Management Discussion and Analysis

The business potential of a credit rating agency is primarily dependent on the overall economic environment. When the economy is buoyant and there are higher levels of borrowing by companies for investment purposes or for creating infrastructure, the demand for a credit rating also increases. While deepening relations or expanding the client base are strategies to be pursued in parallel, the basic foundation is laid by the economic developments in the country.

Fiscal 2015 started off on a promising note with a new government in place which got into action straight away with various positive measures being taken on the policy front as well as on the administrative side. Labour laws have been made relatively more flexible, stalled projects cleared, number of forms to be filled and complied with for doing business lowered, bureaucratic efficiency enhanced etc. On the policy front the government has brought in higher limits for FDI in insurance, opened up railways infrastructure and defence equipment for FDI, inked an agreement with RBI on monetary policy, and stuck to the FRBM path indicating continuity.

The economic trends however continue to be ambiguous. The revised methodology of calculating GDP indicates an increase in the growth rate of GDP from 6.9% in 2013-14 to 7.3% in 2014-15. However such growth is not witnessed when physical growth numbers are viewed. Industrial growth as rebrsented by the IIP grew by 2.8% compared with -0.1% in 2013-14. Overall gross fixed capital formation came down for the third successive year to 28.7% in 2014-15 from 29.7% and 31.4% respectively in 2013-14 and 2012-13. With an average capacity utilization rate of 75.2% as per RBI data for Q4-2014-15, there was also less incentive for industry to expand capacity. The lower rate of capital formation is significant as this can be mapped with demand for long term finance from both the bond market as well as term credit from banks.

Growth in bank credit was at an 18-years low of 9.5% in 2014-15. In fact, within overall credit the two sectors which are of relevance for the rating business, i.e. manufacturing and services grew by 5.6% only. The debt market looked more buoyant with total issuances of Rs 4.34 lkh crore in 2014-15 against Rs 3.13 lkh crore in 2013-14. However a lot of these issuances came from the financial sector, with banks in particular being active as they were allowed to raise special infra bonds that were free of the encumbrances of CRR and SLR. Issuances from core manufacturing and infra companies were limited.

The RBI on its part had held on to the interest rates till January when the first rate cut was invoked of 25 bps to be followed by another cut in March. While some banks did lower their interest rates, the impact on credit has not yet been witnessed. But for the first 9 months of the year, interest rates were kept unchanged as the RBI continued to monitor the CPI inflation number which will be the targeted variable for all monetary policy decisions.

While your company did work on the assumption of overall economic conditions improving in 2014-15 relative to 2013-14, the final numbers did come in at below our expectations. The turnaround in the investment cycle has been delayed and while there are signs of resumption, we will have to wait and monitor such progress even in 2015-16.

Regulatory developments

There were some positive developments on the regulatory front which was useful for rating agencies like yours’.

First the RBI has mandated that banks can issue long-term bonds with a minimum maturity of seven years to raise resources for lending to long term projects in infrastructure sub-sectors. These bonds will be exempted from computation of net demand and time liabilities (NDTL) and would therefore not be subjected to CRR/SLR requirements.

Second, the RBI brought out a circular to discuss the road to banks providing partial enhancement for infra loans. As an initial measure, with a view to encouraging corporates to avail bond financing, it has been decided to allow banks to provide partial credit enhancements to bonds issued for funding infrastructure projects by Companies/Special Purpose Vehicles (SPVs) subject to certain guidelines. The mechanism of improving the Annexure VI to the Directors’ Report credit rating of a bond issued for funding infrastructure projects by Companies/SPVs is to separate the debt of the project company into senior and subordinate tranches. The credit enhancement provided by banks will be able to provide such bonds with partial credit enhancement in the form of a subordinated instrument – either a loan or contingent facility – to support senior project bonds issued by the Companies/SPVs, and thereby improve their credit rating. Partial credit enhancement provided by banks shall be limited to the extent of improving the credit rating of bonds (assigned by a recognized external credit rating agency) by a maximum of two notches [including modifiers {“+” (plus) / “-”(minus)} e.g., migration from AA- to AA+ will be considered as an improvement by two notches] or 20 per cent of the entire bond issue, whichever is lower.

