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In-depth Analysis of CDSL – a company which operates in a Duopoly sector all set for explosive growth!

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About CDSL – Central Depository Services (India) Ltd (CDSL), is one of the two main Indian central securities depository based in Mumbai. Its main function is the holding securities either in certificated or uncertificated (dematerialized) form, to enable the book-entry transfer of securities. CDSL is promoted by Bombay Stock Exchange Limited (BSE) jointly with State Bank of India, Bank of India, Bank of Baroda, HDFC Bank, Standard Chartered Bank, Axis Bank and Union Bank of India.

Shareholding Pattern –

Promoter(BSE) holds 24% and the rest with the public. Interestingly, Individuals with Rs 1 lakh invested hold +20% of BSE and notable institutions such as LIC and Major banks holding a stake in CDSL.

Top Shareholders –

Lets decode their Business –

Fee Income:

According to SEBI regulations, every Indian public listed company is mandated to get itself listed on both the depositories. But unlisted companies have the flexibility to choose from either of the two (CDSL or NSDL). A company that gets listed on the depository must pay the initial cost (registration) and an annual fee (annuity fee) which is determined by its paid-up capital.

In addition to the initial cost, the depositories also levy companies for corporate actions (bonus, right shares, IPOs, etc) and E-voting.

Transaction Income:

The second part of a Depository’s income comes from the Depository Participants (DPs). DPs are registered with Depositories and thus depositories do not deal with the investors directly, they do it through a network of DPs. DPs interact with both the listed securities and investors. An example includes financial institutions or brokers who are registered as DPs to depositories and that authorizes them to transact on the behalf of the investors. ( Transaction charges contribute 23% of the total business. CDSL has reduced its contribution to the overall business by diversifying into other avenues using the existing capabilities.)

Warren Buffet says to look for businesses with float and CDSL satisfies this criterion of the Oracle of Omaha as well. In addition to the above revenue streams, Depositories also take deposits for appointing new DPs, which is kept with depositories as security. These deposits act as a ‘float’ which is invested in fixed income securities that generate interest/dividend income for depositories.

For any transaction that is carried by any investor, the broker has to pay a fixed fee to the depository to get the transaction reflected in the demat form. In simple words, depositories charge their DPs for settlement. This part of the business is bit cyclical, with higher volumes in the market comes higher income.

CDSL has around 11,000 companies admitted, of which 7,500 are listed, rest are unlisted public companies.

For CDSL, around 30% of the total revenue comes from annual issuer charges, which is a stable annuity-like business. Corporate actions such as IPOs and others contribute another 15% of the revenue.

CDSL vs NSDL – (NSDL is unlisted)

From the above image, we can see that CDSL beats NSDL in operational metrics over 4 years and also in the number of depository participants. (CDSL focuses on both institutional and retail DPs, but NSDL’s focus is largely on large institutional DPs preferably large brokers like banks).Now beating the number of depository participants is essential because of a thing we called the Network Effect.

Two things matter a lot for the depository business if we take a close look. First, the number of depository participants with the depository (DP Network) and second, number of listed securities. Naturally, It takes time to build a network of DPs. If a new player enters the market and tries to compete, it would take enormous effort and time to replicate the DP network of CDSL. (giving them a good barrier to entry and moat). CDSL has over the years has focused on non-institutional depositories i.e. targeting more retail-oriented clients and institutions.

Demat Account opening –

From the above image we can see the rapid pace of demat account additions by CDSL. Notice how the gap has widened from 22% more accounts opened by CDSL in 2013-14 to 88% more accounts opened by CDSL in 2017-18.

CDSL Valuation vs NSDL Valuation –

We can see that given its return ratios and superior performance compared to NSDL, CDSL is trading at good affordable valuations. Its sales figures, operating profit, and net profit figures and margins are superior to NSDL making CDSL the clear outperformer.

Factors for growth ahead –

It is a known fact that out of the total Indian Population, only 3-4% have a DEMAT account, with the number only set to grow exponentially (as more people move towards financial assets). To put things into perspective, the percentage having a demat account in the US is 50%!

