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
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
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.
Before diving into a description of the company, its worth giving a brief overview of the IT labor market for
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All in Expenses per employee
11,854 (does not include 33% tax on IT export)
Total Price in market
$23,708 to 35,562
$18,000 to $27,000
Many large companies have outsourced a portion of IT operations to
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
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):
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,
The company has spent $15.3 million purchasing McQue Systems (US) and CQ systems (
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
Non-Services Divisions (Netsol
These businesses account for a very small portion of Netsol’s revenue and profits. They include Netsol
Net-Sol TiG JV (50.1% ownership)
Netsol formed a JV in December 2004 with TiG, a provider of claims related outsourcing in the
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.
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
On January 17th, 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
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
3) Netsol has several existing contracts with the
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)
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.
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
Punjab PV: $26M
Holding Co. Discount: 15M
Estimated total value: $59.7M
Price/share (3/12/07): $1.68
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
2) TiG moves substantially more of technology development to Netsol-TiG JV
3) Increased penetration in
4) Improved operating efficiencies from moving development work from US and
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
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
4) Political Instability