A value look at Netsol Technologies Inc (NTWK)

Overview

Nanocap stock of mediocre software business, currently traded at attractive price with small debt and good cash reserves.

Business

To ensure I understand a business (or at least that I don't miss key parts) I like to use an approach described by Kenneth Jeffrey Marshall in his "Good Stocks Cheap" book.

The idea is to define understanding statement - one sentence that describes a business.

Here is my understanding statement for NetSol Technologies, Inc.

The company is a small slowly expanding financial software provider for auto manufacturers and regional banks primary operating in Asia Pacific region.

The six aspects accounted for the statement are covered below.

Product

The company develops and supports financial software applications.

From 10-K report:

The Company’s primary source of revenue is the licensing, customization, enhancement and maintenance of its suite of financial applications under the brand name NFS™ (NetSol Financial Suite) and NFS AscentTM for leading businesses in the global lease and finance industry.

Customers

Customers are large organizations, vehicle manufactures and regional banks in particular:

NetSol’s clients include Dow-Jones 30 Industrials and Fortune 500 manufacturers and financial institutions, global vehicle manufacturers, and enterprise technology providers, all of which are serviced by NetSol delivery locations around the globe.

NetSol customers include world renowned auto manufacturers through their finance arms and large regional banks. NetSol is a strategic business partner for Daimler and BMW (which consists of a group of many companies in different countries), which accounts for 35.3% and 18.5% of our revenue for our fiscal year ended June 30, 2019.

53.8% of revenue comes from the two biggest customers. This represents serious risk for the business model and should not be left without attention. We cover it in the Risks section below.

Industry

The company belongs to Software industry. However we need to keep in mind that the business is highly dependent on Auto Manufacturers and Regional Banks industries, which are cyclical.

Form

Legal form is corporation (Inc).

The company operates through number of subsidiaries all over the globe.

Wholly owned Subsidiaries:

• NetSol Technologies Americas, Inc. (“NTA”)
• NetSol Connect (Private), Ltd. (“Connect”)
• NetSol Technologies Australia Pty Ltd. (“Australia”)
• NetSol Technologies Europe Limited (“NTE”)
• NTPK (Thailand) Co. Limited (“NTPK Thailand”)
• NetSol Technologies (Beijing) Co. Ltd. (“NetSol Beijing”)
• Ascent Europe Ltd. (“AEL”)
• Virtual Lease Services Holdings Limited (“VLSH”)
• Virtual Lease Services Limited (“VLS”)
• Virtual Lease Services (Ireland) Limited (“VLSIL”)

Majority-owned Subsidiaries:

• NetSol Technologies, Ltd. (“NetSol PK”)
• NetSol Innovation (Private) Limited (“NetSol Innovation”)
• NetSol Technologies Thailand Limited (“NetSol Thai”)

Note: Netsol Technology, Ltd is a public company that is traded on Pakistan Stock Exchange.

Geography

Headquarters: Calabasas, California, US.

Operations: The company divides its operations into 3 geographical regions:

• North America
• Europe
• Asia Pacific (APAC)

The company owns the biggest office in Lahore, Pakistan, where the majority of employees are located.

Customers:

Most of the revenue comes from APAC region 81%, 47% of revenue comes in particular from China.

Status

Based on the historical revenue and number of employees I would define the company status as slowly expanding.

Management

Reading through the reports one will find surname Ghauri multiple times. There are 4 people mentioned.

There are three brothers:

• Najeeb Ghauri (CEO)
• Naeem Ghauri (Director)
• Salim Ghauri (CEO of subsidiary NetSol Technologies, Ltd)

And Faizaan Ghauri (CEO of WRLD3D) is son of CEO Najeeb Ghauri.

Salim Ghauri wrote an autobiographical book "From Nothing To Everything" which reveals some family relationship details I was not able find in the financial reports.

Actually, Salim Ghauri is the one who started original Netsol company in Pakistan and he seems to be a legendary IT figure in his motherland.

