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In recent months, the stock of credit rating agency CRISIL has outperformed the benchmark Sensex. The company, along with other rating agencies, stands to benefit from a potential pick-up in private sector investment, as India Inc will need more loans. This will, in turn, raise demand for individual project ratings, crucial for bank credit. Thus, rating companies are among the early beneficiaries of an investment pick-up.
Further, regulators have been focusing on promoting the corporate debt market for the past two years. Some of the steps taken on this front are relaxation in investment norms for the Employees’ Provident Fund Organisation (allowing it to invest in bonds of select public and private sector companies), permitting insurers to invest in papers rated at least ‘A’, reduction in withholding tax for foreign institutional investors (FIIs) in debt from 20 per cent to five per cent and raising FII limit in the debt segment. These, along with the likely easing of interest rates and higher growth in the small and medium enterprises segment, will augur well for rating agencies.
Given its dominant position in the ratings segment (revenue market share of 35 per cent), CRISIL is well poised to gain from the improving macro economy. In the ratings segment, CARE and Icra command 28 per cent and 20 per cent revenue market share, respectively. CRISIL’s strong parentage (US-based Standard and Poor’s), robust profitability and high cash generation are key strengths. Also, the agency earns significant revenue through research, advisory and risk solutions-related activities, which, too, are likely to do well. The diversified revenue and margin mix cushion the company during adverse economic cycles.
“Unlike CARE and Icra, which are highly dependent on domestic ratings for revenue and operating profits, CRISIL is more diversified, with revenue spread across research, rating, advisory divisions and geographies (India, the UK and the US). Diversified revenue streams help reduce cyclicality in revenue and profitability,” says Jignesh Kamani, analyst at Nirmal Bang Equities.
Bank loan ratings contribute the most to rating revenue (about 50 per cent). However, analysts expect the under-penetrated segments of corporate bonds and small and medium enterprises (SMEs) to catch up. Corporate debt market accounts for a mere 3.9 per cent of India’s gross domestic product, against 10-40 per cent in other emerging markets. It has huge potential to scale up. Similarly, of the 25 million SMEs, only 0.3 per cent has been rated, making most rating agencies bullish on this segment.
Revenue risks for CRISIL and other rating companies include the adoption of an internal rating-based (IRB) approach by banks, in tune with Basel-II norms. But analysts aren’t worried. “Interaction with bankers (from both private and public entities) suggests limited risk of revenue loss from migration to an IRB approach in the immediate future. Experts believe only 50 per cent of banks will be able to migrate to an IRB approach in the next three years,” says Aalok Shah of Centrum Broking. Others say the process will be gradual.
Expensive valuations
Analysts expect the company’s revenue and net profit to grow 15 per cent and 16 per cent, respectively, this financial year. Improved traction in the ratings business (36 per cent of consolidated revenue), along with healthy growth in research revenue (59 per cent of consolidated revenue), will drive the company’s performance in the coming years.
In the advisory business, a small contributor, CRISIL works with regulators, governments, multilateral agencies and companies to shape public policy and establish viable frameworks to enable infrastructure development. It also provides a complete range of risk-management tools, analytics and solutions to customers in India, Africa, West Asia, South Asia, and Southeast Asia. At Rs 56 crore, the advisory and risk-solution division reported a compounded annual revenue decline of 11 per cent during 2008-2013. The company had maintained a cautious outlook on this business after the announcement of results for the quarter ended March. But with a new government in place at the Centre, this segment’s prospects are expected to improve.
At the current market price of Rs 1,780, CRISIL is being traded at 45.8 times, a huge premium over its historical average (five years) one-year forward price-to-earnings ratio of 19.9. Most analysts polled by Bloomberg since May this year are positive on the company, but their average target price (Rs 1,450) is about 19 per cent lower than the current price. While there is no immediate upside, long-term investors could consider the stock on a significant correction.
