August 9, 2015

7 Important Reasons Why Every Stock Investor should read Credit Rating Reports


Credit rating agencies are independent third party organizations approved by market regulators, which provide opinion about the credit strength of any borrower or its debt instrument. Their role has been widely ingrained in debt markets as the pricing of loans/debt facilities to any borrower is based on its credit strength. 

Almost all the lenders use the credit ratings assigned by such independent credit rating agencies for their appraisal and pricing of the borrowing entities. Similarly, debt market participants decide about the sufficiency of yield being offered on market instruments like non-convertible debentures (NCDs) or commercial paper (CPs) by issuing companies by looking at their credit rating. 

In India, there are many approved credit rating agencies. Some of the popular ones are CRISIL (an alliance of Standard & Poor’s), ICRA (an alliance of Moody’s), India Ratings (Ind-Ra, an alliance of Fitch), CARE (owned by Indian Financial Institutions), Brickwork etc, which are very active in assigning credit ratings and preparing credit reports in Indian financial markets. Detailed credit reports are available only to their paid subscribers; however, summary credit reports are available publically on their website and serve good purpose for retail investors


Steps to download credit rating reports:


The best way to get credit rating reports is to search "Company name Credit Rating" on the internet/Google. The first few results will tell the investor whether the company is rated and if yes, then which credit rating agency has rated it. After that the investor needs to go to the website of the credit rating agency, enter the company name in the search field on the website and then download the summary reports available at the credit rating website. The summary credit rating reports are available free to the public.

A few credit rating agencies, provide all the historical ratings on their website. So it becomes easy to get them. However, other agencies like CARE, keep only last 2 years reports and remove older reports from public domain. In these cases, searching online to check whether older reports are uploaded on any other site like stock exchanges, moneycontrol etc. might help. Else, the investor might have to buy the reports from the agencies. Alternatively, investors may try contacting the company investor relations dept. to check if they can provide historical reports to the investor.

Credit ratings vary on a spectrum of AAA to D where AAA means strongest credit strength/lowest possibility of default and D means lowest credit strength/already defaulted on repayment obligations. Various credit ratings are AAA, AA+,AA,AA-,A+,A,A-,BBB+,BBB,BBB-,BB,B and D. As we move from AAA to D, the credit risk increases and the possibility of the borrower defaulting on its debt servicing obligations increases.

As mentioned above, investors in debt markets make extensive use of credit ratings. Credit ratings have been predominantly thought as relevant for debt market participants; however, I believe that they provide a very insightful avenue for equity investors as well.

There are many reasons, which make me believe that every stock market investor should read the credit rating report of her target company. She should not restrict herself to the latest credit rating report, but read all the historical credit rating reports available in public domain and understand the story of movement in the credit profile of the target company.

Let us first understand the critical features that credit rating reports contain, which are helpful for equity analysts and then analyse the credit reports for a sample company as a case study to establish its importance. 

A credit report provides following important inputs:

A) Important Business Details and its Key Strengths & Weaknesses:


The credit rating report serves as a key resource of business information, which has been verified by a third party. Many a times, a company does not disclose many of these details on its website or in its annual report considering them as sensitive information. 

Such information might include market position, kind of relationships with different stakeholders, business characteristics, comparative positioning of its brands, status of its competitors, details of key customers and its business strategy. 

Credit reports also contain details about the factors leading to the business advantage of the company (MOAT), capacity utilization levels, future expansion plans and updates of ongoing plant constructions/debottlenecking including status of financial closure of such expansions.

B) A Glimpse into the Critical Confidential Information:


This is one of the reasons; I read credit rating reports of all the companies I analyse. 


Credit rating analysts have access to most of the information privy only to the company management, which is not available in public domain but is critical to assess the credit strength of any company. A summary/glimpse of critical sections of such information, which every investor can get in the credit report, sometimes tilts the investing decision in a company’s favour or against it. 

Such information might include terms of contracts & agreements with buyers & suppliers including cost escalation clauses & formulas, contingency clauses etc., plant capacities & their utilization levels with sales volumes etc.

