Invert the question "why should you invest in CARE IPO" that so many "analysts" have answered on Friday (just google CARE IPO and you'll find) to:
WHY SHOULD YOU NOT INVEST IN CARE IPO
- It's an IPO which is a means to exit the investment for existing early shareholders like SBI, IDBI etc. If these 'professional' institutions are selling, why should you buy?- None of IPO proceeds will go to the business, and hence IPO doesn't bring any fundamental improvement to the business
(BTW, same was the case for MCX IPO few months back)
- There's likelihood that after an initial jump, the stock price comes down and is available at cheaper price after a couple of months
- Equity markets have run up quite a lot since June 2012, and they might be around the top and might either decline or stay at current levels for a long time from now, and in such sentiments, the IPO stocks might not do very well and can easily come down to more favourable levels.
- I do not understand the business of CARE and it's industry dynamics very well, and hence my analysis of businss might be grossly wrong.
- All the brokerage coverage of this IPO can be 'mis-guided' and brokerages, as almost always, might have vested interests in promoting the IPO
- Owing to the fact that CARE is a rating agency, SEBI has exempted the rating of CARE IPO, possibly since sharing internal financial information to competition can be detrimental to CARE. This means that there's no standard rating for this IPO, and hence the risk of incorrect valuation prevails.
So, we analyze the risk that, even if the business has good fundamentals, the stock may be overpriced in IPO and there's chance of buying it at better levels post IPO. Let us, however, not be conclusive and go ahead to analyze the stock, since there's no strong reason right now to indicate weak business. Here's the next step to do a qualitative analysis of the business.
QUALITATIVE BUSINESS STRENGTH
What does the company do?
Credit Analysis and Research Ltd, CARE Ratings Ltd. was established in 1993 and since then, it has grown as the second largest Indian credit rating agency after CRISIL.CARE ratings has experience in rating:
- Debt Instruments
- Bank loans
- IPOs
- Insurance companies' capacity to pay claims
- Mutual Funds
- Recovery
- Corporate Governance, etc...
CARE has a subsidiary, CARE Research, which provides research reports and custom research on a multitude of industries like Banking, Retail, Automobiles, Infrastructure, Textiles, etc.
What is outlook for credit rating industry in India?
With the introduction of BASEL III system in India, the business volume for rating agencies is going to grow further, since regulation norms are getting stricter and require more financial transactions and credit instruments to be formally rated. Moreover, in my opinion and understanding, the reputation of rating industry plays a big role in getting deals through quickly, since for example, a positive rating by CARE or CRISIL will weigh more positively on a credit instrument like a debt restructuring, than any unknown rating agency. In this respect, CARE and CRISIL will benefit from regulatory reforms in credit markets and they can leverage their positions to grow their top-lines while maintaining healthy profits margins that they currently enjoy.Having said that, there's certainly a threat from international competitors like S&P, Moody's etc. If the landscape changes and these big companies expand in India, it can be a risk of margin erosion for CARE.
Also, from a shorter term (1-3 years) standpoint, as interest rates come down, more investments will be made and hence volumes of business rating will increase, which is a positive development. However, it'll also mean that restructuring business will take hit since more businesses will be able to service their current debts and requirements for further restructuring will reduce. Overall, it'll depend on concentration of business for CARE on how declining interest rates will impact their revenues and profits. However, as per RHP, CARE mentions that increasing interest rates negatively impact their business, and hence, if interest rates turn southwards from here on, as is very likely given the current macroeconomic situation and RBI indications, next 12-24 months can be good for CARE business.
Where is the business of CARE concentrated, and is there any concern due to this concentration?
As mentioned in RHP, more than 85% of revenue for CARE is generated from rating of debt instruments. While CARE is trying to diversify into other areas of ratings, it may turn out to be diworsification and waste of precious cash. On the other hand, over-concentration in debt instruments can be detrimental to the business health in case the general debt instrument transactions are to reduce in volume going forward due to various reasons.On the other hand, given the stability in debt instrument transactions and the fact that they'll grow as macroeconomic situation improves, concentration can be helpful for CARE.
How does CARE stand in credit rating Industry?
CARE is now the second largest rating industry in India, after CRISIL and while latest data is not available, CARE roughly controls about 20-25% market share today.
Does CARE has a strong business moat?
