Sahm Adrangi’s Kerrisdale Capital has doubled down on its position in Luxoft, which is now 20% of the firm’s portfolio. Adrangi shared his thesis exclusively with ValueWalk and explained in an interview why he feels Luxoft is such an attractive opportunity.
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Sahm Adrangi doubles down on Luxoft after downward guidance revision
Luxoft is scheduled to release its next earnings report on Nov. 16, but the company’s stock took a hit last quarter when it revised forward guidance downwards due to slowing growth. Management lowered fiscal 2018 guidance for revenue from $943 million to $920 million and for earnings per share from $3.26 to $2.85, due to declines at Luxoft’s largest customers. Luxoft stock plunged after the revision in August and has never recovered, falling from above $60 per share to closer to $45 per share.
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Kerrisdale Capital, which has about $150 million in assets under management, has held Luxoft shares since the first quarter of 2015, but Adrangi tells ValueWalk that they doubled their position during the third quarter because the stock’s decline made it an attractive opportunity. He feels the sell-off was greatly overdone and that Luxoft is attractive over the long term because of its competitive advantage in high end IT application development.
Instead of focusing on the most basic types of software development, such as building websites, Luxoft offers more complex programming services such as development of self-driving technology, custom client relationship management portals and infotainment systems for vehicles.
“Over the long term we think that for these IT outsourcers that focus on high-end application development, there is a lot of demand for their services. As every company and industry digitizes every function of both their client-facing and internal infrastructure, there’s a limited number of developers graduating from U.S. colleges that can meet that demand. So Fortune 500 companies have to look abroad, and particularly to Eastern Europe where some of the most advanced software engineers are,” Adrangi tells ValueWalk.
Two IT services firms trade spots in Kerrisdale’s portfolio
Adrangi was attracted to Luxoft because of its similarities with Cognizant, which was once Kerrisdale Capital’s second largest holding. In fact, he sees Luxoft as being similarly positioned as Cognizant a decade ago in terms of opportunity and growth trajectory, and Luxoft has traded places with Cognizant in Kerrisdale’s portfolio. The firm has been gradually selling off its stake in Cognizant, and Adrangi explained to ValueWalk why these two IT services have traded positions in his view. Part of the reason boils down to the type of programming they do, while the other part is due to valuation.
“When we talk about Luxoft, we refer to Cognizant because of the growth trajectory,” he clarifies. “It was the size of Luxoft 15 years ago, and since then the stock has gone up 30 times. The reason it has done so well is there’s just a lot of demand out there for developer work, but today that demand is more at the high end versus some of the more basic, commodity type of IT outsourcing.”
One of the ways the firm has differentiated itself from other IT services firms is through its focus on highly-experienced programmers in Central and Eastern Europe, which produce almost 1 million engineering graduates every year. Programmers who work at Luxoft can do much more than basic projects like designing a website. Cognizant, on the other hand, focuses on low-end applications and a labor arbitrage strategy.
There is also one other key difference between the two firms, aside from their ages and the type of programming they do, and that’s customer concentration. It is this difference that Adrangi believes is why many think Luxoft doesn’t deserve a premium valuation multiple. The firm’s business is highly concentrated among a handful of major customers including Deutsche Bank and UBS, while Cognizant’s client base is more diversified. Customer concentration can be chalked up to the stage of the business, however, as Luxoft is at an earlier stage than Cognizant.
Unfortunately the high client concentration has made it appear that the company’s growth is slowing. Deutsche Bank is the firm’s biggest customer, and it has scaled back IT spending because of ongoing restructuring, which has delayed a number of projects. Credit Suisse, a smaller but fast growing customer, also delayed some of its projects, taking a bite out of Luxoft’s forecasted revenues.
“Luxoft won Deutsche Bank and UBS as clients in 2011-2013 and did a great job for those customers, such that DB and UBS hired a ton of programmers from Luxoft,” Adrangi tells ValueWalk. “As those projects unwind, we’re seeing a decline in the number of developers [assigned to their projects]. We’re always going to see that. It’s not surprising to see slow growth at the top customers offset by rapid growth at smaller customers because the top one or two customers always have just gotten so large.”
Additionally, Adrangi says the firm had setbacks in its business with AT&T and UnitedHealthcare, two accounts it gained through acquisitions, but unfortunately for Luxoft, the management of both acquired firms had set unrealistically high growth expectations. As a result, the firm cut its fiscal 2018 revenue guidance from $943 million to $920 million and its earnings per share outlook from $3.26 to $2.85, which tanked its stock by as much as 30% following the last earnings report.
The core of Kerrisdale Capital’s thesis
Adrangi told ValueWalk that the firm has seen 58% revenue growth from clients who are outside its top five accounts with the slowdown in growth among the biggest accounts being more than offset by rapid growth in business from smaller customers. Kerrisdale Capital pegs the long-term compound growth potential at 15%.
One reason for this growth is Luxoft’s expansion into new areas of technology like autonomous driving. The firm’s business has been highly concentrated in the financial services industry historically, but the rapid growth in autonomous driving is presenting new opportunities with a greater than 35% growth rate. The firm’s management has told Adrangi and his team that the automotive sector is a major priority, and one of the auto OEM accounts that was added last year has already become one of the firm’s 10 biggest accounts.
Kerrisdale isn’t the only fund that sees value in Luxoft. The company also features in the portfolio of Logos LP, which featured in the latest issue of ValueWalk’s exclusive quarterly magazine Hidden Value Stocks. In each issue, we feature two under the radar hedge funds and four stock picks. So far, a portfolio of stocks featured has returned 23% since inception.