The above restrictions would apply at the time of issuance of the bond as also when the senior bond amortizes.

More recently in April 2015, the RBI has brought out a paper on large exposures for which it has solicited suggestions. Broadly the idea is to shift a part of the demand for credit from banks to the markets. More specifically the ideas put forward are:

1. Large corporate borrowers enjoying working capital (fund-based) limits above a certain threshold from the banking system should necessarily meet a minimum brscribed percentage of their working capital requirements from the commercial paper market. This percentage should be progressively increased.

2. As the core portion of the working capital requirement is needed continuously/over a long period, corporates may finance this core portion by issue of medium term corporate bonds [popularly known as Medium Term Notes (MTN)] of maturity of, say, 3 to 5 years. As working capital loans are generally secured by current assets of the borrowers, banks and corporates may mutually decide the issues of sharing securities/collaterals with the investors of such bonds.

3. Large corporate borrowers enjoying term loan limits above a certain threshold from the banking system should necessarily meet a certain minimum extent of their term/project loan requirements from corporate bond market.

These decisions when introduced finally, which according to the paper will be in place from 2018 onwards, would widen the scope of capital market activity and increase opportunities for credit rating agencies.

CARE’s evolving strategy

We began the year with a clear vision of expanding the size of our client base as we believe that once we acquire a client, our experience shows that we can retain the relationship forever given our strong customer orientation. We have hence continued to focus on both the large and medium enterprises (LME) and small and medium enterprises (SME) as part of our strategic drive for the year.

While the overall economic environment does provide a boost to the rating business, we understand that this cannot be the sole driving force for your company and therefore, we have worked on the existing structure and built relationships with new companies. We believe that there are still some white spaces that can be occupied within the existing architecture of the rating universe. We have increased our total number of active clients up from 7,754 in 2013-14 to 9,828 in 2014-15.

The overall approach was to look at both the LME and SME segments independently to sharpen our focus. The LMEs are the core of our business, while the SME market is expansive and though the ticket size is small, has vast potential in terms of numbers. This was aided partly by the running subsidy scheme of the NSIC (National Small Industries Corporation), Government of India, where a subsidy is provided to a SME for getting a rating from an empanelled CRA to the extent of 75% once in its lifetime.

Outside the purview of the ratings, we continued to market the grading products like education, real estate, equigrade etc. besides launching some new products. These products we believe can add to a significant volume of business in course of time once the concerned entities see value in the products. For this to happen there is a relentless effort that has to be put in to educate the concerned entities on the value of such a grading.

Large and Medium Enterprises (LME) approach

We do believe that this segment is very important as these companies are the large borrowers which contribute to the growth of capital formation in the country. Being in the capital-intensive space, they are critical for the economy and would be progressively adding to their CARE Ratings investments and are also users of both the debt and the credit markets. Being a relatively late starter in the credit rating business CARE has had to work hard to get these companies on board as the business tends to get sticky where companies rarely move form one agency to another.

Our business teams have been worked hard to talk to these companies and come on board. Here we do have good news to share with you as seen by the progress your company has made in terms of having these big companies on our portfolio. We are grateful to both our business and rating teams for enabling this achievement as delivering a rating on time is even more important than receiving the mandate.

We have managed to increase our share in the BS Top 1000 rated companies to 46% from 43% last year. Our share in the ET Top 500 rated companies increased from 53% to 54%. While we continue to retain leadership in these domains, it must be admitted that moving up incrementally is a challenge which gets stickier given the competitive nature of this industry.

We have continued to build these relations by also providing our own expertise on various issues relating to industry, economy and the financial sector periodically through interactive sessions that are termed knowledge sessions and webinars. The response especially for the webinars has been very good with several clients logging in to hear our views and discuss the same.

We also have in place dedicated teams to work with these companies so as to continue to cement the relationship with them into the long term.

