Wednesday, March 14, 2007

Update on NTWK: Conversation with management

Netsol's CEO and CFO were in Las Vegas today to discuss their company with investors. I set up time to address some of my concerns and get more clarification around elements of my thesis. Overall, the call was mixed. Some concerns were alleviated, but I was disappointed to hear management, in my opinion, avoid several questions and revert to stock stump speeches. There is nothing that peeves me more than management who says the same canned statements every single time they talk about their business, even when asked direct, specific questions. Overall, though i was disappointed with aspects of the call. I am still optimistic on the stock--I believe this can rise based on the story alone (apparently, people in vegas thought so as well--the stock was up 5% in this afternoon). What follows is based on my notes, and includes my own subjective take on management's comments.

Netsol-TiG JV
Management confirmed that they believe 100% growth next year is feasible, and that eventually a majority of TiG's $50 million dollar business should transfer to the JV. At trailing revenue estimated by the CEO at $3 million, that would give us $6 million a year from now, 3 million in profits to the JV, and $1.5 mil to Netsol. Slap a 20 P/E on that and you get everything else for free. Division has growth to 100 employees, and they expect 200 by year end. TiG saves 70% on its labor cost by outsourcing to Pakistan, and appears satisfied with the arrangement thus far. Management hopes to replicate deals like this going forward

Punjab land contract:
I had trouble getting a clear picture from the CEO on his expectations here, but was optimistic on the deal. The world bank has granted $300M to Pakistan to get this done. The money, from what I can tell, is allocated and likely a lock. The main issue is how much, and how long, it will take to distribute that money, and what share Netsol will receive. I am afraid that there is a big gap between what management is expecting from this contract, and what investors have been led to believe. According to IR, and by simple math, a $300M contract over 5 years, split evenly between 2 companies would generate $150M in total revenue, or $25M in revenue in year. Apparently, this is not a given. It is unclear whether the $300M is all to be allocated for the specific contract that Netsol is bidding on, and what the timing of those payments would be. Initially, management said something along the lines of "we don't know how much it will be, whether its $10, $20, $30, or $40 million", which scared me some, as those numbers are well below my estimates and what I had been told by IR. I plan to adjust the my PV estimate for this contract, as it appears as though there are a wide range of possibilities here.

Onto the fun stuff. This conversation was, in a word, sensitive. I asked management why they felt the need to give themselves about options equal to about 50% of the outstanding shares. On the plus side, management pointed to the fact that they have never sold a share, not even when the company was worth $1bil in the tech boom, so the risk of management exercising and selling is somewhat limited (in other words, they actually appear to want to hold onto the shares long-term). Management also apparently used to own 70% of the company, so I view this large options grants potentially as a way they think they can recoup the larger holding they believe they deserve. Understandable, but it still creates and overhang and dilutes shareholder value.

Paying shares in leiu of cash
Maybe I'm over-reacting, but this is just a big red flag in my mind. If you have a CEO insisting that his shares are undervalued, then why is he giving them away in leiu of cash payments? He repeated several times that he did not expect issuance of new shares, though the 10Qs continue to show may small stock payments in leiu of cash. At one rather embarrassing point, the CFO flat out said the company, as recently as 3 months ago, issued a dividend on preferred shares in stock in leiu of cash, and confirmed that this is a choice of the company's. I do believe that the CEO thinks the shares are undervalued, and I think he is giving shares as a way to satisfy the big investors who participated in the latest offering. Again, this is not friendly to minority shareholders.

Though I am still disappointed in management acting against the best interest of regular Joe shareholder, I think there is enough that could go right here for me to build a small position (though not as large as I would have without the management issues). I will be looking for increased traction in the licensing business, as well as continued growth in services revenue, in the months to come.