CDSL Business Analysis: A Toll Road Business
Hi Investors! Welcome to SOIC! We'll discuss CDSL in today's video. It is one of the biggest beneficiaries of the capital market, in our opinion. Before we begin the analysis, we'll discuss 2 interesting Mental Models that Warren Buffet reiterates in his quotations 1. "The best business is a royalty on the growth of others, requiring little capital itself."
This means that the best business to own is something like a toll road, where you have to pay the toll tax. Let's suppose you have to go from point A to point B, you'll have to pay the toll tax on the way There are businesses in the Indian & International markets which act as toll roads or toll collectors. 2. Warren Buffet keeps trying to make us understand through his letters in 1979, 1991, & 2007 I think one of the biggest reasons for success, if any investor commits for 10-12 yrs e.g. Divis, has become a 300/400 bagger in the past 20 yrs Pi Industries has also become a 500 bagger in the past 2 decades What is the reason? Warren buffet tells us repeatedly that "The best business to own is the one that can keep deploying incremental capital at high rates of return." Let's understand what this means.
Our channel's name is School of Intrinsic Compounding, you'll understand the meaning of Intrinsic Compounding. Let's suppose that you've invest Rs.100 to set up a shop or invest Rs.100 as capital in a shop You earn Rs. 30 on investing Rs. 100 Your ROC is ~30% next yr, you'll have the option to take the capital out as salary or reinvest it in the same business because of the size of opportunity If you reinvest in the business, then the business has Reinterment moats Divis, Pi Industries, & Bajaj Finance have reinvestment moats angles Castrol on the other hand, Yes, I may earn Rs. 70-80 from the shop but I cannot re-deploy this Rs. 70-80 elsewhere I won't be able to invest in another avenue This is how businesses like Castrol become like govt. bonds
where the investor only invests for the dividend yield & hardly any tailwinds come after 10-11 yrs, that too, very less. If you're invested in the Indian Market, the nature of it is the growth market You have to take advantage of this growth & there's no other way about it. Similarly, when we talk about the modern world the reason we're lucky is because new types of businesses have been invented These businesses are called Asset Light Compounders Now, shops are being established that don't require Assets CDSL is such an e.g. Warren Buffet in his 2007 letter, has given an e.g.
he explains businesses as great, good & gruesome businesses These 3 businesses are like a bank account Great business will have high interest rate if your money is in the bank Gruesome business will have low interest, inflation (expense) will kill it soon, because the rate of commodities keep increasing Our parents frequently tell us that they could do a lot of things in just 25 or 50 paise Now they say that even Rs. 1,000/2,000 is less to afford much In Gruesome businesses, the inflation itself will eat up the interest rate Good businesses are those where ~15-20% of ROCE will come a Great business is where, e.g. Warren Buffet had invested in a business called See's Candy, at the time he'd invested, only $8 million had been invested as capital employed in the business.
Fast forward to 2006, his 1st investment was in 1979/86 by 2006, $40 million of capital was employed $38 million capital was added upon investing this amount of capital, the business earned return incrementally Warren Buffet's incremental return on invested capital for See's Candy was ~240% the business didn't need the capital but the return was a lot. These are Asset Light Compounders See's Candy, in the U.S.A, had a problem that the consumption of candy or chocolate only increases by 0.5-1% The market is slow growing but when we'll discuss CDSl, CDSL is like the See's Candy of the capital markets it's like a candy business for capital markets The growth of the depositories is ~12-14% CAGR I don't have to reinvest a lot of capital here & secondly there's 12-14% growth here This is truly an Asset Light Compounder Let's understand why we need depositories in the 1st place.
