Nucleus Software Exports Limited (NSL)

Nucleus Software Exports Ltd. (NSL) is a Banking software product company which operates
primarily in selling Lending Solutions softwares. The company has a range of products, most popular
of them being “FinnOne”, lending software that helps originate, account for and disburse loans by
banks and NBFCs globally. As of Mar 2018, company has a total of 150 customers spread across 50
countries, (with India having the largest customer base with 35% revenues as of Mar 20 and
remaining is exports, largest of them being in South East Asia at 20%). NSL processed almost 26M
transactions everyday and has loan book of USD 200 bn under its system.

Unlike core banking solutions which are an end to end solution for a bank, NSL’s solutions are for 2
entities – large legacy banks that have been using old core banking systems which have disparate
upgradation rather than one time all encompassing update, NSLs Lending Solutions are integrated
with other softwares for deposit, branches, FDs etc.(NSL claims that 3 of the top 15 banks in the
world use its software). The other type of entity are the NBFCs which do not need a solution as
strong as core banking due to smaller size of their operations like vehicle finance companies and
housing finance companies (important clients of NSL are General Motors Vehicle Financing and
Manappuram Housing Finance)

NSL released ‘FinnOne Neo’ in 2015, a solution which is entirely available on cloud (hosted on AWS)
and charges a subscription based fee on pay per use model. From its launch till Mar 2018, 17 new
customers have come on board, and the company has said that because of the cloud, the
implementation of the solution only took 4 days in case of Manappuram Home Finance.

Following are the company’s fundamentals over last 10 years (in INR millions) –
Particulars 2011 2012 2013 2014 2015 2016 2017 2018 201
Revenues 2,705 2,823 2,938 3,462 3,531 3,487 3,724 4,118 4,840
increase by   4% 4% 18% 2% -1% 7% 11% 18
                   
EPS 8.2 11.2 13.9 21.4 20.0 10.0 19.4 20.5 25.7
increase by   36.8% 24.7% 53.4% -6.6% -49.8% 93.1% 5.7% 25.4
Core EPS 5.8 6.6 9.3 15.4 12.4 4.1 11.2 13.2 20.1
increase by   36.8% 24.7% 53.4% -6.6% -49.8% 93.1% 5.7% 25.4
                   
OP Margin 7.8% 10.1% 13.6% 18.3% 15.3% 5.1% 10.9% 12.5% 15.6
Other income as 3.5% 7.2% 7.0% 7.3% 9.4% 7.6% 8.1% 7.0% 6.2
a % of sales
 Pre-tax margin 11.0% 17.1% 20.4% 25.5% 24.5% 12.6% 18.9% 19.4% 19.9
                   
PAT 263 353 452 643 647 325 627 626 745
Net Margin 10% 13% 15% 20% 18% 9% 17% 15% 15
Sales/Total assets 0.7 0.7 0.6 0.7 0.6 0.6 0.6 0.6 0.7
Total assets/Net 1.3 1.3 1.3 1.3 1.3 1.3 1.2 1.4 1.3
worth
RoNW 9% 12% 13% 17% 15% 7% 12% 14% 15
                   
Net Worth 2,882 3,141 3,500 3,970 4,384 4,569 5,197 4,613 5,086
Net Cash in Books -1,776 -1,853 -2,617 -3,175 -3,467 -3,509 -4,806 -4,200 -4,991
                   
Core RoNW 24% 27% 51% 81% 71% 31% 160% 151% 792

Following are some of the insights one can derive –

1. Since NSL does not capitalize any software development costs, its Balance sheet is asset light
and it earns very high returns on its capital, adjusted for cash in books.
2. There is a wide distortion between the reported RoE of NSL and core RoE calculated above.
However, as per me, in case of NSL neither is reported RoE, nor the core RoE important. This
is simply because NSL does not need large amount of capital in its business to grow. Thus
balance sheet is not useful to analyse the business at all since even inventories are absent.
3. I have focused most of my attention to analysing the income statement, with the thought of
investing in a Nucleus bond that churned out 89 crores in the last year and will churn out
similar profits with reasonable growth.
4. Company’s margins declined significantly in 2015 on account of it developing an Offline –
Online payment system called “PaySe”, targeting the cashless economy in Tier 3 parts of
India. Although, it won the RBI award for Payment Systems Innovation Contest in 2016, it is
currently being piloted in some villages. Though in all probability no revenues will accrue
from this product, the costs for the same have already been expensed out. As incoming
shareholders, we have no downside from this expenditure already incurred.
5. Further, the revenue growth has slowed down considerably for Nucleus with 3 years out of
last 10 reflecting double digit growth. NSL management attributes the same to large lead
times in financial institutions in making software decisions along with overall slowing growth
in global banking businesses.
6. Further, with the company working mostly with NBFCs, the customer ecosystem is quite
fragile too. With the Covid pandemic threatening the financial health of NBFCs in India,
Nucleus also stands to lose some of its customers who have been growing their loan book
aggressively over last 3-4 years.
7. Significant cash in books for last so many years definitely counts for sub par capital
allocation, and the only remedy I see to it is higher MoS.
8. Although not a direct competitor to Nucleus, OFSS (Oracle Financial Services Software), the
core banking arm of Oracle Corp has much higher margins than NSL despite both being
product businesses –