An equity investor or equity research analyst would not get an opportunity to go through these contracts unlike the credit rating analysts.

C) Key Factors affecting Company's Performance including Key Risks that it might face going ahead:


Credit rating agencies based on their knowledge of the industry, peers and company analysis, provide the users a snapshot of key parameters that are expected to affect the performance of the company. Agencies also highlight the key risk factors that might impact the performance of a company negatively, which should be monitored carefully by the investors.

D) Another Independent Opinion apart from the Statutory Auditor, on the Company’s Financial Position:


Credit rating reports are prepared by financial analysts who analyse the company’s financial information including annual reports while preparing the reports. It serves as another check for the investor that another independent third party has checked the financial information apart from company’s statutory auditor.

E) A Third Party Verification of Investor’s Analysis: 


Credit rating might serve as an independent benchmark for an investor to compare her analysis. E.g., if investor believes that the fundamental position of her target company has improved over the years but on the contrary, finds that the company’s credit rating is going down, then she should recheck her analysis to find out the reasons for such disparity.

F) Year on Year Credit Rating Movement: Good Proxy for the Performance:


If an investor notices that the credit rating of a company has improved over the years e.g. from BBB- to A+, then she can be reasonably certain that the company has shown good business performance and as a result its fundamental strength has improved.

G) Rather than a Rating, it's the Movement of Credit Rating, which is More Important:


This is a critical point. I believe that an investor should focus more on the direction of movement of the credit rating of any company rather than its absolute credit rating level. This is not to say that absolute level is irrelevant. However, I would look favorably at a company “A” whose credit rating has improved from BBB- to A- over the years than another company “B” whose credit rating has deteriorated from AA+ to A over the years, even though the current credit rating of company B is higher than that of company A.

Case Study


Oriental Carbon & Chemicals Limited

 


Oriental Carbon & Chemicals Limited, an Indian insoluble sulphur manufacturer, has been rated by credit rating company ICRA Limited. Credit rating reports of Oriental Carbon & Chemicals Limited from 2008 are available on website of ICRA Limited.

Year
Credit Rating
Download Links
2008
BBB
2009
BBB
2012 (March)
BBB+ (rating watch with negative implications)
2012 (September)
BBB+ (stable outlook)
2013
BBB+ (stable outlook)
2014
A- (stable outlook)
2015
A (stable outlook)

The following has been the financial performance of Oriental Carbon & Chemicals Limited over last 10 years:

Oriental Carbon & Chemicals Limited Importance of credit rating reports in stock analysis by investors

Now let us analyse the key information that credit rating reports of Oriental Carbon & Chemicals Limited have to provide to the stock market investor, which makes studying these reports essential for the stock market investor both as part of initial appraisal as well as regular monitoring exercise.


A) Important Business Details and its Key Strengths & Weaknesses:


1) Company Background:

The 2008 report has the following gist as company background, which summarizes its entire history of Oriental Carbon & Chemicals Limited in a few words:

"Oriental Carbon & Chemicals (OCCL) was incorporated in 1978 as Dharuhera Chemicals Limited (DCL) and in 1983 DCL was merged with Oriental Carbon Limited (OCL), a group company engaged in the production of Carbon Black, to form OCCL. Since 1980, DCL’s Chemicals & fertilizers division in Dharuhera was engaged in the production of sulphuric acid, oleum, single super phosphate (SSP), sodium silico fluoride and stabilized liquid sulphur.
However, the fertilizer business was deemed unviable; the company exited from the fertilizer business in 2001, and Sulphuric Acid & Oleum production was retained. In 1994, OCCL had set-up a manufacturing facility for the production of Insoluble Sulphur, which is now the flagship product of the company. In 2000, the company realigned its focus to concentrate on Insoluble Sulphur and in the process divested its Carbon Black Unit in favour of Continental Carbon Company of USA.
OCCL has a production capacity of 10,000 metric tonnes per annum (MTPA) for Insoluble Sulphur and 41,250 MTPA for Sulphuric Acid & Oleum."