CARE does have at least a moderate business moat owing to the following:
- Established position and experience of 20 years gives them a reputation and CARE (and CRISIL) ratings are valued well by investors. This means more clients go to CARE and CRISIL and hence both these companies enjoy "barrier to competition" due to loyalty of their brand names. This of course, also means that CARE might lose business to CRISIL on similar grounds, but CARE can grow (and has shown to grow as we'll see shortly) its business by capturing market share from smaller players, and hence enjoys the benefit from "high switching cost", since a client doesn't benefit from switching away from CARE to a smaller player as investors won't like this (an example is large drop in share prices of OPTO CIRCUIT when they decided to change their rating agency; while they're switching to CRISIL, the fact that they're changing rating agency brings questions to investor minds). This factor can help CARE ratings to maintain and grow their revenue, while maintaining profit margins.
- "Operational efficiency" of centralized back-end operations in Ahmadabad. This helps reduce costs of duplicate database, reliance on third party data services and inaccurate information. Use of integrated information interface ("i3 interface") by analysts also help improve operational efficiency. This helps keep "costs low" and hence better profit margins.
SWOT Analysis for CARE Business
Strengths
- Established position and experience of 20 years
- Strong management with rich experience from banking industry (IDBI roots)
Weaknesses
- Over-concentration in debt instruments
Opportunities
- Leverage current position and capitalize the growing market (due to better macroeconomics and Basel III norms, etc)
Threats
- Diversification efforts fail and erode capital
- Competition from foreign players like S&P (via CRISIL) and alike.
- "IRB Approach" by banks can damage revenue avenues, as highlighted by the company in RHP risks section.
- Inability to recover annual surveillance fees
- Corporate governance issues can severely damage the reputation of company and can impact the revenues and margins negatively.
- Growth rate can reduce going forward due to larger base and stiff competition can dent profit margins
- Acquisitions may not work out so well
- Regulatory changes can impact business negatively. This document highlights some areas where regulatory changes can hamper the business for rating agencies.
- Delay in regulatory approvals can impact business negatively
- Pending litigation against senior management or company, if decided against the company can severely impact the reputation and hence the business for CARE
Financial History and Summary
According to RHP, the following are salient points for last 5 years of financial performance:
- Very low levels of debt / equity, standing at 0.02 as of latest balance sheet
- Growth of 20%+ in net worth over last 5 years
- PAT growth of 44% over last 5 years and sales growth of 41% in the same period (profit growing faster than sales)
- Consistent positive cash flow from operations
- Regular dividend payment since last 18 years, growing during last 5 years from 45% in 2008 to 100% in 2012. At upper band of IPO price (Rs 750), this is a dividend yield of at least 1%
- Return on Net Worth / ROE of more than 25% in last 5 years
Stock Valuation
By now, we find that the business is healthy, growing, and despite risks from competition and regulation, this is still a very good business justifying efforts to do some quantitative valuation.
Some useful numbers:
- Upper band price: Rs 750 per share
- Current book value: Rs 137 per share
- Current Net Worth: Rs 427 crores
- Current EPS: Rs 37 per share
- Current P/E ratio: 20.27
PEG based valuation
Since this is a fast growing, healthy business, let us first value it using PEG ratio, which comes out to be 0.5 considering ~40% PAT growth. This is very good for such a healthy business that generates 25%+ ROE with zero debt and consistent positive cash flow.
DCF based valuation
Performing 3 different DCF, assuming discount rate of 12%:
- 20% growth for next 5 years and 2% thereafter, fair value is Rs 762 per share, very close to offer price
- 30% growth for next 5 years and 2% thereafter, fair value is Rs 1090 per share, which is more reasonable considering 44%+ CAGR of profits in the past
- A very conservative DCF with 15% PAT growth for next 7 years and no growth thereafter gives a fair value of Rs 660 per share
This tells us that using DCF, CARE IPO is reasonably prices at upper band, if not available at a deep discount.
Relative Valuation
CRISIL and ICRA trade at P/E multiples of 40 and 25 respectively, and hence, CARE IPO is again under-priced at Rs 750 and a P/E multiple of 20. This again supports healthy price for the share.
Summary
While we've used very simple valuation methods, considering the health of business, it is not unreasonable to say that the CARE IPO is fairly priced at Rs 750. It may not be a deep value bargain, but market revaluations can easily take the share price to at least Rs 1000 such that it trades at 30x, more comparable to what CRISIL enjoys. Even a conservative estimate can be about 25% return from the IPO in next one year.
Yes, there're risks, but the risk to reward ratio is favorable to investors. Let us now see how the institutional buyers subscribe to the IPO, and accordingly we can take a call on Tuesday morning to subscribe, depending on liquidity. But at the least, it'd do no harm to subscribe to one lot (20 shares) at upper band price.
