Central Depository Services (India) Ltd (CDSL) Why invest in it Duopoly, Strong Entry Barriers, Robust Growth Potential, Stable Income, Multiple sources of income, Unmatched Profit Margins A business that will keep on growing, keep on piling profits! The Growth Drivers The more people invest in financial assets, the more will be the growth of CDSL. Currently, a staggering 95 per cent savings of an average Indian household comprises physical assets, with the remaining being in the form of financial products. India has one of the lowest savings in financial assets but that is now rising fast and has massive growth potential. Household financial savings in shares and debentures increased to 0.7% of GDP in fiscal year ended 2016, from 0.4% in fiscal 2014 – a rise of 75%! Demonetization, tax drive, and digitalization gave an unprecedented boost to shift of savings from cash, gold, and land to financial assets. Depositories in India are expected to benefit in the future from rising capital market participation, digitalization, value-added service offerings and SEBI initiatives relating to investor education, promotion of financial literacy and regulatory measures. The Growth Enablers Growth opportunities can be tapped only if the company has requisite strengths. CDSL’s capabilities need no analysis, it has been in this business since 1999 and is steadily growing in revenue as well as in profit. CDSL is in an enviable pure duopoly situation enjoying a massive 43% market share with a steady income from multiple sources, growing at a healthy 13% p.a. CDSL and NSDL will continue to rule the markets as it is simply impossible for any new entrant to overcome their extensive network, expertise, technology and brand image. And the Icing on the cake CDSL enjoys unmatched profit margins, its EBIDTA margin in 2017 was a staggering 54.4 %! It is because it has high economies of scale and steady growth in profitability resulting from fixed operating costs. Higher profit margins lead to more profits & growing reserves, which build financial muscle to grow in good times and survive in bad times. An unparalleled stock story, CDSL must be kept in every long term investor’s portfolio. Research Objectives The research should help an investor in answering the following key question that represents our investment philosophy for this portfolio – Will company’s revenue and profits be able to grow steadily for many more years? Stock Selection Criteria To answer the above question, we need to go through the following screening process – A. Initial screening data points: Debt in last three years: Zero Volume growth > GDP growth: Net growth in BO accounts was 13.68% from Fiscal 2016 to Fiscal 2017 Management stake: Promoters 24%, Institutions 50%, and Public 26% B. Checklist for main screening factors: # Section Is Ok? 1 The business ✔ 2 Market leadership ✔ 3 Entry barriers ✔ 4 Long term demand growth for its products ✔ 5 Profit margins and margin expansion ✔ 6 Forensic scrutiny ✔ 7 Innovation capabilities ✔ 8 Management quality ✔ 9 Management stability ✔ 10 Company culture ✔ 11 Valuations ✔ The rest of the report covers these points in detail. Introduction Depository Industry in India Following extensive discussions and consultations with stock exchanges, market participants and investor groups, SEBI released the Depositories and Participants Regulations, 1996, in May 1996 before legislating The Depositories Act in August that year. The Depositories Act, 1996 recommended multiple depository systems in order to accelerate scripless clearing and settlement. The existence of multiple depositories was recommended to encourage competition, which would resulting in economic benefits such as low services fees and better service to investors. The depository system in India is a Rs.2.4 billion industry, as of Fiscal 2016, which has grown at a CAGR of 12% over the last three Fiscals and comprises of two depositories, namely NSDL and CDSL. NSDL, established in 1996, was the first depository in India and was followed by the establishment of CDSL three years later in 1999 shortly following the implementation of compulsory trading in dematerialised securities for all investors in January, 1999. The presence of a multi depository system in India has resulted in a competitive scenario and helped to reduce transaction charges for investors. Historical factors of Depository Growth The growth of depositories in India is linked to growth in capital market transactions, and over the last two decades depositories have witnessed significant growth due to a number of factors as set out below Growth in transaction volumes of instruments in India Equity Market The Indian equity market has witnessed strong growth over the last two decades, resulting in the growth of depositories. Since the launch of the depository system in 1996, trading volumes on the NSE and BSE have increased significantly. In 1999, trading became compulsory in demat form for all investor types, acting as a catalyst for active participation of investors in Indian capital markets. This active participation was demonstrated with the increase in the number