(Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.)
NetSol Technologies (NTWK) is a compelling short for a number of reasons including:
1. Questionable Accounting (Accounts Receivables that would make Autonomy blush)
2. Company sponsored research based on dubious earnings numbers
3. Corporate Governance Issues & a new part-time CFO
NetSol is an automotive leasing software company listed in the U.S., which does business primarily in Asia with most of its workforce in Lahore, Pakistan. The company's core product is software for use by companies primarily engaged in the lease financing of automobiles. While management touts the stability of Pakistan as a reason for investors to like the company, the U.S. Government is taking a different view and in August 2013 "ordered the departure of non-emergency U.S. government personnel from the U.S. Consulate General in Lahore" and further updated the warning on 9/6/13 advising U.S. citizens against "all non-essential travel to Pakistan" citing "the presence of several foreign and indigenous terrorist groups." It turns out geopolitical risks aren't the only risk for this company.
1. Questionable Accounting
Most software companies take a conservative approach to accounting for expenses for development by expensing R&D in each period, which shows up on the income statement. Microsoft (MSFT), a legacy software company which is always working on new products, expenses everything including "payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development." (p.33). Workday (WDAY), a cloud based software company, similarly expenses all R&D, evident through an examination of the cash flow statement (p.6) where the only use of cash for investing activities not spent on marketable securities is purchases of property & equipment.
NetSol, however, takes a hyper aggressive approach to R&D. Nowhere on the income statement does R&D expense appear (p4). Instead NetSol opts to capitalize R&D expenses, which has the direct impact of boosting the company's reported EPS.
The cumulative effect is NetSol's continuous reporting of earnings in excess of what would be reported by the rest of the software industry.
In addition to misleading R&D accounting, NetSol also appears to have issues collecting on its bills. NetSol breaks out receivables into two line items, "Accounts receivable, net" and "Revenues in excess of billings" so comparing NetSol's Days Sales Outstanding vs. other tech companies requires adding these two line items together. The companies in the table below were chosen because they represent software companies across several different business strategies to show the range of DSOs typical of software companies and one alleged accounting fraud, Autonomy. All figures are as of the most recent reporting period other than Autonomy, which is from its most recently reported fiscal year, 2010, prior to its acquisition by Hewlett-Packard (HPQ).
With a DSO ratio so high, even higher than the now infamous $8.8BN Autonomy write-down, one must question the quality of NetSol's earnings.
2. Paid Research & Valuation Implications
Sell side analysts have a habit of taking an earnings number, applying a P/E multiple, and coming up with a price target. This approach to valuation with NetSol distorts reality since NetSol's accounting isn't like everyone else's accounting. Taglich Brothers, a research firm under contract with NetSol to provide equity research, issued an update in September 2013 with its target based on a P/E multiple of 10x to arrive at its price target. Taglich fails to take into consideration NetSol's aforementioned R&D accounting. Taking Taglich's generous 10x multiple and applying to adjusted net income results in the following valuation:
3. Corporate Governance, the Auditor, and a new CFO
NetSol uses Kabani & Company as its auditors. Kabani has received poor marks on its past two (1, 2) PCAOB inspections for several reasons including the following from the 2010 issued report "the failure, in two audits, to perform sufficient procedures to test revenue." Kabani and NetSol, however, have more than just a business relationship. Salim Ghaauri, the brother of NetSol's CEO and head of the Pakistan office, is the CEO of American Business Forum. Also part of the organization is Younus Kamran who is one of the principal managers of Kabani & Co's Pakistan office. Additionally, Vaseem Anvar, part of the executive committee for American Business Forum is the chairman of the audit committee for NetSol's Pakistani subsidiary. One must question whether or not Kabani truly qualifies as independent. Kabani's only other client (p.4) with a material market cap (or should I say that did have a material market cap) is L&L Energy (LLEN), which was written up on 9/19/13 by GeoInvesting and is now approaching a 52-week low.
In addition to the questionable quality of the company's auditor, NetSol has also had a serial problem with internal control effectiveness (FY13 p.28, FY12 p.34, FY11 p.33, FY10 p.4). To address these issues, NetSol announced it hired a new CFO. However, it is worth understanding that the new CFO has not been hired as an employee. Rather, he has been hired on a contract basis as a consultant. Under his contract, he must "seek pre-approval of any revised schedule" beyond an agreed upon 20 hours per week for which he receives $100 per hour. The company sites "nearly two decades of experience"; however, a correspondence filing filed in January 2011 with the SEC indicates he had over 11 years experience, implying in 2013 (today) he should have 13+ years of experience, not nearly 20.
NetSol also cites his "experience providing national and international companies with financial reporting and auditing services." The company referenced in the correspondence filing above, which NetSol's new CFO was advising while part of Pickard & Green, his prior employer, is FusionTech Inc. FusionTech (previously OTC:ZPNP) was an attempted Chinese reverse merger which has been delisted and ceased filings with the SEC in November 2011 following multiple defaults on its debt earlier in the year. According to the 10-K (p.33), prior to his stint in the audit and advising business, the new CFO was the CFO of Keysor Century Corporation. Keysor Century was liquidated in bankruptcy in 2003 following an FBI and EPA raid in 2002 following alleged environmental crimes.
NetSol's earnings are illusory as a result of an election to capitalize expenses. Additional red flags such as a close outside-of-work relationship with the auditors and outlandishly high receivables makes one question more broadly the quality of any reported figures put out by the company. Additionally, the hiring of a part time CFO without any serious experience in high-grading accounting & internal controls should leave investors uncomfortable.
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