Description

Introduction

“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

“The Indian vendors provided a very good quality of people. But we realized in the last few years that people we got from Luxoft and EPAM from a seniority level were much higher and more educated with MBAs and PHDs and had many years of experience. Much more experienced than the Indian vendors. Also the loyalty was also much higher and attrition rate was lower. The domain expertise especially within capital markets was very good. All these components at the end, [Luxoft and EPAM] delivered better performance and delivery of applications compared to Indian vendors and sometimes even compared to Accenture and Cognizant, Luxoft and EPAM were better. Quality of people drives the output.” –Former CIO at UBS

Luxoft shares are an attactive long as the company is poised to double revenue over the next five years. Luxoft’s stock has declined in 2017 as investors have become concerned with the slowing growth of its top customers. However, Luxoft remains positioned as a premium vendor with a strong reputation for high-end software development, and growth outside of the top customers remains very strong.

With a revenue base of over $800 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 more than $14 billion today. LXFT should be able to grow at a similarly high rate over the next 10 years. This view is underpinned by management’s recent guidance of 15% compounded revenue growth and $1.5 billion in revenue by FY ~2022. In fact, we think that forecast is conservative. A more likely scenario: LXFT multiplies its revenue base by at least 3x 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 ~$128, more than double the current trading price.

Luxoft’s differentiated focus stems from its base in the science-centric Central and Eastern European (CEE) region. Unlike the large Indian vendors that derive a lot of their value from labor arbitrage, LXFT utilizes an exceptionally skilled employee base to deliver sophisticated domain expertise. LXFT employs nearly 11,000 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 24% 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.

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. Luxoft’s ~11,000 IT employees represent a mere fraction of the hundreds of thousands employed by the Indian vendors, and its LTM revenue of $817 million is a tiny sliver of a growing $60 billion industry. If LXFT and its CEE peers attain a quarter of the success realized by their Indian counterparts over the past 30 years, LXFT will not remain a $1.8bn company for much longer.

Situation Overview

Weakness in Luxoft shares began in early 2016 due to concerns of slowing growth as a result of troubles with Deutsche Bank (DB), Luxoft’s largest customer. Brexit and the overall weakness of the banking sector further fueled investor concerns. While Luxoft shares saw a modest recovery in the first half of 2017, the company experienced another setback in August when it reported a weak first quarter due to issues at a handful of large customers, including DB. Management lowered FY2018 guidance for revenue from $943 million to $920 million and for EPS from $3.26 to $2.85, sending the shares down by as much as 30% during intraday trading. While the quarter and guidance were disappointing, we believe the steep sell-off was an overreaction to customer issues in a limited number of accounts, and unwarranted given the high growth of other accounts.

Luxoft shares saw some relief when it reported earnings for the second quarter. Going into the report, we believe many investors were on the sidelines due to widespread fear of another shoe to drop (namely UBS). However, revenue from the top two only declined by 10% y/y and revenue from DB actually increased 14% q-o-q, eliminating the concerns that revenue from these customers would decline more than management’s guidance. Further, management provided more clarity around the various growth drivers of the business between M&A, top customers and other accounts. Excluding M&A and the top two customers, Luxoft guided towards 22% organic growth in FY2018.

While shares rebounded about 15% from the levels after reporting Q1, we think the stock is still significantly undervalued. Revenue generated from clients excluding the top five increased by 48% in the latest quarter, growing to more than half of Luxoft’s total revenue. Over time, we think investors’ concerns around customer concentration will be less relevant. Luxoft trades at 15x FY2019 (CY2018) earnings and we’ve increased our investment as the company is poised to grow 15%+ annually over the next decade.