2) Market Position, Comparative Positioning of Brands, Status of its Competitors:

Credit reports of ICRA Limited provide an investor a gist of the market standing of Oriental Carbon & Chemicals Limited viz-a-viz its competitors.

2008:

"OCCL enjoys a dominant market position in the domestic market by virtue of being the only local manufacturer of Insoluble Sulphur in the country. It also enjoys a favourable market position as the ‘Second Alternate Supplier’ in the global industry, which is dominated by Flexsys of USA.."

3) Relationships with Stakeholders:

Credit reports give an investor about the kind of relationship Oriental Carbon & Chemicals Limited has with its customers.

2012 (September):

"The reaffirmation of the ratings reflects long track record of OCCL in the business of producing Insoluble Sulphur (IS), its established market position in the domestic industry by virtue of being   the leading domestic manufacturer of IS, and strong customer base comprising major tyre manufacturers across the world and long-term relations with them."

4) Details of key customers:
The reports provide an investor key information about the customers of Oriental Carbon & Chemicals Limited, which many a times is not disclosed by the company on its website or its annual report as it might consider it as sensitive information:

2008:

"…with strong customer base comprising major tyre companies  in  the  world  like Continental  AG,  Goodyear, Bridgestone, Kumho Tyres etc. for exports  and  Apollo  Tyres, Bridgestone, J K Tyres, MRF Tyres, Ceat Tyres, Goodyear India, Birla Tyres etc in the domestic market."
2015:

"The company’s customer base comprises almost all major tyre manufacturing companies of the world with whom it enjoys long standing relationships"
5) Business strategy:

Credit reports of Oriental Carbon & Chemicals Limited provide an investor the critical summary of the business strategy being followed by the company. These inputs can be very vital while understanding the business of the target company and thereby taking the investment decision.

2008:

"In order to move away from the commoditized nature of the product, OCCL  has  ventured  into manufacturing of tailor made grades of Insoluble Sulphur, which command a premium over conventional grades of Insoluble Sulphur as the European markets are witnessing a shift from conventional grades to value-added grades of Insoluble Sulphur
OCCL is also engaged in the production of Sulphuric Acid & Oleum, which constitutes about 20% of the total sales of the company. Since these products are sold to selective customers locally, the company doesn’t compete with larger players in the industry."

2013:

"OCCL is steadily focusing on increasing the share of value-added grades of Insoluble Sulphur, which command a premium over the conventional grades."
6) Factors leading to the Business Advantage of the Company (MOAT):

Credit reports of Oriental Carbon & Chemicals Limited, provide a glimpse into whether the company has a sustained business advantage over its peers and if yes, then what are the key factors leading to such advantage:


2013:

"Closely guarded technology, capital-intensive nature of the business, hazardous nature of Sulphur and long gestation period of about one and half years involving quality checks and approvals from the tyre manufacturers for commercial production act as the entry barriers for other players in the industry"
2008:

"OCCL was engaged in the production of Carbon Black which was hived off to Continental Carbon Limited in 2000 but the company continued to benefit from the business relations with tyre companies in the country"
7) Capacity utilization:

Many a times, companies might not disclose the capacity utilization levels, considering it sensitive information. An investor might get such information as part of the credit rating reports. 

2013:

"In 2012-13, the company set up a greenfield project at Mundra SEZ with a capacity to produce 11,000 MTPA of IS. The capacity utilization remained moderate at 81% in FY13 on the back of subdued demand from Europe, the key market for OCCL."
8) Future Expansion Plans, updates of Ongoing Plant Constructions/Debottlenecking and Status of Financial Closure of such expansions etc.:

This is one essential section of company’s performance, which is usually provided in credit reports of all the companies. It provides the investor, most of the information required to assess the project execution capability of company’s management & its track record, including any delays, overleveraging etc.