The Value Proposition of these Depositories we'll also discuss the industry structure how many depositories exist & why there are only 2 in the country Let's first discuss the Value Proposition of Depositories. Looking at the evolution of the capital markets, there used to be the Ring Trading System a.k.a. Open Outery System I think you all must've seen Harshad Mehta's show, where the ring trading system was depicted how individuals were interacting with each other, sometimes there were arguments & fights at the time, they had a paper-based system not electronic system After which, Screen Based Trading System was introduced Nowadays, we have Mobile Based Trading System There's some shift towards AI, which I think is difficult/complicated.
Now, the market is moving towards using electronic mediums An interesting thing that happened due to usage of paper was, until 1995-96, some problems occurred 1. Risk of Fraud due to usage of paper 2. Late deliveries, due to usage of papers at times, the delivery wouldn't even occur.
Imagine, you're using any brokering app & purchasing a stock then you find out that it'll be delivered after 30 days into your demat acc. or depository participant (DP) If the delivery is this late, then people will lose trust in the system As the Indian capital markets evolved, SEBI introduced a law in 1999, which enabled legal creation of depositories We have 2 depositories: NSDL & CDSL What do depositories do? Let's take an e.g. of a bank account A bank account electronically stores your funds Similarly, a depository stores all your securities in an electronic form & facilitates any settlements electronically your securities can be debentures, bonds, ETFs, units of mutual funds, you can even store the govt. securities in these depositories When we look at the depositories' value proposition, There are 3 key participants 1. Depository:
a. NSDL: National Securities Depository Limited, this is promoted by the National Stock Exchange (NSE) b. CDSL, estb in 1999 this promoted by Bombay Stock Exchange (BSE) 2. We have the Depository Participants in the middle these are all your brokers or clearing corporation or NBFCs The brokers include: Zerodha, HDFC Securities, ICICI Securities, Groww app, etc.
3. Beneficiary Owners An interesting thing to note is, who are these Beneficiary Owners? These are Retail Investors like yourself and us. Beneficiary Participants like Zerodha, Groww app, etc. These facilitate your trade in stocks to settle into your depository Your depository is like a tijori (locker/vault) where all your securities are safely stored. If you want to under the Value Proposition, understand the depository as your tijori (locker/vault).
All the brokers are its beneficiary participants You might ask why you're called Beneficiary Owners? In the older physical shares, in the company books, your name would be registered owners Now, the NSDL & CDSl are the registered company owners & you are these stocks' beneficiary owners. This is the ongoing trend. An interesting thing to note, if we understand the entire system how does settlement, etc. occur? In the 1st process, suppose we have a seller, if the seller decides to sell, & the depository participant e.g. Zerodha
in the 1st step, the DP of seller will transfer the share to the BO account, which goes to the Clearing Member CDSL receives this order 2nd step: Pay-in of Securities your stocks move from Clearing Members to Pool Account of Sellers to the Clearing Corporation As we can see here, the CC of stock exchange (Clearing Corporation) to the stock exchange & the Clearing Bank Similarly, if you've sold, there must be a buyer. 3rd step: Payout of Securities if someone's sold a stock, then someone must be buying also Similarly, since the stocks commonly remain within the NDSL & CDSL the securities moves from CC (Clearing Corporation) to CM (Clearing Member). It moves to the buyer's DP: Depository Participant In the 4th step: the buyer receives the delivery instructions from its DP Throughout the process, CDSL & NSDL provide the necessary infrastructure to hold securities in an electronic form & to transfer them between accounts in a depository. It is like a digital infrastructure, it is sort of a tijori (locker/vault) please keep this in mind An interesting thing that's occurring is If we look at the global scenario, suppose Australia, Germany & Canada, these countries also have only 1 depository these depositories are run by their stock exchanges Similarly, India also has only 2 depositories which are operated by both stock exchanges (NSE & BSE). What is the Entry Barrier in the industry? There are 5 Sources of Key Entry Barriers. Let's understand the 1st Entry Barrier in detail.
1. Licence Cost & requirement of net-worth You need to have a net-worth of Rs. 100 cr to open a depository, few people can come up with this amount so the 1st was Licence Cost.
