Central Depository Services Limited. If you’ve been investing in Equities or Debt in India, there’s an almost 50% chance that you’ve heard about this company. In fact, if you’re an investor in India, there’s also an almost 50% chance that you’re currently using the services of this company. Otherwise known as CDSL, it is the only other Depository for financial instruments in India (Apart from ‘National Securities Depository Limited’ or ‘NSDL’).
What’s interesting to note is that, as of January 2017, NSDL held Rs. 134 lakh crore worth of securities and CDSL, a meagre Rs. 18 lakh crore. However, the Market Share (Based on Revenues), was 58% for NSDL and 42% for CDSL.
There’s one thing these Depositories need not worry about: the opportunity size. The opportunity size for Depositories in India is, for the lack of a better word, massive. India’s AUM/GDP Ratio, a prominent measure of a country’s investment penetration, is abysmal at 7%, compared to the Global Average of ~30% and ~60% for developed nations. Even a country like Brazil (38%) pips India by a wide margin. In fact, it is common knowledge that only ~2% of Indians invest in the capital market.
Considering the straight-forward nature of the industry, this story will be a simple one: a slow and steady race to accommodate more and more Indian citizens in the financial markets, while enjoying a statutory protection of Margins by SEBI (Of course, this also means the complete absence of upward pricing power). The key to unlocking wealth in such a ‘boring’ narrative rests in the gush of free cash that can be produced with little to no investment. So then, the question to crack would be: “How much cash is too much cash?”
SEBI has actually mandated that companies need to provide Balance Sheet related data only during Q2/H1 Results. So, I have taken the P&L related data from the Q3 Results, but the Balance Sheet related data as of Q2/H1.
Notes: Investments Assets
Noteworthy is the fact that, CDSL has a LOT of Cash on their books. This is present mostly in the form of investment in long-term and short-term financial instruments (Both Equity and Debt). The details are as below:
In fact, Rs. 613.93 Crores is a whooping ~27% of their Market Capitalization. Whew!
Notes: Subsidiaries (Minority Interests)
CDSL holds 3 Subsidiaries: CDSL Ventures Limited, CDSL Insurance Repository Limited and CDSL Commodity Repository Limited. The first and the last are completely held, while the middle one is held to the extent of 54.25% directly and indirectly. I have used CDSL’s own P/BV of 3.74 to Value CDSL Insurance Repository Limited and remove 45.75% of the total from CDSL’s final value (Because 45.75% of CDSL Insurance Reporitory Limited’s Profits does not accrue to CDSL).
Notes: Risk-free Rate
India’s current 30-year Government Bond Yield or the ‘Risk-free Rate’ stands at 7.701%
Notes: Company Beta
I did manage to calculate the Beta for CDSL and the CAGR for NIFTY 50 (The usual – inputs for calculating Cost of Capital).
But you may notice something is amiss almost immediately. NIFTY 50’s CAGR for the last ~1.5 years is just 7.72% or so. If I use this to calculate CDSL’s Cost of Capital, I will end up with the figure ~7.718%, which is as good as saying that an investment in CDSL is equivalent to investing in a Bond guaranteed by the Sovereign of India. This sounds ridiculous, because it is. The recent market draw-down has distorted this figure. So, I’m going to stick to the long term average CAGR of NIFTY 50 — which is about 13% (A ballpark, sure, but a good one).
Notes: Cost of Capital
I haven’t entered any industry related data for obvious reasons. So, we will be using the Company Beta to calculate the Cost of Capital (Instead of the Bottom-up Beta-based calculation I usually do).
The Capital Conversions
This really isn’t worth a special mention. CDSL has some Operating Lease obligations, as calculated below.
This isn’t going to affect CDSL’s Value in any material way. At least I’m not leaving any stones unturned.
Now, I shall try to put numbers to the stories we talked about CDSL earlier. I will justify them too, as much as possible.
High Growth Period
CDSL is an important institution and it is in a perfect duopoly with NSDL. It is unlikely that SEBI will mandate another Depository, simply because there isn’t a need. So, both CDSL and NSDL will have a very high Competitive Advantage Period (CAP). In my model, the longest number is 20 years, so I have selected just that.
