Netsol Investment thesis-- a work in progress

Netsol Technologies

Overall Thesis:

Netsol technologies is a US-based holding company with operating subsidiaries in the US, UK, and Asia, most of which provide enterprise software and related IT services. The company leverages its low-cost development offices in Pakistan to provide rock-bottom prices (and higher margins) then found in most IT companies. I believe this stock can become a multi-bagger over the next several years due to multiple catalysts. There are several ways of describing just how undervalued Netsol is. Take your pick:

1) You get all Netsol’s businesses for free based on the estimated PV of one contract that Netsol has a high probability of winning at the end of 2007.

2) You get a 78% stake in Netsol’s Pakistan subsidiary, with a $20M public market value (66% of the market cap), for free.

3) You buy a Worldwide IT services firm with a low labor cost, growing at 50% YoY, for 1x FY07 revenue, 15 P/E, with multiple near term catalysts that, in the next few years, could create a business with earnings power of $25M (nearly equivalent to the companies’ current market cap).

In a nutshell, this is one of the most exciting risk/reward plays I have seen in a long-time.

The Pakistan IT Labor Market—Why Pakistan?

Before diving into a description of the company, its worth giving a brief overview of the IT labor market for Pakistan. With the rising popularity of outsourcing, labor prices in many of the top outsourcing markets have been experiencing upward pressure. India, in particular, has been subject to export taxes and rising labor costs that have raised the cost of doing business there, and sent companies looking elsewhere. Pakistan is about 25-40% cheaper than India, likely even more so with the recent excise tax levied on IT export services there. Below is chart comparing the avg. cost of the average IT employee in US vs. India vs. Pakistan (pre-excise tax):

INSERT TABLE

	US	India	Pakistan
All in Expenses per employee	$58,598	11,854 (does not include 33% tax on IT export)	$9,000
Total Price in market	$58,598	$23,708 to 35,562	$18,000 to $27,000

Pakistan has a ready supply of quality, cheap labor, and is in a much earlier phase of outsourcing than India. The total revenue generated by Pakistan IT companies has grown from only $20 million in 2003 to $70 million in 2006, a CAGR of 52%. Some estimates claim that this is under-reported nearly 8x due to the numerous small companies and individuals in this fragmented market. Assuming the $70M is correct number, Netsol PK (their Pakistan subsidiary), has about 12% of the market

Many large companies have outsourced a portion of IT operations to Pakistan, including IBM, TRG, ZTE, and NCR. Pakistan has high levels of tech savy, English speaking residents, and a 15 year tax holiday on IT exports (vs. India which recently levied a 33% tax on IT services exports). Overall trends appear strongly in Pakistan’s favor, with continued high growth expected for the foreseeable future.

About the Company

For a $30 million dollar company, Netsol has an extremely complex operating structure that I believe may be obscuring some of the value in the name. In addition, several one time charges related to acquisitions, as well as significant sales investments that are just beginning to bear fruit (due to long lead times) are also hindering current profitability.

The company has won numerous recognition from the Pakistan government, including “IT Exporter of the year”, which was given to it by the Prime Minister. It also has Cmmi level 5 certification, which has been attained only by about 100 companies WW, and is considering the benchmark for quality in facilities, particularly when dealing with offshore companies. It is not a fly-by-night outsourcing outfit, but a serious, highly regarded business.

Netsol has two primarily lines of business: a suite of software products and solutions for the leasing industry (The Global products group), and a for-hire, outsourced application development and IT services group (The Global services group). In turn these two business lines are operated across a set of different subsidiaries in multiple markets. I have outlined the subsidiaries and

McQue Systems and Netsol CQ (Global Products Group):

Overview

These groups focus on selling Leasesoft, which comprises a suite of four asset-based leasing/financing software application that for customers in the lease and financing industry. The product is still in the early stages of its adoption, with the majority or revenue (70%+) coming from APAC. This group has won several large accounts and strategic agreements with division of Damien Chyrsler, Toyota, and Yamaha. The product has been particularly strong in APAC, where it has become the leading option for Chinese auto manufactures.

Acquisition Strategy

The company has spent $15.3 million purchasing McQue Systems (US) and CQ systems (Europe) in 2005 and 2006 for about 1.5x revenue and a P/E of about 15. Netsol transitioned half the staff at each location to their offices in Pakistan, resulting in immediate cost savings, and simultaneously ramped up sales efforts in both regions in order to more aggressively penetrate these markets. The company views these new operations as strengthening their core Leasesoft offering, while simultaneously allowing better access to both the US and European markets through their subsidiaries. The company also set up a UK subsidiary (Netsol UK), to pursue future opportunities in Europe.

Valuation

Long term, Netsol should enjoy improved growth and margins from these business beyond that possible in their pre-acquisition state. They expect to migrate 50% of development in the US and UK to Pakistan, which should result in labor savings of about 40% overall (all-in cost/employee is 80% less in Pakistan). This is an attractive collection of business that appears to be doing well on its own right, but not core to my analysis. I conservatively value Mcque systems and Netsol CQ business at their cost at time of acquisition in 2005 and 2006 ($15.3M). Though there is still $1-2M left on the Mcque Systems acquisition (in the form of an earnout), I will assume that this amount is off-set by the increase in value due to operating efficiencies generated by moving development offshore.

