Why I'm Buying Longtop Financial Technologies

Jun.15.09 | About: Longtop Financial (LFT)

While we have had many positions in Chinese stocks, this is the first time I've had Longtop Financial Technologies (NYSE:LFT) in the portfolio. Friday morning, the stock was down over 8% and hit as low as $26... after bouncing back to $27, I am beginning a 1.5% stake in the name. This is the 20 day moving average; there is also a gap in the chart down at $24 where I'd increase the position, so I'll place a limit order down there.

While it is always iffy with some of these Chinese names, and I usually stick with the mid cap or larger, there is a 17% stake held by a prominent hedge fund called Tiger Global. Tiger Global also has a sizeable stake in an old name of mine, Mercadolibre (NASDAQ:MELI) which is another favorite, so we think along the same lines. Of course any sale by Tiger, and the stock of LFT will be hit...

The last earnings report is here, growth is quite impressive and the string of contract signings as you go through the press releases is also eye opening.

  • Total revenues for the quarter ended March 31, 2009, were US$25.9 million, an increase of 60.3% year-on-year [YoY] from US$16.1 million in the corresponding year ago period, and exceeded Company guidance of US$24.0 million. Software development revenues of US$21.1 million contributed 81.3% of total revenues, a YoY increase of 55.7%, and exceeded Company guidance of US$20.0 million.
  • Total revenues for the fiscal year ended March 31, 2009, were US$106.3 million, an increase of 61.3% YoY from US$65.9 million in the corresponding year ago period. Software development revenues, which were 84.3% of total revenues for the fiscal year ended March 31, 2009, amounted to US$89.6 million, a YoY increase of 62.4%. The YoY increase in our revenues resulted in part from the appreciation of the RMB in fiscal 2009 from an average US dollar to RMB exchange rate of 6.87 in fiscal 2009 compared to 7.46 in fiscal 2008. Excluding the impact of this appreciation, our total revenues would have increased by approximately 48% YoY.

They break out their revenue into 4 categories - "Top 4 banks", "Other Banks", "Insurance" and "Enterprise" - almost all their business is in the top 2 categories, with "Top 4 Banks" making up about half. It's good to be connected... especially in China. However, they just made a recent acquisition which will thrust them deeply into the Insurance market going forward.

  • Software development revenue from the Big Four Banks in the fourth quarter was US$8.0 million, an increase of 33.5% YoY. Big Four banks accounted for 37.9% of software development revenues for the fourth quarter, as compared to 44.2% in the corresponding year ago period. Software development revenue from the Big Four Banks for the fiscal year ended March 31, 2009, was US$42.0 million, an increase of 52.8% YoY due to strong demand from two of our three Big Four Bank customers. Big Four Banks accounted for 46.9% of software development revenues for the year ended March 31, 2009, as compared to 49.8% in the corresponding year ago period.

Gross margins for the year were just under 70%, with a drop in the last quarter down to the 63% range. We'll want to keep an eye on this to see if it pops back up. A good explanation for both the quarter and year here .... much better than I've seen in most Chinese company PR's

  • Adjusted Software Development Gross Margin was 68.6% in the fourth quarter as compared to 70.7% a year ago due to the acquisition of Jactus which closed in the fourth quarter, inflationary increases in salary and a higher mix of customized revenue which has a lower gross margin than standardized revenue with 73.3% of software development revenue coming from customized solutions in the quarter as compared to 70.0% in the corresponding year ago period.
  • Meeting Company guidance, Adjusted Software Development Gross Margin for the fiscal year ended March 31, 2009 was 72.9% as compared to 76.1% in the previous year primarily due to: (i) 65.1% of software development revenue coming from customized solutions in the 2009 fiscal year as compared to 58.3% in the corresponding year ago period; and (ii) inflationary increases in salary.
  • Adjusted Other Services Gross Margin for the fiscal year ended March 31, 2009 declined to 49.0% from 69.1% a year ago due to investment in additional headcount, inflationary increases in salary and a higher mix of lower gross margin ATM revenues resulting from our acquisition during the 2009 fiscal year of Huayuchang, a provider of ATM maintenance services.
  • Adjusted Total Gross Margin of 69.2% for the fiscal year ended March 31, 2009 was in line with Company guidance.

