TechLahore

Netsol is one of Pakistan’s major software outsourcing companies. And if you’ve been following Netsol stock on the NASDAQ (NTWK), you’ll find that over the last couple of months, the stock price has roughly doubled. This is mostly due to a recent earnings call where management disclosed healthy growth and also an increasing percentage of future business expected from license revenues for their LeaseSoft application. What does the future hold for Netsol and what does it’s past warn us about? Read on…

If you do your basic stock research on Netsol, you’ll find extensive and well written pieces like this analysis of why Netsol stock is going to fare well in the months ahead. This particular article was written back in March and many of the positive aspects highlighted in it are the main reason why Netsol stock has performed well over the past few months. However, the question is, is it a good time to buy now? The answer, as these sorts of things normally are, is pretty complex. Netsol’s future is not entangled only with its customers, management team and partners, but also with the political and economic outlook for Pakistan itself. The bulk of NTWK’s market cap is actually dependent on Netsol PK (Pakistan).

It’s not just the operational and HR elements that are tied to how events shake out in Pakistan, it is also revenue growth which is dependent. The juiciest potential deals expected to be closed by Netsol are not international, but rather very local. They are things such as the Punjab Land Records Automation project. While in the west these deals are looked upon as “$300M” opportunities, it remains to be seen, given the climate in Pakistan, whether they end up happening or not. Is there a risk that with a change in the Punjab Government, this project suffers major setbacks or, in the worst case scenario, goes away?

The other issue is, even if Netsol does continue to get good business, how will they scale locally? There just aren’t enough people being produced for them to support an additional 400 hires a year (all mainly in Lahore). Where did I come up with that number from? Well, if you assume even a 25% attrition rate, given their current headcount of 650, they’ve got to hire 160 people every year just to stay at-par. On top of that, when you add 30% headcount growth to serve new business, you’ve got their headcount growing at about 400 heads a year over 2008. In, 2009 just to maintain parity, they’ll need to make 220 new hires. While the new education and University initiatives being invested in by the Government are going to help, the effects are not going to be felt in any great measure prior to 4-6 years. So in this period, Netsol will have to either pay premiums above market to keep people on hand, thus reducing margins, or hire more developers in China or even the US. Which would mean again, margins would be reduced.

I don’t mean to sound negative. I am NOT saying Netsol absolutely can’t hire 400 people in a year. But if you’re familiar with the IT industry, specially in Lahore, it’s going to be a challenge. And these have got to be 400 guys with decent skill levels.

But, there’s positive things here as well. For instance, growing LeaseSoft revenues imply that the headcount doesn’t need to grow at the same rate as revenues. That’s where the advantages of a product kick in big time. So, if Netsol gets some good, high margin LeaseSoft deals closed in their export markets, that would bode really well for the financial scalability of the company. If you hear the recent earnings call where Naeem Ghauri spoke to this issue, management sounds pretty confident.

The other positive factor to consider is that Netsol probably has an edge over other software companies in getting the local government business. Ok, they may not get everything they’re bidding for, but even half would be good. The risk here, and we’ve talked about it previously, is that inordinate delays get inserted into the governmental decision making process. Hopefully, the local Netsol sales team is covering this well.

Overall, Netsol seems like an interesting investment at this time. While their stock is at a 52 week high, it used to be hovering in the mid $70s back in the boom days. Yes, that was an unsupportable valuation based on fundamentals. But that wasn’t the only reason why Netsol suffered. They also had quite a bit of board room drama which affected their perception in the marketplace. That is one of the big question marks hovering over Netsol’s future potential. At the end of the day, it’s pretty clear that they are still a company run by three brothers. And that doesn’t necessarily score high points on the corporate governance index. In fact, if you look at Yahoo! Finance’s rating, this is what they have to say:

“NetSol Technologies Inc.’s Corporate Governance Quotient (CGQ®) as of 1-Oct-07 is better than 6.8% of CGQ Universe companies and 2.8% of Software & Services companies.”

The biggest favour Netsol can probably do to its shareholders and itself, is to really restructure the company to reduce the complexity in its many JVs, holding companies etc. to project a single unified brand and a single entity to the market. And also upgrade to a management team that is not only very competent, but also takes the “family run” criticism off the table.

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