Non-Services Divisions (Netsol UK, Netsol USA, Netsol Connect, Netsol Omni):

These businesses account for a very small portion of Netsol’s revenue and profits. They include Netsol UK and Netsol USA (largely non-functioning subsidaries), Netsol connect (a $1mil/year, break-even ISP, in which Netsol owns about 50%), and Netsol Omni (less than 50k in revenue, 50% stake, break-even). Netsol UK formely was a large contributor, but appears to have moved the majority of its operations to Netsol CQ. It still is responsible for biz dev functions in the UK (e.g. future JVs), but is not a major contributor on its own right. These business are marginally profitable (less than 200k in profit). For simplicities sake, I will value them at nothing.

Net-Sol TiG JV (50.1% ownership)

Overview

Netsol formed a JV in December 2004 with TiG, a provider of claims related outsourcing in the UK. The JV gives each approximately 50% of the combined company, and calls for TiG to gradually transition the bulk of its technology development business to the JV ($50M a year in revenue). This allows TiG to significantly lowers its cost of service without the risk and struggle of setting up its own outsourcing operation. The business grew over 100% YoY in FY06, and accounted for approximately $500k in net income after adjusting for minority interest. Net operating margins are a whopping 50%.

Valuation

Currently, this business has only received about 5% of TiG’s total technology development business. If and when TiG does transfer over the whole business to the JV, this business could generate $12.5M annually in net profit for Netsol, adjusted for minority interest. Slap a 15 P/E on that, and your looking a $187M business, or 6x Netsol’s current market cap.

For now, how should we value a business that generated 500k in profit, is growing 100% annually, has 50% net margins, and has what seems to be an eventual lock on about $50M of business? Given the small size and relatively short operating activity, lets say a 30 P/E off FY06 (equivalent to 15-20x forward FY07 estimates), or about $15M.

To recap::

McQue Systems: $8.6M

CQ Systems: $6.7M

Netsol TiG JV (50.1% stake): $15M

Total Value: $30.3

Netsol Market Cap (@1.68): $30.5M

Netsol PK (78% interest)

Overview

Netsol PK is the most talked about of Netsol’s holdings. It is traded on the Karachi stock exchange, and has an estimated market cap of $23.4M (netsol’s stake is worth $18.3M), but owners of NTWK get it for free. This division sells Leasesoft and professional services to APAC, which to date has been the companies’ most successful region (it generated about 60% of FY06 revenue). This division produced $8.4M in revenue in FY06, and recently reported a blowout Q2, with revenue up 129%, and net profit margins increasing fourfold, hitting 41%. In addition to increasing success selling Leasesoft into Asia, this division has made increased inroads with the Pakistan government for a series of contracts. This division appears to be trading for about 2x trailing revenue, which appears a significant discount assuming the 40% net profit margin holds, and given the 100% growth. That said, this thesis does not rely on this subsidiary trading at a higher valuation multiple…

The $300M Punjab land records contract

On January 17^th, apparently under the radar of Netsol investors, the company announced that it is a finalist for the $300M Punjab land records contract. The day of the announcement, the stock didn’t budge. I am still perplexed as to why this announcement has had seemingly had little effect on the stock-price but, after further researched, am convinced that this announcement alone justifies the stock’s entire market cap.

The World Bank, in conjunction with the province of Punjab, selected Netsol as one of four finalists (from 9 local vendors) for the $300M land records project to manage and automate the provinces land management system. Two vendors will ultimately be selected, with expected revenues to each of $25M over the next 5 years. Netsol expects this business to be high net margins, on par with the margins generated from currently from the Netsol PK business (~40%). The final two vendors are expected to be selected by the end of the year.

So, what are their chances of Netsol winning? Well, as a baseline scenario, it would appear that they have a 50%. For several reasons, I believe the likelihood is much higher—in fact, I am more concerned that the project will be delayed or cancelled then I am concerned that Netsol will lose the deal. Here is my thinking:

1) Netsol is the largest IT services provider in Pakistan in terms of revenue

2) The Pakistan government has awarded them multiple recognitions for being the best “IT services exporter” in the country.

3) Netsol has several existing contracts with the Pakistan government on other IT projects

4) Netsol’s Cmmi level 5 facility is one of only 100 worldwide, and I believe is likely to be one of the only ones in Pakistan, given the length of the accreditation process and quality standards (note: I have not been able to confirm this).

5) Two firms will be selected and, given the scope of the project and Netsol’s leading position in the market, I’d imagine their experience will be a strong factor (even if, for some reason, the other smaller companies do a better job)

Valuing the Punjab opportunity

To determine the value of the deal, I have assigned probabilities to the following scenarios:

A: 80%: Netsol wins the deal

B: 20%: Contract is cancelled or Netsol loses out on deal

Below is the value for each scenario

A: $25M revenue @ 40% net margin = $10M/yr. 10M x 5yr = $50M. @ 15% discount rate yields PV of $32.

