading lot size from Rs1mn to Rs0.1mn), foreign institutions (FII investment limit in corporate bond, government bond increased) and domestic institutions.

SME segment remains the next big opportunity for the CRAs with mere 1mn of the total of ~30mn SME units rated till date. This segment is the backbone of large industries and contributes 8% to the GDP, 40% to industries and 45% to exports. According to experts, the benefit of rating has encouraged at least 60% of initially rated SMEs to review their rating in subsequent years.

While the Indian banking system is geared to meet the capex requirements (to the extent that they are capitalized), cap on sector-wise exposures and past experience (ie aggressive lending during FY06-09 and its fallout in subsequent years) will make banks refrain from undue exposures. Reforms across core sectors of growth and subventions from the central bank could support investment growth.

We expect rating revenue for our coverage universe (CARE and CRISIL) to witness 17% CAGR over FY14-16E (vs 12% CAGR in FY11-14) led by improvement in systemic volumes (both corporate bond including SME rating and bank loan ratings) and also gradual improvement in pricing. These companies enjoy healthy EBIDTA margins (CRISIL at 30%+ and CARE at 64%) given their ability to adequately sweeten their core assets.

Credit rating agencies are asset light model businesses. Free cash flow (FCF) yields are well in excess of 4% and dividend payout at 50%+. Judicious deployment of surplus cash is vital from the shareholders perspective and hence CRAs have resorted to payback or taken up acquisitions. Return ratios (RoCE / RoE) too are on the better side and are similar to those of some FMCG / Internet companies. Consolidation could be the next big wave. Valuations however will be on the higher side.

While default study / stability reports depict the stress in the system they are also used for assessment of the quality of rating and can dampen the credibility of CRAs if they fail to recognize early signs of stress as was the case with global rating agencies during the recent financial crisis. Other risks include that of implementation of internal rating based (IRB) approach by banks following Basel II requirement and longer than expected time towards revival in corporate bond market.

Penetration of Indian corporate bond market is low at ~3% vs China (10.6%), Singapore (30%) and Japan (42%).

Asset light model similar to those of FMCG / Internet companies; valuations for CRA are on the lower side when compared to these

Default study assesses the stress in the system


Outlook and recommendations

FY08-11 was characterised by a strong investment cycle. Funds mobilised by corporates under the bank and corporate bond issue routes witnessed 21.4% CAGR over the same time frame. With a relatively nascent market, pricing was on the better side and consequently, rating revenues for the top two credit rating agencies saw 36% CAGR over the FY08-11. The trend reversed in FY11-14 with mere 12% CAGR in rating revenues (despite 15.2% CAGR in systemic volumes), partially due to under-cutting.

With early signs of revival in investment cycle, we expect gradual improvement in rating revenues, led by a combination of increase in volumes and price led growth, albeit at a gradual pace. We are factoring in 15.2% CAGR in systemic volumes (bank credit to witness 15.6% CAGR and corporate bond issue at 10.9% CAGR over FY14-16E) and are factoring in 17% CAGR in rating revenues for our coverage universe (CRISIL and CARE).

We initiate coverage on CARE with a Buy and a target price of Rs1,150 (valued at 20x FY16E EPS). CARE offers a perfect play on rating business with superior margin profile, FCF yield (4%), 60%+ dividend payout ratio and return ratios (RoCE at 39%). This, in addition to talks of stake-sale to a strategic investor and inorganic growth will enable it to leverage on brand and diversify the revenue mix. Valuations at 16.3x FY16E EPS are on the lower side to the true potentials and warrant re-rating.

We initiate coverage on CRISIL with a Hold and a target price of Rs1,340 (valued at 30x CY15E EPS). Strong parentage (S&P owns 67.7%), well-diversified revenue mix, healthy margin profile (30%+ EBIDTA margin) and superior return ratios (RoCE / RoE) remain key strengths for CRISIL and the stock has traded at significant premium to its peers. Early signs of revival in economic activities and a pick-up in corporate capex cycle will see a surge in ratings business and augment earnings growth for CRAs. We are factoring in 16% CAGR in revenues / adjusted PAT respectively over CY13-15E.

Signs of pick-up in corporate capex cycle to augment earnings growth


Slowdown in investment cycle impacts rating business; expect gradual recovery.

FY11-14 was characterized by weak investment activity due to policy lapses, elevated interest rates and moderation in GDP growth. Funds mobilised via bank credit and corporate bond issue moderated to 15.2% CAGR over FY11-14 vis-a-vis 21.4% CAGR in FY08-11.

Green-shoots have emerged following reforms across core sectors of growth. The decisive election outcome and stable government have raised the prospects of revival in investment activities and pick-up in corporate capex cycle.

The current situation is more of re-adjustment after a long period of lower growth given internal and external risks. Expect gradual recovery beginning H2FY15.

Weak investment activities see growth rates moderate

The period between FY11-14 was characterised by moderation in corporate investment activities following policy lapses, elevated interest rates, weak corporate savings and delay in project implementation. The same was also reflected in moderation in gross fixed capital formation to 1.7% from 8%+ during FY09-11 and declining investment activities by both public and private sector. Bank credit to industrial and service sectors moderated from 21.2% in FY08-11 to 15.5% in succeeding years. Funds raised via corporate bond issue (both private placement and public issue) also saw lower growth at 11.7% in FY11-14 vis--vis 24.4% in the preceding cycle.

Exhibit 1: Gross fixed capital formation saw moderation Exhibit 2: Public and private sector capital formation

Source: RBI, Centrum Research Source: RBI, Centrum Research

Exhibit 3: Funds mobilised via bank credit* and corporate bond issuance moderated to 15.2% CAGR over FY11-14 vs 21.4% CAGR in FY08-11.

Source: RBI, SEBI, Centrum Research *denotes credit to industrial and services sector.

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FY13 saw a feeble Rs4.6tn of project investments compared to average of Rs18tn during FY07-11.


Green shoots emerging, policy reforms to aid revival in investment activities

Policy reforms across core sectors of growth (Oil & Gas, power, road) in the recent past have created a basis for revival in investment activities. Assessment of some of the indicators industrial outlook survey, quarterly order book and capacity utilisation survey and institutional assistance by corporates in Q4FY14 points to early signs of green-shoots emerging. Q3FY14 saw sharp increase in institutional assistance by corporates to Rs791bn vis--vis Rs575bn for H1FY14. Industrial outlook survey pointed to higher optimism with respect to production, order books, capacity utilisation and exports. ~800 companies that participated in the survey guided for 11% yoy / 7% qoq growth in their order book.

Exhibit 4: Trend in institutional assistance by corporates

Source: RBI, Centrum Research

Exhibit 5: Average new order book has seen a growth

Source: RBI, Centrum Research

Current situation more of re-adjustment after a long period of lower growth

Policy lapses, external shocks, sticky interest rates and inflationary pressures had stalled investment activities for a long time. With the immediate need to revive industrial activities, policy makers and private sector in the recent past have taken some efforts to improve productivity. A lot of expectations have been built up following a decisive election and a stable government. With GDP growth having bottomed out and focus on investment activities, economists point to gradual improvement in GDP growth to 6.5% by end-FY16. Accelerated pace of reforms across stressed sectors could see GDP growth inch upwards of 7% on a sustainable basis.

India remains in very early stages of the adjustment phase and hence can be vulnerable to shocks both internally and externally. Leading corporates, lenders and associations have talked about gradual recovery beginning H2FY15 following stable government, easing interest rates (real interest rate turning positive) and reforms across stressed sectors. We believe the new government will have to respond quickly to the deteriorating macro environment while containing fiscal deficit, asset quality of banks and importantly ensuring appropriate policy measures towards distressed sectors.

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QoQ growth Yoy growth

Rs bn No of projects Project Expenditure

FY10 754 4,560

FY11 697 3,752

FY12 636 1,916

FY13 425 1,964

FY14YTD 391 1,366

Q1FY14 96 254

Q2FY14 116 321

Q3FY14 179 791

By the end of January 2014, CCI and PMG had together undertaken resolution of impediments for 296 projects with an estimated project cost of Rs6.6 trillion. As at end-March 2014 around 284 projects worth RS15.6 trillion are under the consideration of PMG for which issues are yet to be resolved.