Small and Medium Enterprises (SME) approach

The SME pie of the business is a very important one for your company. Given the large number of such units in the country, which has been estimated to be over 1.5 mn working firms, the potential is enormous. We have viewed this section from two points of view. The first is to habituate them to the concept of a rating as we believe that once the SME sees the benefit in the rating in terms of getting access to a loan facility from a bank or a lower interest rate to be paid on a loan, they would come back for a rating. The NSIC Scheme for providing them with a subsidy was essentially devised to allow this to happen.

The second is more from the perspective of the medium and long term, where we do envision that there would be a substantial number of SMEs which would work their way up with scale and join the fold of becoming a LME at some point of time. A relationship hence which is already established can be leveraged at a later date. Therefore, SMEs are an integral part of the rating business.

We did create a separate SME team where the focus was on having our own employees who as business development officials would operate from several locations to garner business and forward the information to our Knowledge Centre from whereon the rating analysis would be taken up by the rating teams. To this extent, we had deployed our employees in several locations.

Change in course

During the course of the year, however, the Government of India had stopped the NSIC scheme as the amount that was allocated was consumed.

Therefore, there was a slowdown in this line of business. However, our own focus on SMEs was two-pronged: the NSIC cake was one part but the bank loan rating business for these entities carried on in parallel. We have since been concentrating on the bank loan rating portion of the SME rating to fully utilize our own human resources that were scaled up for this segment.

For the current year, we have to take into account the fact that the government has lowered the budgetary allocation under the NSIC scheme this year from Rs 85 crore (Budget revised for 2014-2015) to Rs 26 crore (Budget 2015-2016). While we will continue to try and convince the relevant ministries in the government of the usefulness of this programme to review this allocation, our concentration will be on getting more of these entities under the bank loan rating.

Alternative rating products

As part of broadening our own expertise in the rating space, we have been looking at the various products that can be rated/graded as they can add to the basket of offerings for the concerned industry which in turn will provide indicators to the users of the products. We have done so for education institutions, real estate, renewable energy etc. This we believe will add a modicum of diversification to the rating frontiers.

During the year we made some inroads into mutual funds rating and rated 36 schemes. The number of assignment under (RESCO) increased from 43 to 217 and those for (ESCO) from 11 to 40.

We have built specialized teams to deal with these grading products so that there is focus in terms of business development as well as grading processes.

Global revenue strategy

Our global ventures have made significant progress since last year. ARC Ratings has already started assigning ratings to various sovereigns with India being the first one followed by Malaysia, Mauritius, and Portugal. The ARC Ratings teams had interactions with various government officials, multilateral institutions, and academics on their visits to India for doing the sovereign rating. Also as part of business development, they were introduced to our own clients who do raise funds from global markets on a regular basis. We are hopeful that some of them would turn to ARC Ratings for a global rating when accessing these markets.

The ARC business model for CARE Ratings is brdicated on two lines. First, the success of ARC Ratings would involve an income flow in the form of dividend to the company. Second, with a sovereign rating already being assigned to India, companies from India that get a rating from ARC Ratings when accessing international markets would warrant a referral fee for your company. A beginning has been made but we understand that this venture will take time to generate significant income for your company.

Performance in 2014-15

While the overall economic environment has improved in statistical terms, we have not seen that in terms of investment activity, raising of funds in the debt market and growth in bank credit especially in the non-retail segments. Admittedly, there have been several measures taken by the government to improve the investment climate which is laudable. But we have to still wait for some time to see these actions get translated into hard numbers. In short

- The investment cycle has still to improve. We have not seen too many new projects coming up and it appears that potential investors are still adopting a wait and watch approach.

- Industrial growth is yet to takeoff. While there have been some upward blips in the data on capital goods sector, they seem to be localized and not generalized.

- Bank credit has to go back to the range of 18-20%.

- Government spending is necessary to initiate the recovery process. This has been missing in the last three years.

- Interest rates have to come down at two levels – the central bank and the transmission through the banking system. While RBI has lowered rates twice, there is still some haziness when it comes to perceived inflation which will be a guiding factor for future investment decisions.