B: 0

Total value of the opportunity: $32M*.8 = $26M

This also does not include the benefit to Netsol of any follow on work from this deal, or the fact that winning this deal will likely lock Netsol as the go-to vendor for future large projects in the region.

Conservative sum of parts valuation

Though I believe this idea works better when you look at is as an undervalued play with many things that can go right, I’ve put together a sum of parts valuation based on the work done above, adjusted for a 20% holding company discount. Debt is minimal (and offset by receivables), so I have chosen to use market cap rather than EV.

McQue Systems: $8.6M

CQ Systems: $6.7M

Netsol TiG JV (50.1% stake): $15M

Netsol PK stake (@ market): $18.3M

Punjab PV: $26M

Holding Co. Discount: 15M

Estimated total value: $59.7M

Value/share: $3.14

Price/share (3/12/07): $1.68

Premium: 87%

I think the above uses conservative estimates, and that the long-term upside is much higher. Another way to look at this is to see the potential earnings power of the business if a couple things go right. If Netsol wins the Punjab contract, and if TiG transitioned 50% of their technology development business to the JV, then those two catalysts alone would generate $15M in net earnings in FY08. Put a 20 P/E on that, and you have a 300M market cap (10x the current market cap).

Catalysts:

1) Punjab Land contract announced (end of 2007)

2) TiG moves substantially more of technology development to Netsol-TiG JV

3) Increased penetration in Europe and US markets due to recent acquisitions

4) Improved operating efficiencies from moving development work from US and UK to Pakistan

5) Increased recognition by the street. This is worth explaining a little bit more. First, the obvious: Netsol is in a hot space, and has a great story. If the business traded at multiples anything like the Indian outsourcers, it’d be a strong double to triple in the near-term, with sustained 30-40% annual gains assuming the multiple stayed constant and performance remained strong. The second point worth noting is that management and employees are very invested (too invested; see risks) in the success of the company. The brothers that founded the company several years ago own ownership stakes, through options and current holdings, in about 44% of the company. They also referred several times, in their recently published 10-QSB, specifically to aggressively marketing the idea to the micro-cap and larger investor community

Risks

The story is, of course, not without risks, though given the multiple catalysts I believe shareholders are well compensated

1) Dilution and Entrenched Management

As of their latest 10-QSB filing, the company had 17,514,000 shares outstanding. Additionally, the company has 8.6M options outstanding, and 2.6M warrants. Most the options have a lifetime of 10 years. Clearly, this amount outstanding is egregious, and nearly initially caused me to throw the idea away. Luckily, the strike price of most the options and warrants is at or above the current stock price. I have been unable to find a detailed breakout of all the options and their strike price (so many have been issued in so many instances, that I’m not even sure such a list exists), but from what I can tell of those I did track down, the majority seem to have been issued at the price the stock was trading at at the time of issuance. The last filed 10K lists the weighted average of all options outstanding at $2.60 . From the current price, the stock has over 50% to move before it hits $2.60, and the exercise of options is likely to pick up. I think this limits the stocks potential on the extreme upside case (e.g. above $4), but that it should have minimal impact in the near term up to that point. I also don’t like the sign this sends about management, but I am comforted that they have extremely high (albeit too high) incentive to drive the stock price substaintially from here.

Additionally, I am particularly disturbed that the company pays for a good deal of services with stock in leiu of cash. This is a big red flag for me in general, though I am able to get a little bit comfortable with this since management has such a strong stake in the shares (if management was selling shares and had little/no skin in the game, I would be a lot more worried). I have calls out to IR and management, but have yet to receive more color on this issue.

Unsurprisingly, management also appears overpaid, with the top two executives receiving $250k and $280k annually, in addition to their enormous options holdings. Again, I don’t like the signal it sends, but at least large underwater options holdings provide strong incentive to move the share price.

2) Lack of focus

Clearly, this company is trying to do quite a lot for a $30M business. I have strong doubts about them executing on all fronts. Little progress appears to have been made on the acquisitions, and I would not be surprised if those fail to generate any significant benefit long-term. Luckily, I believe there is enough that is likely to go right for the idea to work out, and that the areas they are likely to fail (e.g. expanding outside APAC) are not central to my overall thesis.

3) Increased Competition & Margin Erosion

Unlike India, there is not a limitless supply of labor in Pakistan. The total population is about 160,000,000, which although large does not provide the same “unending supply” that appears to exist in India. That said, this is likely years off from becoming a significant issue, as the outsourcing trend in Pakistan is still in its infancy. Also, clearly the margins are not sustainable long-term. I expect the deterioration to be gradual, and by the time this has an impact the stock should be significantly higher.

4) Political Instability

Pakistan is not the most stable region in the world. There could be a variety of political events that could jeopardize the entire investment. If such an event were to occur, however, I’d imagine it would be part of larger global implications, which would likely beat down all equity markets. I am admittedly not an expert in Pakistan affairs, though I feel I am being effectively compensated for the risk.