Micro: Leasing Software




At the end of each year a special stock buying situation occurs, and I like to pick up some beaten down bargains before the window closes. Typically between November 15 and December 31, stock owners reduce income taxes by selling some losing positions. This is especially important in 2013, as even mediocre investors likely have substantial trading profits that need to be protected from Uncle Sam.

Since 1950, 80% of the periods comprising the last 7 trading days of each year and the first 3 days of the following year have been positive for stocks. The average gain during those periods has been 1.5%. Tax selling in the weeks immediately before Christmas may be one dynamic that has funded these “Santa Clause Rallies.” Additionally, tax selling is generally credited as a cause of another market phenomenon known as the “January Effect,” the tendency of small cap stocks to outperform in January.

I am very respectful of the market philosophy of not trying to “catch a falling knife.” There are reasons why a stock has underperformed and is being sold for tax benefits. Therefore, I have a few filters I prefer to use before investing in a value proposition that is on sale during tax-sale season:

  1. The negative influence on the stock was limited to a one-time or short-term event.
  2. Positive influences are probable in the following year.
  3. I prefer small caps that were possibly oversold by retail investors (January Effect candidates).
  4. The stock should have reasonable fundamentals and growth prospects.
  5. The stock should be showing signs of reversing the fall.

One candidate that meets these requirements is NetSol Technologies (NTWK), a software developer for the leasing market, with finance and leasing arms of most of the world’s leading auto makers as clients. The company announced blow-out annual earnings in September, but was subsequently hard hit by sellers fearing big costs associated with an aggressive expansion plan outlined in the annual conference call. A few weeks later, there appeared a vicious short attack in a SA article citing “potential” accounting irregularities, and traders and short sellers hammered the stock. The company issued a professional but mild rebuttal that got little exposure and minimal market reaction. Finally, a disappointing first quarter earnings report dropped the stock into the bargain basement. However, 2014 should be kinder to NTWK as present growing pains subside, and new products could put NTWK back on path to achieve its stated initiative of double digit revenue growth and expanding margins for the next five years.

(click to enlarge)

I think part of the problem for this company is some misunderstanding of the company culture. NTWK is not a fly-by-night newcomer. It went public in 1997, was a dot.com darling and survived when most others crashed by cutting costs, working closely with solid clients and eventually emerging as an enterprise with a double-digit growth profile. On April 23, 2013, the company’s first and only CEO, Najeeb Ghauri, stated in an interview with a NADAQ reporter that the company “has never lost a single client.” One reason the relationship is so important to both NetSol and its clients is that NTWK’s product is customized to work with the various accounting and enterprise programs utilized by each client. Daimler Benz (OTCPK:DDAIY) is different from Nissan (OTCPK:NSANY), Toyota (TM), BMW, Volkswagen (OTCQX:VLKAY) and other NetSol clients, so the custom application creates a long-term marriage.

About half of the revenue comes from service fees working for new and existing customers. The other half of revenue is split between software license sales/renewals and maintenance fees for existing licensees. These activities represent some reliable, recurring revenue. The NetSol bread and butter is getting its foot in the door, and then working with the clients to continually upgrade and improve their systems, which manage the full spectrum of the leasing cycle, from applicant processing to disposal of assets, and all the administrative and accounting functions in between. NTWK has focused on financing and leasing operations in Asia, India and Middle East markets primarily, but also has clients in Europe, the US and Latin America. A company initiative is to double US and Latin American operations in the next three years. This is part of the reason for the recent introduction of its next generation leasing software platform, NFS (NetSol Financial Suite) ASCENT.

Are NetSol’s negative influences near-term or systemic?

In September, NTWK reported annual earnings indicating a 27% revenue increase, and earnings per share more than doubled.

Net Revenues: 2013 2012
License fees 17,756,444 13,369,701
Maintenance fees 9,550,471 7,866,930
Services 23,490,243 18,538,893
Total net revenues 50,797,161 39,775,524
EPS .95 .39

So why is NTWK selling with a PE of 5 times trailing earnings? As the stock shot above $12, the company clarified in the conference call that it was embarking on an aggressive plan to hire about 300 engineers and build a facility in Pakistan for their workplace. The company explained that their customers were indicating the need to upgrade and expand their NTWK services, and growth with new markets and customers required them to add staff to meet it. The company stated that it would require about 6 months of training before the new engineers would be productive, so they could not provide guidance for the following quarter or year. Traders immediately realized that the added expansion costs would negatively impact the stock for at least two quarters, and they bailed out.

Seeing the stock’s weakness after a blow-out year, the short seller, a first-time SA contributor, published an article attacking the company, implying “potential” accounting problems. Specifically, he stated that the company was “hyper-aggressive” in capitalizing R&D instead of expensing those outlays. Also he cited “red flags,” trying to imply insider deception at NTWK due to long-term relationships with it’s auditor and investor relations company, which both had past clients in their history which had duped investors. Given the company culture of developing and maintaining relationships, it is understandable that NTWK would stay with the firms that helped them survive the dot-com bubble implosion. This inclusion of unrelated stock failures was irrelevant, but, combined with the accounting concern, the short attack was effective in dropping the stock several points.

Regarding the accounting concern, the FASF rule is that the engineering costs should be capitalized if the company expected to realize revenue generation from the effort. Of course the R&D was primarily to meet needs of existing clients and respond to their suggestions to improve the existing software; therefore, NTWK was well within the guidelines for its selected accounting method. Actually, the company could gain a tax advantage by expensing those costs, but that would seem to be more subject to scrutiny, given the company’s business model. The short seller further cited unrelated technology companies that expensed those costs, without regard for business differences and tax preferences…another irrelevant point.