Particulars 2011 2012 2013 2014 2015 2016 2017 2018 201
Revenue 2,874 2,997 3,147 3,474 3,741 3,905 4,131 4,427 4,527
increase by   4% 5% 10% 8% 4% 6% 7% 2
                    
EBIT 28% 36% 34% 33% 35% 38% 38% 37% 39
PAT 27% 37% 29% 31% 36% 31% 25% 27% 27
                   
RoNW 18% 21% 14% 15% 15% 35% 22% 36% 26
Core RoNW 34% 40% 28% 39% 42% -793% 49% 485% 57

As can be seen from above, OFSS’ operating margins are more than 2x the margins of Nucleus.
Although higher product revenue component (90%+) compared to NSL’s 70% and R&D incurred at
parent level could be a part of the reason, the low margins at NSL are still a concern.

Business Analysis

NSL’s product as per me, exhibits switching costs since moving its lending platform from one vendor
to another would be very difficult for the customer and the company boasts of a high retention rate
(although not quantified). Also, based on interactions with 2 industry veterans, Nucleus was
renowned for its quality of product.

However, looking at the kind of engineers hired by NSL, the technology that NSL is working on seems
to be quite old. Further, there is some amount of client concentration with top 5 clients contributing
almost 32% to company’s revenues, names of which have not been mentioned. Further, there are
significant open questions with respect to company’s business, covered below, which make me
unsure of intrinsic business quality

Company addition of customers (in number of new deals) over its history (vs. competitors) has been
–

201
Particulars 2010 2011 2012 3 2014 2015 2016 2017
Nucleus 17 27 14 7 8 3 5 7
SAP 15 8 1 7 8 2 9  
Misys 5 6 4 2 2 2 6  
Polaris 2 2 2 1 0 2 5  
Sopra
Banking             14 12

Although NSL’s additions have been slowing, it was ranked at the top place for 10 years in the
lending solutions category globally. These ranks are only based on number of deals and not value of
the deals though. As per the management commentary, Sopra banking Software and NSL do not
compete directly in many markets.

Valuation

Perhaps what attracts me the most to this investment idea is the valuation. With a current market
cap of INR 702 Crores, and cash in books worth INR 532 Crores, this business, which brought in
operating profits of INR 71 Crores in 2020, is valued at mere INR 169 crores.

Which is perhaps scary, since I am unable to understand the discount which is given by the broader
set of market participants to the current cash in its books. Nucleus management has been very
conservative with its cash and has been hoarding the same in its books since years, mostly citing
acquisition opportunities In fact, it even cancelled the INR 9 per share of dividend it had announced
right before the coronavirus pandemic hit citing conservation of resources (cash in books is INR 189
per share).

Although I think the decision of conserving cash made sense, they seem to be almost drowning in it.
Further, always being 10 feet away from the truth, I cant discard the possibility of some of the cash
simply not being there (considering the valuations the company has commanded in most of its
history). However, listening to calls that go back years, I am willing to put my neck and money out to
claim that I do not sense any shenanigans here. I could be totally wrong about this, but based on the
consistency of the management commentary, I am willing to take that risk and am thus invested.

Open Questions:

1. What is the margin profile of the product and services business?

2. They count HDFC Bank as one of their clients. If HDFC Bank is using Oracle Flexcube, why do
they need Nucleus FinnOne?
3. What is the break up of Licence Fees, Implementation Fees and AMCs?
4. What has been the trend of new signings for the company, and how is AMC charged?
5. Despite this being a product business, why is there no operating leverage in the employee
cost?
6. What is the revenue contribution of FinnOne, FinnOne Neo and FinnAxia to company
revenues?
7. How much discount should be given to cash in books?