Here’s how I did it:
- I listed down India’s Total Population from 2011-2018 (Source)
- I listed down CDSL’s Number of Account Holders from 2011-2018 (Source and recent Annual Reports)
- I listed down the Historical Sales data of CDSL (Source)
- Based on this, I was able to calculate two things: The ‘Penetration’ figure (CDSL Number of Account Holders / India’s Total Population), which stands at about 1.09% in 2018 and the ‘Sales per Account Holder’ figure (CDSL’s Sales / CDSL’s Number of Account Holders)
- I pulled down India’s estimated Total Population figure for 2040 (Source)
- I assumed that 22 years from now, the ‘Penetration’ figure will be 10% (This is on the lower, more conservative side, compared to the Opportunity Size we discussed earlier)
- Working backwards, I estimated that CDSL might have a Sales of Rs. 2,286.92 in the year 2040.
- In other words, the CAGR of CDSL’s Sales for the first decade and a half might be closer to ~11.12%
It’s always good to cross-test an assumption with some other evidence. Coincidentally, CDSL’s Average Return on Equity for the last few years is around 17.11% or so. The Dividend Payout Ratio (DPR) is around 33.72% or so. Putting these two together, we will arrive at the Self-sustainable Growth Rate (SSGR) of ~11.34% roughly. This is in line with our above findings.
CDSL’s Margins are mandated by SEBI. This is a double-edged protection. On one hand, CDSL is unlikely to face a downward pressure on Margins at any time in the future (Unless their employees hold a rally for drastic increase in Salaries). Along the same lines, CDSL also cannot increase its Margins because it literally has no pricing power whatsoever. SEBI’s word is final and binding.
This is quite visible in their historical figures:
The ‘fixed’ nature of CDSL’s expenses manifest more strongly during a market down cycle (Such as from 2013 through 2014), when their Sales was stagnant, but they weren’t able to control their expenses. However largely, while there are fluctuations here and there, the Margins revert to mean. So, I’m going to use the historical average Margins as the proxy for the future figures.
I have, however assumed a minor drop in Margins towards the end of the Business Cycle, simply because it is a natural occurrence for all businesses (But lesser so here, owing to the ‘protection’ by SEBI).
The standard assumptions. Historical Average Corporate Tax Rate converges towards India’s Average Corporate Tax Rate and then towards the Global Average Tax Rate.
I am making a big, but reasonable assumption here. I am assuming that, as time goes on, CDSL’s management will be able to continue generating Sales while the need for reinvestment decreases more and more. This ‘scale’ is a huge Value center for CDSL and enabler for producing a gush of Free Cash Flows. Over the long term though, things revert to mean.
According my our assumption above, the Reinvestment Rate shows a decreasing trend.
Return on Capital
The Return on Capital figure remains fairly stable, as it has for CDSL in its long history.
The Depreciation figure remains fairly stable, since CDSL isn’t an Asset-heavy business.
Cost of Capital
As mentioned earlier, I have calculated the Cost of Capital based on CDSL’s Beta (‘Company Beta’), using the Capital Asset Pricing Model (CAPM).
With the ‘Assumptions’ explained in detail, let’s move on.
The yellow-colored Diagnostics comment reads: A mature firm often does not generate a Return on Capital far exceeding the Risk-free Rate or the kind of Returns it generated when it was a young firm. This statement is true, of course. The remedy? Does the firm enjoy a superior pricing power? If not, consider decreasing the Operating Margin estimates.
I think CDSL enjoys Pricing Power, thanks to SEBI. So, there’s no need to reduce the Operating Margin estimates. In any case, this is not a red flag. Let’s proceed.
The Cash Flows
Based on our assumptions above, this is how I think CDSL’s Cash Flows will evolve:
This assumes that CDSL will produce a steady stream of Free Cash Flows in the future. If you think this is too good to be true, this is what CDSL has been doing in the past:
Once again, this is possible because CDSL does not need to reinvest heavily to produce more Revenues. The Demand is organic (A rarity in the business world).
Cutting quickly to the chase, here is how much I think CDSL is worth:
I personally think CDSL is fairly valued at Rs. 176, which is indicative of a 23% overvaluation. I have used only a 5% Margin of Safety instead of the 10% I regularly use, because I think CDSL’s revenue streams are safer and more consistent than the average Indian company’s revenues.
The Sensitivity of Value
The ‘Sensitivity of Value’ tool shows you the different Values assignable to CDSL based on different assumptions of Terminal Sales Growth and Cost of Capital.
Please note that I generally do a ‘Monte Carlo Simulation’ after this section in most of my posts. However, in this case, I feel like the assumptions I have made are quite stable. The only substantial variation, I feel, can come from the Terminal Growth Rate and Cost of Capital assumptions, which this tool already takes in to consideration.
