CDSL Business Model and Research Report

"Go for a business that any idiot can run - because sooner or later, any idiot probably is going to run it".

-Peter Lynch

Fundamental investing requires investors to remain in it for the long-term and to apply effort and research to their stock selection, along with staying updated on the news and industry trends. But there are a few businesses that are considered as "No Brainer", i.e., which do not demand very complex analysis or keeping track of industry or macro factors.

One such example is CDSL Ltd - Central Depository Services (India) Limited

CDSL Ltd: Overview of the company

Initially promoted by BSE Ltd., CDSL is one of the two securities depositories operating in India and the only listed Depository. The company offers dematerialization services for different types of securities, including equity shares, preference shares, mutual fund units, debt instruments. CDSL currently holds a 58% market share in terms of investor accounts, with 589 registered depository participants.

Let's understand their business model in detail

Business Model of CDSL

Before getting into the revenue sources, one needs to understand what depositories are and whom do they cater to?

Depositories: Depository is a type of institution that holds securities (Shares, bonds, debentures etc.) in an electronic form (in financial terms, it is known as dematerialized form or Demat Account). The work of a depository is similar to a bank. Just as a bank holds money on behalf of its depositors, a depository holds shares and other securities on your behalf of its investors. However, unlike bank accounts, an investor cannot open his Demat account directly with the Depository; rather, he needs to go through an intermediary known as depository participants.

Depository Participants (DPs): More popularly known as stockbrokers, DPs are an intermediary between the Depository and the investors. So an investor is a member or client of a Depository participant (when they open a Demat account), whereas a Depository participant is a member of a Depository. Basically, brokers offer a platform for the transaction, but securities are held by Depository in Demat form.

Apart from depository service, the company is also engaged in other services and earns a good amount of revenue from it.

Revenue Sources

● Annual issuer charges:- Every issuer (Listed securities) is required to pay an annual fee to the depositor, which is decided by the market regulator, SEBI and remains the same for both depositories. Currently, it is levied at the rate of Rs. 11 per folio (ISIN position) subject to the Nominal Value of Securities admitted (Paid-up capital). 

● Transaction Charges:- As mentioned earlier, investors' holdings are kept by the Depository, but the transaction is carried through the broker/DP. For any transaction done by an investor, the broker has to pay a fixed amount to CDSL for the transaction settlement. 

● Online data charges:- The company is also engaged in KYC services through its subsidiary CDSL Ventures Ltd (CVL). CVL is the largest KYC Registration Agency (KRA) in India, with 60% of the market. The primary revenue in the segment includes one time charges for KYC creation and additional charges for data fetching 

● IPO & corporate action charges:- The company also facilitates crediting of securities for initial public offerings and other corporate actions, such as share splits and consolidation, as well as payment of dividends. For these services, CDSL charges a fixed amount to the issuer company based on the number of folios. 

● Other segments:- Besides the above category, the company also earns through account maintenance charges, E-voting charges, ECAS charges and other operating revenues. 

Revenue Break-up for the Financial Year 2019-20 

Source: CSDL Annual Report 

The major part of the revenue, around 34%, comes from Annual issuer charges, which is a kind of stable revenue stream. The transactional charges, which are the 2nd biggest contributor, is quite cyclical in nature as the income on this dependent on the transactional volume. 

What is Moat? 

● Operates in a duopoly market:- Depository business in India operates under a duopoly structure with 2 leading players NSDL and CDSL. CDSL enjoys a market-leading position with a 58% market share. Additionally, the business operates in a highly regulated environment with a strong entry barrier coupled with decent growth prospects. 

● Asset Light business model:- The company has an asset-light business model with minimal fixed cost requirement. Due to this, CDSL enjoys a significant degree of operating leverage and an excellent operating margin of 62% (As per TTM data). Thus any rise in income will directly expand the net profit and ROE. 

● Network effect:- Another great moat that discourages new players to enter the industry is the Network effect. The company has 589 registered DPs across India and 289.34 lakhs investor account as of Q3 2021. Due to the higher switching charges, DPs prefer to stay with the Depository for a long period, and this offers a stable revenue stream for the depository company and makes it difficult for a new entrant to compete with the existing players. 

● Diversified Revenue stream:- CDSL, along with its subsidiaries, offers a variety of services to several financial players such as mutual fund houses, securities market, insurance companies. This helps the company earn from multiple sources and remain less vulnerable to market cycles. 

What is good? 

● Steady growth & Room for growth: - The company's total active BO (Beneficial Owner) accounts have grown at a CAGR of 19% from 1.08 crore in FY 2015-16 to 2.12 crore in FY 2019-20. Though the industry has grown tremendously in the last few years, the Indian capital market is still highly underpenetrated in terms of equity participation, and there is significant room for growth.

Source: Investor presentation Q3FY21

● Business execution:- Despite being a late entrant in the depository market, CDSL has outgrown its competitor NSDL with its unique business strategy. CDSL focuses on retail DPs, particularly discounted brokers, and with its relatively low fee structure and relaxed registration requirements, it has become India's largest Depository in terms of DP accounts. 

What is bad?

● Cyclical revenue streams:- Transactional charges and IPO charges which together contribute 29% to the revenue, are market-linked in nature. These income are dependent on stock market performance, and the downfall in market level may bring volatility in the total revenue. 

● Regulatory hurdles:- The charges for some of the services like annual issuer charges are controlled by SEBI, and thus the company does not enjoy any pricing power on the same. The e-KYC segment is also exposed to the risk of changes in government policies. 

Financials of CDSL

● Revenue & Profitability:- CDSL has been consistently growing both in terms of revenue and profit. The revenue has grown at a CAGR of 15.52% and 16.38% in the last 3 and 5 Years period. As explained earlier, the company requires low incremental Capex and Opex, and thus the bottom line grew at a higher rate on the back of increasing operating leverage.

Source: ticker 

The business had an excellent profit margin of 47% as of March 2020. Further, due to the jump in operating revenue in the last 3 quarters, the PAT margin has improved by 10.7% to 58.13% (March 2021) as per the latest quarterly result. 

● Strong Return Ratios:- Though the return ratios of the company are volatile in comparison to the other NBFC, it appears to be quite high. The hefty cash and investments in the books have weighed down the return ratios, but due to regulatory requirements, CDSL is required to carry these liquid assets. However, given the asset-light business model with strong growth drivers, the ROE is expected to improve in the coming years.

Source: ticker 

● Healthy Balance sheet:- CDSL has an absolutely clean balance sheet with zero debt and good cash reserves. As of March 2020, the company had an investment worth Rs 273.38 crore and cash worth Rs 54 crores. 

Source: Ticker

Conclusion

The equity investment in India has a very low penetration of 2-3%, whereas, in developed nations such as the USA, the ratio stands at 45%. With the growing financial literacy and the relative outperformance of Equity instruments over other asset classes, the share of equity investments as proportions to total household savings & investments is expected to rise.

One more growth trigger for the company is the recent MCA guidelines which makes it compulsory for the unlisted companies to dematerialize their shares before any transfer or corporate action. Out of 80,000 unlisted companies, around 11,000 have been admitted for dematerialization till now. The company's duopoly business structure, repeat business in several offerings, and robust financials makes it a no brainer stock. However, regulatory factors and competition from the equally strong player, NSDL, may create a risk to the company's future growth.