Description

Investment Summary

Central Depository Services India Limited is a high quality capital light mid cap business in India ($2.5bn enterprise value) that is a buy and hold investment in any global small mid cap portfolio. The company is a market infrastructure company, operating in a sweet spot with huge tailwinds from the growth in Indian equity capital markets. 

The company listed on the NSE in 2017 becoming the first depository in the Asia-Pacific region and the second depository in the world to get listed. 

I have owned the stock for the last several years and while the stock has been a exceptional performer, I expect the stock to compound at mid teens CAGR over the next decade outperforming the Sensex and NIFTY indices. Any sell off in Indian markets would be a blessing in disguise as it can be seen as an opportunity to average into CDSL.

The company counts amongst its shareholders value investors including PPFAS Asset Management Private Limited. 

At a high level, lets look at the company's past track record. Over the last decade, CDSL has grown revenue 8x from $14.5mm to $109mm from FY14 to FY24, growing revenue every single year. 

In Q4 2023, the company had 10.9 million new demat accounts, highest ever in single quarter and 32.6 million new demat accounts for the fiscal year.

To put this growth in perspective, what took 22 years for CDSL was accomplished in one year, highlighting the extraordinary acceleration of growth. This brings the company's total number of demat accounts to 116 million in FY2023-24 and market share of nearly 80%.

Digitisation initiatives have played a crucial role in expanding access to stock markets and depository services, benefiting investors across tier 2 and Tier 3 cities, who are now actively participating in financial markets.

CDSL has grown net profits roughly 8.5x from $6mm to $50mm from FY14 to FY24. CDSL has been profitable since inception.

Gross profits has similarly increased nearly 8x from $14mm to $107mm in the last decade with cash gross margins nearly 100% with tremendous pricing power. 

For every $1 in revenue, CDSL converts 40%+ of every dollar of revenue to operating cash flow. The company has grown operating cash flow 10x from $4mm to $46mm 

Operating cash flow and free cash flow has grown over 15% nearly 60% of the time. 

Free cash flow has multiplied 10x from $3.7mm to $37mm meaning for every $1 of revfenue, CDSL converts 25-28% into free cash flow. CDSL has been FCF positive since inception 

Tangible book value has grown from $42mm in FY2014 to $171mm by FY2024. 

Importantly, CDSL is extremely capital light, the ratio of CFO/capex since inception is nearly 3x.  There is no inventory on the balance sheet, and minimal receivables, quality of earnings is high with operating cash flow matching accounting earnings.

The company has not raised capital since its IPO. The company has been investing for growth through internal cash flow and the net change in cash on balance sheet, is due to operations, not financing. 

Return on unlevered equity is extremely high as tangible book less excess cash is negative. If one looks at the drivers of ROE, it is as a result of high net margins of 40%+ and a consistently net cash balance sheet since FY2010. Return on assets is 20%.

The company has increased dividends per share over the last several years, again through internal cash flows and on its 25th anniversary paid a special dividend.

Dividends accounted for ~65% of FCF since inception, I expect dividends per share to steadily increase. 

I calculated the incremental ROICs on the business in various phases and they are consistently over 50%. The company consistently earns returns on incremental capital well in excess of its cost of capital.

Business Overview  

CDSL is a market infrastructure institution providing secure depository services to market participants, including exchanges, clearing corporations, depository participants, issuers, and investors. In simple terms, CDSL facilitates the holding of securities in dematerialized or electronic format.

CDSL enables investors to securely hold a wide range of asset classes in dematerialised form, providing access to the Indian capital markets. This includes investments in various securities such as equities, debentures, bonds,  Exchange Traded Funds (ETFs), units of mutual funds, units of Alternative Investment Funds (AIFs), Certificates of Deposit (CDs), Commercial Papers (CPs), Government Securities (G-Secs), etc. leveraging cutting-edge technologies and robust security measures. 

Other consistent revenue-generating services offered by the Company include e-voting, email address updation facility for companies/issuers and e-notice services to registered companies, enabling their shareholders to receive notices in electronic form and to allow shareholders to cast their votes electronically, remotely or at the meeting venue.

