CARE Ratings IPO, should you invest?

I will analyze the CARE Ratings IPO in this article.

IPO Dates

7 – 11 December 2012

CARE Ratings business

CARE Ratings is in the business of credit rating. When banks issue loans to borrowers they look at ratings given by independent rating agencies like CRISIL, ICRA, India Ratings and Research (earlier Fitch), CARE Ratings, and Brickworks. When a company makes a private placement of debt they get rated. Major expenses in this business are staff costs since its a knowledge business. Link to the Red Herring Prospectus is given at the end of the article.

Key competition

CRISIL and ICRA are strong competitors and are listed in India. India Ratings and Research (earlier Fitch) and  Brickworks are the other unlisted competitors.

Entry Barriers

Credit rating agencies need a SEBI license to start business. There are entry barriers in that no one can start a credit rating business at the drop of a hat. You can read about the SECURITIES AND EXCHANGE BOARD OF INDIA (CREDIT RATING AGENCIES) REGULATIONS, 1999.

RBI also assigns eligibility to credit rating agencies for banks to be able to use their credit ratings for risk management under Basel II norms. Basel II norms are linked with banking regulation.

Financial performance of CARE Ratings

I have considered unconsolidated numbers (subsidiary has been neglected as it does not contribute significantly to the financials).

Figures are in Rs. crore.

FY08FY09FY10FY11FY12Six months ended Sep 12
Sales54.999.9152.1172.2217.1102.5
EBITDA40.478.8123.7131.5163.471.8
PAT26.752.485.787.5115.750.0
Net worth83.3133.5213.5294.2376.7426.8
EBITDA (%)74%79%81%76%75%70%
PAT (%)49%52%56%51%53%49%
RoE32%39%40%30%31%12%
Dividend paid3.53.14.86.228.5NA
Dividend payout as % of PAT13%6%6%7%25%NA

 

Return on equity is healthy. Operating margins are quite high.

They have cash on books of around Rs. 27 crore as of September 2012. They also have investments which are cash-like (mutual funds, Government securities, FMPs, etc.) of around Rs. 337 crore. Together we can assume liquid assets of Rs. 364 crore.

Why is CARE Ratings doing an IPO?

The CARE Ratings IPO is not for raising fresh money into the company. This is an Offer for Sale (OFS) where existing shareholders are selling shares to the public, which includes retail, n0n-retail (sometimes called HNI category) and QIB (institutions).

Since no money is being raised, there will be no equity dilution. Hence it will be business as usual, unlike IPOs where the company raises for money specifically for an expansion plan or for reducing debt.

Peer comparison

CRISIL is a diversified company as compared to ICRA and CARE Ratings and is a market leader. It is more than 3.5 times the size of ICRA and CARE Ratings . I have provided a link for CRISIL Investor presentation at the end of this article. CRISIL is owned by Standard & Poor (S&P), a leading global ratings major. Moody’s is the promoter of ICRA with a 28.51% stake. CARE Ratings is owned by Indian banks, financial institutions and a few private equity names.

Figures are in Rs. crore.

CRISILICRACARE Ratings
Sales796207217
EBITDA28084163
PAT20654116
EBITDA (%)35%40%75%
PAT (%)26%26%53%
RoE50%18%31%
5 year sales CAGR24%18%41%
5 year EBITDA CAGR26%17%42%
5 year PAT CAGR25%16%44%

 

CARE Ratings stands out as better when compared to similarly sized ICRA. It has got the best margins of all, but CRISIL is delivering better returns on equity to shareholders. CARE Ratings is growing fastest in the peer set. .

 

Issue details

Issued shares28552512no. of shares
Offer for sale7199700no. of shares
Price band700750
Mcap19992141
IPO size504540
P/B4.75.0
P/E (annualized FY13)20.121.5
P/E (FY12)17.318.5

 

In comparison, CRISIL trades at a trailing P/E multiple of 35 times as per Bloomberg data seen on 6 Dec 2012 while ICRA trades at 25 times respectively.

On relative valuation terms, CARE Ratings seems decently priced  at the announced price band.

Discounted cash flow analysis

Free cash flow to firm (FCFF) for CARE Ratings is as given below:

FY08FY09FY10FY11FY12Six months ended Sep 12
FCFF3160899910617

 

I have added operating cash flow and subtracted net additions to fixed assets (capex) to get this figure. In FCFF calculations we have an interest component with tax shield. I have not included it because this company has no debt, hence no interest payments.

FCFF has grown by a compounded annual growth rate (CAGR) of 35% from FY08-12. This does not include the “other income” they reap from the ample investments they hold.For example, in FY12, out of Rs. 217 crore of total income, they had Rs. 28 crore of other income from investments.

Assumptions

  • Growth rate of FCFF for the next 5 years of 15% (a hefty discount to the 35% actual rate seen in the past)
  • Terminal growth rate of 5%. Many will ask why, so high? Credit growth is usually 2 times higher than GDP in the economy. Please have a look at the Excel link provided at the end of this article for credit growth rates in India. I normally take a 3% terminal growth rate. Considering the business I have slightly increased the rate.
  • Hurdle rate or discount rate of 15%

With these assumptions I get a net present value of future cash flows as Rs. 1291 crore. There are Rs. 364 crore of liquid assets which we add to the NPV to get a total value of Rs. 1656 crore.

This compares with Rs. 2141 crore as market capitalization were we to consider the upper end of the price band for the CARE Ratings IPO.

There does not seem to be any margin of safety in this IPO.

Risks

One important risk factor is that the RBI can allow banks to use internal ratings rather than external credit ratings from the likes of CARE Ratings. It can commence grant of approvals from March 31, 2014. Around 20-23% of CARE’s recent income figures come from this business. Potentially this could reduce. The other side of the story is that most banks in India are yet not advanced enough. There might be a few which switch to internal ratings.

A very important risk factor is quality of ratings. Questions have been raised about CARE’s rating of Deccan Chronicle and why they could not spot problems with the company.

Read this and this.

It’s not too comforting to an investor. These two links were online newspapers. This third link is an article by a private firm. This article is worth reading.

The jury is out about what exactly went wrong in the Deccan Chronicle story. There is a regulatory risk if a rating company does not perform its duties properly.

Conclusion

By relative pricing, CARE Ratings IPO pricing looks reasonable. DCF analysis does not show a margin of safety. There are certain unanswered questions on risk. I will avoid this IPO.

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More reading

CARE Ratings IPO Red Herring Prospectus (RHP)

CRISIL annual reports and presentations

ICRA annual reports

Credit growth in India – RBI data

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Comments

  1. Mahamkali Seshagiri says

    This is fine,balanced analysis. It appears from what I have seen that this IPO has been generally welcomed. Even Business Line on which I primarily depend,has recommended an “Invest” on it. It needs courage to go against the general opinion.

    • says

      Mahamkali, thanks! Like the famous words which said that we need not swing our bat at every pitch that comes our way unlike baseball. We can choose.
      Anyway in ipo’s the odds are stacked against the investor since there is no track record. And, there is higher information assymetry.

      I found the regulatory risk point important.

      This one might gain and rise. That’s fine with me.