Efforts underway to revive corporate bond market, bank loans still the preferred route

Corporate India has relied on external source of funding; more under the equity mode. Within debt, bank funding remains the preferred route.

Corporate bond penetration remains low at mere ~3% of GDP. FY14 saw 16% yoy decline in funds mobilised via corporate bond issue.

Efforts are underway to revive the same (both primary and secondary market). Encouraging participation from various investors ie retail (reduced the trading lot size from Rs1mn to Rs0.1mn), foreign institutions (FII investment limit in corporate bond, government bond increased) and domestic institutions.

SME segment is the next big opportunity given the highly under-penetrated market. SME is the backbone of large industries and contributes 8% to GDP, 40% to industries and 45% to exports. The benefit of rating has made at least 60% of initially rated SMEs to re-rate in subsequent years.

Corporate India has relied on external source of funding; more under the equity route:

According to the pecking order theory, profitable firms tend to finance through their internal sources first and then external sources. Among external sources, companies tend to finance with debt or issue of corporate bonds first and then equity. However, analysis of company finances indicate that they do not follow the pecking order theory and have instead depended more on external sources rather than internal sources. A further study reveals that a large part of funds mobilised were through the equity window especially during FY08-10 given favourable market conditions. While the recent euphoria in capital markets will see corporates resort to the equity route, reforms across the corporate debt market and increase in FII limit will see flows via the debt route too.

Even as systemic bank credit has moderated to 14-15% yoy levels from the peak of 25%+ in FY07-08, corporate India has continued to raise money under the bank loan window. One of the reasons for the same is the prevalence of cash credit system that takes care of cash management for the corporate. The illiquid corporate bond market has seen limited investor interest. According to an RBI survey, during 5-year period of FY06-10, 67.4% of the total corporate borrowing was financed through bank loans. The said proportion had increased to 71% in FY11.

Exhibit 6: Historically corporates have resorted to equity route for their capital requirement

Exhibit 7: Bank loan remains the preferred route given working capital nature of the funding facility

Source: RBI report on Corporate Bond market in India, Centrum Research Source: RBI report on Corporate Bond market in India, Centrum Research

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2006-2010 2010-11 2011-12

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Corporates have in the past resorted to equity route for their capital requirement


Indian corporate bond market remains underpenetrated

The Indian corporate bond market has remained highly under-penetrated as reflected in its ratio to GDP at a mere 2.8% as at FY14. This compares poorly with 10.6% for China, 30% for Singapore and 42% for Japan. One of the reasons for under-development of the corporate bond market is the structure of the Indian financial system and regulatory interventions. The government bond market remains highly penetrated at 40%+ of GDP and this could be mainly due to the relatively higher interest rate regime when compared to global economies and the need for higher government borrowings to achieve fiscal deficit targets.

Penetration of Bank credit to GDP and Corporate bond issuance to GDP

Exhibit 8: Bank credit* penetration remains steady Exhibit 9: Corporate bond penetration has declined

Source: RBI, Centrum Research * denotes industries and service sector Source: SEBI, Centrum Research

FY14 saw slower corporate bond activities; expect gradual improvement.

FY14 saw 23% yoy decline in private placement of corporate bonds to 1,924 issues (FY13 issuances were at 2,489). In value terms, cumulative amount raised via private placement for FY14 stood at Rs2.7tn vis--vis 3.6tn for FY13, a decline of 24% yoy. Uncertain business environment (both internal and external factors), elevated levels of interest rates (repo rate was raised by 50bps in FY14) and inflationary concerns saw corporates defer their capex plans.

With a stable government, expectations have now revived on investment activities and consequently on the health of corporate India. While the Indian banking system is geared to meet the capex requirements a) regulatory cap on sector-wise exposures b) episodes of the past (ie aggressive lending during FY06-09 and the fallout of the same in subsequent years) will see banks refrain from undue exposures. With need to comply with Basel III norms and the current scare capital position, banks are unlikely to aggressively aid capex growth. ALM mismatch also remains a major problem. The huge capex requirement (12th five year plan has pegged investment requirement at Rs56tn for the infrastructure sector) will warrant a surge in corporate bond market. Emphasis on reviving the corporate bond market will augment growth, albeit gradually.

Exhibit 10: Corporate bond issuance saw a dip in FY14 Exhibit 11: and also in value terms

Source: SEBI, Centrum Research Source: SEBI, Centrum Research

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Measures like partial credit enhancement etc to aid improvement in corporate bond market

Indian corporate bond market is highly illiquid


Efforts underway to develop the corporate bond market

In general, development of corporate bond market is correlated to the overall development of the economy. This is because development brings less volatile investment environment, less government involvement in commercial activity and strong creditor rights with transparency and good corporate governance. GOI, RBI and SEBI have initiated reforms in the corporate bond market to address the factors impeding the overall development of markets.

Exhibit 12: Efforts to develop corporate bond market

Policies recommended to develop the primary market in corporate bonds

Policy recommendations by Patil Committee to improve the secondary market in corporate bonds.

Rationalise stamp duty structure across the country and fix stamp duties based on tenor and issuance value.

Use the existing infrastructure of national stock exchanges to establish a system to capture all information related to trading in corporate bonds and disseminate it to the market in real time.

Eliminate tax deducted at source (TDS) for corporate bonds in line with Government securities.

SEBI should set up a separate trading platform for institutional investors in line with bond market as in other countries

Enhance the issuer base by encouraging corporations to borrow from the bond market rather than from banks.

Reduce shut periods and adopt a unified convention of day count for corporate bonds. Bottom of Form

Develop market makers in the corporate bond market similar to primary dealers in the Government bond market. Bottom of Form

Introduce exchange traded derivatives to provide ways to hedge risk of holding physical bonds.

Enhance the scope of investment by provident /pension /gratuity funds and insurance funds in corporate bonds. Make bond ratings the basis for such investments rather than the category of issuers. Encourage retail investor participation through stock exchanges and banks. Increase foreign investment limits for corporate bonds to encourage foreign investor participation.

Reduce the minimum market lot for corporate bonds from `10 lakh to `1 lakh to encourage participation of retail investors.

Consolidate issue of privately placed bonds. Avoid fragmentation or multiple numbers of issues to improve liquidity and depth in the market. This is also expected to favour public issues over private placement.

The secondary market for ABS products does not exist as these instruments cannot trade in the stock exchanges. Legal and regulatory issues need to be sorted out to facilitate growth of securitisation. The existence of secondary market for securitisation would help transfer risks by repackaging loans and selling them as bonds such as mortgage backed (MBS) and asset backed securities (ABS).

Create a primary issuance data base to provide information to investors to make a valued decision. Information on credit rating and credit migration should also be provided as part of the data base.

There is a need to create specialised long term debt funds to cater to the needs of infrastructure development. This will enable larger volumes of debt financing to flow to infrastructure projects and help distribute risks across diverse projects.

Source: RBI, Report on study of corporate bond market in India.

Other measures include

Encouraging retail participation: One of the key measures towards encouraging retail participation is the reduction in trading lot size of investors from Rs1mn to Rs0.1mn. The retail investor market in corporate bonds, however, is still shallow given the lack of awareness and attractiveness when compared to other small savings schemes.

Encouraging foreign Investment & domestic institutions: The Government of India (GoI) gradually increased the cap on FII limits for corporate bonds to US$51 billion from US$40bn earlier. Foreign holdings in government bonds too have been increased to US$30bn. The existing sub-limits of corporate debt ie (a) US$1bn for QFIs, (b) US$25bn for investment by FIIs and long term investors in non-infrastructure sector and (c) US$25bn for investment by FIIs/QFIs/long term investors in infrastructure sector have been merged effective April 1, 2013.

In developed countries, institutional investors like insurance companies and pension funds play a vital role in the corporate bond market. However, in India, insurance companies are permitted to hold a maximum of 25% of their portfolio in bonds rated less than AA. Pension funds are regulated to invest about 10% of the funds in corporate bonds that are investment grade. Also with compliance to SLR requirements, banks hold nearly 27% of their assets in approved government securities (vis--vis the regulatory requirement at 22.5%). With a view to enlarge the investor base and market making, primary dealers have been allowed to invest in corporate bonds up to a sub-limit of 50% of their net owned funds effective January 30, 2013.

