Crisil Ltd | Quality Matters - Part 3
Let's first take a look at how the company performed in CY 2019. Figures in Cr. -
CRISIL reported a minor Revenue decline in 2019 along with PBT of Rs. 492 cr. in 2019 vs Rs. 502 cr in 2018. The relative bigger fall in PBT in 'Research' division was offset by an increase in PBT for 'Ratings' division. Margins remained same during the years. A key change in the balance sheet was the increase in cash and cash equivalents for CY 2019 from 18%~ to 29%~.
Segment Wise performance -
Here's how PBT margin evolved over the years for their main segments, Ratings & Research:
As per CRISIL's reported numbers, margins for Research division looks to be under pressure from 2018 where the margins fell from a long term average of 30%~ to 22%. As stated above, we believe that margins took a hit mainly on account of (i) fall in demand for research due to global slowdown (FIs shifting focus to risk management) (ii) impact by MiFID II regulations introduced in 2018 by EU. Operating leverage increases the impact of these factors.
Expansion in margins in the Ratings division was possibly on the account of huge increase in bond issuance by the NBFC sector during 2017-2019. Since most of the costs for CRISIL are fixed (employee costs), operating leverage helped the company to expand their margins. The year 2019 gave some pricing power when the IL&FS fiasco unfolded, giving rise to the demand of quality ratings only by investors and issuers. The company saw increase in new customers coming to them along with strengthening relationship with its existing clients.
Here's how CRISIL Research and Ratings segments have been growing (CAGR) over the 3, 5, 7 and 10 years period.
It is evident that the growth rate in Research segment has been slowing down over the past few years. Competition and their competitive pricing, coupled with research moving in-house has indeed taken a toll on this segment. However, CRISIL has started investing and building its analytical segment to offset the slowdown in research segment and as discussed, we are seeing demand getting picked up for their various analytics products.
Even Ratings segment has been growing at a modest pace of around 5-6%~ over the past few years. The recent NBFC crisis will indeed help curb rate shopping and help CRISIL in a positive way now as investors slowly start realising what has been going on in the industry. We are not putting a number to the expected growth rate here, but we do expect the growth to pickup in future in their ratings segment.
Overall company performance -
Although it looks like CRISIL is maintained its net profit margin around 20%~ every year, but if we deduct 'Other income' which do not form part of its core business, we see that 'CORE Net profit margin getting deteriorated slowly every year standing at 15.66% in CY19 against 19.53% in CY14.
'Employee cost / Sales' ratio has been maintained at 50-51%~ which is a good sign that atleast company's major fixed costs are not growing faster than its revenues. The company model is such that it works on high operating leverage where fixed costs form 70%~ of the company total costs. What operating leverage does is, revenues can grow unproportionately to costs but at the same time, company will have difficulty cutting down costs during bad times and then the revenues will decline faster than the costs resulting in margin deterioration.
CRISIL has been earning a good 41-45%~ ROCE over the years. Because of the the asset light structure, CRISIL is able to generate high ROCE which in turn lets CRISIL accumulate cash which can be further used for divided distribution or reinvestment by acquiring other related companies (inorganic growth). On average, the company has been generating non-cash sales of 11-15%~ which is in line with its peers. This means that most of the business sales are in cash where risk of payments getting delayed or written off is reduced.
We ran an extensive test on how the profits are getting booked, its revenue recognition policy, cash flow vs reported profits, growth in auditor fees, cash taxes vs P&L taxes paid, change in reserves over the period etc and found that the company is not engaged in manipulation. In the interest of keeping the article as short as possible, we are not covering it in detail here.
Finally, let's have a look at what (we think) should be the fair value of the company and how the company has produced value over time.
As of May 2020, CRISIL is trading at Rs. 1500~ and our model suggests a fair value range of Rs. 1250-1350~. NOTE: Valuation is subjective and can be full of bias. Different people can have different perception and expectations from a business.