This we believe would hopefully fructify together in the course of 2015-2016, albeit at different speed and magnitude, and hence we do have a more positive outlook for the credit rating business.

Our financials have been largely influenced by these underlying business numbers and for the full year this is how it looks.

Our rating income has increased by 12.3% from Rs 226.91 crore in 2013-2014 to Rs 254.92 crore in 2014-2015. This has been on account of an increase in the new business as well as surveillance cases. This is where there are three factors involved that have contributed to this increase in income: number of clients, number of assignments and volume of debt rated. They not just contribute to the income earned but also add to the future surveillance cases.

Other income increased by Rs 7.91 crore from Rs 35.66 crore to Rs 43.57 crore. This comprises the investment income earned by your company during the year. Given the high volume of cash that is generated, we do invest the surpluses in relatively safer avenues such as FMPs, tax-free bonds, fixed deposits. The earnings will vary on the structure of interest rates brvalent in the system as well as tax laws which will guide our tenure of investment.

Total expenses increased from Rs 85.72 crore to Rs 101.39 crore. This was due to higher staff expenses of Rs 70.67 crore as against Rs 60.60 crore last year. Our staff strength has increased from 594 as of March 2014 to 655 in March 2015. Besides we have also made a provision on account of the ESOP Scheme for the year for Rs 5.29 crore. This scheme has been introduced to reward employees for their performance and also hence serve as an employee retention tool.

Operating profit for the year was Rs 155.82 crore as against Rs 143.74 crore last year while PAT was Rs 140.33 crore as against Rs 128.67 crore last year.

Looking forward in 2015-2016

Macro prospects

2015-2016 has started off on a positive note from the point of view of the government and RBI. The government has made higher allocations of capital expenditure this year both in the Railways Budget as well as the Union Budget. By also asking the departments to spend the allocation from the beginning of the year, it may be expected that infrastructure will get an impetus which in turn will bring in corresponding private investment. The RBI has also lowered rates once in June over and above the 50 bps cut in January-March 2015 with a firm statements that it expected banks to lower their base rate too and start lending to companies. Banks may be better positioned to lend now with the NPAs hopefully stabilizing though they would have to make adjustments for restructured assets when making provisions this year. The debt market should hence hopefully see more traction from even non-financial companies this year, and realistically speaking the traces should become bold in the second half of the year. The risk factor is the possible sub-normal monsoon which can upset plans of rate cuts and overall demand. A clearer picture will emerge once the season is through and a fair picture of the agriculture story emerges.

We are looking at GDP growth in the region of 7.8-8% on the assumption of the farm sector being satisfactory and industrial growth moving to the 5-6% range. Along with this growth path, growth in bank credit would also move to the level of 14-15% which would still be lower than 18- 20% growth which was associated with the GDP growth rate of 8-9% (under the earlier methodology with 2004-05 as base year).

An imminent increase in interest rates by the Fed could upset the balance of payments with the flow of foreign funds slowing down. However higher interest rates in a phased manner over the next year which is what the market is expecting would also make borrowing from overseas more expensive. This will also mean that the demand of funds would be channeled partly to the corporate debt market.

Hence the overall outlook for the credit rating industry looks a little more positive than last year as the economy moves gradually on the upward path.

The road for CARE Ratings

We would be following the developments in the economy very closely and analyze the investment trends as well as changes in the financial markets so as to bring in some sharper focus on the sectors to target. Infrastructure would be one segment that could receive some momentum.

Expansions in other industries would be monitored closely as any early signs of a turnaround would be felt in only some industries to begin with and the others would follow over time.

Therefore, we would continue with our strategy on increasing the size of our client base as well deepen these relations as it could be more likely that the larger companies on our portfolio would be the drivers of investment in the year.

Admittedly, the withdrawal of the SME-NSIC subsidy does impact the overall canvas, but the effort will be to enlarge other segments to cover up for these dark spaces. The team is already working on the potential of bank loan ratings for these units and there is close coordination with the relevant banks too.

We do see the challenges before us in 2015-2016 as there is a major assumption, realistic though, of the economy actually moving into second if not third gear during the second half of the year.