One way to broaden the investor base is through advancement of the fund management industry through the creation of mutual funds

The growth of pension funds was a crucial factor in the development of bond market in Chile and other Latin American countries.


SME segment: The next big market opportunity

Worldwide, MSMEs have been accepted as the engine of economic growth and for promoting equitable development. The major advantage of the sector is its employment potential at low capital cost. According to central estimates, MSME segment comprises 8% of overall GDP, 45% of industrial output and 40% of exports. RBI in its recent report pointed out that 30mn MSMEs provided employment opportunity to 70mn persons in manufacturing more than 3000 products. However, with slowdown in investment activities by large corporates and the relatively un-organised nature of the sector, MSME segment has witnessed limited credit flow.

MSME is the backbone of the large industries. According to CRISIL rating, only 67,000 SMEs of the total estimated MSME units of 30mn have been rated clearly and this offers a penetration opportunity. The report pointed out that between FY05-13, rated MSMEs saw interest savings of Rs3bn as bankers offered interest rates lower by 0.25% - 1%.

Exhibit 13: Interest rate concession offered by banks to rated SME enterprises

Source: CRISIL report on MSME, Centrum Research

In order to promote more MSMEs to get themselves rated, National Small Industries Corporation (NSIC) is proactively taking up credit rating of SMEs by subsidising them, subject to a cap of Rs40,000, up to 75% of rating fee. While the government subsidy is applicable only for the first year, rating agencies pointed out that at least 60% of MSMEs have renewed their ratings in subsequent years as cost-benefit is on the better side.

Exhibit 14: SME unit - Benefits of rating

Source: CRISIL report on MSME, Centrum Research

CRISIL is a dominant player and has a wide reach in catering to the MSME segment. Till date CRISlL has rated ~60,000 SME units. This compares to SMERA which has rated ~27,000. ICRA and CARE are recent entrants to the SME loan ratings game.

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Ratings Improved business

performance

Nearly 93% of units in MSME sector are dependent on self-finance and do not get any monetary support from the financial institutions.


Credit rating agencies - Asset light model with superior return ratios; credibility plays a vital role

Credit rating agencies operate on the asset light model. Superior margin profile and healthy return ratios remain key strengths. Judicious deployment of cash is vital from shareholders return perspective.

Stability report / default study of credit rating agencies is of utmost significance in determining the health of corporates and also the credibility of the ratings assigned.

Consolidation, the next big wave for the industry.

Rating agencies: Business model and sector dynamics

The business of rating agencies is directly linked to the health of investment activities in the economy. It is however not similar to banking business that one can correlate and look at in terms of margins, asset quality, growth, capital adequacy, management, valuation etc. Rating agencies business revolves around the state of the financials of the corporates and more specifically on their capital requirement via both equity and non-equity route. Credit rating agencies got a major uplift following implementation of bank loan rating (BLR) in 2008.

BLR business enabled huge surge in rating revenues

Until 2007 and to a certain extent even today, in any loan related transaction, the lender (ie a bank) is the price decider as the borrower continues to realise the need for ratings. Bank loan rating (BLR) received a fillip after RBI mandated Basel II regulation for banks in 2007. The regulation mandated all banks to adopt standardised approach by March, 2009. Under the said approach, rating assigned by the external credit rating agencies acted as a measure of credit risk for banks. Although credit rating is not mandatory for loans below Rs100mn, banks have resorted to rating as capital utilisation is better for rated loans and in-turn saves on risk-weighted assets and especially for loans rated A and above.

Exhibit 15: Capital savings due to rating of instruments

9% Basel I Basel II Capital

saved(Rs mn) 1000 Risk weight Capital

required (%) Risk weight

Capital required (%)

AAA 100% 90 20% 18 72

AA 100% 90 30% 27 63

A 100% 90 50% 45 45

BBB 100% 90 100% 90 -

BB & below 100% 90 150% 135 (45)

Unrated 100% 90 100% 90 -

Source: CARE DRHP, Centrum Research

BLR was a huge game-changer for rating agencies that saw three top CRAs CRISIL, ICRA and CARE witness 24%+ CAGR in rating revenue, primarily aided by a spurt in BLR business over FY08-13.

Exhibit 16: Trend in rating revenue for the three leading CRA

Rs mn FY08 FY09 FY10 FY11 FY12 FY13 FY14 CAGR (FY08-14)

CRISIL 779 1,353 1,675 1,984 2,258 2,573 2,817 23.9%

CARE 508 929 1,358 1,697 1,768 1,973 2,278 28.4%

ICRA 603 885 1,061 1,291 1,394 1,496 1,644 23.6%

Source: Companies, Centrum Research* CRISIL is Dec ending company.

Asset light model

Credit rating agencies operate on an asset light model. They are highly profitable entities as is reflected from EBIDTA margins in excess of 30%+ and RoCE at ~28%. Diversified revenue stream (rating, research, advisory) and contained cost structure have enabled CRAs to generate healthy ratios.

In 1992, credit rating became mandatory for the issuance of debt instruments with maturity/convertibility of 18 months and above. Subsequently, the RBI guidelines made rating mandatory for issuance of commercial paper


Yields on the corporate bonds are on the higher side to bank loan rating

Rating revenues are predominantly in the nature of initial ratings (IRF) and annual surveillance fees (ASF). Initial rating fees are paid up-front ie at the time of beginning of the assignment. Surveillance fees are charged through the tenure of the instrument.

Even as system-wide funds mobilised saw 15.2% CAGR in FY11-14 (as shown in exhibit 3), rating revenues for the top two rating agencies saw a lower 12% growth over the same time frame. One of the reasons for lower rating revenues was the prevalence of under-cutting.

With a view to avoid such practises, SEBI directed CRAs (effective August, 2013) to disclose their floor rate (ie minimum charges). Currently IRF is priced at 0.1% (fixed deposits, debentures, CP) while SR is at 0.03% / 0/05% on outstanding bonds / issuer ratings for all major credit rating agencies. The actual fees charged could be on the higher side to the minimum floor rates. ICRA, bank loan ratings, IRF are at 4bps and ASR at 2.5bps of the loan facility.

In a mature market with increased rating volumes, emphasis on ratings by certain segments could see improvement in yields, albeit at a later phase.

Operating ratios similar to those of FMCG / Internet companies

The asset light models of CRAs are similar to those of some FMCG companies and also internet companies that generate similar EBIDTA margins, RoCE and RoNW. These companies however trade at a PE far in excess of those of credit rating agencies.

Company Name EBITDA Margin (%) RoE (%) RoCE (%) PE (x)

FY14 FY15E FY16E FY14 FY15E FY16E FY14 FY15E FY16E FY14 FY15E FY16E

FMCG / Internet companies

Info Edge India* 34.4 34.8 35.8 18.1 19.6 20.3 14.3 16.6 17.5 55.4 46.0 36.6

Just Dial* 30.9 29.7 35.1 24.4 24.5 27.9 24.9 26.5 30.3 78.7 63.6 42.6

ITC Ltd 36.8 37.9 38.4 36.1 36.6 37.2 - - - 31.3 26.7 22.8

Colgate Pamolive* 18.1 19.2 19.9 95.3 92.2 95.5 90.3 87.6 95.4 37.7 32.8 28.4

Nestle* 22.9 21.4 21.5 58.7 49.3 48.1 35.4 32.6 33.8 39.0 36.6 31.7

Credit rating agencies

CRISIL* 32.5 32.3 32.2 39.0 36.6 36.7 34.0 33.3 33.4 41.9 36.5 31.1

ICRA 28.1 31.3 32.5 19.0 20.6 21.2 30.6 31.5 30.6 34.1 28.9 24.6

CARE* 63.9 61.4 62.8 28.3 28.0 30.2 39.2 38.9 41.9 21.2 19.3 16.3

Source: Bloomberg, Centrum Research * denotes Centrum estimates

Prevelance of under-cutting impacted rating revenues.