Recently, SEBI and the Ministry of Corporate Affairs (MCA) has notified that all unlisted public companies need to get dematerialized and get admitted with either depository.

This is a new avenue for Indian depositories. There are around 65,000 unlisted public companies that needs to be dematerialized.

Apart from unlisted public companies, MCA in the next leg will target the dematerialization of private companies, which is a huge pie – there are more than 7 lakh private companies in India.

Risks –

Uncertainty in the E-KYC Business: Approximately 15% of CDSL’s total revenues comes from E-KYC business. The government recently has authorized CERSAI (Central Registry of Securitization Asset Reconstruction and Security Interest of India) to act as, and to perform the functions of, the central KYC records. If in the future, CKYC is the only KYC that is to be maintained, then the KYC business of CDSL will be under threat.
But currently, CDSL is not facing any issues in its market leadership and it has started with new avenues that will negate the impact of any possible threat from CERSAI.

Cyclicality in the business: Depository business in the long-term mimics the stock market performance ( as more IPOs, more corporate actions, etc) and stock markets are cyclical by nature. Transaction charges/IPOs which forms around 23% and 16% of the total business respectively are directly linked to the performance of the capital markets. The downturn in the overall markets can bring some volatility in the revenues. However, management is trying to reduce the cyclicality by venturing into new avenues and aims to reduce depository business to 60% from 80% at present.

Management Change: One of the key people who is instrumental to the diversified business structure and strong business hold by CDSL has been Mr. PS Reddy. As per the SEBI guidelines a person cannot head a depository for more than 10 years. While CDSL is still trying to extend his tenure, but as per current SEBI directives, Mr. PS Reddy needs to retire soon. He has created a very strong organization as a whole and has not made bad capital allocations in the last decade. If the company is not able to find a strong
successor to PS Reddy, it can be a material risk.

The emergence of a third player: Economically it does not make sense for SEBI to grant a depository license to any new player. However, many times in the past, SEBI has indicated that it may come out with a third player. It has recently changed its guidelines for granting a depository license by removing the requirement of a sponsor and easing the net-worth requirements. It is very unlikely that a third depository will come in an already over-crowded depository business. However, if it happens, it will impact the profitability of the existing depositories.

Cash Flow Analysis – The Final Piece of the Puzzle –

One key barrier in the evaluation of small and mid-cap companies is the quality of their earnings. The growth in sales and profits should translate into cash flows for the company. There should be a good comparison between the accounting and cash profits to understand the quality of the earnings.

Therefore it is important that one check the earnings quality through the proper analysis of the Cash Flow Statements (which many people miss looking at).

In many cases recently, the companies which de-frauded investors had
their money stuck in their working capital which meant accounting profits weren’t converted into cash profits.

We begin with cash flow from operations. We divide it into two parts i.e. Gross Cash Flow from Operations (GCFO) and Net Cash Flow from Operations (NCFO).( Difference being the ‘changes in working capital’.)

As a thumb rule, for a manufacturing company, NCFO as a percentage of GCFO should not be significantly below sixty percent. This simply means ideally not more than 40% of the money should be stuck in
working capital. Applying the same rule on CDSL over FY13-18 we get a number on an average which stood at 96% which is well above the 60% percent rule.

We also compare the net cash flow from operations with operating profits because theoretically, they should be close to each other. For CDSL both accounting and cash operating profits were close.

The company has got a very lean working capital cycle of 11-12 days, that makes business more strong and stable from the earnings quality perspective.

Summing it up –

So CDSL operates in a duopoly segment with market leadership, has free float, has a good network effect, no debt, strong management, really positive outlook , strong triggers ahead and trades at affordable valuations. Therefore we recommend this company as a Buy for long term as we feel that it can be a great compounding business and stock.

The Above article has been written after brainstorming with my Twitter Friend Meet Shah. A big thanks to him for this! The healthy discussion and brainstorming led to good learning for both of us. He can be reached out here

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