In general the points in the short seller’s article were mostly based upon innuendo and its own manipulation of accounting, but it should not be discarded completely. The company business model generates engineering work before revenue collection, and collections have been slow. NTWK has added a new CFO recently and there has been inconsistency in that position. The company has noted, and reports bear out, that the Accounts Receivable collection has improved, but remains more than 100 days of sales, which is high. This is actually not very unusual for companies operating in Asia, where payments are notoriously slow. Also, the credit quality of the major auto manufacturers should be reliable, but the high AR is the largest problem that I see in the accounting area.

In the latest quarter, ending in September, the company introduced the ASCENT software, but the only impact on the earnings for that quarter were the costs associated with the launch of that product, as new deals had not had time to be finalized. Since then the company has announced that Nissan Thailand has adopted the new software. The company also reported reduced revenue in the September quarter, explaining that clients were holding off license purchasing and upgrades, aware that NTWK was developing a better product. This also meant that service fees were reduced, as those are partly triggered by license sales. The company results indicated a net loss, and the stock dropped below $5 from the $12 it sold for after blow-out annual earnings.

Expectations for 2014

At its current price, NTWK appears to be a reasonable value, selling well below book value and with a market cap below annual revenue. If the company meets its goal of 55 – 60% gross margins for 2014 and double digit revenue growth, it will need a fast acceptance of the ASCENT platform and booming sales in the rest of 2014. However, analysts are assuming that the losses will continue for the current quarter, with profit in the last half of the fiscal year (ends in June) just balancing out the losses in the first two quarters. They also expect NTWK to produce more than $1 per share earnings in 2015. Although accounting issues can cloud the book value and EPS calculations, YAHOO statistics indicate that operating cash flow exceeds $1 per share, even including the weak recent quarter. However, I should mention that any investor considering an investment in NTWK should expect cash flow to be plowed into the growth and expansion initiatives this year.

The intelligent stand might be to wait until a couple quarters have been reported to be sure that ASCENT will take off as expected, and risk missing the chance to get in at a bargain price. After all, we should know by mid-year if the 300 new engineers will be producing profitable services, making the drag of the current training costs look like a smart investment. On the other hand, short sellers may be waiting for the year’s end to buy back shares, and the January Effect could be a particularly powerful tailwind on the NTWK stock. Waiting until everything is clear and verified is a luxury that stock traders do not have. Technically, the stock is showing signs of life, so the bottom may be in.

Ii is difficult to determine the seasonality of license sales and renewals for NTWK, but many such software vendors experience slow end of year sales, with the best quarters being the first two calendar quarters in the year (NTWK’s last two fiscal quarters). This has to do with capex budgets and spending, and I think that is why the timing of the new release was made late in the year, to take advantage of a ramp up to a busy marketing effort in early 2014.


NetSol Technologies has been in the business of developing programs to facilitate the processing, administration and accounting for leasing companies, particularly those in the auto industry since 1997. We have had this stock on our radar for some time, because the auto leasing business in emerging countries has only begun and there is much room for growth. NTWK has chosen a niche that is not free from competition from generic software, but the special custom features of its products and customer service are the differentiating factors in its market. The proof is the long-standing relationships with the leasing divisions of many of the world’s leading auto makers, which provide a valuable recurring revenue stream. The company has established management and has weathered tough times before. There is a lot to like about NTWK.

Concerns about operating in potentially unstable locations, complicated accounting that arguably is not as conservative as some companies, high levels of accounts receivable and unknown acceptance of the next generation product are clouds that have hung over the company lately. Those have kept the stock price at a level that has frustrated investors this year. That frustration is exhibited in tax selling, which appears to have created an oversold situation.

Of those concerns, the one that is most important to me is the question about the acceptance of the ASCENT platform. It is good to remember that NTWK is in constant contact with its clients, performing improvements to the existing systems and listening to their needs. I have to think that before embarking on an aggressive expansion of staff and facilities, that the NTWK management had good visibility about the market for the new technology. In fact, if the industry widely expected a newer version to be available that meets new needs, the potential buyers certainly would wait for that product. This explains the lack of activity in the past quarter, which could indicate that pent-up demand will materialize as new IT budgets are established by clients and potential clients in early 2014. Management has also indicated that they feel that the ASCENT product has enough competitive advantage that they will not be offering deep discounts to make sales. The company is focusing on larger contracts and expanding margins. Those deals can take longer to finalize and the company has indicated the pipeline is healthy.

Software companies typically carry a PE of more than 20, and at the end of 2014, we expect that NTWK will be earning at an annual $1 EPS clip and growing revenues at a 10-20% rate. By the end of 2014, a PE of 20 would create a target price of $20 per share, opposed to the current $4.80 share price. Although we are more conservative, that is not out of the question, as it would represent a price of 4 times sales and less than 3 times book value. The company may have been able to continue for some years with an EPS near the 2013 level of $.95 without the drama and risk of the aggressive growth plan. However, we would not be so interested in a small company that was satisfied with only treading water.

I do think it is reasonable to expect that NTWK will have some lumpy revenues, as big clients move the needle, and growing pains with the new platform. However, I agree with the strategy of making a controversial move to dramatically increase market share and grow the company. There is some leverage in the revenue and earnings growth potential, because sales of the new ASCENT system also create additional service fees. It is a speculative bet for sure, but the current tax-selling season is probably the best time to place that bet. We think the NTWK management has worked hard and been through much to get this company healthy, and they would not jeopardize that on an ill-planned expansion. We have lower expectations than they do, but we do expect NTWK to double in 2014 to $9.60.


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