Default study plays a vital role in assessing the health of corporates

Default study plays a vital role in assessing the health of corporates and credibility of the ratings assigned by the CRA. The ratings can also be used to determine any early warning signs of worsening health of corporates. SEBI has directed CRAs to disclose data pertaining to movement of credit rating from one notch to another, history of credit rating of all outstanding securities, list of defaults, average default rates etc on their websites at regular intervals.

Exhibit 17: CARE Default rate study

FY2010-14 Non structured Instrument Structured Instrument

One-year default rate Three-year default rate One-year default rate Three-year default rate

AAA 0.00% 0.00% 0.00% 0.00%

AA 0.00% 0.85% 0.00% 0.00%

A 0.38% 2.08% 1.59% 4.17%

BBB 1.61% 6.07% 0.70% 5.33%

BB 4.82% 13.13% 13.58% 30.00%

B 8.93% 24.66% 41.67% 0.00%

C 28.71% 28.57% 0.00% 0.00%

Source: CARE Default study report, Centrum Research

Exhibit 18: CRISIL Default rate study

1988-2013 One-year cumulative

default rate Three-year cumulative

default rate

CRISIL AAA 0.00% 0.00%

CRISIL AA 0.03% 0.92%

CRISIL A 0.70% 6.19%

CRISIL BBB 1.48% 7.89%

CRISIL BB 4.98% 15.19%

CRISIL B 8.86% 24.02%

CRISIL C 18.89% 39.41%

Source: CRISIL Default study report, Centrum Research

Exhibit 19: ICRA Default rate study

last 5-years Non structured Instrument Structured Instrument

One-year default rate Three-year default rate One-year default rate Three-year default rate

AAA 0.00% 0.00% 0.00% 0.00%

AA 0.00% 0.00% 0.78% 1.17%

A 0.40% 1.90% 1.08% 1.80%

BBB 3.20% 6.20% 0.85% 1.42%

BB 4.80% 7.40% 0.00% 0.00%

B 8.10% 9.70% 0.00% 0.00%

C 22.00% 22.60% 0.00% 0.00%

Source: ICRA Default study report, Centrum Research


Consolidation: Can it be the next big wave?

Credit rating agencies are owned by entities with interest in the financial sector. S&P owns 67.7% in CRISIL, Moodys currently owns 28.5% in ICRA and has made an open offer for another 26.5%, CARE (top 2-shareholders) comprise 31.5% (Canara Bank 14.6% and IDBI Bank 16.93%) and have been looking to divest their stake.

An asset light model business that generates 30%+ EBIDTA margins, 30%+ RoCE and healthy RoEs (well in excess of 30%) will continue to attract investors interest from a strategic buyout point. A combination of organic and inorganic growth has seen international agencies diversify their revenue mix and improve their return ratios. One classic case is that of Moodys which through acquisitions has been able to reduce its exposure to rating related revenues from 80% in CY06 to 58% in CY13.

Exhibit 20: Moodys CY13 revenue mix well diversified

Source: Moody CY13 annual presentation, Centrum Research

We believe the next big wave could be the process of consolidation in credit rating agencies. While improving sentiments following expectations of pick-up in rating volumes could delay the process, acquisitions under such situations could equally be at much higher valuations. We have tried to analyse the synergies that the relatively new and comparatively smaller sized rating agencies can offer to the three large players or an outsider having interest in the rating business in India. Brickworks scores well in terms of revenues, EBIDTA margins and the product offerings. The rating agency offers the entire gamut of services bank Loan, NCD and SME ratings and can be a good acquisition target.

Exhibit 21: Trend in revenue - Brickworks has witnessed sturdy rise in its revenue

Revenue FY09 FY10 FY11 FY12 FY13 CAGR (FY09-13)

SMERA 70 134 184 205 245 36.8%

Brickworks 12 50 91 109 230 108.9%

Source: MCA, Centrum Research

Exhibit 22: EBIDTA margins Brickworks scores well over SMERA

% FY09 FY10 FY11 FY12 FY13

SMERA 8.6 21.6 16.3 7.4

Brickworks 18.2 29.8 46.8 32.0 38.4

Source: MCA, Centrum Research

29%

13%

58%

Enterprise Risk Solutions

Professtional Services

Research data & Analytics

SMERA operates on low margins due to large part of rating from SME segment

Brickworks revenue improved steadily in the past 3-years


Valuation, view and key risks

Weak business environment had impacted corporate capex requirements during FY11-FY14. The same is also reflected from moderation in credit growth to sub-18% levels over the same period and muted corporate bond activity. This had impacted rating revenues. A decisive election outcome with a stable government has raised the prospect of policy reforms across stressed sectors leading to the revival in corporate capex plans. Considerable efforts have been made in reviving the corporate bond market and increased benefits from rating will see more enterprises undertake rating activity. Credit rating agencies stand to gain in such situations. We initiate coverage on the sector with a positive bias CARE (Buy) and CRISIL (Hold).

FY08-11 saw 21.4% CAGR in funds mobilised by corporates under the bank and corporate bond issuance route. With a relatively nascent market, pricing was on the better side and consequently, rating revenues for the top-2 credit rating agencies saw 36% CAGR over the FY08-11. The trend reversed in FY11-14 with a mere 12% CAGR in rating revenues (despite 15.2% CAGR in systemic volumes) partially due to under-cutting.

With early signs of revival in investment cycle, we expect gradual improvement in rating revenues, led by a combination of increase in volumes and price led growth, albeit gradually. We are factoring in 15.2% CAGR in systemic volumes (bank credit to witness 15.6% CAGR and corporate bond issuance at 10.9% CAGR over FY14-16E). We expect 17% CAGR in rating revenues for our coverage universe (CRISIL and CARE).

Recommendation

CARE: We initiate coverage on CARE with a Buy and a target price of Rs1,150 (valued at 20x FY16EPS). CARE offers a perfect play on rating business with superior margin profile, healthy FCF yield (4%), 55%+ dividend payout ratio and return ratios (RoCE at 40%). Efforts towards reviving corporate bond market and early signs of pick-up in investment cycle will augment earnings growth. This in addition to talks of stake-sale to strategic investor and in-organic growth will enable leverage on the brand and diversify the revenue mix. Valuations at 16.3x FY16E EPS are on the lower side to its true potential and warrant re-rating.

CARE trades at 34% / 48% discount to CRISIL and ICRA. While the discount to CRISIL is justified given the superior profile of the latter, we believe the valuation gap between CARE and ICRA is on the higher end as it scores well on all ratios when compared to its peer ICRA. With improving business dynamics and relatively better stability report / default study we expect the gap to narrow. We have thereby valued CARE at 20x FY16E EPS and arrived at a target price of Rs1,150. Initiate with Buy.

CRISIL: We initiate coverage on CRISIL with a Hold and a target price of Rs1,340 (valued at 30x CY15E EPS). Strong parentage (S&P owns 67.7%), well-diversified revenue mix, healthy margin profile (30%+ EBIDTA margin) and superior return ratios (RoCE / RoNW at 58% / 39%) remain key strengths for CRISIL leading to the stock trading at a significant premium to its peers. We are factoring in 16% CAGR in revenues / adjusted profit respectively over CY13-15E. We have valued CRISIL at 30x CY15E EPS and arrived at Rs1,340. Our blue sky scenario suggests potential target price at Rs1,480 (based on 33x 1-yr forward PE, similar to valuations of CY05-07 that was characterised by revival in investment cycle). The macro-conditions prevailing then and now are different and hence re-rating will be a gradual process.


Key risks

Shift to Internal rating based approach can impact rating revenues significantly

RBI circular dated July 7, 2009 advised banks to apply for migration to an internal rating based (IRB) approach for measuring credit risk from April 1, 2012 onwards. The IRB Approach will allow banks, subject to the approval of RBI and fulfilling certain requirements, to use their own internal estimates for some or all of the credit risk components in determining the capital requirement for a given credit exposure. Bank loans are currently rated by an external agency and in the event of this being evaluated by the banks internal team it could severely impact the revenue for credit rating agencies and especially CARE that derives ~50% of its revenue from the BLR related market. ICRA has ~26% of its revenue from BLR. Proportion for CRISIL is lower at ~10%.

