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7th October 2019 (Version 3)
Executive Summary
Different business models of services sector entities and their unique characteristics make it imperative to put in place a separate framework for assessment of credit risk. Service sector entities typically include educational institutions, advertising agencies, IT and IT enabled services, as also other bodies in the hospitality and the healthcare sectors. Apart from these conventional services, new age services such as manpower supply and taxi fleet operators have contributed to the expansion of the service sector universe. From a credit rating standpoint, it is important to have a clear understanding of the business models of these entities, the risks involved therein and key risk mitigants. The two key factors of service sector entities are:
Firstly, the balance sheet of a service entity does not capture its most crucial asset - human resource. Secondly, unlike manufacturing/trading entities that have the flexibility of carrying unsold goods as inventory, service sector entities cannot store their services. The cost structure of a service enterprise mostly comprises period costs that vary with time rather than with level of activity for a certain period. Considering the high fixed costs of a service entity, stable revenue generation is more important as compared to a manufacturing/trading entity with relatively variable cost structure. From a credit perspective, working capital financing for most service sector entities is largely limited to receivables financing (i.e. post sale financing) as opposed to inventory financing which is also available to manufacturing and trading entities.
From a broader perspective, Acuité has identified the following common factors for analysis of service sector entities:
Industry Risk
Given below are the risk factors that Acuité takes into account with regard to credit rating of service sector entities:
Based on a critical analysis of the above factors, Acuité evaluates the industry risk of the entity and performance of the segment in which the entity operates. In case the entity's performance is divergent from industry trends, Acuité would recognise such divergence and factor in the same in the overall risk assessment.
Market Position
Acuité takes into account the following while evaluating the market position:
The revenue visibility of entities such as schools and hospitals will be comparatively more stable than that of airlines, hotels and IT-enabled services. The divergence in revenue stability is essentially due to the insularity of entities like schools and healthcare from economic cyclicality. Acuité believes that relatively stable operating cashflows for such entities vis-a-vis other service entities (hotels and hospitality) support the former's ability to raise debt. From a debt servicing perspective, the lenders will prefer borrowers with stable stream of cash flows rather than a volatile cash flow stream and hence, as a corollary, entities which are relatively insulated from cyclicality will be a better credit risk.
The profile of the customer base of a service entity is critical from a business resilience perspective. From a credit risk perspective, a diversified clientele profile is preferred to a concentrated one. Acuité, in addition to diversity of the clientele base, also evaluates other finer aspects such as nature of the relationship between the entity being rated and its customers. A higher level of integration between the service provider's business and that of the customer's will be critical in this regard. For e.g. a captive BPO of an investment bank will have customer concentration risk. However, if the credit quality of the investment bank is satisfactory and the dependency of the investment bank on the BPO is high, the captive BPO may be considered a low risk on the market assessment.
Similarly, for service entities with a retail focus such as schools/health care facility, higher the economic strata of the clientele, higher will be the pricing power and better will be the market position assessment. In the hospitality sector, it is important to ascertain whether a particular hotel is driven by business or tourism clientele. Tourism-dependent hotels are more prone to event risks whereas a hotel dependent on business traffic will be influenced by economic cyclicality. Similarly, in an ITeS segment, there could be focussed concentration on the BFSI space. In such a scenario, downturns in the sector could impact the flow of business from the BFSI industry. Acuité recognises these aspects related to the market position of an entity.
The range of services offered by an entity plays an important role in determining stability of earnings. For e.g. a logistics company providing end-to-end solutions has an advantage over one that has presence in only one/two segments of the logistics value chain. So is the case with an entity with regional presence vis-à-vis another with nation-wide operations. A hospital chain operating nationally with multi-speciality services and in-house diagnostic facilities would typically have a lower business risk compared to a hospital operating from a single location with limited services to offer. Accordingly, for such diversified entities, Acuité believes that diversity of revenues across sectors/geographies mitigates risk of revenue fluctuations to a large extent and imparts resilience to the credit profile of the entity being rated.
The growth drivers of the services sector are brand image, track record and customer satisfaction. An entity with an established brand name definitely has an edge over others. Strong brands can facilitate business growth in terms of volumes/market share enabling easy market penetration resulting in improved financial performance. Acuité evaluates these factors based on the extent of premium in margins/higher growth in revenues vis-a-vis its peers. In certain industries, such as hotels the ability to attract franchisees is a strong indicator of the brand image.
Other things remaining the same, an entity with large portfolio of established brands will score higher on the market position assessment.
The market position assessment of a service sector entity will also be influenced by its distribution network. A wider distribution network will enable the entity to service its customers efficiently. A wider distribution can be acquired by expanding to various geographies organically or inorganically. In case of inorganic growth route wherein, the service entity acquires an existing operation in a new geography and rebrands it, the distribution network would grow faster. Typically, an established cinema chain which has a strong urban presence and is trying to expand into rural geographies would try to acquire existing screens in Tier 2 and Tier 3 geographies rather than constructing these theatres all by itself. Other things remaining constant, an entity with a wide distribution network will score higher than the one with presence in one or two towns. The ability to scale up operations organically/inorganically is also crucial while assessing the credit profile.
Operating Efficiency
Operating efficiency refers to an entity's ability to manage its cost structure efficiently so as to mitigate the impact of adverse revenue fluctuations on profitability margins. This can be done by containing fixed costs in the overall cost structure for a given level of output of services.
Different business models adopted by service entities to moderate the overall level of fixed costs would qualify for a higher rating on the Operating Efficiency parameter.
Manpower resource is one of the key factors that contributes to the success or failure of a service entity. Continued availability of skilled manpower is crucial for success of a service enterprise. Tie-ups with institutions such as colleges, academies ensure continued stream of talent. Apart from external tie ups, in-house training/skill development verticals in an organisation will have a positive impact from an operating efficiency perspective.
Acuité considers metrics such as manpower cost as a percentage of operating revenues, revenue per employee and profit per employee while comparing productivity across peers.
Acuité observes that higher the level of integration across the value chain, more operationally efficient the service level entity is likely to be. For instance, a training institute which has a tie-up with a leading bank will benefit by way of key inputs such as training faculty, course content and practical training infrastructure which can be provided by the bank.
Hence, due to the operational benefits arising out of such integration, the training institute would qualify for a higher rating on the Operational Efficiency parameter. A health care facility with in-house diagnostic facilities will score more than a standalone hospital with limited ancillary facilities.
Financial Risk
While assessing financial risk, Acuité examines the capital intensity of the entity being rated. Certain entities such as airlines, educational institutions with relatively higher capital intensity will be evaluated on parameters applicable to manufacturing entities. For other entities with relatively lower capital intensity, Acuité will accordingly factor in the differences in the financial risk assessment.
Management Risk
Management risk shall be assessed on parameters such as integrity of the management, competence and risk appetite. Integrity assessment will cover known instances of defaults/delinquencies and serious transgression of laws. Competence will be assessed on the basis of the credentials of the management, their past track record and ability to manage the business and regulatory environment. Risk appetite refers to the policies of the management with regard to risk management.
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