So, to conclude, if you need a massive Margin of Safety in CDSL, you should consider purchasing it at Rs. 140, the ‘Pessimistic Value’ level. If you are, however, extremely optimistic about the company’s future, then you may consider buying it right away, because the ‘Optimistic Value’ is Rs. 361. The ‘Probable Value’, as already calculated, is Rs. 185.
Of course, if you disagree with me, feel free to download the model and value the company for yourself personally. In fact, I insist that you disagree with me, so we may start a valuable conversation in the comments section below.
How Much Cash is Too Much Cash?
If it’s not apparent already, I personally think CDSL has a lot of potential value hidden in the form of their Investment Assets. As you can see, I have valued their Investment Assets at Book Value (i.e. As reported in the Results). This itself forms a sizable amount of the company’s overall value. Imagine what this additional Cash could do in the hands of a seasoned investor. Just to make it more apparent, imagine a unlikely scenario in which Warren Buffett has bought out CDSL. Would you still value the Rs. 613.93 Crores at Book Value? Well, I wouldn’t. I would personally peg it at at least 2x Book (On the conservative side), taking CDSL’s estimated per Share value to Rs. 232, indicating a good Margin of Safety and a stark undervaluation.
Of course, CDSL is not owned by Warren Buffett and their Investments are largely in Debt funds and a few Equity investments. To make things worse, the earnings from these investments aren’t something to write home about.
In my opinion, CDSL can unlock value for its shareholders via the following methods:
1. Pay Dividends: CDSL already has a high DPR of ~35%, but clearly they can pay more by way of Dividends and still manage to generate Sales. They don’t need the money. Instead of giving it out and letting their shareholders earn returns on their own terms, CDSL is hoarding Cash and earning abysmal returns on the same. However, one also has to note that paying Special Dividends is not very efficient, since it attracts Dividend Distribution Tax in the hands of the company and also a tax in the hands of the shareholder. But hey, in the land of the blind, the one-eyed man is king.
“..the depository shall not carry on any activity whether involving deployment of funds or otherwise without prior approval of the Board: Provided that prior approval of the Board shall not be required in case of treasury investments if such investments are as per the investment policy approved by the governing board of depository.”
According to the latest half-yearly filing, their Cash and Cash Equivalents (Underlined in red below) stands at Rs. 613.93 Crores (Please note that some of their “Investments” are long term in nature, but that is beside the point). In stark comparison, their Non-Financial Fixed Assets / Business Assets / Core Assets (Highlighted in yellow below) are only about ~Rs. 75 Crores.
Most of their “Investments” are in Bonds and Debt Mutual Funds. Since they are so fond of investing in Debt instruments, I should assume that they need to hire someone as good as Howard Marks to make this magic happen. I’m just kidding. It just seems unlikely to me that this will happen.
(Depositories and Participants) Regulation, BSE cannot hold more than 24% stake in CDSL. Here’s the restriction explained straight from the horse’s mouth:
CDSL buying back its own stock would mean that BSE’s shareholding in CDSL would get increased beyond 24% eventually–and that can’t happen. So, unless BSE chooses forego their holdings in CDSL for the benefit of the individual investor in CSDL (And to the loss of the individual investor in BSE), there isn’t much to hope for in this method.
Update (13/07/2019): The Government of India has introduced Buyback Tax on the July 2019 Union Budget. This is a big dampener and may very well make Buybacks a bad option for CDSL.
Taking into account all of this, it looks to me like the best way to create value for CDSL shareholders would be Dividends. I’d say CDSL would become a good investment if the Dividend Payout Ratio (DPR) was closer to 90% and change. On further inspection, CDSL’s DPR used to be 40-50%, but dropped to 35-40% after the IPO.
Update (13/07/2019): What more? It looks like the Management isn’t open to the idea of increasing Dividend Payouts. In a Concall, the question about increased Dividends was brought up. Here is the response:
“Market is weak, that time also we are ensuring
dividend and keep ratio at the same level or more. So for that purpose only, we require. And if I
give it to you, then my other income is going to reduce which will reduce my profits.“
Peter Lynch, too, addressed this issue once. He said, in his usual comical style:
“The more cash that builds up in the treasury, the greater the pressure to piss it away.”
Will CDSL piss away the potential fortune they’re sitting on or will they correctly perform Shareholder Value-accretive activities going forward? Sadly, that’s anybody’s guess.