But this is unlikely in immediate future

Interaction with industry experts and bank agencies suggest longer than expected time towards implementation of the said norms. Agencies suggested that the process may get delayed as a) even if a bank comes up with its own internal rating framework, it is mandatory to get it vetted by RBI (which itself is a lengthy process), b) smaller PSU banks are not likely to have a proper internal rating framework in place (given the lack of technology, know-how, union related problems) and c) lack of standardisation and transparency.

Gist of recent Reserve Bank of India speech on: Growing NPAs in Banks: Efficacy of Ratings Accountability & Transparency of Credit Rating Agencies

Although the road has been set for Indian banks to migrate to an internal rating based approach for evaluating their credit risk, the ability and preparedness of these banks to migrate to the internal rating approach is expected to be contingent on banks being in a position to test data based on the models to be used for this purpose. Banks would thus necessarily have to rely on external credit ratings for their calculation of credit risk until all the systems are in place.

Earlier recognition of potential threat

Default study and also stability report play vital roles in assessing the health of corporates. The crisis period of FY08-09 could have been avoided but for the failure of the rating agencies to signal the stress in the system. International agencies saw the brunt of the crisis as was reflected from near 50% decline in their valuation multiple over the same period. With green shoots emerging, it is testing times for credit rating agencies to assure faith of corporates and also investors. Failure of the same could significantly impact the growth prospects of CRAs.

Other risks include

Risk of attrition (core asset base of a CRA), inability to retain EBIDTA margins at current levels given the competitive environment (the same to a certain extent is now abated due to base floor price on rating business) and failure to adequately utilise cash on the balance sheet.

Centrum Equity Research is available on Bloomberg, Thomson Reuters and FactSet

Well placed for the up-cycle; initiate with Buy We initiate coverage on CARE with a Buy and target price of Rs1,150 (valued at 20x FY16EPS). CARE offers a perfect play on rating business with superior margin profile (EBIDTA at 64%), healthy FCF yield (4%), 60%+ dividend payout ratio and return ratios (RoCE at 39% / RoE at 28%). Early signs of pick-up in investment cycle and efforts to revive corporate bond market will augment earnings growth. Stake-sale to a strategic investor and inorganic growth will help the company leverage on the brand and diversify the revenue mix. Valuations at 16.3x FY16E EPS are on the lower side to its true potential and warrant re-rating.

Expect 16.5% CAGR in revenues; margin sustainability could be a challenge: Muted investment activities saw system-wide moderation in ratings business as reflected in mere 10.3% CAGR in rating revenues for CARE over FY11-14. Expectations of revival in economic activities and acceleration in corporate capex plans and the near leadership position in the rating business will enable CARE to garner 16.5% CAGR in its rating revenues over FY14-16E. While EBIDTA margins at 64% remain industry best, sustainability could be a challenge given the higher proportion of low yielding SME business and employee related expenses.

Stake-sale to open new avenues; acquisitions will supplement growth: CRISIL and ICRA stand to gain over CARE given their strong parentage. While attempt at stake-sale by key holders failed in the recent past, it could happen any time. Buyout by a strategic investor will enable the entity to play on the rating business in India. CARE, on the other hand can leverage on the brand name (as with its peers) and technology / business out-sourcing. Successful inorganic growth, though difficult (as reflected in the success of CRISIL and failure of ICRA) will ensure effective utilisation of cash and supplement further expansion in return ratios.

Ability to combat challenges remains vital: One of the reasons for lower multiple for CARE could be the mono-line revenue stream (~98% revenues are rating related, 50% of which is from BLR) and consequent risk to earnings in the event of implementation of IRB approach by banks / moderation in rating volumes. Interaction with industry experts suggest longer than expected time for migration to IRB approach and can be avoided if CARE is able to successfully diversify its revenue portfolio. Default study / stability report plays an important role in the assessment of credibility of CRAs and can severely impact acceptance by investors.

Valuation and view: CARE trades at 34% / 48% discount to CRISIL and ICRA. While the discount to CRISIL is justified given the superior profile of the latter, we believe the valuation gap between CARE and ICRA is on the higher end as the former scores well on all ratios. With improving business dynamics and better stability report and default study to ICRA, we expect the discount gap to narrow. We have thereby valued CARE at 20x FY16E EPS and arrived at a target price of Rs1,150. Buy.

Target Price Rs1,150 Key Data

Bloomberg Code CARE IN

CMP* Rs940 Curr Shares O/S (mn) 29.0

Diluted Shares O/S(mn) 29.0

Upside 22.3% Mkt Cap (Rsbn/USDmn) 27.3/459.4

Price Performance (%)* 52 Wk H / L (Rs) 984/415

1M 6M 1Yr 5 Year H / L (Rs) 984/398

CARE IN 17.5 27.8 31.9 Daily Vol. (3M NSE Avg.) 125213

Nifty 10.6 20.1 25.0

*as on 4 June 2014; Source: Bloomberg, Centrum Research

Shareholding pattern (%)*

Mar-14 Dec-13 Sept-13 June-13

Promoter - - - -

FIIs 15.7 13.9 13.4 13.6

DIIs 50.5 49.8 50.2 48.6

Others 33.9 36.3 36.4 37.8

Source: BSE, *as on 4 June 2014

One Year Indexed Stock Performance

Source: Company, Centrum Research

Centrum vs. Bloomberg Consensus*

Particulars (Rs mn)

FY15E FY16E

Centrum BBG Var (%) Centrum BBG Var (%)

Net sales 2,656 2,586 2.7 3,114 3,061 1.8

EBIDTA 1,631 1,639 (0.5) 1,955 1,883 3.8

Rep. PAT 1,412 1,420 (0.5) 1,671 1,630 2.5

*as on 4 June 2014; Source: Bloomberg, Centrum Research

Bloomberg Consensus* Centrum Target Price (Rs)

Variance (%)

BUY SELL HOLD Target Price

(Rs)

7 1 1 950 1,150 21.1

Source: Bloomberg, Centrum Research Estimates

Aalok Shah, [email protected]; 91 22 4215 9075

Y/E Mar (Rsmn) Revenue EBITDA EBITDA (%) Adj. PAT YoY (%) EPS (Rs) P/E (x) P/BV (x) RoCE (%) RoE (%)

FY13 1,988 1,339 67.4 1,133 5.4 39.1 24.1 6.3 39.6 28.3

FY14 2,294 1,466 63.9 1,286 13.5 44.4 21.2 5.6 39.2 28.3

FY15E 2,656 1,631 61.4 1,412 9.8 48.7 19.3 5.2 38.9 28.0

FY16E 3,114 1,955 62.8 1,671 18.3 57.6 16.3 4.7 41.9 30.2

FY17E 3,677 2,273 61.8 1,933 15.6 66.6 14.1 4.1 43.0 31.0

Source: Company, Centrum Research Estimates

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CREDIT ANALYSIS NSE CNX NIFTY INDEX

Buy

Initiating Coverage

Rating agencies

05 June 2014

INDIA

CARE

18 CARE

CARE pure play on rating business with superior returns profile

CARE Ratings (CARE) is the 2nd largest rating agency with 34% market share in the business. Operating margins at 64% as at FY14 (33% for CRISIL and 30% for ICRA) are the best in the industry and is the result of well contained cost structure and a large part of rating business coming from large and mid-corporate segment. 4%+ free cash flow yield and a 60%+ dividend pay-out ratio with superior return ratios (RoCE at 39% and RoNW at 28%) add further comfort. CARE offers a perfect play on the expected pick-up in the ratings business (both corporate bond market and bank loan rating) and offers an excellent opportunity to a strategic investor at relatively cheap valuations of 16.3x FY16E EPS of Rs57.6 vs CRISIL 31.1x CY16E EPS of Rs44.7 and ICRA 24.6x FY16 consensus EPS estimates of Rs95.6

Exhibit 23: SWOT analysis

Strength:

2nd largest loan rating agency. Enjoys 34% market share in the rating business*

Superior EBIDTA margins - 64% vs 33% for CRISIL and 30% for ICRA.

Free cash flow yield at 4%+ and 60% dividend pay-out. RoCE at 39% and RoE at 28%, second best to CRISIL.

Opportunities:

CARE a perfect play on rating business in India following revival in investment activities and consequently surge in corporate bond market and bank loan ratings.

