Investment Thesis:

We believe Lionbridge Technologies (LIOX) offers an attractive risk/reward opportunity over the next 18 months given its market leading position, margin improvement potential, cash flow generation capacity and valuation.

 

LIOX’s stock price has declined 35% since its Q1 earnings call (through 7/05) as the market reacted to delays in realizing merger related cost savings.  Despite the recent negative sentiment, LIOX is a fundamentally healthy company.  It has a unique market leading position in an attractive space that is expected to grow at 8-10% annually.  Currently trading near 7x  2007 EBITDA, LIOX is not dirt cheap but it is considerably undervalued for such a high quality business.  LIOX business requires very little Capex.

 

Background

 

Having acquired larger rival Bowne Global Solutions (BGS) in the fall of 2005, LIOX is the undisputed leader in the market for globalization and localization services.  Globalization and localization services primarily refer to the linguistic, cultural and technical modification of products to adapt them for international markets.  For the most part, manual translation is outsourced to third party single language translators and success in the globalization business rests on efficient project management, quality control, high touch customer service, and effective utilization of technology.  The market for globalization and localization services is estimated to be a $4-6B opportunity, 50-60% of which is managed internally, and is expected to grow at 8-10%.

 

With the acquisition of BGS, LIOX is now over 3x the size of the next largest competitor and an order of magnitude larger than the majority of providers in this space.  The market is highly fragmented, including only two vendors with revenue greater than $100M.  The second largest provider, SDL International ($135M), recently acquired the industry standard translation memory software platform Trados and is positioning itself as a language tools provider as much as a service provider.  There are a handful of up and coming privately held service providers in the $50-60M range, another dozen between $15M and $30M, and hundreds of small translation companies that tend to be operated as lifestyle businesses.  Lionbridge has been a consolidator in the space, having made nine acquisitions in eight years.  The company IPO’d in 1999 and has since expanded from $90M to $400M in annual revenue.

 

There is a tremendously broad range in the scale of clients and projects in this market, and as such benefits to scale on the vendor side are not universal – there is an appropriate sized vendor for every customer.  All providers have access to third party translators, and improvements in global communication and technology have enabled a productivity explosion that smaller firms can take advantage off.  However, LIOX’s global footprint and integrated processes and technology (including its proprietary workflow platform) offer a substantial advantage in serving global clients with large-scale and complex globalization needs.  Microsoft is LIOX’s largest customer, representing approximately 20% of revenue. 

 

Thus far LIOX has done an excellent job of managing client relationships through the BGS merger, and while revenue did not grow organically in Q1, the company expects to see top line growth return in Q2.  While LIOX does not sign long-term contracts that guarantee revenue levels, the company experienced considerable recurring demand for its services given the lifecycle characteristics of its clients’ products.

 

 

Valuation & Economics

 

Fully-diluted Shares Outstanding:            61mm

Stock Price (7/05/06):                            $5.36

Debt:                                                    $91mm

Cash:                                                    $24mm

Market Cap:                                          $328mm

Enterprise Value:                                   $396mm

 

On a pro-forma basis, the combination of LIOX and BGS produced $24M in EBITDA in 2005 on just over $400M in combined revenue.  At the end of 2005, management cited $20M in “identified” overhead savings, including $17M that had already been “acted upon,” and indicated that more savings were to come.  Overhead savings coupled with an expected 100BP gross margin improvement from the transition of BGS volume to the LIOX workflow platform provided the basis for management’s 2006 EBITDA guidance of $50-60M on $400-430M in revenue.

 

A word on the company’s overhead.  LIOX’s income statement contains a large bucket of costs for General and Administrative expenses.  Included in the company’s G&A is not just corporate overhead but all of the company’s project management costs, production offices, etc., which are largely fixed (within a given revenue range).  The company’s Cost of Revenue is predominantly variable and represents the cost of translation services, most of which is outsourced.  Operating leverage is decent with contribution margins of 30% on incremental revenue.

 

The BGS acquisition offered significant cost saving opportunities combining the infrastructure of the two companies.  In particular, BGS’ operating model contained a lot of localized production and project management resources, including numerous offices in high cost geographies such as Europe.

 

As Q1’s results illustrated, however, management’s merger related cost savings proved to be too aggressive in the short-term.  Q1 EBITDA of $7.4M ($8.3M excluding stock based compensation and non-operating costs) fell below expectations.  More importantly, management failed to cite further acted upon cost savings and acknowledged that some savings are now up to two quarters behind schedule – delays were primarily associated with office closures and headcount reduction in Europe.  Arguably, management should have been more sensitive to the constraints regarding the reduction of people related costs in Europe.

 

While we consider management’s as of yet unrevised 2006 EBITDA guidance to now be unreachable (especially the upper end), we believe investors are too focused on the short-term disappointment.  Current sell-side EBITDA estimates range from $33M to $41M.  To us, $33M makes little sense.  The company has achieved $13M of the $17M in acted upon savings – $12.4 of which is visible in the P&L from 3Q05 to 1Q06 – and is now operating on an annualized overhead cost basis (including sales & marketing and research & development) of just under $104M, excluding D&A and stock based compensation.  Cost creep should be more than offset by savings that have yet to hit the P&L and the company should exit 2006 with annualized overhead costs of roughly $102M, exclusive of any savings incremental to the $17M acted upon at the end of 2005.

 

At present we remain confident in the company’s revenue objectives for 2006.  If LIOX is able to achieve a 36% gross margin in 4Q06 as it expects to, the company will exit the year with at least $45M in run rate EBITDA (assuming annualized revenue of $408M or 4x the low end of current Q2 guidance of $102M) .  If the company hits the midpoint of its current revenue guidance for all of 2006, it is likely to exit the year at a $420M run rate with $49M in EBITDA. 

 

Looking forward to 2007, the company expects to return to 8-10% top line growth and to squeeze and additional 100bps out of gross margin over the course of the year, leaving 2007 at 37%.  If it can achieve 36.5% gross margin on average for 2007, LIOX should be able to generate $55-60M in EBITDA in 2007.  This range is based on overhead costs of $104 to $104.5 and revenue of $435 to $450.

 

At the current enterprise value of $396 LIOX is trading at 6.6x to 7.2x our estimated 2007 EBITDA range of $55 to $60.

 

Lionbridge has low capital investment requirements ($7-8M recent annual capital expenditure) and should be able to pay down $20-30M in debt this year.  Given its market position, growth prospects, and operating leverage, we are willing to apply a 9-10x EBITDA multiple, and we think that as investors begin to look towards the company’s 2007 potential, the stock could climb to $7.50-9.  This represents a 40% to 68% increase over the current price.

 

Outlook

 

While Lionbridge has been beaten up over delays in short term costs savings, it has quietly done an excellent job of managing other aspects of the integration.  By aligning its sales force early and prioritizing customer relationships throughout the process, the company was able to avoid any significant customer attrition and maintain its top line – an achievement that may be more important to the health of the business than short-term cost savings.  The company was also apparently able to retain talent from BGS and its own organization during the transition.  Channel checks have yielded universally positive customer feedback, and Q2 revenue guidance of $102-105M is an indication that the company is beginning to grow again.  While some overhead savings will continue to roll in, the company’s focus going forward will center around gross margin improvement and organic revenue growth.

 

 

Risks

·       Continued slow execution on targeted cost savings

·       Official revision of guidance highly likely with Q2 earnings release

·       Potential customer attrition although little of significance has occurred thus far

·       Management credibility weakened by failing to meet aggressive targets. Stock could remain in the penalty box for a while