2. Switching Cost & Exit Barriers Suppose you're Zerodha & you've been growing with CDSL for a long time, you won't be able to easily switch the amount of critical data because your business will experience a disruption this is an element of Switching Cost Along with Switching Cost, there's also the element of Exit Barriers, which also exists in the CDMO & CRAMS business Similarly, the depositories have in-built Exit Barriers You won't be able to easily Switch your depository 4. High Operating Leverage There is a lot of fixed cost within this business 2 Sources of Fixed Cost: 1. Employee cost: all the employees I've hired. 2. Expenditure/investment in the IT systems
These are the 2 sources of Fixed Cost, This is a High Operating Leverage business If someone wants to compete with me in this business, they'll have to remain a loss making business for yrs while they win customers. Since the Fixed Cost is high, after a point, they will be profitable until then they'll have to remain a loss-making business 5. Regulation Interestingly in 2017-18, SEBI removed a competition regulation allowing other people to open a depository but surprisingly, others aren't opening up depositories because there are Exit Barriers in the business This is called a MOAT Attack this means that competitive advantage was attacked but nothing actually happened This is how we know that there's a lot of Competitive Advantage in the business If anyone wants to understand how to observe industry structures or how to analyse an industry, & how we find competitive advantage in different industry structures? how we observe industry growth rates, how to use the different tools of research? how to read Annual Reports, Con-calls, etc.
All of this is part of the SOIC Membership. We're also going to introduce SOIC Deep Dives which will be a part of the SOIC Continuous Classes. We've recently shared a detailed Checklist in our SOIC Continuous Classes, which consists of 8-9 pages. We believe that if any retail investor follows this Checklist, 90% of the time, Warren Buffet's 2 Rules of Investing "1: Don't lose money & 2: Don't forget rule no. 1." will be easily followed/adhered to.
if you invest on the basis of the Checklist, at least your capital won't be lost We're going to introduce SOIC Deep Dives, within this, we'll Deep Dive in 1 sector. Starting with the Insurance sector in August We'll also Deep Dive into a business. After the Insurance Sector, we'll analyse an Agro-Chemical business that not many are aware of. This will be a detailed Deep Dive. If anyone is interested in the Membership, the link is in the description below. Coming back to CDSL Let's see how CDSL earns money? How does it earn revenue? CDSL has different sources of revenue.
1. Annual Issuer Charges their revenue for the FY13 is ~INR 39 cr. whereas their revenue in FY21 is ~INR 86 cr. It is basically like a custodial fee. Suppose a company is listed, e.g., if Laurus Labs is listed, the for every portfolio holder, Laurus Labs has to pay a custodial fee, if Laurus Labs has 3/4 lakh retail investors or portfolios it has to pay a custodial fee for these portfolio holders.
What is this custodial fee? Until 2005, there no such concept of a custodial fee CDSL & NSDL spoke to SEBI, SEBI introduced a custodial fee at a Flat Slab In 2009, they charged ~Rs. 5 per folio but in 2014, this increased to ~Rs. 11 per folio Listed companies pay custodial fee of Rs. 11 per folio this amount hasn't increased since 2015, There is an optionality that it could increase. As we'd seen in the IRCTC's case, it's a business where, if you want to travel by train IRCTC remains with us from the beginning of our journey until the end.
Similarly is a company wants to become listed, so from the beginning of its journey until the end if it gets delisted, becomes bankrupt, etc., until then CDSL & NSDL remain with the company. This is a toll tax on someone else's growth. This is the toll tax on the Indian capital markets because the participation of retail investors is increasing If we look at the volume of daily transactions on NSE, they are growing at a CAGR of ~22% & there's ~40% participation of retail investors. This is a megatrend in the making, where retail investors are becoming increasingly independent in their decision making.