Buyout by strategic player to enable leverage on technology (as is the case with CRISIL and ICRA) and the brand name.

~Rs5bn of cash balance (18% of current market cap) can support in-organic growth and strengthen revenue mix and profitability.

Weakness:

Mono-line revenue stream can impact the revenue growth in the event of system-wide growth slowdown.

Increased share of low yielding SME rating business saw EBIDTA margins decline from 76% in FY11 to 64% in FY14.

General perception of being a PSU enterprise (key holders ie 3-PSU banks own 37.5% stake) has seen stock trade at a discount. This is even as it scores well on all parameters to ICRA and also its default study / stability report.

Threat:

Internal rating based approach under Basel-II norms can impact revenues significantly as ~50% of revenues are from bank loan rating.

Ability to maintain EBIDTA margins at current levels could be a challenge.

Failure of acquisition can severely impact the return ratios (as seen from the success of CRISIL and failure of ICRA).

Source: Company, Centrum Research *Denotes among top-3 rating agencies and excludes CRISILs S&P outsourcing business.

We have touched upon each of these arguments in detail in the report hereunder.

19 CARE

Expect 16.5% CAGR in revenue over FY14-16E; combination of volume and pricing

The current phase of systemic slowdown in corporate investment activities (as reflected from decline in corporate bond issues) and competitive bank loan rating (BLR) market have taken a toll on rating revenues for all CRAs. CARE rating revenue / profit after tax saw a modest 10% / 12% CAGR over FY11-14. This compares to 49% / 50% CAGR in revenues / PAT over FY08-11 that was characterised by strong investment cycle and consequently sharp rise in bank credit to sectors of industrials and services (21.2% CAGR over FY08-11) and surge in corporate bond market issuances (24.4% CAGR).

The period FY12-14 saw volume and pricing on the lower side due to muted investment activity, competitive ratings market and prevalence of under cutting. With expectations of revival in economic activities and acceleration in corporate investment, the near leadership position in the rating business will help CARE improve its ratings revenues (both corporate bond and bank loan rating).

Even as we are factoring in 16.5% CAGR in rating revenues over FY14-16E, we expect growth to accelerate from H2FY15 (given near term challenges and the need to accelerate reforms across core sectors of growth) driven by 12% increase in volumes and gradual improvement in yields ie both initial rating fees and surveillance fees. However, with margin pressures rising from gradual rise in proportion of relatively lower yielding SME rating business and cost pressures (more specifically employee related costs), we expect growth in net profit to be lower at 14% CAGR over FY14-16E. Higher than expected surge in ratings volume coupled with improvement in yields and stable costs would see upward movement in profit growth.

Exhibit 24: Expect 16.5% CAGR in rating revenues Exhibit 25: and 14% CAGR in net profit.

Source: Company, Centrum Research Estimates Source: Company, Centrum Research Estimates

Exhibit 26: Driven by 12% CAGR in total volumes rated Exhibit 27: and gradual improvement in pricing ie yields


Price led growth to be gradual

Until August, 2013 the competitive rating business had resulted in huge price undercutting. While CRAs do not disclose their initial rating fees and surveillance fees separately, interaction with industry experts and calculations suggest huge undercutting in the initial rating fees (IRF) especially on the BLR front in the past. However, with a cap on floor rates (effective August, 2013, CRAs are required to disclose minimum fees) we expect pricing environment to remain stable. Also with a mature market and increase in capex cycle, we expect gradual improvement on the pricing front as well, though it be a bit back-ended.

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10% revenue growth in FY12-14 could have been driven by more of value growth

20 CARE

Industry best EBIDTA margins; sustainability could be a challenge

Though CAREs EBIDTA margins at 64% have declined from 70%+from the recent past of they remain the best among rating agencies CRISIL (33%) and ICRA (30%). The superior margin profile is the result of a) low cost operating structure (cost per employee is at Rs1.0mn vis--vis Rs1.5mn for CRISIL) and limited presence in the relatively low yielding SME business that save on costs. A large part of back-end operations are carried through a centralised office in Ahmedabad. CARE also saves on rent related expenses as most offices are owned by the company.

Trend in EBIDTA margins

Exhibit 28: Trend in EBIDTA margins Exhibit 29: CARE vis--vis CRISIL and ICRA

Source: Company, Centrum Research Estimates Source: Companies, Centrum Research

We believe its ability to sustain margins at current level will be a challenge as a) employee cost at Rs1mn is by far the lowest in the industry. With intense competition in the rating business and talent crunch, any revival in the industry will warrant poaching (similar to IT industry) and b) increased penetration into relatively low yielding SME segment will dilute the margin profile. CARE ventured into these businesses beginning 2011 and has seen its margin contract from 76.4% in FY11 to 64% levels as at end FY14. While SME rating remains the next big business opportunity (as discussed in our sector piece), yields are on the lower side vis--vis cost attached on rating and could impact the overall margin profile. With employee related expenses (ESOP expenses of Rs55mn to be debited to P&L in FY15 and increased proportion of SME ratings), we expect EBIDTA margins to decline to 62% levels by end-FY17E.

FCF yield + dividend pay-out ratio on par with CRISIL; return ratios better

As discussed in our sector report, rating agencies business follows the asset light model that generates huge cash. CARE has ~Rs5bn under cash and cash equivalent as at end FY-14 (18% of current market cap). Effective utilization of the same is vital to ensure healthy return ratios. CAREs FCF yields at 4%+ and dividend payout ratio at 60%+ are near par with CRISIL (FCF yield at 4% and dividend payout at 56% levels). RoCE at 39% and RoE at 28% add further comfort.

Exhibit 30: Trend in operating cash flow Exhibit 31: Return ratios too remain comfortable


77.5%

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RoE RoCE

CARE currently operates through 60 SME clusters and plans to expand the reach to 140 clusters

CRISIL (rated close to 60,000 units) and SMERA (rated nearly 28,000 units) remain market leaders in SME ratings

21 CARE

Excess reliance on rating business exposes CARE to concentration risk

One of the potential risks to CARE is in terms of its concentrated revenue exposure. Unlike CRISIL or even ICRA that has diversified their revenue mix across various avenues, 98%+ of revenues for CARE are still through the rating business route. This in-turn can potentially expose the company to concentration risk and if IRB approach is to be implemented by banks, the impact could be severe as compared to its peer set as CARE has ~50% of its revenue under BLR route. While the management has talked about acquisition to diversify its revenue mix (as in the case of CRISIL) it however has still not been able to do it.

Exhibit 32: Revenue mix Concentrated exposure can lead CARE to revenue slowdown

Source: Companies, Centrum Research Estimates

In addition to the risk to earnings due to concentrated revenues, CARE is also exposed to risk in terms of its relatively superior EBIDTA margins. Even as the company has been able to contain its EBIDTA at 64%+ for a fairly long time, increasing need for talent (core asset of any CRA) will warrant relatively higher cost structures. Also, with greater emphasis on SME rating, blended margins will slide further down. One of the possible ways to mitigate the said risk would be to tap the opportunity in corporate bond market ensuring relatively stable ratings and improve on surveillance fees.

0

25

50

75

100

CRISL CARE ICRA

(%)

Rating Advisory & Others Research BPO / professional services

Slowdown in investment activity during FY11-14 saw CARE revenues witness mere 10% CAGR vs 21% CAGR for CRISIL and 14% for ICRA.

22 CARE

Stake sale; inorganic growth could be the next trigger

Stake sale to a strategic player can augment growth

CRISIL and ICRA by virtue of their strong international parentage (S&P owns 67.7%/ Moody owns 28.5% and has made an open offer to increase its stake to 55%) have leveraged on the growth opportunity in both the rating business and also research. In recent times, key holders (Canara Bank 14.6%, IDBI Bank 16.9%) have expressed their intention to sell their stake in CARE. The need for stake sale is more to fund their own capital requirements following Basel III compliance and more specifically in the context of their huge impairment ratio. While the process failed then, it may succeed in the near future.

Buyout by a strategic player can be a win-win situation as the investor gets an entry point in the relatively under-penetrated but improving rating market in India and also play the revival in corporate cycle story at relatively cheap valuations. CARE, in turn can leverage on the technology as was the case with CRISIL and ICRA.