2008:

"OCCL has recently undertaken a debottlenecking project which would enable the company to increase its existing capacity  marginally  by January 2009.
Going forward, OCCL plans to set up a manufacturing facility in Mundra SEZ. The company expects to benefit from savings from freight for servicing of export orders and other fiscal benefits on account of operations based in SEZ.
The capital outlay for the project is expected to be around Rs 750 million, which is significant in comparison to the current size of the company and exposes the company to project execution risk. However, the project is yet to achieve financial closure."
2009:

"The company is expected to implement the project in two phases. In the first phase, the company would set up the facility with the capacity to produce 5,000 MTPA which can be expanded to 10,000 MTPA in the second phase of the project.
Out of total capex of Rs. 750 million for the phase I, OCCL plans to raise term loan of around Rs. 500 million, while the rest would be funded through internal accruals. The company expects to achieve financial closure for the project by January 2010 and the commercial production is expected to start from July 2011."
2012 (March):

"The ratings, however, are constrained....residual project implementation risk for the phase II of the Mundra Special Economic Zone (SEZ) project; which is partly mitigated by the successful commissioning of the phase I without material time or cost overrun and advanced stage of the phase II."
2012 (September):

"OCCL had a production capacity of 12,000 metric tonnes per annum (MTPA) for Insoluble Sulphur (IS) and 41,250 MTPA for Sulphuric Acid & Oleum as on March 31, 2011. However, the production capacity of IS has increased to 23,000 MTPA post completion of Phase II of Mundra greenfield project in May 2012."


B) A Glimpse into the Critical Confidential Information:


As mentioned earlier, this is one of the most important reasons; I read credit rating reports of all the companies I analyse. 

Credit rating analysts have access to most of the information privy to the company management, which is not available in public domain but is critical to assess the credit strength of any company.

Credit reports of  Oriental Carbon & Chemicals Limited, over the years have provided key inputs, which help the investor understand the evolution of business of the company over the years.

2008:

"OCCL’s inability to pass on the price increase in the past has negatively impacted its performance. Although the company has now taken measures to pass on the price increase by entering into quarterly contracts instead of annual contracts with customers, yet it remains exposed to fluctuations in the prices."
2009:
"ICRA also notes that the sharp fluctuations in raw material (Sulphur  and  other petroleum derivatives) prices had adversely impacted the profitability of the  company  during  2007-08; however, the company has taken measures to pass on the raw material price rise to the customers in a timely manner, which is reflected in the improvement in the profitability of the company  during  2008-09.
Since 2008-09, the company started entering into quarterly contracts instead of annual contracts with customers to provide itself the flexibility to pass on the raw material price increase. This has resulted in significant improvement in the profitability of the company in the last one and half years."
These inputs have helped the investors understand the sudden change in the operating profitability of Oriental Carbon & Chemicals Limited 

We can notice in the financial details of Oriental Carbon & Chemicals Limited that the operating margins, which declined from 18% in FY2006 to 12% in FY2009, improved to 32% in FY2010 and have been stable at about 25% since then. Therefore, the explanation for sudden improvement and stabilization of margins of OCCL can be found in the credit rating report.

2013 (November):
"In FY13, exceptional profit on the sale of Tarapur land along with reversal of profits has helped company to report net profit."
This critical input helps investors understand the reasons for improvement in the margins of Oriental Carbon & Chemicals Limited in FY2014.

2014:
“The revision of the long-term rating reflects the increase in scale of operations of the company attributable to rise in sales volumes of Insoluble sulphur (IS) aided primarily by more approvals from overseas customers….”
2015:
“….the company’s products are making inroads into the hitherto untapped but large markets like the US where tyre manufacturers have been receptive in a bid to diversify their suppliers from the one or two that they currently rely on for IS Supplies; the increase in scale of operations of the company attributable to rise in sales volumes of IS primarily due to more approvals from overseas customers…” 

C) Key Factors affecting Company's Performance including Key Risks that it might face going ahead:


Credit reports of Oriental Carbon & Chemicals Limited help an investor understand the key factors influencing the business performance of the company including the key risk parameters that need continuous monitoring by the investors.

