Kerrisdale Capital Investing Notes – Luxoft Holding Inc (LXFT)
Premier Software Developer with Cost-Effective Eastern European Talent – Long-Term Potential to Compound at 20%
“We were impressed with the quality of Luxoft’s people. More than 70% of Luxoft employees are senior specialists with over 7 years of experience, and over 80% are educated to Master’s or Ph.D. level. At Luxoft we’ve found teams of experts ready to grill you with tough questions. And that’s what you need on complex projects.” – Daniel Marovitz, Former COO at DB’s global banking unit
[drizzle]We are long shares of Luxoft as we believe the company is poised to double revenue over the next five years, and then do so again over the subsequent five. Luxoft’s stock has declined in 2016 as investors have become concerned with slowing growth. The recent move by the U.K. to leave the European Union exacerbated the weakness as the European banks (including Deutsche Bank, Luxoft’s largest customer) are being pushed to multi-year lows. However, Luxoft remains a premium vendor whose services are mission critical for clients. The recent renewal of a five-year Master Services Agreement (MSA) with Deutsche Bank illustrates customers’ reliance on Luxoft despite a challenging market environment.
With a revenue base of over $680 million, Luxoft resembles Cognizant (CTSH) 10 years ago, highlighted by a comparable growth trajectory. Cognizant’s revenue exhibited a remarkable 37% CAGR over a 15-year period, developing from a modest $89 million in 1999 to a $10 billion offshore powerhouse. We think LXFT can grow at a similarly high rate over the next 10 years. Our view is underpinned by management’s recent guidance of 20% compounded revenue growth, $1.5 billion in revenue by FY 2020, and a resulting market capitalization of $3 billion within five years. In fact, we think that forecast is conservative. A more likely scenario: LXFT multiplies its revenue base by 4-5x supported by its position as a best-in-class provider of high-end software developers serving a massive total addressable market. Our DCF analysis suggests shares are worth ~$108 today (105% upside) and likely more in time.
Luxoft’s differentiated focus on high-end software development is executed via engagement of leading programming talent in the science-centric Central and Eastern European (CEE) region. Unlike the large Indian vendors deriving value primarily from labor arbitrage, LXFT’s value proposition is predicated on an exceptionally skilled employee base to deliver sophisticated domain expertise. LXFT employs nearly 9,000 offshore programmers in the CEE geography, a region deeply rooted in science and technology; these emerging economies produce nearly one million engineering graduates annually. The company has already achieved success with this strategy, growing revenue at a 27% CAGR over the last five years while building out proficiency in sectors such as financial services and automotive. Furthermore, Luxoft commands a premium bill rate and generates the highest revenue per employee within the offshore industry. In an industry that competes aggressively for talent, LXFT boasts the lowest attrition rate among its peers.
The offshore IT services industry is well-positioned to grow, fueled by a significant enduring cost differential between U.S. and non-U.S. IT employees. The current climate of hyper-paced digital advancements within every industry, coupled with a shortage of talent in the U.S., will result in continued outsourcing of labor to countries with a cheaper and more abundant workforce. While the total offshore IT industry is expected to grow at 9% through 2019, the application outsourcing sub-segment in which Luxoft operates is projected to grow at 14%. Luxoft’s ~9,000 IT employees represent a mere fraction of the hundreds of thousands employed by the Indian vendors, and its LTM revenue of $681 million is a tiny portion of a thriving $60 billion industry. If LXFT and its CEE peers attain a quarter of the success realized by their Indian counterparts in the late 90s and early 2000s, LXFT will not remain a $1.7bn, or even $10bn, company for much longer.
I. Situation Overview
Weakness in Luxoft’s shares began in early 2016 due to concerns of slowing growth and the perceived risk of losing Deutsche Bank (DB), Luxoft’s largest customer. The sell-off of Luxoft was exacerbated by Brexit and the overall weakness of the banking sector, leading to all-time lows for DB shares. The market now completely ignores fundamentals and Luxoft’s significant growth opportunity evident by the recent direct correlation of Luxoft’s shares with DB. We believe these concerns are overblown. Even in the most turbulent times (financial crisis of 2008-2009 and European debt crisis of 2012) Luxoft managed to grow within its largest clients. We believe over the long-term, current concerns around Luxoft’s relationship with DB will prove to be short-lived as the business continues to execute, grow and diversify.
Luxoft’s projects for Deutsche Bank are mission critical
Luxoft focuses on Deutsche Bank’s front-office rather than back-office functions, with its projects supporting entire processes that are critical for operations. Furthermore, as a result of increased regulations, the majority of Luxoft’s services help to keep Deutsche Bank in compliance with regulatory bodies in both the EU and the U.S. An example of a project that Luxoft assists with Deutsche Bank is Arena. Arena was a platform that was co-developed by Luxoft about 10 years ago and is a critical trading platform used for equities (acts as order management system for DB’s equity traders). This has been an on-going project for years and is just one of many that Luxoft’s ~2,600 engineers at DB help to manage (more examples of specific projects are available later in this report).
We find it unlikely that Luxoft faces any imminent risk of completely losing this account given the renewal of the DB MSA earlier this year which runs through 2020. DB, which has utilized Luxoft since 2003, plans to reduce costs significantly through ‘Strategy 2020’ but based on our conversations with management, we don’t expect those cuts to impact LXFT.
Deutsche Bank historically consolidated smaller IT vendors and shifted more work to Luxoft
In previous financial crises (financial crisis of 2008-2009 and European debt crisis of 2012), Deutsche Bank consolidated many of its smaller IT vendors and shifted more work to Luxoft. In 2012, Deutsche Bank undertook a major vendor consolidation and reduced the number of large IT vendors from 12 to 4. Luxoft benefited from that consolidation and attained Key Strategic Vendor status which led to an expanded footprint within the investment bank. While Luxoft is certainly larger today at DB than it was in 2012, we believe that given Luxoft’s critical role within DB’s core operations, any potential consolidation will likely occur with smaller, less-strategic vendors.
Today, non-strategic vendors account for about ~40% of Deutsche Bank’s IT offshore budget (equivalent to ~$800 million of total ~$2 billion). We think any further consolidation would result in re-allocating more of the budget to strategic vendors. Luxoft’s CEO believes that going forward the share of strategic vendors could grow from 60% to 80%, positioning Luxoft favorably as a top strategic vendor.
Luxoft has minimal exposure to the British Pound
Despite the significant European exposure, Luxoft will not be impacted