of shares traded on the BSE rising from 18.22 billion in Fiscal 2002, to 76.25 billion in Fiscal 2016, giving BSE a 24.7% share of total shares traded, while trading on the NSE increased from 27.84 billion shares to 220.18 billion shares in the same period, giving NSE a 74.2% share of total shares traded. As of March 31, 2016, there were 14.57 million and 10.79 million demat accounts, respectively, at NSDL and CDSL. The number of demat accounts with NSDL and CDSL grew at a CAGR of approximately 5% and 8% respectively. Furthermore, 15,638 companies had signed up for dematerialisation at NSDL while 10,021 companies had signed up for dematerialisation at CDSL. The number of companies available in demat form grew at a CAGR of approximately 12% for NSDL and 5% for CDSL. Debentures and bonds Aside from equity shares, the dematerialisation facility was also extended to instruments such as commercial papers and bonds. The number of active instruments and the dematerialised value of debentures/bonds increased at both depositories between Fiscal 2012 and Fiscal 2016 Mutual funds The Indian mutual fund industry remains one of the fastest growing and most competitive segments of the securities market. In Fiscal 2016, the net inflows to the industry were the most significant since Fiscal 2009, and the assets under management (“AUM”) were at an all-time high. This growth may be jointly attributed to a positive outlook in domestic markets, along with well-timed initiatives by the SEBI to re-energise the mutual funds industry The AUMs of the mutual funds industry grew by approximately Rs.6,456 billion during the last five years. The cumulative net assets of all mutual funds, as of March 31, 2016, was Rs.12,328.24 billion as compared to Rs.10,827.57 billion on March 31, 2015, representing an increase of 13.9%. Despite the eligibility of mutual funds units to be held in dematerialised form, some remain held in book entry form. The number of mutual funds held in dematerialised form is expected to increase over time resulting in higher revenues for depository companies. Adaptation of the multi-depository system led to faster growth The adoption of a multi depository system in India has led to competition between the CDSL and NSDL, which has resulted in the following advantages. Growth in the number of DPs Growth in the number of DPs implies there is a greater amount of business for the depositories. Therefore, every depository strives to grow its depository services across the country. The number of DPs has increased significantly over the last 15 years. CDSL witnessed a CAGR of approximately 10% between Fiscal 2001 and Fiscal 2016. India’s multi-depository system has a wide presence across the country, which has in turn helped investors to transact with DPs locally. As of October 31, 2016, there were approximately 26.7 million BO accounts in India. The number of BO accounts held by CDSL has grown at a CAGR of 8%, from 7.9 million in Fiscal 2012 to 11.6 million in Fiscal 2016, while that of NSDL has grown at 5% CAGR over the same period. Background & Operations: Central Depository Services (India) Ltd (CDSL) commenced its depository business in 1999 and was initially promoted by the BSE, which subsequently divested a part of its stake to leading Indian banks. CDSL offers services to depository participants and other capital market intermediaries, corporate, capital market intermediaries, insurance companies and others. It is the leading securities depository in India by incremental growth of Beneficial Owner (“BO”) accounts over the last three fiscals and by the total number of registered Depository Participants (“DPs”) It offers services to the following clients: Depository Participants and other capital market intermediaries: CDSL offers dematerialization for a wide range of securities including equity shares, preference shares, mutual fund units, debt instruments, government securities. As a securities depository, it facilitates holding of securities in electronic form and enable securities transactions (including off-market transfer and pledge) to be processed by book entry. The DPs act as its agent and offer depository services to the BO of the securities. The Registrar and Transfer Agents (“RTAs”) and Clearing Members (“CMs”) are the other intermediaries involved in the process of issue and transfer of securities on its electronic platform. Corporates: CDSL offer facilities to issuers to credit securities to a shareholder's or applicant's demat accounts to give effect to a range of non-cash corporate actions such as bonus issue, subdivision of holdings and conversion of securities in a merger, amalgamation or in an initial public offering. Capital market intermediaries: It offers KYC services in respect of investors in Indian capital markets to capital market intermediaries including to mutual funds. Insurance Companies: It offers facilities to allow holding of insurance policies in electronic form to the holders of these insurance policies of several insurance companies. Others: CDSL also offer other online services such as e-voting, e-Locker, National Academy Depository, easi (Electronic Access to Security Information), easiest (Electronic Access to Security Information and Execution of Secured Transaction) drafting and preparation of wills for succession (myeasiwill) mobile application (myeasi, m-voting) and Transactions using Secured Texting (TRUST). It also regularly conduct investor meetings and other awareness programs. CDSL’s revenue from operations includes transaction charges, account maintenance charges and settlement charges paid by DPs and annual fees, corporate action charges and e-voting charges paid by companies whose securities are admitted to its systems. It has connectivity with clearing corporations of all the leading Indian stock exchanges including the BSE, National Stock Exchange (“NSE”) and Metropolitan Stock Exchange of India. It has also entered into MoUs with depositories globally including with DTCC, JASDEC and Euroclear. Its revenue from operations includes transaction charges, account maintenance charges and settlement charges paid by DPs and annual fees, corporate action charges and e-voting charges paid by companies whose securities are admitted to CDSL’s systems. Market Leadership In terms of revenue, CDSL holds an approximate market share of 43% while NSDL’s market share is 57%. As of April 30, 2017, CDSL had: Over 12.4 million investor accounts. In Fiscal 2017, it held a 59% market share of incremental BO accounts with a net growth in BO accounts of 13.68% from Fiscal 2016 to Fiscal 2017. Over 253 billion securities of 9,934 issuers under its custody representing a total value of Rs.18.3 trillion. 589 registered DPs who had over 17,000 service centres across India. Over 15 million KYC records with a market share of approximately 67%. CDSL is satisfactorily providing its services for decades now and there are no unfulfilled needs of its clients. CDSL and NSDL will continue to rule this niche business segment. Number of BO Accounts In terms of market share of demat accounts, CDSL has been growing at a higher rate with a CAGR of 8%, compared with 5% for NSDL.CDSL has experienced a growth in market share from 39% in Fiscal 2011 to 43% in Fiscal 2016. Number of Incremental BO Accounts Furthermore, CDSL’s market share with respect to incremental demat accounts has been growing at a higher rate, with a CAGR of 28% (as opposed to NSDL’s 14% growth) from Fiscal 2011 to Fiscal 2016. Consequently, CDSL has gained in market share with respect to incremental demat accounts from 46% in Fiscal 2012 to 58% in Fiscal 2016. Entry Barriers Mentioned below are the factors that help CDSL to remain at top and detract competition (though there is just one competitor) Pure Duopoly & Strong Parentage CDSL and NSDL are the only two companies in this business. The industry has a strong entry barrier as each of the current depositories are promoted by each of the two major stock exchanges in India i.e. NSDL by NSE and CDSL by BSE. With strong parental lineage, these depositories have a clear advantage over any new entrant (if any). Extensive Network CDSL has tied up with 9,934 companies to issue their securities in demat form. It has 589 registered DPs who have over 17,000 service centres across India. It keeps over 15 million KYC records of investors. It is next to impossible for any new entrant to snatch away clients from CDSL/NSDL, both have decades of experience and are well entrenched. Once a depository gets an account, it becomes a lifelong source of income for it. Stable income, profits and rising reserves – Growing financial muscle to lead CDSL, along with its subsidiaries, has a stable revenue base due to repeat business from multiple streams in the Indian financial services. It collects fixed annual charges from registered companies and transaction-based fees from DPs which leads to stable income. It offers services to capital markets, mutual funds and insurance companies. Its clients include DPs, corporates, stock exchanges, clearing corporations, registrars and the investors. In addition to depository services, CDSL Ventures undertakes common Know Your Client (“KYC”) services for investors in the capital markets including to the mutual fund industry. It also provides facilities allowing holding of insurance policies in electronic form and enable policy holders to undertake changes, modifications and revisions to insurance policies. Its largely fixed operating costs result in high economies of scale. Its main costs are employee wages and post employee benefits and software development and maintenance costs. Its stable business and steady revenue growth has allowed CDSL to consistently pay dividends and build its reserves. A strong financial position is a big weapon in competition. Deep Domain Expertise and Systems Perfected over Two Decades Complex domain expertise evolves over a period of time and becomes a strong entry barrier. Management systems and people expertise becomes more efficient and cost effective. CDSL has a management team with extensive experience of capital markets. Senior members have an average work experience of over 25 years which will helps in strategic and business decisions. State of the art