Guidance

  • "We are off to a promising start in fiscal 2010 with our agreement to acquire Sysnet which will make Longtop the second largest IT service provider in China's insurance industry by market share. Our outlook for 2010 is positive based on our sound business fundamentals and ongoing strong demand from our customers."
  • Total revenues of US$142.0 million, representing an increase of 33.6% YoY from revenues of US$106.3 million in fiscal 2009. Software development revenues are expected to be US$122.0 million, a YoY increase of 36.2% from US$89.6 million in fiscal 2009;
  • Adjusted Net Income of US$63.0 million or US$1.20 per diluted share, an increase of 22.1% YoY from Adjusted Net Income of US$51.6 million in fiscal 2009.

Longtop's fiscal year ends in March 2010, and on a forward PE basis the stock trades at 22x; not cheap - but this company is growing at a 50% rate (which will slow next year), and you have shrinking US consumer discretionary stocks now trading for 40x+ forward earnings, so all things being relative, it's not an awful valuation. That said, if the very crowded reflation, China, emerging market trade begins to implode - valuation will mean nothing as the lemmings crowd out the same door all at once. Also the price to sales is whopping...

Investors Business Daily has an article on this name in early April...

  • Because of its newness, the financial software industry in China looks like America's did 10 or 15 years ago: highly fragmented. Longtop's market share is in single digits, but nobody else has significantly more, even giants like IBM (NYSE:IBM - News).
  • "The banking industry in China is woefully underinvested in IT," said Jefferies analyst Joseph Vafi. "In retail banking, a lot of customers don't even have online access to their accounts."
  • Analysts say that a native company has a considerable advantage in China, with its unique language, writing system and ways of doing business. The banking industry there is dominated by the Big Four: Bank of China, China Construction Bank, Industrial and Commercial Bank of China and Agricultural Bank of China. Longtop has a strong relationship with three members of the Big Four, which supplied the majority of its software revenue in the past.
  • Longtop, in fact, risked too much customer concentration from this in the past, with more than 80% of its 2007 software revenue coming from the Big Four. But last year that figure dropped to 50%, and in the most recent quarter it was below 40%.
  • That's not because Big Four revenue is shrinking. It's just that total sales have been growing so fast. In the fiscal third quarter, which ended Dec. 31, sales jumped 79% from the year before to $33 million. Profit rose 52% to 32 cents a share.
  • "We don't see any lasting impact on customer spending" because of the crisis, said Charles Zhang, Longtop's investor relations director. "We don't see any delay or cancellation of products."
  • Longtop's bread and butter remains the basic banking IT functions: managing ATMs, online banking, call centers, credit cards and so on. It continues to draw new business by fine-tuning its offerings on those fronts.
  • In December, it launched its E@able online banking solution, handling such core services as account management, payments and transfers. Zhang says this fills a gap in previous offerings, which were more focused on ATMs and customer service. "E-banking is another area where we see huge potential as Chinese Internet users increase," he said.
  • Longtop can compete in its crowded field partly on price. Analyst Karl Keirstead of Kaufman Bros. says the fact that it's headquartered in provincial Xiamen, rather than Beijing or Shanghai, keeps its operating costs down. He says that despite its small size by U.S. standards, Longtop has an advantage in scale over other homegrown developers. This lets it keep up multiple delivery centers, while making the occasional buyout to expand its offerings.
  • Zhang says government policies should also help Longtop by spurring bank lending for infrastructure projects. The government's stimulus also bolsters IT specifically through tax breaks.
  • Still, the consensus is that Longtop won't be able to maintain its earnings at past levels. Last year's pretax margin topped 50%, which Keirstead calls "unsustainable." Both the company and analysts expect margins this year to run somewhere in the 40s.

Hat tip to reader Keith P for making me take a second look at this name after I assumed it was just a plaything of daytraders. It's been on one of my watch lists for over a year and I never delved into it, until the past 10 days.

What you want to watch in the long term here is acquisitions, diversification (i.e. the move into insurance opens a new avenue) and the gross margins. But in the short term, all that matters is "China is hot" - when that trend changes this stock will be punished like any other.

Longtop Financial Technologies Limited, together with its subsidiaries, develops software and provides information technology [IT] services to financial services industry in the People’s Republic of China. It engages in the development, licensing, and support of software solutions; provision of maintenance, support, and other services; and provision of system integration services related to the procurement and sale of third party hardware and software.

Long Longtop Financial Technologies in fund; no personal position