Slowdown of top customers

The first quarter miss was due to issues with DB, Luxoft’s largest customer, and Credit Suisse, a fast-growing newer customer. At DB, the continued restructuring of the investment banking division led to deeper cuts than anticipated. This restructuring delayed numerous new projects which Luxoft had expected to ramp up between Q3 and Q4 of FY2018. Management now anticipates that these previously planned projects will not launch until FY2019, meaning that run-rate revenue from DB for FY 2018 will now be ~$150 million, significantly lower than what we and other investors had forecast. Luxoft also projected delays at Credit Suisse (CS), a customer that was previously growing at 30-35% a year. While the ramp-up at CS was initially occurring very quickly, a major project has been delayed to FY2019, reducing the growth rate to ~15% in FY2018 (vs. the previously forecast ~30%). Further, Luxoft had reallocated about 300 engineers from DB to CS for this project, driving down utilization (to 75% vs. historical ~80%). Margins were negatively impacted.

We believe the issues around DB and UBS were somewhat addressed when Luxoft reported its second quarter. Revenue from DB grew 14% q-o-q and UBS declined by only 2% y-o-y.

In addition to these issues, Luxoft had setbacks with two newly acquired accounts: AT&T and UnitedHealthcare. Luxoft inherited these relationships through recent acquisitions, and the management teams of the acquired companies had budgeted optimistic growth rates which now appear unrealistic.

As a result, Luxoft lowered FY2018 revenue guidance by $23 million (from $943 million to $920 million) on its first quarter call. While we were disappointed with the results, we remain optimistic that Luxoft is well-positioned to outgrow these issues as growth outside the top five customers was 55% in the trailing twelve months. As large customers like DB and UBS stabilize and projects are shifted to FY2019, and with growth from fast-growing smaller accounts continuing at 40-50% annually, we project Luxoft will grow ~15-20% in FY2019, further reducing top five customer concentration.

Strong growth outside of Top 5 accounts

With Luxoft still in its nascency, customer concentration shouldn’t be the serious concern that the market has made it out to be. At a current revenue base of $848 million, we believe that Luxoft will be many times larger in the future, as evidenced by its continued rapid expansion outside of its top five customers. Luxoft reported 55% revenue growth over the last twelve months from accounts outside its top 5; we are confident that customer concentration will cease to present an issue in the not too distant future.

Our revenue projections call for 17% top-line CAGR over the next 10 years. We believe that Luxoft’s 15%+ growth over the next 1-3 years will be supported by a proliferation in accounts outside the top 5. For DB, we assume no growth over our projection period. Management expects DB to trough around $150 million over the next year, with potential for growth in FY2019. For UBS, we assume no growth. We do not assume significant growth for Harman beyond the $50 million threshold, and expect CS to be on a similar trajectory as UBS. Outside of these large clients, we arrived at 25% CAGR, a hurdle which we think Luxoft will surpass given recent performance, as well as its growing portfolio of high potential accounts (“HPAs”). Growth outside of Luxoft's top 5 clients has been 50%+ in each of the past two years.

The number of what Luxoft management calls "high potential accounts" (HPAs) has increased from 12 at the IPO in 2013 to 51 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 medium-term. Management guides to over $340 million of revenue from HPAs in FY 2018, representing ~50% growth y-o-y (including revenue from HPAs acquired through tuck-in M&A). HPAs will account for at least 35% of revenue in FY2018 versus 29% in FY2017.

The slowdown of the top accounts should be offset by rapid growth from smaller customers. There’s upside from the fast-growing automotive segment which grew at 75% in the last quarter. Management has 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 allocates capital to M&A and, with its unlevered balance sheet, future tuck-in acquisitions provide another avenue of growth in excess of the base scenario.

Valuation

Luxoft currently trades at 15x FY2019 earnings, meaningfully lower than both the S&P 500 (~19x CY2018) and EPAM (~26x CY2018). EPAM is Luxoft’s closest publicly traded comparable and is significantly more diversified with its five largest customers representing 26% of total revenue versus 53% at Luxoft. EPAM's valuation premium to Luxoft appears to mainly be the result of EPAM's greater customer diversification. As Luxoft continues to grow outside of its core five customers, customer concentration will become less of an issue and the valuation delta should narrow. At 20x FY19 earnings, Luxoft would trade at $72/share, over 35% higher than today’s price.

Luxoft’s valuation also looks very attractive on a discounted cash flow basis. Using a growth assumption of a 17% CAGR on the top-line over the next 10 years, shares are worth $128, representing 140%+ upside.