infrastructure CDSL has state-of-the-art IT systems. It has deployed its core depository system based on a centralised architecture providing real-time updated information to users. Its system can be accessed over the internet as well as the intranet though a secure channel using multi-factor user authentication. It has deployed state-of-the-art server hardware, enterprise flash storages and highly resilient network infrastructure. Long term demand growth for its products Retaining clients: (Growth enablers) Affordable and dependable services CDSL provides affordable depository services, offering convenience of selecting a DP close to them. It is directly connected to its DPs through its centralised database systems which ensure relatively low initial set up costs and minimal incremental costs. This allows DPs to offer depository services on a real-time basis to its investors at competitive prices. CDSL has contingency terminals to ensure DPs' access to information remains unaffected in case of technical disruptions at a particular DP location. It also provides internet access to DPs as a contingency measure. Moreover, it also provides BOs access to their respective accounts on the internet. It has developed expertise in handling large data volumes due to several years of experience of working with a large network of DPs across the country. Improve efficiency and service quality: CDSL aims to upgrade its IT infrastructure and systems to improve market efficiency and transparency, enhancing user access and providing flexibility for future business growth and market needs. It also plan to invest further in its IT and data management systems to improve productivity and time savings thereby increasing operating efficiency. Efforts by CDSL to Improve Future Growth (Growth drivers) Developing new DPs and leveraging existing DP network: India's demographic dividend with a large working age population and a low dependency ratio, increasing literacy and rising per capital income are likely to drive future growth of the Indian depositories. CDSL will leverage their extensive network all over India to take its offering to new investors. It aims to expand its network of DPs and service centres to better reach potential investors. CDSL currently expect that a significant portion of its new DP relationships will include DPs present in tier II and tier III cities. Introducing new services: It is planning to expand its NAD project to include more educational institutions in the future. It has also registered as a KYC Service Agency (“KSA”) & Authorised Service Agency (“ASA”) and as a KYC User Agency (“KUA”) & Authorised User Agency (“AUA”) with the UIDAI. Continue investor education initiatives to foster a rise in the number of potential new investors: CDSL will continue to focus on financial inclusion through retail participation. It conducted over 400 investor awareness programs in Fiscal 2017, allowing investors across geographies, professions and age groups to come together and learn about the advantages of holding securities in dematerialised form and the investment opportunities available to them. It plans to, and has initiated steps to, further these programs by targeting the general public in tier-2 and tier-3 cities in India to introduce and explain the benefits of investing in securities. It is and will continue to work with various regional newspapers to attract a large number of potential new investors to these events, where it intends to distribute informative booklets in English, Hindi and other regional languages. External Factors Supporting Future Growth (Growth drivers) Depositories in India are expected to benefit in the future from rising capital market participation, digitalization, value-added service offerings and SEBI initiatives relating to investor education, promotion of financial literacy and regulatory measures. Rising capital market participation India's inherent strengths, coupled with a concerted push from the government, have ensured that the country remains one of the world's fastest emerging economies. According to CRISIL, India's demographic dividend, growth in per capita income and savings, along with government initiatives will boost participation in the capital markets. Demographic dividend: India is at the peak of a demographic dividend, with a large working age population (15-64 years) and a low dependency ratio (proportion of children and elderly). According to a 2014 United Nations Population Fund's State of the World Population report, India had 356 million people in the 10-24 year age group, which is approximately 87 million more than in China. According to the 2011 Census, 62.5% of India's population falls within the working-age group of 15 to 59 years old. This larger working class is expected to increase the amount of investments, which may result in growth for depositaries. Growth in per capita income: India’s per capita income rose to Rs.93,293 in Fiscal 2016. In real terms, per capita income is estimated to have grown by 6.2% in Fiscal 2016, compared with 5.8% in the preceding Fiscal. However, gross national income was lower than GDP between