It's a big world out there, and keeping up with the local needs and demands of customers is an increasingly significant part of growing global sales. To that end, maybe it goes without saying that the translation and product localization services offered by Lionbridge Technologies (NASDAQ:LIOX) are certainly necessary. Likewise, the company's development and testing services allow companies to more efficiently test and improve their mobile, web, and software releases prior to full commercial launch.
That all sounds fine, and Lionbridge boasts some major customers like Microsoft (NASDAQ:MSFT), Nokia (NYSE:NOK), and Google (NASDAQ:GOOG). Unfortunately, the company hasn't been able to really carve out a lucrative niche for these services, and the company's revenue growth, margins, and returns on capital have been unimpressive for some time now. Although I do think there is significant untapped potential in this business, investing in the shares today requires a certain degree of faith that management will figure out the right combination to unlock that potential.
Need Isn't The Issue
I don't think I have to spend a lot of time outlining why or how there is a significant global demand for Lionbridge's language and content services (Global Language and Content, or GLC). Companies like Nokia and Microsoft sell their phones, software, and so on in scores of countries, and the products (as well as the documentation) need to be intelligible to the local market. While some large companies try to handle these tasks internally, it's not always (or even "often") cost-effective to keep staff on hand to address the language/localization needs for every country in which a company may try to market products.
What is more challenging, though, is establishing solid pricing and returns for these services. It may not make sense for a single company to hire staff to handle translation and localization for 40 or more countries, but it doesn't make much more sense for Lionbridge either if they cannot generate enough business/demand to leverage the staff they need for a particular region. Likewise, many companies work with small businesses on an outsourced basis for these services and that tends to reduce pricing power (and Lionbridge, too, often uses subcontractors).
Technologies like GeoFluent may help in time. GeoFluent is a cloud-based translation technology that allows for the real-time translation of communication forms like online chats and forum posts. With GeoFluent, a company could use a centralized customer service operation to handle customers from a range of countries and languages.
Development And Testing Coming Along
While Lionbridge's GLC business has been volatile, including a disappointing first quarter performance in 2013 tied to weakness in Europe, the Global Development and Testing (GDT) business has been coming along.
This business handles a range of testing needs for clients including testing mobile and web apps, testing new games, localization testing, and certification for local vendors and system integrators. Said differently, companies like Microsoft and Hewlett-Packard (NYSE:HPQ) use Lionbridge to make sure that new products work as anticipated and that local service providers can, in fact, properly support the technology for customers. Poor service/functionality upon launch (think back to the releases of games like Diablo III or the latest SimCity iteration) can anger and alienate customers, and so it often makes more sense to pay external parties like Lionbridge to run thorough tests prior to launch.
This, too, is a competitive market. Traditional IT service outsourcers like Infosys (NASDAQ:INFY), Tata, and Accenture (NYSE:ACN) offer some testing services that overlap/compete with Lionbridge, but even so the margins here are better. Unlike the single-digit margins of the language/localization business, Lionbridge's development and testing operations generate margins in the high teens and better revenue growth as well.
The Model Needs Work
Microsoft has long been a major source of Lionbridge's revenue (nearly one-quarter recently), and the company's top 10 customers have often contributed 50% to 60% of the company's revenue. While it's a good thing on balance to have major global enterprises like Microsoft and Nokia as customers, the lumpiness of major product development/launch cycles has led to lumpy performance at Lionbridge.
I also believe there are fundamental issues with how the business has been run. Reported consolidated revenue has barely grown since 2006, and the company's gross margins (consistently in the low 30%'s) don't speak to strong pricing power. While Lionbridge only has just so much pricing power (before customers would consider going in-house or finding other consultants/contractors), the margin here doesn't suggest a great deal of perceived value in the services. Moreover, with the margins being what they are, the company has never earned its cost of capital over the long term.
Can this change? I do believe the potential is there. GeoFluent sounds like a strong offering for the global customer service market and I would only expect the demand for localization services to increase. Likewise, development and testing service demand should remain a solid growth opportunity. Even so, absent a significant change in the company's direction, whether in management or its approach, there are reasons to doubt whether that potential will ever be realized or tapped.
I'm going to need more evidence before I give the company much of the benefit of the doubt. Frankly, I think my long-term revenue CAGR estimate of 5% is plenty generous relative to the sub-2% growth rate seen between 2006 and 2012. I'd also note that I do not believe that Microsoft's acquisition of Nokia's handset business will put much, if any, of Lionbridge's revenue at risk.
Likewise, projecting a consistent mid-single digit free cash flow margin (leading to free cash flow growth of over 15%) seems fair given the company's historical performance. I don't disagree that Lionbridge could do better than this, but I'm not willing to project that they will.
The Bottom Line
My cash flow modeling suggests a fair value for Lionbridge shares of around $4, which really isn't enough to generate much enthusiasm from me. Were the company to start generating better revenue growth and margins, the stock would certainly outperform but I think that opportunity has to be set next to the malaise of the last few years. I'll be monitoring this one for signs of improvement, but investing today takes a greater leap of faith than I'm willing to make with my own money.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.