So one can say it is a family business. With its all pros and cons. Having executives who co-founded the company, and have skin in the game is usually good. However, I believe they act in the interest of the company and own interest, but not in the interest of the shareholders.

Audit, Compensation and Governance committees consist of the same people: Burki, Caton, Kazmi, Tolentino, which are very unlikely to be really independent.

The following makes me think that the management is not shareholder friendly:

• The company does not pay dividends even though it sits on excessive cash.
• Since 2017 the company invested into WRLD3D (which is managed by Faizaan Ghauri) in form of Convertible Promissory Notes, about $4.1M in total. WRLD3D has a website and a github account where one can inspect some activities. However as it happens with most of the startups, WRLD3D is likely to burn cash without any return to Netsol Technology Inc or its investors.
• Similar story with Drivemate where the company put $2.6M, which are reflected as "Long term investment" on the balance sheet.

Risks

Shareholder-unfriendly management

As it was mentioned in Management section, it looks like the current management team is not oriented to deliver value to the shareholders. This is probably the most serious qualitative argument against owning the stock. Theoretically such a company could be become a target for activist hedge funds, but this scenario is very unlikely, because capitalization of $32M is to small for most of the funds.

Competition

As it mentioned in 10-K report the company has many competitors.

In the case of NFS™, we compete chiefly against leading suppliers of IT solutions to the financial industry, including names such as White Clarke Group, Cassiopae, LineData, FIS, International Decision Systems (IDS), Data Scan, Alfa, 3i Infotech, Finnone and Nucleus Software.

In the IT based business services areas, we compete with both smaller local firms and many global IT services providers, including names such as Wipro, InfoSys, Satyam Infoway, HCL and TCS (Tata Consulting).

Wipro, InfoSys are bigger Indian pubic IT companies, that provide much wider range of services in comparison with Netsol Technologies Inc.

Others are hard to evaluate, because they are not public.

I believe that most of the ongoing competition is about signing contracts with new customers.

The financial software and services that Netsol provides has a lock-in effect. Integrating a huge piece of financial software into a large business is quite complicated, requires a lot of effort, customization and sometimes continuous maintenance.

Switching costs to another software and service provider would be just unjustifiably high. Apart from integration of new software (that costs effort and money by itself) it would also require migrating the existing data.

Currency risks

From Q4 2019 Earnings Call:

A decrease in the value of the U.S. dollar compared to foreign currency exchange rates generally hasn’t affected increasing our revenues, and it also increases our expense with denominated currencies other than U.S. dollar.

Similarly, as the U.S. dollar gains strength relative to foreign currency exchange rates, it tends to reduce our revenues but it also reduces our expense with denominated currencies other than the U.S. dollar.

To put it into more simple words: the lower foreign currencies fall, the better it is for the company's net income. And in some years "Gain on foreign currency exchange transactions" was accounted for significant portion of net income. (E.g. for fiscal year ended June 30 2019 it was about 50%).

Let's check the hypothesis against real data. Let's compare USD/PKR currency pair with "Gain on foreign currency exchange transactions" in the net income statement for the last 4 years.

There is clear correlation between PKR per USD YoY and Gain as 5 of revenue columns.

Loss of key Customers

As it was mentioned earlier Daimler and BMW accounted for 35.3% and 18% of revenue respectively. Losing one of these customers will hit the top line significantly.

Dilution

Shares and stock options are part of compensation plans. They are reflected in Net Income Statement as expenses. However one should keep in mind the new shares outstanding dilute not only earning, but also book value.

Coronavirus

I tend to think the company is relatively well positioned to survive in the time of COVID-19 lockdowns. Firstly, the company has sufficient cash reserve ($22M). Secondly, 90% of employees are IT professionals, meaning they can easily work from home. As it was mentioned above, 46% of revenue is accounted for China, the country that already overcame the COVID-19 epidemic.

Regarding revenue from other countries the future is quesitonable: it's unlikely that customers will drop because of a one-month lockdown. But if it has to continue for longer, some customers may cut expenses, and are likely to terminate the contracts with the company.

