Credit Analysis and Research Ltd’s (CARE Ratings’) share sale offer price of Rs.700-750 appears to be competitive at first glance. At the higher end of the price band, the company trades at 18.49 times its earnings for fiscal 2012 (FY12). In comparison, peer rating agencies such as Crisil Ltd and Icra Ltd are trading at 34.7 times and 26.5 times, respectively.
The latter two credit rating agencies have been trading near these valuations for the past couple of months; thus their seemingly higher multiples is not the result of the recent run-up in prices alone.
A couple of other factors also help make CARE Ratings’ offer price look attractive. One, its earnings before interest, taxes, depreciation and amortization (Ebitda) margin for the half-year ended September is 69%. That compares favourably with Icra’s 32.9% for the first half of this fiscal year and Crisil’s 31.7% for the first half of calendar 2012. Second, CARE Ratings’ return on equity was 30.7% in FY12, better than Icra’s 16%, even while substantially lower than Crisil’s 42% (annualized number based on the last two quarters’ numbers). And according to CARE Ratings’ prospectus, its stand-alone profit after tax improved at a compounded annual growth rate of 44.3% between FY08 and FY12. That, too, compares well with Crisil’s annual average profit growth of 25.3% and Icra’s 17.4%.
The higher operating margin can be attributed to CARE Ratings’ smaller presence in the small and medium enterprises segment, which has lower returns. It also has a low-cost back-office in Ahmedabad, which helps it restrict its employee costs to less than one-quarter of its sales, compared with nearly one-half for the other two raters. But the main reason its margins are higher is that it gets most of its revenue from the ratings business, which is clearly a high margin business. The margins of Crisil and Icra are lower because they are diversified companies, with interests in research and consulting.
On the flip side, it means that CARE Ratings has all its eggs in one basket. For the year ended March, 86.4% of its revenue came from ratings. The remainder, according to its prospectus, was mainly investment income. If banks decide to rate their loans internally, which the Reserve Bank of India may allow them to do so by March 2014, it will impact CARE Ratings more than others. That may also explain the higher multiples that the markets have assigned Crisil and Icra.
In its red herring prospectus, CARE Ratings talks about how it wants to develop its research business and expand. While it certainly has the cash to do so, such a move will likely lead to a reduction in margins. Besides, such a move will take some time to materialize.