Kerrisdale Capital, a private investment manager, is known as a short-seller that publishes reports on companies that it finds overvalued, like its report on biotech Prothena earlier this month. What some people may not know is that the firm also holds many long positions in overlooked companies with cheap valuations or that are attractively priced. In a recent interview with ValueWalk, Sahm Adrangi, Kerrisdale’s chief investment officer, discusses his firm’s largest position in Luxoft, a global software development and IT provider. In the article, Adrangi shares why he believes Luxoft is poised to double revenue over the next five years and why the shares should be worth triple the current trading price in 10 years.
What Does Luxoft Do?
While many consumers are aware of offshore IT services in India, not as many are familiar with the large base of programmers from the Central and Eastern European (CEE) region that are highly proficient in science and technology. Rather than compete with Indian offshore providers that leverage high labor headcount with lower billing rates, Luxoft employs nearly 11,000 exceptionally skilled programmers in the CEE area that specialize in high-end software services for sectors such as financial services and automotive, serving clients primarily in North America and Western Europe. Indian vendors oftentimes recruit recent college graduates and novice developers; in contrast, 80% of Luxoft’s employees have a master’s degree and at least five years of professional experience. This approach enables Luxoft to charge a premium rate, generating the highest revenue per employee within the offshore industry.
Luxoft’s clients rely on them for advanced, customized IT solutions for the application services sub-segment within the IT services industry, allowing them to differentiate themselves from some of the small Eastern European competition and Indian providers. Revenue generated from clients in financial services and automotive account for nearly 80% of total revenue. While revenue from the automobile segment accounts for only12% of total revenue, the industry is rapidly expanding and evolving to incorporate sophisticated components that Luxoft has expertise in.
Why is Luxoft Priced Low if it’s Such a Great Stock?
Adrangi first identified Luxoft as a great buying opportunity when Luxoft shares began to show signs of weakness several years ago due to a number of factors. Originally, the stock had been pitched as a short, and given Kerrisdale’s penchant for short selling — the fund raised one of the largest co-invests for a short target last year — it’s not surprising that the firm’s largest long position came out of diligence originally on the short side. With Luxoft, Investors were primarily concerned with slowing growth as a result of troubles with Deutsche Bank (DB), Luxoft’s largest customer. Brexit and the overall weakness of the banking sector also increased investor worries.
In 2017, Luxoft management lowered FY2018 guidance for revenue from $943 million to $920 million and for earnings per share from $3.26 to $2.85, as they expected revenue generated from Luxoft’s largest customers to slow down—thus resulting in a steep sell-off. More recently, Luxoft experienced project delays with Credit Suisse, a fast-growing newer customer that was previously growing at 30-35% a year. A major project has been pushed back to FY 2019, reducing the growth rate to ~15% in FY 2018.
In addition to issues with DB and Credit Suisse, 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.
Adrangi believes that investors were overreacting to customer issues in a limited number of accounts while ignoring the high growth of other accounts.
Significant Growth Opportunities
Luxoft currently has a revenue base of $817 million. Kerrisdale believes 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 58% revenue growth over the last twelve months from accounts outside its top five. While much attention is focused on Luxoft’s work in the financial services sector, there’s likely additional upside from the developing automotive segment which continues to grow at 35%+. Adrangi is confident that customer concentration will cease to present an issue in the not too distant future.
A Sliver of the Offshore IT Industry
While global offshore IT services are expected to grow 9% annually through 2019, Luxoft operates in the application outsourcing sub-segment which is projected to grow 14% annually over the same period. Growth of the offshore IT industry will be supported by the cost differential between U.S. and non-U.S. IT employees. Based on Susquehanna research, U.S. IT personnel are expected to command a 66% and 25% premium to Indian and Eastern European employees, respectively. Adrangi believes this cost delta will continue to drive demand for outsourcing work to these geographies. Luxoft employees not only cost less, but have proven domain expertise, particularly in the financial services and automobile sectors.
Furthermore, the shortage of engineering talent in the U.S. shows no signs of waning. With an increasing percentage of master’s and Ph.D. degrees being earned by international students, U.S. employers continue to rely on foreign talent to fill science, technology, engineering and mathematics (STEM) jobs. This gap between the supply and demand of STEM graduates in the United States is particularly evident in specialized fields such as software development. Should these trends persist, the U.S. is projected to face a shortage of one million STEM workers by 2022.
Increase Number of Employees
Given Luxoft’s relatively small scale of nearly 11,000 engineers, Adrangi believes that Luxoft can exceed overall market growth by a significant margin over the next decade. 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.
Adrangi projects that if Luxoft’s IT employee base grows at only a 10% CAGR (compound annual growth rate) (identical to the overall offshore application outsourcing industry), Luxoft’s revenue base would be over 3x larger in 10 years.
Luxoft currently trades at 13x FY2019 earnings, meaningfully lower than both the S&P 500 and EPAM, which 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. Adrangi believes the valuation gap between Luxoft and EPAM is primarily due to customer diversification. As Luxoft continues to grow outside of its core five customers, he estimates that customer concentration will become less of an issue and that the valuation delta will narrow. At 20x FY19 earnings, Luxoft would trade at $74/share, over 50% higher than today’s price. Adrangi’s discounted cash flow analysis suggests an intrinsic value of ~$128/share, implying 170% upside.
Kerrisdale is in for the Long Run
This is not the first time Kerrisdale has made public its position in Luxoft. In October 2016, Kerrisdale published a report on Luxoft explaining its long thesis. In a series of tweets, Adrangi writes:
“We are long $LXFT, a high-end IT svcs provider trading at depressed valuation. Full report http://kerr.co/lxft
$LXFT focuses on high-end software development and sources engineers in Central and Eastern Europe
Sell-off in 2016 due to concerns around customer Deutsche Bank. But $LXFT expanded footprint within DB, UBS during prior fin crises
More importantly, $LXFT growing rapidly outside top 5 accounts. Sales ex top 5 grew 56% in FY16. Customer concentration will dissipate
More importantly, $LXFT growing rapidly outside top 5 accounts. Sales ex top 5 grew 56% in FY16. Customer concentration will dissipate”
Kerrisdale’s Previous Picks
Could Adrangi be right about Luxoft’s future growth? Only time will tell, but you could take a look at Adrangi’s past bets that have recently made it in the news. You can find all of Kerrisdale’s reports on its website, where people can sign up for its investment newsletters for free.
Most known for short selling and publishing research, Adrangi first made a name for himself shorting Chinese companies and telecoms — such as Globalstar several years ago — and has since broadened his approach to invest in longs and other sectors. But Kerrisdale occasionally also conducts activism on longs. In 2013 he engaged with Lindsay Corporation management to optimize the company’s cash deployment and consider shareholder-nominated directors to provide independent views to board deliberations. Mr. Adrangi led the proxy contest to replace the directors of Morgans Hotel Group, with two directors from his slate elected in 2014.