Fiscal 2012 and Fiscal 2015. This buoyant trend in per capita income is expected to continue. In the short-to-medium term, disposable income is expected to rise as a result of: (i) the government’s implementation of the Seventh Pay Commission’s recommendations; (ii) the One Rank One Pension scheme; and (iii) sustained low inflation, which will enable greater domestic consumption. Improving literacy: Literacy in India, defined by Census of India as the ability to read and write in any language from the age of seven, was 74.07% in the 2011 Census, which represented an increase of 14% since 2001. The adult literacy rate among those aged 15 and above was 69.3%, which again represented an increase of 14% since 2001. The literacy rate in India has been steadily rising over the last three decades due to various initiatives such as Sarva Siksha Abhiyan, Mid-Day Meal Scheme and the Right to Education Act 2009, as well as increased spending on education by the central and state governments. Going forward, literacy rates are expected to improve further. New value-added service offerings: Indian depositories are expected to evolve and add newer services, such as those detailed below, which are expected to contribute to future growth. For example, record keeping is a significant challenge for investors, financial institutions and intermediaries. There is currently no common platform where an investor can access all the details of their investments. The concept of the provision of a single demat account for all financial assets was announced in the budget of Fiscal 2015. A single demat account is envisaged as a one-stop account for all financial investments including pension funds, fixed deposits, life insurance policies and public issues. It will bring all financial investments under one electronic platform, allowing intermediaries to attract other investors to mutual funds and equities more easily, as well as introducing uniformity to current know your customer processes. SEBI Investor Education and Financial Literary Initiatives: The SEBI intends to boost participation in the Indian capital markets by combining regulatory measures with both investor education and the promotion of financial literacy thorough various awareness initiatives, as described below. Investor awareness programmes and regional seminars The SEBI has organised over 1,350 investor education programmes, in collaboration with exchanges, depositories and various trade bodies such as investors’ associations, widening its reach over the years. The SEBI also seeks to create awareness through regional investor education seminars. This initiative conducts workshops led by specially trained lecturers who provide investors with useful information related to the securities market. These seminars are attended by the SEBI and trade bodies’ officials from various levels. These seminars are conducted across the country, focussing on tier-2 and tier-3 cities. Over 260 programmes have been conducted since the beginning of the initiative in Fiscal 2012. Mass media campaign: The SEBI has broadcast important messages to investors through television, radio, print media and bulk SMSs. These messages are intended to educate people about the SEBI’s grievance redress mechanism, the SEBI complaints redress system (“SCORES”) and toll-free helpline. The SEBI's main aim is to caution investors about schemes seeking to mobilise capital for speculative purposes by offering unrealistic returns. It also urges investors to avoid relying on hearsay when investing and instead carry out proper due diligence. High Profit Margins & Margin Expansion CDSL enjoys high economies of scale and steady growth in profitability resulting from fixed operating costs (employee wages, post employee benefits, software development and maintenance costs). This leads to very high profit margins. Its EBIDTA margin in 2017 was a staggering 54.4 %! CDSL is able to expand its margin by improving efficiency and scale of economies. Forensic scrutiny Company’s auditors are DELOITTE HASKINS & SELLS. Details of legal issues - One minor outstanding criminal litigation Company One minor outstanding civil litigation involving Company There are no actions by statutory or regulatory authorities, Tax proceedings involving our Company 8 Direct tax cases involving Rs 11.99 4 Indirect tax (service tax) cases involving Rs 398.44 No pending proceedings initiated against our Company for economic offences There are no pending proceedings initiated against Company for economic offences. No fines imposed or compounding of offences under the Companies Act in the last five years There are no instances of non-payment of statutory dues There have been no material frauds committed against Company in the last five years. There have been no inquiries, inspections or investigations initiated or conducted under the Companies Act in the last five years No outstanding litigation against Company or any other persons or companies whose outcome could have an adverse effect on Company There are 5 outstanding criminal litigation involving promoter, none is significant There are 9 outstanding civil