Lack of Liquidity

Average traded volume is about 35,000 shares per day, with current price of $2.73 per share it makes about $95K daily. So for many investors it may be not easy to get in or out without moving the price.

On the other hand, during panic or euphoric days, lack of liquidity results into volatility which creates good buying or selling opportunities for small retail investors.

Liquidation value

The information below is based on 10-Q report, that represents balance sheet state as of 31 Dec 2019.

To determine a liquidation value I've applied a technique similar to one described "Pitch the Perfect Investment" by P. Sonkin and P. Johnson on p. 74-75.

I am only considering assets that can be liquidated and applied 21% corporate tax, because most of the assets are outside US.

Notes:

• "Convertible note receivable" (investment in WRLD3D) and "Long term investment" (investment in Drivemate) are completely excluded, because I do not believe the company can derive any value from those investments.
• Most valuable parts of "Property and equipment" are Building ($6.3M) and Land ($1.6M). This matches the fact that the company owns Lahore Technology Campus, 140,000 square feet of office space (see 10-K)

I think we can reasonably say that liquidation value lays somewhere in a range of $1.16 - $1.75 per share.

Fair share price

I will calculate fair value using the following formula:

Value = Net Current Asset Value + Future Earnings Value

Net Current Asset Value

Determining Net Current Asset Value (NCAV) is relatively easy: we subtract Total Liablities from Current Assets. I defined Current Assets as sum of Cash and Receivables, excluding "Convertible note receivable" (as mentioned in Liquidation Value section, I do not believe it has any real value).

So NCAV per share is $2.00.

Future Earnings Value

Normally I would prefer to project Free Cash Flow in the future and perform discounted cash flow analysis.

However, since the business does not have any moat (competitive advantage) and is cyclical and unstable in terms of earnings, it is not possible to project free cash flow reliably.

So I have to come up with a different valuation approach, inspired by CAPE (cyclically adjusted price-to-earnings).

The idea is the following:

• Take earnings per share for about last 10 years
• Adjust for inflation
• Calculate average earning per share
• Project earnings per share into the future and calculate present value of them.

Notes:

• I prefer to use earnings per share over net income, because earnings per share fairly reflects dilution effect, caused by equity compensation plans (stocks, options, etc).
• For inflation rates I used https://www.usinflationcalculator.com/
• In August 2012 the company performed a reverse split 1:10 of common shares, so we have to adjust for it respectively.
• I assume no growth, because I do not see any.

I calculated cumulative average for each single year to see how a data from one year may impact the average.

I think there are 2 candidates for average net income per share, that should be considered: $0.15 and $0.24.

In the calculation I assume fixed earnings each year and will use the following formula:

Present Value of Perpetuity = Earnings / Discount Rate

I use 12% as Discount Rate. But also add 10% and 15% for the sake of comparison.

So fair value of the future earnings lays somewhere in the range of $1.25 - $2.00 . We may also consider $2.40 as optimistic upper limit.

Now, when we know the components, let's finally calculate the fair value of the share, again with ranges:

• Optimistic: $2.00 + $2.40 = $4.40
• Neutral: $2.00 + $2.00 = $4.00
• Pessimistic: $2.00 + $1.25 = $3.25

Applying 33% margin of safety to $3.25, we get $2.15.

Risk / Reward

As value investors we should always search for investment opportunities with asymmetric risk / reward.

Let's try quantify risk and reward so we can compare them.

Risk = Share Price - Liquidation Value per Share
Reward = Fair Value - Share Price

Let's check how Risk/Reward Ratio change depending on share price, assuming liquidation value and fair value stay constant.

We see that in terms of Risk/Reward Ratio it's probably not worth buying the stock if its price is over $2.75.

Summary

With the price ranges of the last month ($2.02 - $2.90) Netsol Technologies (NTWK) may be a good investment from conservative point of view for a retail investor with a small capital, who can tolerate a not shareholder-oriented management.