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
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 by the recent devaluation of the British Pound. In the latest fiscal year, revenues from the Pound accounted for 7% of total revenue while expenses accounted for 12%. With a greater exposure to the pound in expenses, we actually expect margins to improve y-o-y as a result of the Pound devaluation. As evident by the chart below, Luxoft is paid by clients primarily on a USD and Euro basis.
Strong growth outside of Top 5 accounts
With Luxoft still in its nascency, customer concentration isn’t an immediate concern for us at a current revenue base of $681 million, because we believe that Luxoft will be many times larger in the future, and it’s rapidly expanding beyond its top five customers. Luxoft reported 56% revenue growth in the FY 2016 from accounts outside the top 5; we are confident that customer concentration will not present an issue in the not too distant future.
Our revenue projections call for 15% top-line CAGR over the next 10 years. We believe that Luxoft’s 20%+ growth over the next 1-3 years will be supported by proliferation in accounts outside the top 5. For DB, we assume little-to-no growth over our projection period. Management has made it clear that its base case is for DB to stabilize around $200 million over the next few years. For UBS, we have revenue reaching around $200 million, per management guidance. We do not assume significant growth for Harman beyond the $50-60 million threshold, and expect CS to be on a similar trajectory as UBS. Outside of these large clients, we arrived at 30-35% growth, a hurdle which we think Luxoft will easily surpass given recent performance, as well as the growing portfolio of high potential accounts (“HPAs”).
The number of high potential accounts increased from 12 at the IPO in 2013 to more than 40 at present. Clients are classified as HPAs if management believes the accounts have the potential to reach at least $5 million in recurring annual revenue within the short-to mid-term. During the 9-month period ending 12/31/15, revenue from this account base grew at 177% y-o-y and comprised at least 25% of revenues in FY2016.
Overall, we foresee the slowdown of the top accounts being offset by a large and diverse customer base experiencing strong growth. While much attention is focused on Luxoft’s work in the financial services sector, there’s likely additional upside from the developing automotive segment (more detail on this sector later in the report) which continues to grow at 40%+. Luxoft CEO Dmitry Loschinin said automotive remains a high priority and the firm’s investments appear to be paying off as an automotive OEM account added last year is already a top 10 account. Luxoft has demonstrated a willingness to allocate capital for M&A and, with its unlevered balance sheet, future tuck-in acquisitions provide yet another avenue of growth in excess of our base scenario.
Excess demand at other clients
Through our diligence with management, former executives and current customers, we discovered that demand far outpaces supply and Luxoft struggles to hire enough talented engineers as fast as it would like. Historically, Luxoft had excess demand to allocate an additional ~1,000 engineers for current customers. We think even in the unlikeliest scenario that projects get scaled down significantly at Deutsche Bank, Luxoft’s revenue base would be protected by its ability to reallocate personnel to other customers.
Luxoft publishes very detailed job postings on its careers website (http://career.luxoft.com/) and we believe the number of job postings is a good proxy to measure excess demand. Throughout 2016, the number of job postings stayed in the ~620 area, implying that demand remains very strong.
Concluding thoughts on current Deutsche Bank situation
Despite the challenges Deutsche Bank faces in an uncertain economic environment, Luxoft has proved resilient in similar macro environments and we believe Luxoft will ultimately grow out of this perceived issue as management continues to expand within other customers. Given the 20%+ growth and long-term potential to compound, we think Luxoft is too cheap at 18x earnings. Luxoft’s projects are long-term in nature, with average engagements of at least 3-5 years; moreover, Luxoft is entrenched with DB until at least 2020, and growth from accounts outside the top 5 is resilient. We anticipate that the recent sell-off of in the stock price will prove temporary, and expect to see a significant return on our investment as Luxoft shares are currently trading at bargain prices.
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