Summary of service Offerings:

● Dematerialization of Securities: Converts physical shares to electronic form, simplifying handling and reducing risks.
● Electronic Book-Entry Settlement Services: Enables faster settlement of trades in securities markets.
● Secure Trading Platform: Provides a convenient platform for holding and transferring securities electronically.
● Corporate Action Services: Facilitates corporate actions (e.g., rights issues, bonus issues) to benefit both investors and corporates.

CDSL’s services empower investors, stock exchanges, depository participants, and corporates. The company is technology-driven, offering applications such as:

● easi: Electronic access to securities information.
● eDIS/easiest: Digital debit/credit requests.
● smart: SMS alerts for transactions.
● e-voting: Electronic voting services.
● eMargin Pledge: Electronic margin pledge setup.
● eFIM: Tracking Foreign Portfolio Investor (FPI) and NRI investments.
● eSDD: Facilitates SAST transactions for promoters.
● eNotices: Electronic notices from corporates to shareholders.
● KYC Services: Includes a wide range of Know Your Customer (KYC) related services.
● And many more.

CDSL has established three subsidiaries:

1. CDSL Ventures Ltd: Offers KYC services in the mutual fund industry and is the first and largest KRA in India.

2. CDSL Insurance Repository Ltd: Provides insurance-related services.

3. CDSL Commodity Repository Ltd: Operates under the framework of the Warehousing Development and Regulatory Authority.

History

CDSL (Central Depository Services Limited) began its operations on 15th July 1999, facilitating the settlement of trades in dematerialized (demat) mode through BOI Shareholding Ltd, which served as the clearing house for the Bombay Stock Exchange (BSE). Over the years, the company has achieved several important milestones that have contributed to its growth and expansion in the depository business:

2005: CDSL reached a significant milestone, crossing 1 million active demat accounts.

2006: CDSL Ventures Ltd. was incorporated, marking the company's expansion into new service areas.
Expansion Through International MOUs: In subsequent years, CDSL entered into strategic agreements with key global institutions, including: Depository Trust & Clearing Corporation (New York), Korea Securities Depository, Japan Securities Depository, Taiwan Depository & Clearing Corporation

2012: CDSL Ventures KRA was launched by SEBI’s then-chairman, Mr. U.K. Sinha, making it India’s first and largest KYC registration agency (KRA).

2019: CDSL received SEBI approval to open an IFSC (International Financial Services Centre) branch at GIFT City, Gujarat.

2020: CDSL inaugurated India’s first IFSC branch at GIFT City.

2021: CDSL achieved a milestone by crossing 40 million active demat accounts and became the first depository to open 5 crore active demat accounts.

2023: CDSL set further records by becoming the first depository to join the Account Aggregator framework as a Financial Information Provider and by crossing 100 million active demat accounts.

Market Position

CDSL holds a leading position in India’s depository business, currently commanding a 76% market share. In 2023-24, CDSL captured an impressive 88% share of new demat accounts opened.

Last year, CDSL became Asia's only listed depository to serve over 115.6 million investors. The company also takes pride in being present in nearly all pin codes across India.

Furthermore, CDSL leads in terms of EBITDA margin, with an operating profit of 56.90%, while its competitor, NSDL, has a lower operating margin of 28%. In Q4 2023, the company had 10.9 million new demat accounts, highest ever in single quarter and 32.6 million new demat accounts for the fiscal year.

Before getting into how CDSL is competitively better than NSDL, it is important to understand the key performance indicators of both players. 

In many of the indicators, CDSL continues to lead. The company's competitive pricing is another advantage, with lower transaction charges based on the volume of trades. Retail investors, who form the backbone of CDSL's clientele, are growing rapidly.

On the other hand, NSDL, relies heavily on foreign institutional investors (FIIs), is seeing declining market participation. FII ownership hit an 11-year low in 2023-24, while retail investors contributed an average monthly inflow of INR 166 billion ($2 billion) into equities. CDSL is well-positioned to benefit from this retail investment boom. Even in a scenario where NSDL shifts focus to the retail segment, CDSL holds a first-mover advantage.