This is an extremely interesting trend. Related to this, when we discuss the companies, suppose when Laurus Labs's IPO was available in 2015-16, Like we'd discussed in the IRCTC video, you can use its app to book your tickets, etc. Similarly if Laurus Labs wants to get listed in the stock exchanges, they'll have to pay the IPO Charges to the corporates when IPO is allocated, they pay ~Rs. 10 per folio. so it's Rs. 10 from the beginning of their IPO allocation Another charge, Corporate Action Charges are also levied, Whenever a company splits, issues bonus shares, these are called Corporate Actions Even for these CDSL & NSDL levy some charges Similar to how IRCTC is with passengers during their journey, CDSL is also present for the companies during their listed journey Another interesting trend is The trend of E-Voting, & E-AGMs You can use your phone apps to vote Looking at their revenues from the IPO & Corporate Action Charges From Rs. 4.9 cr. it has increased to Rs. 34.5 cr. in the past 8 yrs.
These charges have been increasing over the yrs The Annual Issuer Charges are Annuity in nature i.e., these are high recurring revenues (recurring in nature). There's a cyclicality element to the IPO Transaction Charges depending on the no. of IPOs in the market 3. Transaction Charges These have increased from Rs. 22 cr. to Rs. 120 cr.
The market is linked to this. In Transaction Charges, the DP charges are levied on the basis of whenever there's a Debit Transaction In CDSL & NSDL case, they charge roughly Rs. 5 per Debit Transaction Suppose you had 1k shares of a company, if you sell it Rs. 5 will be levied as a Debit Transaction with the DP These are called Transaction Charges.
These are also linked to the market. The amount of buying & selling depends on the environment of the market Is it a Bull or Bear Market? If I remove the markets, as the participation of the retail investors is increasing, Gradually we're able to observe this acting as a Structural Trend in the long-term This is another source of revenue that's growing structurally in the past 8-9 yrs. 4. Another source of revenue that falls under the 'Others' category We've spoken about E-AGMs, many companies are hosting electronic AGMs, because offline isn't possible a.t.m. There are ~5,635 companies that avail CDSL's E-Voting services An interesting thing to note in the Annual Issuer Charges, both businesses have the Optionality that there are ~80-85k companies whose shares haven't dematerialised yet.
Dematerialised, haven't converted to digital format- still existing in physical form. There are several pvt. companies in these ~80-85 companies & lots of start-ups Slowly their shares are also dematerialising In FY21, CDSL had ~1650 companies whose unlisted shares have been dematerialised This is also part of the Annual Issuer Charges & is an interesting trend. Let's do a P2P Comparison between CDSL & NSDL Looking at the Incremental Market Share.
In CDSL, incrementally new accounts are being opened, it has a market share of ~78% in 2020 which at a time used to be ~39 or 55% CDSL's market share has increased in 13 yrs, from 23% to ~54% in 2020 There are 4-5 major reasons behind this. 1. CDSL is a proxy on the growth of companies like Zerodha because Zerodha is exclusively working with CDSL. Zerodha is the DP, it's using CDSL's depository to provide services to its BO Fintech companies like Angel Broking or Zerodha, are working more with CDSL than NSDL.
For some reasons: a. NSDL has on-premise servers you'll have to install severes on your premises. Whereas CDSL's servers are centralised, it's like plug-and-play, You won't have to install it within your premises.
2. If you open an account with CDSL, you need ~Rs. 50 lakhs whereas, NSDL requires Rs. 1 cr. to be deposited 3. CDSL offers Tariff Based slab to its clients whereas, NSDL offers a Fixed-Rate Structure 4. due to which CDSL is receiving more market growth is,
A min. net requirement for an account by DP, or broker at CDSL is Rs. 2 cr. whereas with NSDL, it is ~Rs. 3 cr. This is why, when we look at the no. of active accounts with CDSL & NSDL CDSL is growing at a rate of ~18% CAGR, it's the 1st depository which has had more than 3 cr. accounts opened. NSDL doesn't have this, because it's targeting institutional clients & bank-based brokers This was their comparison. At this time, CDSL is incrementally gaining market share from NSDL Samit Vartak, the CIO of SageOne says I have tremendous respect for him because I find his philosophy very intriguing "Be the disruptor and not the one who is disrupted.