We do not use DCF or any such model, rather we took the historical data and tried to value the company based on historical performance. Ofcourse, the value will be adjusted based on the future expectations after all its the future earnings that give value to the business, not the past. But we restrict the earnings to a certain limit as we believe humans are bad forecasters and tend to get too optimistic / pessimistic at times.
We removed some one-time expenses and earnings from the business, assumed a tax rate of 30% (not 26%~, conservative practise + it does not look sustainable for long). We found out the normalised earnings for CRISIL, adjusted how margins in each segment i.e. Research, Ratings and Advisory would change. Afterwards, we gave a PE multiple of 28 to the company earnings based on expected (conservative) growth and uncertainties (risks) related to the business. Finally this value was adjusted for surplus cash and MV of investments on CRISIL balance sheet. This is how we got our fair value range of Rs. 1250-1350 for CRISIL.
THE GOOD AND THE BAD
(I) The first one being, management. A company's management can be analysed by breaking it into (i) Ability and (ii) Intent. In short, CRISIL's management ability can be very well analysed from business' financial performance over the years. CRISIL is the market leader in credit rating space in India. The company actually gained market share in Ratings industry. Planning -> Management is actually very forward looking in the sense that it realises what the industry needs in the coming years and starts working on those products. It listens to the needs of its clients. Their Analytics segment was built because the management saw the growing demand for risk solutions other analytical tools ahead of time (first mover advantage).
Management's intent is good and in the interest of creating value for the business and shareholders. The company has the lowest one-year default rates across CRAs. Along with that, CRISIL’s stability rates across CRAs too are the highest at each investment grade rating category. The management is very honest about the future prospects of the business in their annual reports. They don't shy from disclosing upcoming problems in their business (for example, research segment). Their estimates of future bank credit growth have been actually very accurate and conservative.
(II) Second, it is a low risk business. CRISIL has a diversified revenue base unlike its peers. The ratings segment is protected by strong entry barriers, making this industry as Oligopoly. The company generates high levels of cash on low amount of assets. The company is asset light, doesn't have to invest heavily into business leaving opportunities for company making acquisitions and growing inorganically as well.
Their parent company S&P is engaged more or less in the same business and can provide valuable support in times of crisis. (It is interesting how ICRA - Moody's subsidiary, came back up very quickly after IL&FS crisis and not CARE). Their other segments, research, analytics and advisory is here to stay for long term and cannot be replaced at-least in the near future. Their client base is also diversified in the sense that CRISIL caters to both buy & sell side firms, investment banks, traditional banks etc. Lastly, CRISIL also has good profit margins (20%~), which gives it ability to re-price its products accordingly in a competitive environment.
(I) CRISIL has a low growth rate. Overall company revenues have been growing at 6-7%~ CAGR over the past few years and the growth rate is not expected to climb sharply anytime soon. The main asset for the company are Employees. Therefore, majority of the costs they incur are employee costs. The growth rate in employee 'salary' is actually 8-12%~ in the industry and is expected to increase. Cheap labour cost of India advantage will slowly erode. What this would mean for CRISIL is, fixed costs will grow faster than revenues which ultimately will put a pressure on margins. It would be exciting to see whether CRISIL will be able to generate more revenue per employee in order to maintain margins.
(II) Second, CRISIL operates in sensitive business environment. Take its Ratings division for example. One incorrect rating to a popular / huge business and the years of good reputation will go to drain, or at-least take a big hit. The ratings industry is also highly regulated and is subject to all future policy changes by RBI and SEBI. Even the actions of other CRAs can have an impact on the entire industry in terms of harsh regulations being created.
The Research industry is also undergoing a major change now that MiFID II regulations have been introduced. There is a real threat of more and more businesses taking their research in-house. Competition in this industry has been rising due to which margins are getting deteriorated. The research industry is itself easy to enter. Quality really matters in all of CRIS