CDSL Stock Rise: Is The Optimism Misplaced?

Central Depository Services Limited’s (CDSL’s) stock has given its investors a return of almost six times over a period of one year. The meteoric rise of CDSL’s stock stems from the rapid increase in the number of investors wanting to invest in the Indian markets.

The shares of its sponsor, Bombay Stock Exchange (BSE), which owns 20 per cent of CDSL, have almost tripled during the same period. CDSL serves as an entity that holds financial securities in a dematerialised form.

The optimism around CDSL is evident from its valuations — the stock trades at almost 40 times the sales for the year 2021. These valuations are similar to Zomato’s.

Nevertheless, some facts show that investor optimism around the stock might be misplaced.

Is The Growth Sustainable?

The Indian markets have attracted hordes of retail investors in recent years. With low interest rates and high liquidity, global and Indian markets have been on a roll over the past one year, despite the debilitating impact of the Coivd-19 pandemic. Quite surprisingly, most new investors entered the markets right in the middle of the pandemic.

A simple Google Trends analysis shows that searches for phrases like, “How to buy shares”, “Zerodha”, “How to open a demat account” reached their highest levels in March, during the beginning of the lockdown.

CDSL’s data shows that it crossed the 3 crore accounts benchmark in January 2021 and reached 4 crore accounts by July, a 33 per cent increase in just seven months. To put this into perspective, the company used to add 10-30 lakh accounts each year during the 2014 to 2019 period, and even lesser during the bear market phase before 2014. The high growth rates are a recent phenomenon in the industry.

Dependence On Stock Markets

The current increase in accounts has coincided with a rapid increase in stock prices, implying that if the market performs badly, the company might see lower growth or possibly negative growth.

For the quarter ended in June 2021, the company reported revenues of Rs 117 crore, an 80 per cent jump over the same quarter in the previous fiscal. The company derives a majority of its revenue through transaction-based charges and annual account charges. During a bear market, both trading volumes and new account additions are likely to be much lower, resulting in lower revenues for CDSL.

The previous bull-market that ended in 2008 saw many demat accounts becoming idle and trading volumes fall drastically. For the period 2010 to 2014, CDSL’s revenue from operations fell from Rs 81 crore in 2010 to Rs 75 crore in 2014 due to low market activity. In the current scenario, it is unlikely that CDSL’s stock could sustain at these levels if its earnings keep falling for three years straight.

Investors should also remember that its earnings are dependent on the rates Securities and Exchange Board of India (SEBI) sets. The company has no pricing power of its own. Given its fixed costs, any fall in earnings could compress CDSL’s margins.

Diversification Hurdles

In order to lower its dependence on the markets, the company has tried diversifying into insurance repository services, commodity repository services, academic repository services and bullion repository services. But these businesses are yet to contribute to the company’s earnings substantially. The company is still dependent on its financial depository business to make money.

Unlike other companies, the highly-regulated nature of the business makes it difficult for CDSL to step beyond the depository business and grow its earnings. However, National Securities Depository Limited (NDSL), CDSL’s only competitor, has stepped into banking, with a payments bank licence. So far, CDSL has not shown any inclination to enter similar businesses.

Excess Cash

As of March 2021, the company had more than Rs 700 crore of liquid assets (cash plus current investments) on its balance sheet. In contrast, the company has only Rs 77 crore worth of plant, property and equipment listed on its balance sheet.

Quite visibly, the company does not need to reinvest much cash into its business. A low capital-expenditure requirement implies that the company’s cash keep piling up in its bank account. Usually companies reinvest their cash into the core business, but given its low capital requirements, reinvestment is not an option for CDSL.

Similarly, CDSL also cannot grow inorganically, though acquisitions, because it operates in a highly-regulated sector where it is bound by SEBI’s regulations.

Logically, with these limitations, the company should pay out cash to its investors, rather than holding on to the cash indefinitely. However, CDSL has not paid out the cash reserves to its investors. So far, the management has cited regulatory needs and the need for a strong financial position to attract more players on the platform.

But the management’s reasons for not distributing cash reserves might not be limited to regulatory needs.

A Principal-Agent Problem?

CDSL might have a principal-agent problem in paying out cash reserves. During a conference call in January 2019, CDSL’s ex-managing director and chief executive officer, P S Reddy indicated that the management is not open to paying out dividends as it would lower the company’s interest income.

“So, and if you see our income depends on a market. 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.”

The last statement indicates that management and shareholder incentives might be clashing in CDSL’s case.

Let’s understand this in greater detail. The company has deployed its cash reserves in interest-bearing instruments. Interest income forms almost 15 to 20 per cent of CDSL’s total income. Interest income drops straight into the bottom line, as there are no costs associated with such income, thus boosting margins. Hence, interest income plays an important role in CDSL’s finances, especially during rough periods. Thus, the management might be reluctant to pay out cash.

In contrast, from the investors’ perspective, the company has been deploying cash into instruments that pay interest at a rate of 6-8 per cent. Since CDSL is unable to find other high-return opportunities, the low return on surplus cash has been depressing the return ratios of the company. If the company pays out the cash through dividends or buy-backs, investors can deploy cash into riskier investments and generate higher returns for themselves.

Though investors have been pushing for higher cash distribution, the company still continues to hold high cash reserves.

High Valuations

CDSL trades at almost 40 times its financial year 2021 (FY21) sales and almost at 63 times its FY21 net profits. Investors should also remember that FY21 might be an anomaly year as the company has not recorded such a huge jump in earnings in the last 10 years. If compared to FY20 figures, CDSL trades at almost 56 times its FY21 sales.

For most investors, the most attractive aspect of CDSL’s business is its recurring earnings, low capital requirements, strong cash flows and huge cash balance. However, the company is dependent on the markets for its earnings to grow. And even if the earnings continue growing, they must grow at a pace that would justify the current valuations.

Further, if the company does not pay out cash or deploy cash in high-return opportunities, an investment thesis focusing on the strong cash flows and asset-light model would require revision. While CDSL continues to be an excellent business, investors should be wary of its current valuations and focus on the management’s capital allocation strategy.