RoE accretive inorganic growth can provide further impetus

In our sector report, we briefly touched upon how the industry can see potential consolidation. CARE, with huge cash & equivalents, has been talking of a buyout in either analytics space or other business segments such as training, knowledge process outsourcing, risk management and support services to rating agencies and other financial institutions.

A suitable acquisition target is a challenging task (as seen from the success of CRISIL and failure of ICRA) and hence the buyout can be RoE negative. One of the possible reason for the delay in the acquisition is the fear to take over un-viable entities. While consolidation / acquisitions are not time / sector specific, we have tried to run a case scenario looking at potential acquisition of Brickworks by CARE and the key ratios thereby of the merged entity. Brickworks revenues are 10% of CAREs. While margins are on the lower side, return ratios are relatively superior with RoCE at 45%.

Exhibit 33: Merged entity: Acquisition of Brickworks will be returns accretive

Rs mn CARE# Brickworks* Total

Revenue 2,294 221 2,515

Others 357 10 366

Net sales 2,651 230 2,881

EBIDTA 1,466 88 1,554

EBIT 1,794 86 1,880

PAT 1,286 60 1,346

Total assets (average) 4,580 191 4,771

Networth (average) 4,541 131 4,672

Return ratios (%)

EBIDTA margins 63.9 40.0 61.8

PAT margins 56.1 27.2 53.5

RoCE 39.2 45.2 39.4

RoE 28.3 45.7 28.8

Source: Company, MCA, Centrum Research Estimates # FY14 * denotes FY13

The strategic stake sale and acquisitions are two independent events and can take precedence as and when they occur. The consolidated entity post these events will stand considerably stronger given its returns profile and strong parentage (as in the case with CRISIL and ICRA).

Other initiatives

In Nov 2011, the company acquired 75.1% equity interest in Kalypto, a company providing risk management software solutions with a focus on enterprise risk management for banking, insurance and other financial institutions for Rs89mn.

CARE Ratings has already made global forays with its operations in the Republic of Maldives. It has also entered into arrangements with other organizations in countries like Mauritius, Nigeria and Ecuador for providing technical expertise, risk management solutions and to expand rating activity to new territories.

A significant development in recent times was the launch of ARC Ratings. CARE, along with four partners from Malaysia, Brazil, Portugal and South Africa, launched an international credit rating agency named ARC Ratings, SA, in London in January 2014. ARC aims to rebuild trust and enhance reliability and transparency in the international credit rating industry. It offers a more comprehensive and pragmatic view on credit risk; and is registered with ESMA (European Securities and Markets Authority), thus adhering to stringent regulation standards.

CARE cash + investments stood at Rs4.9bn vis--vis its capital position at Rs4.8bn (FY14)

CARE management has been talking of acquisition for sometime

23 CARE

Ideal cash on balance sheet can constrain RoEs to sub-30% levels

CRISIL has judiciously utilized its cash balances by either resorting to buy-back at frequent intervals or through acquisitions. Consequently, its RoE at 39% is the best in the industry. CAREs RoE is low at 28.3%%. One of the reasons is the excess amount of cash & equivalents on the balance sheet (Rs4.9bn as at end-FY14) with yields at ~10% vis--vis the potential RoEs at 25%+. While CARE has been talking about acquisitions for a long time, relatively unviable acquisitions can further strain profitability. This was seen in the case of ICRA.

Exhibit 34: CARE RoEs are better than ICRAs, albeit on the lower side to CRISIL.

Exhibit 35: RoCE too fares well

Source: Company, Centrum Research Estimates * ICRA estimates are consensus est. Source: Company, Centrum Research Estimates* ICRA estimates are consensus est.

IRB approach can materially impact earnings growth

With near 50% of revenues from BLR ratings, CARE remains highly vulnerable to implementation of IRB approach by banks following RBI directive. Interaction with experts however showed the need for longer than expected time for banks to adopt the said approach. However, CARE will have to utilise this time to improve its revenue mix.

Slowdown in revenues due to more SMEs; higher costs can eat up margins

Any significant slowdown in revenue growth partially due to higher SME related volume growth or pricing pressure coupled with sticky operating expenses, more particularly employee related costs could severely impact profitability. The period between FY11-14 saw revenue CAGR at 14.5%. The growth in operating expenses however was on the higher side at 27% CAGR.

20

40

60

80

100

FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15E FY16E FY17E

CARE CRISIL ICRA*

10

25

40

55

70

FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15E FY16E FY17E

CARE CRISIL ICRA*

24 CARE

Default study / stability report an important determinant

In our sector part, we briefly touched upon the relevance of the default study and stability report of a credit rating agency. Default study denotes the movement in rating and can partially be taken as a factor to determine the quality of rating assignment.

By virtue of its strong parentage and probably being first entrants, CRISIL and ICRA have historically carried an image of being the best rating agencies in terms of their default study and stability report. CARE lacks the same conviction that could be due to the lack of such backing. Recent trends and analysis of these reports however show improvement for CARE. These reports are more indicative of rating standards and do not necessarily mean unjustified ratings.

Exhibit 36: Default rate study (non-structured instruments, for the last five years)

Rating category (%) CARE ICRA CRISIL

One-year Three-year One-year Three-year One-year Three-year

AAA 0.00 0.00 0.00 0.00 0.00 0.00

AA 0.00 0.85 0.00 0.00 0.03 0.92

A 0.38 2.08 0.40 1.90 0.70 6.19

BBB 1.61 6.07 3.20 6.20 1.48 7.89

BB 4.82 13.13 4.80 7.40 4.98 15.19

B 8.93 24.66 8.10 9.70 8.86 24.02

C 28.71 28.57 22.00 22.60 18.89 39.41

Source: Companies, Centrum Research

Stability report

Exhibit 37: CARE One-year rating Transition Rates for the period Mar 2003- Mar 2013

Rating Category (%) AAA AA A BBB Below Investment Grade

AAA 98.8 1.2 0.0 0.0 0.0

AA 1.2 95.4 2.9 0.2 0.3

A 0.0 4.0 86.7 7.8 1.5

BBB 0.0 0.1 3.9 87.9 8.1

Below Investment Grade 0.0 0.0 0.0 10.1 89.9


Exhibit 38: CRISIL : One-year average transition rates: between 1988 and 2013

Rating (%) AAA AA A BBB

CRISIL AAA 97.1 2.9 0.0 0.0

CRISIL AA 1.4 92.6 5.0 0.6

CRISIL A 0.0 3.4 87.1 6.1

CRISIL BBB 0.0 0.1 2.8 87.4

CRISIL BB 0.0 0.0 0.0 3.4


Exhibit 39: ICRA - One-year average transition rates - between 2003 and 2013

Rating Category (%) AAA AA A BBB and below

AAA 97.0 3.0 0.0 0.0

AA 1.9 95.0 2.8 0.2

A 0.0 3.2 87.4 8.6

BBB and below 0.0 0.0 2.5 85.9


Unlike CRISIL and ICRA where fresh ratings are assigned (and reviewed in case of movement in the ratings) by an internal committee, CARE has an external committee that rates all rating proposals above BBB+. The external committee that includes industry experts (Mr. Y. H. Malegam, Mr. P.P. Pattanayak etc.) has been in place since inception. All fresh ratings (excluding certain SME ratings) and cases with change in ratings are referred to this committee. This practise has in turn helped CARE present reasonably strong stability reports vis--vis its peers.

Default rate for CARE is better than its peers in select segments

Stability in top rated categories too remain superior vis--vis ICRA

25 CARE

Valuation, view and recommendation

We believe CARE rating is well positioned to leverage on its near leadership position in the rating business following the revival in the corporate investment cycle. A combination of volume growth and gradual improvement in pricing will enable CARE see 16.5% CAGR in its rating revenue over FY14-16E. Though EBIDTA margins have declined in the recent past, they remain industrys best. Healthy cash position, free cash flow yield at 4%+, dividend yield at 60%+ and RoCE at 39.2% add further comfort. Stake sale to a strategic investor could give CARE leverage on technology (as was the case with CRISIL and ICRA) and brand name. Also, the acquisition of a profitable entity could enable the company to diversify its revenue mix while ensuring superior return ratios.

