Value Investing Bridgewater’s Ray Dalio Discusses the Impact of China’s Growth on the World Economy |
| Bridgewater’s Ray Dalio Discusses the Impact of China’s Growth on the World Economy Posted: 07 Aug 2019 08:51 AM PDT |
| Long Thesis. CARE Ratings Ltd NSE:CARERATINGS Posted: 07 Aug 2019 05:34 AM PDT Note: 1 lakh = 10^5 and 1 crores = 10^7. FY17 = 1 April 2016 to 31 March 2017 This was written on Tuesday so the PE multiple might be a bit off. CARE Ratings is India's second largest credit ratings agency. It is the second player in an oligopolistic market, with high barriers to entry. At 11x trailing EPS this seems like the perfect place to buy a great business at a decent price. THE BUSINESS CARE's core business is exactly the same as credit rating agencies across the world. They rate corporate bonds and bank debt of companies that are borrowing money. CARE gets paid a % of the bank loans/ bonds by the company that wants to borrow money. After the company borrows money, the rating process is not over. CARE has to rate the debt of the company as long as it has debt outstanding (which the company has to pay for). This process is required by SEBI and so CARE gets a steady recurring revenue stream as long as the company has debt outstanding. WHY THE STOCK IS CHEAP In September of 2018 India's largest transport finance company's subsidiaries defaulted on its bank loans (IL&FS default). This triggered a review in 2018 by SEBI (India's market regulator) about the processes of credit rating agencies. CARE and ICRA (Moody's subsidiary in India) had both rated IL&FS AAA till it defaulted on its debt. CARE stock has fallen ~62% from its 52 wk high of 1395. To add to the problems of the company an anonymous complaint was received by SEBI that the senior management took bribes to give better ratings to IL&FS. The CFO resigned recently with no explanation given. This has had investors spooked about the future of the company. The company reported weak Q1 numbers, and the price fell 36% (as of 6 Aug). The Q1 numbers are The company is currently facing short term headwinds (weak corporate borrowing, regulatory scrutiny leading to CEO fired, CFO resigning) and so Mr. Market has marked down the price of the company. There is unwarranted negative sentiment about the company. THE THESIS 1.You don't need smart management to run the business. CARE's business is a toll booth into the debt markets and for borrowing from banks. All management has to do is: A. Rate companies B. Return cash to shareholders. CARE's management has understood B very well and has had a payout ratio of 65%. On the point of A, I feel that after the IL&FS scandal, the increased regulatory scrutiny has led the ratings agencies to be more conservative in their ratings, and this is a plus in the long term. Even if SEBI bans Rajesh Mokashi from ever running a ratings agency, they have enough depth to get new management. And in the end management doesn't matter that much in this business. (Proverbial idiot being able to run a business) 2.The impact of regulatory scrutiny is over-emphasized The main concern of the bears is that: SEBI will ban CARE from rating companies like they did with Deloitte for auditing. This seems unlikely. The main complaint SEBI has with CARE seems to be that they revised their ratings extremely quickly just before the default. From a recent new article: "Despite four changes to ratings rules in the last three years for improving transparency and processes, agencies still make abrupt, multi-level downgrades from top ratings to junk, rattling the market. A case in point is the sudden downgrade of bonds sold by Infrastructure Leasing and Financial Services Ltd (IL&FS) and related entities after they defaulted on payment obligations in September." source: https://www.livemint.com/market/stock-market-news/sebi-rbi-examining-business-models-of-rating-agencies-1558030782374.html The most likely things seem to be: 1. SEBI requires that the ratings agencies keep the ratings committee separate from management. 2. They have a probability of default on the rating. Neither of these damage the earnings/cashflows of the company. In the long run in my opinion, these rules should improve the quality of ratings, and so reduce future regulatory scrutiny is reduced. 3.The business is still a high return on capital business Excluding cash and ST investments, PreTax ROC (EBIT/ (Assets- NIBCL)) has been between 42% and 30%. Even if you assume that they cut prices (after all they will get stares from regulators for increasing prices just after the crisis), and if they have lower margins as a result of this, EBIT margins could go down to 30% if the price per rupee of debt rated goes down even 10%. This business has high operating leverage and this means that if in the future, they are able to increase the price per rupee of debt rated by 10%, then margins will go up very quickly. Either way RoC should remain in the downside 20%, and in the upside 40%. The company will sustainably earn in excess of its cost of capital even in the most poor environment,
The corporate bond market in India is expected to double by 2023. This means that if and when the economy picks up then CARE should see revenue growth in the mid-teens and the operating leverage along with it. This increases the top possible margin to 60% EBIT like it was in FY16 and FY17. High ROC + Long growth = Great Business to own for the long term
Employee expenses are up 16% YoY and "Other expenses" are up 24% YoY. My (unproven) hypothesis is that the company is trying to send a message to regulators that they aren't making too much money and so shouldn't be fined as harshly. IS THE COMPANY A FRAUD? I don't think the company is a fraud despite the CFO resignation. It does sound suspicious and does warrant further investigation. My personal hypothesis is that the CFO knew that the company would come under investigation and didn't want his name tarnished. But as I showed earlier, you don't need a Jack Welch-like person to run this business. You just need someone who rates bonds and pays out dividends. VALUATION Comps trade at 25x ttm EPS and CARE trades at 11x ttm EPS. The market should recognize this discount when the cloud over the business from SEBI scrutiny and the slowing economy goes away. Another way of approaching this is that the company needs close to zero capex in excess of depreciation. From FY15 to FY19 Net PPE increased by only 1722 lakhs (1 lakh = 10^5 rupees) while EBIT increased by 1686 lakh rupees. Almost all of the net income can be treated as FCF. This means that (although we haven't got the FY19 CF statement), FCF for FY2019 will be in the range of net income. If FCF is 10767 lakhs, market cap is 147400 lakhs, the company trades in the range of 13x FCF. This implies a 7.6% FCF yield + a growing stream of cashflows. This is clearly cheap and has a long way to go. Bear Case Net Income stays constant forever and regulators fine the company 10% of revenues. This leads to a 1 time drop in earnings. The company is valued without growth at a 14x FCF multiple. This implies an upside of 7%. Base Case Revenues grow at 6% (GDP level) Net Margin stabilizes to 30% so FY 21 Net income is 10143 lakhs. This should be valued at a multiple of 25x (as a net margin of 30% implies a RoC in the high teens/low twenties which warrants such a high multiple). This means that a market cap of 25 billion rupees in 2021. That means that investors today will get a 33% annualized return. The regulators don't fine the company Bull Case The economy picks up and grows at 8% (The RBI target). The RBI reduces regulation on corporate bond markets and they go to developed market levels. CARE would have 15% revenue growth and extremely high margins implying a 50% upside when operating leverage kicks in. If valued at 30x earnings (justified due to the 30%+ ROC that the company will have in the case), investors should see a 50%+ annualized return for the next few years [link] [comments]  |
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