Conclusion

Despite the challenges Luxoft faced over the last few quarters with its large customers, the shares are oversold. The market is preoccupied with these large customer issues while ignoring the strong growth among Luxoft’s broader customer base. The current valuation of 15x FY2019 earnings significantly undervalues Luxoft as the long-term opportunity to compound has not changed. While top-line growth in FY2018 will be off by $23 million, the market plainly overreacted by sending shares lower by 25-30%. While shares have rebounded modestly since that drop, the stock is still significantly undervalued. In the current elevated market marked by lofty valuations, Luxoft represents one of the most attractively priced growth stories. As Luxoft continues to scale and find success with a larger set of customers over the long-term, shares should re-rate significantly higher.

Appendix: Business Overview

• Unique Central and Eastern European-based IT outsourcing firm focused exclusively on high-end software services. Luxoft has nearly 11,000 offshore computer programmers and serves clients primarily in North America and Western Europe. Relative to its peers in India, Luxoft does not compete on price, but on providing teams of programmers who understand clients’ businesses and industries intimately, and are capable of providing advanced, customized application development and other IT solutions. Rather than compete with Indian offshore providers that leverage labor arbitrage to undercut rivals, Luxoft focuses on high-end software services. Indian vendors oftentimes fill their ranks with novice developers, heavily recruiting recent college graduates; in contrast, 80% of Luxoft’s employees have a master’s degree and at least five years of professional experience. This approach has enabled Luxoft’s developers to command a premium bill rate relative to the prevailing industry standard, as well as cultivate a reputation for unrivaled quality of work.

• 11,000 total firm headcount highlights LXFT’s relatively small position in the industry and potential growth opportunity. Tech Mahindra (TechM), which is only the sixth largest Indian offshore player, boasts an employee base that is still 9x that of Luxoft. With $817 million in revenue, LXFT accounts for barely a sliver of a mammoth $60 billion industry. If Luxoft can multiply its headcount by ten and deploy those new programmers at similar margins and revenue per employee, the company’s valuation could also easily multiply by a factor of ten. Given the abundance of high quality engineers available in Central and Eastern Europe, Luxoft’s ability to source new talent shouldn’t be a formidable challenge. In the science-centric CEE geography, nearly 1 million students graduate annually with a degree in engineering. Russia and Ukraine together account for nearly 600k engineering graduates annually.

Source: World Economic Forum 2015 / UNESCO Institute for Statistics.

Note: Excludes China and India.

• Extremely compelling valuation vis-à-vis growth opportunity. For an emerging IT services player with a unique niche in the growing offshore IT services industry supported by a favorable demographic (i.e. high concentration of smart engineers in CEE), the current share price undervalues LXFT’s opportunity to multiply its revenue base by at least 3x over the next 10 years. If LXFT’s IT employee base grows at only a 10% CAGR (identical to the overall offshore application outsourcing industry), LXFT’s revenue base would be over 3x larger in 10 years. The DCF above suggests an intrinsic value of ~$128/share, implying 138% upside. 

• Attrition rate among lowest in the industry. In the IT outsourcing industry, talent is amongst a company’s most valuable assets. Luxoft’s employee attrition is one of the lowest in the field, due partly to its mature and highly experienced workforce in addition to its comparatively high pay for the region.
  
  

• Success with Deutsche Bank and UBS Demonstrates High Customer Value Proposition. Luxoft’s enormous historical success with marquee clients such as Deutsche Bank and UBS is representative of the company’s ability to exponentially scale new accounts. As a result of these long-term relationships (DB has been a customer since 2003, UBS since 2008) and focus on front-office assignments (revenue mostly generated in investment banking and wealth management), Luxoft has developed in-depth subject matter expertise in the financial services industry. Revenue from both clients nearly doubled in the two-year period between FY’13 and FY’15.

Catalyst

• Further reduction of customer concentration
• New contracts and growth in verticals outside of financial services
• Continued strong growth of automotive vertical
• Potential acquisition target for acquirers looking to add digital capability