While CAREs discount gap to ICRA has averaged 13% (since inception), it has widened to 20% in the recent past (1-year) primarily because of the open offer by the promoter Moodys which is looking to raise its stake to 55% from 28.5% currently (open offer of Rs2,000 in Feb14 revised upwards to Rs2,400 in May,14).

CARE scores well on all aspects compared to the latter including the default study / stability report. CAREs EBIDTA margin at 64% compares well to 30% for ICRA. RoCE / RoNW for CARE are at 39% / 28% respectively vis--vis 29% / 21% for ICRA. However, on the valuation front, ICRA trades at 24.6x FY16 consensus EPS vis--vis its 5-year average PE at 18.2x.

With limited pricing history for CARE (listed only in Dec2012), it is difficult to assess the peak valuation multiple of the previous investment cycle (CY05-07) as in the case for CRISIL. With differential in return ratios, one cannot attribute CRISILs multiples to CARE and hence the near best comparable peer set is ICRA. ICRAs 1-yr forward PE (3-year average) is at 18.6x. This period, however was characterized by weak investment cycle and consequently lower growth. We have ascribed 10% premium to the said multiple (on the back of improving earnings growth and also expectations of improvement in investment cycle) and valued CARE at 20x FY16E EPS of Rs57.6 and arrived at a target price of Rs1,150. Our target price is by far the highest among consensus estimates and we expect the same to play out in a phased manner. Our DCF based valuation suggests a target price at Rs1,200 and supports our target price.

One of the possible reasons for lower valuation multiple for CARE historically has been the risk of higher exposure to BLR linked businesses. While the risk prevails, we believe banks are unlikely to migrate to IRB approach anytime soon. Stake sale to a strategic investor, enabling leverage on technology and brand name and inorganic growth will diversify revenue mix and warrant re-rating.

Exhibit 40: CARE discount gap to ICRA has widened to 20% in the past 1-year

Exhibit 41: CARE 1-yr forward PB

Source: Bloomberg, Company, Centrum Research Estimates Source: Bloomberg, Company, Centrum Research Estimates

-30

-20

-10

0

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20

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40

-

5

10

15

20

25

30

Dec-12

Jan-13

Feb-13

Mar-13

Apr-13

May-13

Jun-13

Jul-13

Aug-13

Sep-13

Oct-13

Nov-13

Dec-13

Jan-14

Feb-14

Mar-14

Apr-14

May-14

(%)

(x)

CARE - 1-yr forward PE Discount to ICRA (RHS)

10

14

18

22

Jan-13

Feb-13

Mar-13

Apr-13

May-13

Jun-13

Jul-13

Aug-13

Sep-13

Oct-13

Nov-13

Dec-13

Jan-14

Feb-14

Mar-14

Apr-14

May-14

Jun-14

P/E Mean

Mean + Std Dev Mean - Std Dev

ICRA trades at 29x 1-yr forward PE, 35% premium to its 3-yr average 1-yr forward PE of 18.6x

26 CARE

Exhibit 42: Quarterly financials

(Rs mn) Q1FY13 Q2FY13 Q3FY13 Q4FY13 Q1FY14 Q2FY14 Q3FY14 Q4FY14

Income statement

Net sales 275 624 456 633 347 653 538 757

Other income 85 42 79 81 156 55 67 79

Total Income 360 665 535 714 503 707 605 836

Operating expenses 147 160 147 195 194 177 214 244

EBIDTA core 128 464 309 438 153 476 325 513

EBIDTA margins (%) 46.6 74.4 67.8 69.2 44.2 72.9 60.3 67.7

Depreciation 5 11 5 5 5 8 7 9

PBT 208 494 383 514 304 522 385 583

Tax 40 163 105 157 61 172 104 170

PAT 168 331 278 356 243 351 280 413

Ratios

Growth YoY (%)

Net sales

26.0 4.7 18.1 19.5

EBIDTA

19.5 2.6 5.1 17.1

EBIT

19.6 3.5 4.4 16.5

PAT

44.6 5.9 0.7 16.0

Margins (%)

EBIDTA 46.6 74.4 67.8 69.2 44.2 72.9 60.3 67.7

EBIT 75.6 79.3 84.0 81.1 87.7 80.0 71.4 77.0

PAT margin 61.0 53.1 61.1 56.3 70.1 53.7 52.0 54.6


CAREs Q4FY14 results were ahead of consensus estimates with operating revenue at Rs757mn. Higher than expected revenue growth was driven by higher surveillance income and improved pricing on the BLR front. With 25.1%yoy increase in operating expenditure, operating profit grew by 17.1%yoy. The quarter saw Rs143mn pertaining to ESOP related expenses debited to P&L. Adjusted for the same, employee cost would have increased by 8%. FY15 will have additional Rs550mn of ESOP related expenses and we have factored in the same accordingly. Consequently, net profit at Rs413mn grew 16% yoy vs consensus estimates at Rs380mn.

28 CARE

Exhibit 45: Shareholding pattern (%)

Q4FY14 Q3FY14 Q2FY14 Q1FY14

Promoter - - - -

FII 15.7 13.9 13.4 13.6

DII 50.5 49.8 50.2 48.6

Others 33.9 36.3 36.4 37.8

Source: BSE

Company Background

CARE Ratings commenced operations in April 1993 and over nearly two decades, it has established itself as the second-largest credit rating agency in India. CARE Ratings has also emerged as the leading agency for covering many rating segments like that for banks, sub-sovereigns and IPO gradings.

CARE Ratings provides the entire spectrum of credit rating that helps the corporates to raise capital for their various requirements and assists the investors to form an informed investment decision based on the credit risk and their own risk-return expectations. Our rating and grading service offerings leverage our domain and analytical expertise backed by the methodologies congruent with the international best practices.

Exhibit 46: Key management personnel

Name Position Profile

Mr. A.K. Bansal Chairman Mr. A.K. Bansal is the Chairman and an Independent Director. He worked as Executive Director of Indian Overseas Bank between 2010-13

Mr. Venkataraman Srinivasan

Independent and Non-Executive Director

Mr. Srinivasan is an Independent and Non-Executive Director. He holds a Bachelor's degree in Commerce from University of Mumbai and is a qualified Chartered Accountant. He has more than 26 years of experience as a practicing Chartered Accountant.

Mr. D. R. Dogra MD & CEO

Mr. D. R. Dogra is the MD & CEO holds a Bachelor's and a Master's degree in agriculture from Himachal Pradesh University and a Master's degree in business administration (FMS), from University of Delhi. He is a certified associate of the Indian Institute of Bankers. He has more than 35 years of experience in the financial sector and in credit administration. Prior to joining our Company, he was associated with Dena Bank.

Mr. Rajesh Mokashi DMD

Mr. Rajesh Mokashi is the DMD and holds a Bachelor's degree in Mechanical Engineering from VJTI, Mumbai and a Master of Management Studies degree from University of Bombay. He is a qualified CFA and has also cleared Level III of the CFA Program conducted by the CFA Institute, USA.

Source: Company

29 CARE

Financials

Exhibit 47: Income Statement

Y/E March (Rs mn) FY13 FY14 FY15E FY16E FY17E

Y/E, Mar (Rs. mn) FY13 FY14 FY15E FY16E FY17E

Net Sales 1,988 2,294 2,656 3,114 3,677

Growth (%) 11.6 15.4 15.8 17.3 18.1

Expenditure 649 828 1,025 1,160 1,404

Employee Cost 507 606 789 886 1,081

EBITDA 1,339 1,466 1,631 1,955 2,273

Growth (%) 8.7 9.5 11.2 19.9 16.3

EBITDA margin (%) 67.4 63.9 61.4 62.8 61.8

Depreciation 26 29 32 36 39

EBIT 1,599 1,794 1,975 2,338 2,703

EBIT margin (%) 80.4 78.2 74.4 75.1 73.5

Other Income 286 357 376 419 470

Interest expenses 0 0 0 0 0

PBT 1,598 1,794 1,975 2,338 2,703

Tax 466 507 56

Documents

Credit Rating - Sector Initiation - Centrum 05062014