Care Ratings: Reasonable valuations factor in downside risks
Credit Analysis and Research (CARE) Ratings is coming out with an IPO to garner up to Rs 540 crore at a price band of Rs 700-750 per share.
The entire IPO represents an offer for sale of 25% stake held by a host of institutional investors such as IDBI Bank, Federal Bank, SBI, IL&FS and Canara Bank amongst others. Although the company will not receive any issue proceeds, the offer represents only a partial exit by these institutional investors, most of who will continue to hold stake in the rating agency post the IPO. This instils confidence. More importantly, CARE’s performance has been good with strong growth and high margins. While CARE's high margins and return on equity may inch lower as the company gradually diversifies its concentrated portfolio (a large chunk of revenue comes from high margin rating business) and geographical presence, growth rates should remain healthy going ahead. Also, valuations are lower than its closest peer ICRA, which provide comfort and factor in potential risk in the rating business consequent to implementation of RBI guidelines in 2014.
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Trading margins for growth
CARE is India's second largest rating company and enjoys much higher EBITDA margins (70%) as compared to peers such as CRISIL and ICRA. Negligible contribution of low-margin research business to the revenues and lesser exposure to small and medium enterprises ratings are the key drivers of these high margins. Notably, ratings form about 87% of CARE's overall revenues, which exposes the company to any slowdown in the Indian debentures/bonds markets. Also, as per RBI's new norms, banks can adopt internal ratings mechanism for their credit offerings by 31st March 2014. Such bank loans/facilities form about 21% of CARE's rating business revenues, which could be adversely impacted if banks go in for internal ratings post April 2014. The management though believes that not all banks will be able to make this transition due to lack of infrastructure required and hence, there is a cushion.
However, the management expects its EBITDA margins to trend lower as it increases its international presence as well as due to scaling up of its research business going forward. The company plans to grow its businesses both geographically as well into newer segments. It is planning on monetising the research operations and entering into KPO and training domains. The company is also looking at inorganic ways of growth and has already acquired a Sri Lanka-based risk management company - Kalypto in November 2011. CARE plans to bring Kalypto's products in Indian markets as well. In addition to its existing operations in Nigeria, Maldives and Mexico, CARE now plans to enter into South Africa, Brazil, Malaysia and Portugal markets. While these plans augur well for its future growth, they may eat away some of its EBITDA margins at least in the interim.
Valuations & Outlook
CARE's revenues and net profit have grown at a compounded rate of 41% and 44%, respectively over FY08-12. Even for FY12, the same grew by 26% and 31%, respectively. At the upper price band of Rs 750 and assuming a bottomline growth of 25% in FY13, the stock is priced at 15 times earnings, which is at a good discount to its nearest peer. While the significantly larger peer CRISIL is trading at 31 times one-year forward estimated earnings, the multiple stands at 21 times for ICRA – the third largest rating agency in the country. Even on historical basis, at Rs 750 a share, CARE’s issue is priced at 18.5 times its FY12 earnings while its closest peer ICRA trades at 27 times FY12 earnings.
While the changes in key regulations governing rating agencies remain a key risk, the rating company's limited experience in international markets along with higher competition are among key challenges. But, most of this is already reflecting in IPO valuations, which have been pegged reasonably lower than its nearest peer.
"Historically, credit rating agencies have traded at 17-18 times one-year forward earnings. CARE's valuations look sanguine in this context. Going forward, the multiple gap between CARE and ICRA should come down", believe analysts at Emkay Global.
On the whole, CARE enjoys strong financial position, well-established brand positioning and richly experienced management. The fast growing and high cash-generating business, higher margin profile and reasonable valuations make this offer a good investment opportunity.