Look for companies which are gaining market share." The company that's able to gain market share will be able to gain earnings growth This is what is happening in CDSL's case. Another interesting thing to note is, in their con-call of Q2FY18, the MD of CDSL said (who's now changed) CDSL should be seen as a company that's providing a platform for large-scale databases & large-scale digitisation and that could be any industry & not just confined to capital markets An interesting trend emerged here, CDSL doesn't consider itself as an infrastructure for capital markets It considers itself as an infrastructure for many industries Riding the trend of digitisation & becoming a digital locker. in 2015-16, let's consider its revenue from subsidiaries, it's hardly ~18% In 2020, the revenue from subsidiaries is ~20% They have 3 subsidiaries: 1. CDSL Ventures Limited
2. CDSL Insurance Repository Limited 3. CDSL Commodity Repository Limited 1. The CDSL Ventures Limited is the 1st & largest KYC registration agency They have ~2.16 cr. records what's interesting here is, if a broker wants to open someone's account, 85% of revenue from this business for CDSL comes through Fetch this means that if someone's KYC is completed, CDSL has their KYC record They'll get 85% revenue because the broker is fetching your KYC from CDSL's record remaining 15% of the revenue comes from new individuals complete their KYC & CDSL has their record These are 2 sources of revenue.
A good thing is, this is library business i.e., the larger the library I have, the better the business There is some sort of economies of scale as the data increases, the KYC of individuals the more competitive advantage I have because anyone can easily fetch their KYC from me. this is their 1st subsidiary business. Their revenues from Other businesses is their business has grown from ~Rs.13 cr. to ~Rs. 48.3 cr.
In the Online Data Charges, their business has grown from Rs. 11.6 cr. to Rs. 56 cr. In their 2nd business, of Insurance, we can interestingly observe that. They had begun as an Insurance Repository, they're trying to dematerialise the physical copies of insurance they're also working with different insurance companies They have ~5.5 lakh E-Insurance accounts This is a huge optionality that can play out. It isn't yet mandatory to dematerialise the insurance in the future, this might become mandatory.
3rd business: Commodity Repository What's interesting is that if a trader or farmer would pledge his goods for loans they'd stored their goods in a warehouse The Warehouse would issue a physical receipt Ever since CDSL has entered the scene, the Value Proposition is, they'll dematerialise the physical receipt & make it electronic If a bank has to issue a loan against those pledged goods, this electronic receipt would be helpful for the banks especially since the transactions were bilateral between farmers & banks with the physical receipts, there's a risk of frauds. This would bring about transparency in the system The warehouse would have records of the generated receipts, the farmer would have proof of their pledged goods at the warehouse, the bank would also have a good transparent proof & the receipt can be used to invoke pledge This is their 3rd Value Proposition. CDSL's sales from Subsidiaries is ~30% This is an ultimate Optionality business, if it actually becomes a digital infrastructure of sorts, or a tijori (locker/vault) of many different industries Multiple Optionalities can play out within CDSL. Let's consider some more Sources of Optionalities. 1. Pledging Platform (already playing out) Shares will be formally pledged with the likes of CDSL & NSDL & they'll charge a small fee.
SEBI has recently changed the Pledging Norms, shares are now being formally pledged with CDSL & NSDL. They send an OTP, on which they're also earning a fee. They'd received revenue of ~Rs. 2.7 cr. this is also gradually increasing, but it's difficult to say how much it would increase to 2. Dematerialisation of the shares of unlisted companies The shares of 80-85k unlisted companies can dematerialise. 3. Insurance: as we've discussed that
if the dematerialisation of insurance does become mandatory, it can become a very interesting play 4. National Academic Records can also become dematerialised this is also an interesting source of Optionality However, govt's launched an app 'DigiLocker' it's also solving the problem to some extent, but the depositories can also play a role in fetching data 5 .Single Demat account can be created a uniform Demat account can be created where all your financial assets can be stored Your Mutual Fund Units can be stored in the depositories, instead of storing with the RTAs This is another Source of Optionality These are the different Sources of Optionalities that can play out Let's discuss the Key Source Mental Model of the Operating Leverage.