CDSL’s Strategies has been Helping it Gain Consistent Market Share

Back in 2007, NSDL dominated 77% of the market, while CDSL held only 23%. Over the years, CDSL has captured significant market share by offering lower prices. Setting up a DP (Depository Participant) account with CDSL is more affordable, requiring a minimum investment of 20 million compared to 30 million for NSDL. The deposit requirement for CDSL is ₹50 lakh, while NSDL’s is 10 million. CDSL also offers slab-based pricing, unlike NSDL's fixed-rate structure, making it more attractive to a wider range of customers. 

Revenue Expansion Opportunity Coming from Unlisted Company

In October 2023, the Ministry of Corporate Affairs mandated the dematerialization of shares for all small and government companies. Under the regulation, companies with a paid-up capital of more than 40 million and turnover below 400 million must dematerialize their shares by September 2024. Although the details of the regulations are still at a very nascent stage, CDSL management has expressed optimism and is engaging with stakeholders. This regulation is expected to drive additional revenue for CDSL, which has already invested in the necessary infrastructure to support the new requirements.

Revenue Expansion Opportunity From Insurance Sector:

As of April 1, 2024, insurance policies must be held in electronic format, presenting a significant opportunity for CDSL’s subsidiary, CDSL Insurance Repository Ltd. CDSL has already signed up 46 companies and processed 1.4 million insurance policies by the end of June 2024. The company generated ₹99 lakh in revenue during Q1 FY25, up from ₹71.38 lakh in FY 2023-24. CDSL continues to invest in its technology stack and workforce, positioning itself for strong growth in this sector. 

No of Active Demat Accounts (1 cr = 10 million)

Custody Value (1 crore = 10 million)

Management and Corporate Governance

CDSL operates as a fully management-led business, guided by a robust leadership team.

The board is chaired by Mr. Balkrishna V. Chaubal, with Mr. Nehal Vora serving as the Managing Director and CEO. The board also includes Dr. Binalkumar N. Patel, Ms. Rajeshree Sadnavis, and Mr. Sidhartha Pradhan as Public Interest Directors.

Mr. Balkrishna V. Chaubal: The Chairperson of CDSL, Mr. Chaubal, retired from the State Bank of India as Deputy Managing Director after serving the bank for 38 years. He brings a wealth of experience in banking and financial services to his role at CDSL.

Mr. Nehal Vora: The Managing Director and CEO, Mr. Vora, began his career at SEBI in 1996, where he managed the derivatives and new product division. He later moved to BSE Ltd, where he served as the Chief Regulatory Officer. Mr. Vora has also led the broking and investment banking compliance division at DSP Merrill Lynch.

Shareholding Pattern

As of August 2024, CDSL’s promoter shareholding stands at 15%, entirely held by BSE Ltd. The remaining shares are held by public shareholders.

Financials and Valuation

The key value drivers for CDSL over the next decade will be strong growth rates, returns on capital  and operating cash flow growth and prudent capital allocation through increasing dividends per share.

As mentioned in the investment summary, CDSL has grown revenue 8x from $14.5mm to $109mm from FY14 to FY24, growing revenue every single year. 

Since FY 2020, revenue growth has been explosive at 16%, 42%, 50%, 2.2% and 48% each year respectively. I expect revenue growth to grow at 15% CAGR over the next decade, as Indians continue to move assets from physical assets into financial assets.

Gross profits has similarly increased nearly 8x from $14mm to $107mm in the last decade with cash gross margins nearly 100% with tremendous pricing power. CDSL has grown net profits roughly 8.5x from $6mm to $50mm from FY14 to FY24. CDSL has been profitable since inception.

For every $1 in revenue, CDSL converts 40%+ of every dollar of revenue to operating cash flow. The company has grown operating cash flow 10x from $4mm to $46mm. Free cash flow has multiplied 10x from $3.7mm to $37mm meaning for every $1 of revfenue, CDSL converts 25-28% into free cash flow. CDSL has been FCF positive since inception 

While headline multiples to cash flow don't scream value, this was the case even 4 years ago and so solely relying on headline multiples is misleading because everyone can see those multiples on Bloomberg or Capital IQ. Understanding the business is key.

The key drivers of the stock are the strong growth prospects of CDSL, capital light business and competitive advantages. Looking at trailing cash flow yields of 3% is misleading, because the company is a small mid cap grower operating in India's growth economy. If one acts as a business owner, and buys and forgets CDSL, I expect the stock to compound at mid teens CAGR over the next 10 years. It should be a core part of a small cap portfolio and market sell offs will be a blessing to dollar cost average. 