1) Influencing Factors:

2008:
"The company is expected to benefit from the favourable prospects in the tyre industry driven by radialisation of tyres as Insoluble Sulphur is a key ingredient for vulcanisation of rubber."
2012 (September):
"Going forward, the ability of OCCL to achieve optimal capacity utilisation for Mundra plant in view of modest demand prospects and efficiently managing the higher working capital requirements along with the improvement in operational performance of SDL would be key rating sensitivities."
2) Risk Factors:

2009:
"The ratings, however, are constrained by the cyclical nature of the business and the high capital intensity of the business leading to moderate return indicators in the past. ICRA also takes note of the primarily debt-funded capital expenditure (capex) plan of OCCL to set up a green-field IS plant at Mundra Special Economic Zone (SEZ). As the capex plan is large in relation to current balance sheet size of OCCL, the company is exposed  to  significant  project implementation risks."
2012 (March):
"The rating watch follows the recent announcement of acquisition of 50% stakes in Schrader Duncan Limited (SDL) by OCCL. The acquisition of relatively weaker entity SDL, which may become a subsidiary of OCCL, could adversely impact the consolidated financials of the company.
2012 (September):
Post-acquisition, OCCL has also provided guarantees for the bank limits of SDL, which ICRA has factored in while reaffirming the ratings. ICRA notes that, while the acquisition of SDL, a financially weaker entity, would modestly impact the consolidated financials of the company, its consolidated credit profile will not be materially impacted because of the anticipated comfortable cash generation from its own operations, which will render its key coverage metrics well within the current rating category."

D) Another Independent Opinion apart from the Statutory Auditor, on the Company’s Financial Position:


The fact of company’s financial statements having been analysed by a credit rating agency of repute and there being no adverse comment about the accounting policies in the credit report, provides another independent check about the quality of accounting practices being followed by Oriental Carbon & Chemicals Limited.

E) A Third Party Verification of Investor’s Analysis:


Oriental Carbon & Chemicals Limited has witnessed continuous improvement of revenue, profits, margins and reduction in debt over the years. Alongside, the improvement of credit rating of Oriental Carbon & Chemicals Limited from BBB to A serves as a check that the fundamental position of the company have indeed improved over these years.

F) Year on Year Credit Rating Movement: Good Proxy for the Performance:


As mentioned above, the improvement of credit rating of Oriental Carbon & Chemicals Limited from BBB in 2008 to A in 2015, serves as a vital evidence that the company has been performing well financially & operationally, thereby leading to improvement in the fundamental position of the company.


Thus, we can see that the even the summary credit reports of Oriental Carbon & Chemicals Limited provided publically by ICRA Limited on its website contain very vital pieces of information, which might or might not be available to investors from company website, its annual reports, equity research reports or other public sources. These inputs help an investor understand the business of Oriental Carbon & Chemicals Limited in a better manner and take an informed investment decision.

Therefore, I suggest that an investor should read all the available the credit rating reports of all their target companies, including the recent most as well as the historical reports. Reading credit rating reports will add value to her analysis and help her take better investment decisions.

P.S:


  • I have used the financial data provided by screener.in and credit rating reports by ICRA Limited while conducting analysis for this article.
  • This article is not any investment recommendation of any of the stocks discussed in it. The mention of the stocks is purely for illustrative purpose.
  • You may read “SelectingTop Stocks to Buy - A Step by Step Process of Finding Multibagger Stocks” to select fundamentally good stocks for investment. 


DISCLAIMER

 


The views and opinions expressed or implied herein are my own and do not reflect those of my employer, who shall not be liable for any action that may result as a consequence of my views and opinions.

Registration Status with SEBI:


I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013, since May 25, 2016.

Details of Financial Interest in the Subject Company:


Currently, I do not own stocks of any of the companies discussed above. I have disclosed stocks in my portfolio on a dedicated page (My Portfolio). I request you to see the list of stocks I own, because it is assumed that my views can be biased when I opine about any stock which I own and therefore, have a financial interest.