We'll also discuss the Valuations. We'll 1st discuss the Key Sources of Operating Leverage. Operating Leverage is when after an extent, my fixed cost become fixed the sales growth flows down to my Operating Profits my margin expands bcz, my 1 source of cost is fixed cost CDSL has 2 biggest Sources of Cost 1. IT Cost & 2. Employee Cost
Employee Cost as % of sales: Whenever the sales grow, this cost as % decreases this is known as Power of Operating Leverage. Their revenues have grown from ~40-50% from FY20 to FY21 I think by ~30-40% We can see that as % of Sales, employee & other expenses have decreased from 60% to 38% whereas, the Operating Profit Margin Expansion has increased from 40% to 62% this is known as the Ultimate Operating Leverage Business When the sales fall, their employee & other expenses increase The operating also gets deleveraged in these businesses Such businesses, similar to when we'd discussed Saregama, Tips Industries, Vaibhav Global, IEX, etc. We include these businesses in SOIC's Bucket 1 these businesses should rec a higher valuation because these are higher quality businesses because the EBITDA's Free Cash Flow conversation is a lot I'm not talking about talking about EBITDA to Operating Cash Flow EBITDA: A business' Earnings Before Interest, Taxes, Depreciation & Amortisation A business' Operating Profit, without expenses s.a. Taxes, Interest, Depreciation, A business' true Operating Profit which is all, almost converting to Free Cash Flow in such types of businesses There will be 2 types of investors in such businesses 1. A long-term investor, who thinks that an SIP can be done in this business because there's a multi-decade runway for opportunity in this business I think, the Indian Capital Markets have ~1-1.5% Financial Savings
Imagine if this Savings increases to even 6-7% & there are chances for this increase because there's no alternative for investors at the moment RBI's Repo Rate is at 4% SBI's FD rate is ~4.5-5% People will have to come to the Stock Market. This Source of Optionality can play out here, as a Multi-Decadal Runway for Opportunity. 2nd type of investor: This is a Shallow-Cyclical business There are 3 Types of Industries: 1. Deep Cyclical 2. Shallow Cyclical
3. Structural I think that CDSL is a Shallow Cyclical business This means that for some yrs their revenues will grow rapidly, because their revenues ~30-40% are linked to the markets If we consider the Trans action & IPO Charges, ~35-40% revenues are linked to the market movements depending on how many IPOs are coming about & no. of transaction occurring There can a little Volatility in these sources of revenue We call such businesses Shallow Cyclical, when there is a down-turn because in the Equity Markets, there can't be Bull Market for eternity When there are down-turns in such markets, such businesses typically give a good opportunity for investors to accumulate As we've seen in BKT, when down-turn occurred some brokerages had announced Rs. 300-350 price targets
Today this business is for Rs. 2,200-2,300 Many investors & brokers forget that Shallow Cyclicality is the nature of a business 2nd Type of Investors could think in such a way Actually both types of investors are right in their own way the 1st investor believes in longevity period who believes Shallow Cyclicality is a Structural trend that'll get covered in 10-20 yrs 2nd type of investor would want to get a company at a bargain Do let me know in the comments section how you found this video. Please let me know which company you'd like us to analyse next: 1. A hidden IT company, I won't tell you its name,
2. LTTS 3. A book review of Psychology of Money by Morgan Housel Do let me know in the comments section.
I'd appreciate constructive feedback for this video. Thank you for joining us! I hope to see you in the next session of SOIC.