litigation involving promoter, none is significant There have been 6 actions by statutory or regulatory authorities against Promoter, none is significant There have been no inquiries, inspections or investigations initiated or conducted under the Companies Act in the last five years regarding promoter Innovation capabilities Even though it has a huge market share, comfortable growth, and faces no big competition threat, but still CDSL strives for innovative growth. Some of its efforts are mentioned below. CDSL has taken a new initiative to digitise school and college records. It already has 54 university tie-ups and by the end of the year, it hopes to have 800-900 universities on board. From this academic year, the site is fully functional and universities, colleges and schools will have the option of uploading their students' mark sheets, transfer, learning certificates and other documents directly to the portal. CDSL has also recently been in partnership with some global data repositories. It has teamed with them on many fronts like technology, fraud and risk management, capital markets assessment. Awards for innovation CDSL has received several awards and accolades over the years including the following recent awards: 2016 “BFSI Tech Maestros Award” in the IT leadership category “Dell-EMC Transformers Award” for security transformation “BFSI IT Leadership Award” in the IT leadership category 2015 “EMC Transformers Award” in the best use of IT to transform business category “IDG’s CIO100 Award” for enterprise IT excellence “NetApp Innovation Award” for Enterprise Mobility 2014 “IDC Insights Award” in the CIO category, awarded by the International Data Corporation “EMC Transformers Award” in the best use of IT to transform business category Management Mr. Padala Subbi Reddy is the MD & CEO. He has been on CDSL’s Board since March 6, 2009. He completed his bachelors in arts (economics) from Andhra University and a master’s degree in arts (economics) from University of Hyderabad. Prior to joining CDSL, he was associated with BSE as Chief GM of surveillance and inspection. He is also a member of various committees of SEBI including the Secondary Market Advisory Committee and Corporate Bond and Securitization Advisory Committee. He is also a member of the National Council for Capital Markets of Confederation of Indian Industry and the Associated Chambers of Commerce and Industry of India. Mr. Bharat Sheth is the Executive VP and CFO. He completed his bachelor’s in science from Mumbai University. He is a qualified chartered accountant from the ICAI. He has been associated with CDSL Company since May 27, 1998. Prior to joining CDSL, he was associated with Shepan Consultant Private Limited as a designated director. He has over 25 years of experience as a statutory auditor, share accountant and co‐manager or registrar to public issues, registrar and transfer agents to issuers. Joydeep Dutta is the ED and Group Chief Technology Officer. He completed hisn bachelor in electrical engineering from University of Kolkata and masters in electrical engineering and computer science from Tuskegee University, USA and Drexel University, USA, respectively. He has been associated with CDSL since July 7, 2014. Prior to joining CDSL, he was associated with various ICICI Bank group companies in India and multi‐national companies in United States. He has over 34 years of diverse work experience in India and US in industries in both management consultancy and company executive roles. Management stability CDSL works to retain talent. Its HR philosophy as given on its site is mentioned below - “CDSL is a dynamic and vibrant organization with an enthusiastic team determined to accomplish CDSL's mission of providing world-class depository services. We believe that the ultimate identity and success of CDSL will reside in the exceptional quality of our people and their efforts. For this reason, we are committed to hiring, developing, and retaining the best people in our industry. “ Company culture CDSL has a professional work culture. It aims on staying ahead by building its people talent. IT team forms the biggest segment and training is an ongoing phenomena. “We provide training on a range of topics including our products and services, market developments in India, ethical and responsible conduct, health and safety in the workplace, technical and language skills, leadership and interpersonal effectiveness and career development. We utilise in-house resources as well as external resources, such as various public seminars and conferences for training purposes. We have also conducted comprehensive five-day training programs for DPs on training and compliance and satellite-based special training programs for professionals including compliance officers and auditors.” Valuations The only peer of CDSL is NSDL, which is unlisted. At CMP of Rs 286, it is trading at a PE of 28.8. We recommend investing because of its duopoly, non-cyclical nature, high profitability, and robust growth potential. Recommendation Accumulate CDSL on dips below 270 for 2-3 years of horizon with return expectation of about 30% p.a.