CDSL Valuation: How Much Cash is Too Much Cash?

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').

The Company

If you had invested in the Indian markets prior to 1995, you may have volumes to talk about the difficulties faced by holding shares in physical format ("Share Certificate"). Thankfully, SEBI created "The Depositories Act, 1996" and NSDL, promoted by NSE, became operational soon. After half a decade of uninterrupted monopoly, CDSL, promoted by BSE, became functional in 1999. To put it shortly, CDSL stores your shares or debt instruments in electronic format (Commonly known as 'De-materialized' format) and charge a regular fee for providing the service. Economic Times has a neat little write-up on what it means to be a Depository.

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The Industry

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.

These figures aren't misleading. The nature of the Depository Services business is that Revenues are a function of how many DP Holders use their platform and not a function of the worth of their holdings. To put it another way, DP Chargers are largely fixed and mandated by SEBI. In fact, here's a very recent update by SEBI: SEBI changes demat account rules by the Hindu Business Line. So, it's not far-fetched to say that CDSL's Profits are a direct function of how many DP Holders they have and how often they transact. The kicker is, this business is "Asset-light". As in, CDSL will not require much by way of investing in Fixed Assets to generate Sales. Of course, they do have to invest in Technology from time to time, but most of their Demand in organic.

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?"

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The Numbers

I have taken the following numbers from CDSL's 2018-19 Q3 Results, 2018-19 Q2 Results and the 2017-18 Annual Report. For making historical comparisons, I have used sites like Screener and RateStar as well.

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%

(Source: World Government Bonds)

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).

(Source: Yahoo! Finance)

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).

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The Capital Conversions

Operating Lease

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.

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The Assumptions

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.

Sales Growth

CDSL's Revenue is protected by SEBI. But it is also mandated by SEBI, meaning they cannot advertise to attract more customers. Clearly then, their Revenues are a direct function of how many customers they naturally get and how often the transactions happen. According to CDSL's own admission in the document CDSL Demat Account Holders, this statement stands true.

As I did with my D-Mart Valuation, I have tried to indirectly derive the implied Sales Growth of CDSL until the year 2040 (Roughly ~22 years from now).

Here's how I did it:

1. I listed down India's Total Population from 2011-2018 (Source)
2. I listed down CDSL's Number of Account Holders from 2011-2018 (Source and recent Annual Reports)
3. I listed down the Historical Sales data of CDSL (Source)
4. 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)
5. I pulled down India's estimated Total Population figure for 2040 (Source)
6. 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)
7. Working backwards, I estimated that CDSL might have a Sales of Rs. 2,286.92 in the year 2040.
8. 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.

Operating Margin

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:

(Source: CDSL - RateStar)

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).

Tax Rate

The standard assumptions. Historical Average Corporate Tax Rate converges towards India's Average Corporate Tax Rate and then towards the Global Average Tax Rate.

Capital Turnover

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.

Reinvestment Rate

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.

Depreciation

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.

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The Diagnostics

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.

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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:

(Source: CDSL - Screener)

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).

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The Value

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.

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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.

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The Model

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.

(Source: Numbers and Narratives - CDSL)

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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.

2. Do Acquisitions: For companies struggling to scale, inorganic means of Growth can prove to be valuable. Unfortunately, SEBI's Depositories and Participants Regulations, 2018 makes this impossible (Ironically, the SEBI link I had earlier got was removed for some reason and I was able to find the document again only on NSDL's website). Quoting directly from the regulation:

"..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."

3. Invest Efficiently: By 'efficiently', I mean to say that CDSL needs to start investing their Cash balance in such a way that it generates a return equal to or more than their current Cost of Capital of ~13% levels. As such, CDSL does not need too much Capital Expenditure. Let me prove it to you. CDSL's IPO came in at roughly Rs. 523.99 Crores:

(Source: Chittorgarh)

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.

4. Do Buybacks: Out of the suggested alternatives, this is the best. Buybacks are good. Heck, done at the right time, Buybacks are GREAT. Buybacks, unlike Dividends, do not attract Tax. If you agree with my estimates, the best price to do a Buyback would be anything below ~Rs.176. Unfortunately again, CDSL cannot afford too many Buybacks. Remember, BSE holds the majority stake in CDSL. Again, according to Regulation 7 of the SEBI (Depositories and Participants) Regulation, BSE cannot hold more than 24% stake in CDSL. Here's the restriction explained straight from the horse's mouth:

(Source: BSE's Letter to SEC)

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."

Prof. Aswath Damodaran wrote a similar piece on Apple, in case you want to see that as well: How much cash is too much cash? Looking at Apple. Of course, his conclusions were very different, because CDSL and Apple are wildly different companies.

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.