Risks 

1. Rising Technology and Employee Costs

Technology and employee expenses continue to represent a significant portion of CDSL's total costs, and these are rising. As of Q1 FY25, technology-related expenses accounted for around 9% of revenue, up from 8% in FY23-24. Over this period, technology spending grew by 65%. Employee costs are also substantial, representing 12% of revenue, with CDSL’s employee spending being 30-40% higher than that of its competitors. If CDSL fails to generate sufficient revenue from its technology investments or does not achieve adequate revenue per employee, these costs could become unsustainable.

2. Regulatory Risks

As a market infrastructure institution, CDSL, along with entities like NSDL, BSE, and NSE, faces high regulatory risk. Regulatory authorities such as SEBI regularly conduct inspections, and any deficiencies in compliance could result in penalties or operational restrictions. Pricing for depository services is also determined by SEBI, meaning any unfavorable pricing decisions could negatively impact CDSL's revenue. Furthermore, increased regulatory costs, combined with rising technology and employee expenses, could place additional pressure on margins.

3. Single Demat for All Investments

There has been high level discussion about introducing a single demat account for all types of investments. While CDSL’s management views this as a long-term proposition and has not provided specific details, it could pose risks to depositories. CDSL currently charges fees based on the type and number of investments. Although trading volumes may remain consistent, a shift to a single demat structure could complicate operations and impact the fee structure, potentially reducing revenue. The probability is low.

4. SEBI's "True to Label" Regulation

SEBI's "True to Label" regulation, which comes into effect in October 2024, aims to ensure greater transparency in how market infrastructure institutions charge clients. Under this mandate, all charges billed to clients must reflect the exact amount received by the market infrastructure institution, removing any volume-based discounts. While this regulation does not directly affect CDSL, it could lead to increased compliance costs and pressure on margins, especially as depository participants (DPs) face higher operational expenses. CDSL’s management has not disclosed the full impact of this regulation.

Catalyst

CDSL has several catalysts that will continue to underpin its growth, returns on capital, cash flows and capital allocation

1. Stock Market Participation and IPO Participation Growth in India

The Indian stock markets have reached record highs and this has been driven by strong retail and Domestic Institutional Investor (DII) participation. Retail and DII participation in the industry increased from 58.7% in 2019 to 62.9% in 2024. Non-institutional investors now account for 50% of cash volumes in FY24, up from 38% in FY14.

In the first half of 2024 alone, total DII inflows reached $28.5 billion, compared to $22.5 billion in 2023. Based on current trends, Foreign Institutional Investors (FIIs) no longer significantly influence market direction, as DIIs and retail investors have become the primary drivers.

Additionally, IPO participation has been robust, with CDSL’s revenue from corporate actions and IPOs directly benefiting from the increase in public offerings. In August 2024, IPO fundraising hit a 27-month high, marking the busiest month for public offerings since May 2022. Positive regulatory changes, a strong domestic economy, and growing retail investor engagement are strong catalysts for businesses like CDSL.

2. Mechanisms Enhancing Stock Market Accessibility

Various mechanisms such as T+0 settlement, faster IPO listings, quicker trading of bonus shares, simplified registrations for Alternative Investment Funds (AIFs) and Foreign Portfolio Investors (FPIs), and the introduction of electronic consolidated account statements in 23 languages are making the stock markets much more accessible to a broader audience. These initiatives aim to boost financial inclusion and promote equality, ultimately driving higher retail participation in the markets.

3. Surge in Demat Accounts

As highlighted above, the number of demat accounts has seen significant growth. An interesting trend has emerged where individuals and families are opening multiple accounts, including accounts for their non-adult children. This surge is driven by several factors, including the increased number of IPOs, attractive IPO premiums, favorable buyback prices, and a growing demand for more lucrative investment opportunities.

4. Surge in Equity Mutual Fund Investments

Mutual funds, particularly sectoral and thematic funds, have experienced exponential growth. According to a recent report by ICRA, inflows into sectoral and thematic mutual funds surged by over 8,000%, reaching ₹181 billion crore in August 2024, compared to just ₹2bn in August 2019.