Luxoft: A Tale Of Two Elections Leading To One Opportunity

| About: Luxoft Holding (LXFT)
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Summary

Ignoring fundamentals, Luxoft stock has been negatively affected by the political events in Ukraine.

The fundamental business is going strong, both in absolute terms and relative to the Indian IT services companies, and deserves a premium.

There seems 30-40% upside as performance helps the stock to shed off near-term blues.

For anybody following the IT services sector, it's hard to miss the divergence between Luxoft Holding Inc. (NYSE:LXFT) stock, which has a majority of its operations out of Ukraine and Russia, and stocks of Indian IT companies. Both Luxoft and Indian IT services sector stocks have been affected by political events in their respective geographies, but fundamentals suggest that Luxoft offers an opportunity, whether analyzed in isolation or relative to the Indian IT stocks.

Looking at the stocks, investors are either over-analyzing the effect of politics on the fundamentals of IT services sector or under-appreciating the power of these businesses, independent of the politics of the land. While Luxoft stock has suffered due to investor concerns around political events in Eastern Europe, the Indian IT services stocks like Cognizant (NASDAQ:CTSH), Wipro (NYSE:WIT) and Infosys (NASDAQ:INFY) have benefited from the promise of the new government accelerating the pace of economic reform.

Fundamentally, there is a marked difference between the performance of Luxoft, which is growing nicely, making operational improvements, expanding headcount, launching proprietary platform solutions and has a good visibility, and Indian IT service names that are suffering from low growth, management issues, visa issues and overall margin issues due to over-reliance on low-margin businesses.

Not much affected by politics

Although no business is ever 100% immune from what happens politically in the country, but for the IT service providers in general and Luxoft in particular, other than the physical risk to the delivery centers and employees, there are limited political risks. There are no reports to suggest that there is any such risk to any of Luxoft's facilities. Looking at sheer fundamentals of the business, the company seems to be in a sweet spot, with clients in Western Europe and North America, economies that are doing well, and the majority of its operations in Eastern Europe that is struggling economically.

Source: IBS Group

As a policy, the company doesn't allocate all the work of any client to one delivery center, and as the chart above shows, the workforce is well-distributed between Russia, Ukraine and the rest of Eastern Europe. From the revenue standpoint, as the chart below shows, there is no exposure to Ukraine.

Source: Luxoft's latest quarterly results

Indeed, the currency volatility has been favorable for the company, with a weak Russian ruble, Romanian leu and Polish zloty, especially against the euro. The company has very limited exposure to the Ukrainian hryvnia, because even though the company pays its employees based in Ukraine in hryvnia, the contracts are denominated in U.S. dollars. Overall, a stronger euro has helped the company on the top line, and weaker currencies have helped the company on the margin front.

Fundamentally well-positioned, with good near-term dynamics

Luxoft has been able to grow organic revenue at 25% CAGR for the last few years, and growth from the top 5 clients has been double that average, as the chart below shows. The revenue, 80% of which comes from existing customers, is diversified around verticals, customers and geographies. Going forward, the number of "high-potential" accounts, businesses that can grow from zero to $5m in less than 3 years, are close to 15, with more than 5 being added in the last few months.

Source: Luxoft presentation

Growth drivers: Some of the drivers that can accelerate this steady growth rate are fast-growing verticals like auto and proprietary product platforms. Revenue for the auto and financial verticals grew at 73% and 39%, respectively, in the most recent quarter, and looking at some of the projects, the company can maintain this growth rate in the near future.

Recently, the company has started to build an advanced engineering center focusing on connectivity and telematics in the car, and launched an ABS (Asset Backed Securities) practice that focuses on securitized products, both of which point to the company's ability to focus on high-value added solutions, besides the revenue growth opportunity.

Luxoft also develops its own proprietary portfolio of products that can be a significant contributor to the revenue growth, besides enhancing its value to the clients and offering cross-selling opportunities. Two products, Horizon and iStockTrack, have started to contribute to the top line.

Operational improvements: Almost all operational performance metrics are improving. Attrition, one of the biggest concerns during the IPO, is constantly declining and now stands close to an all-time low of 9.9%, down 3% over the last year. The average productivity of an engineer is close to $69,000 and improving.

Better placed compared to the India-based outsourcing companies

Indian IT services stocks, as a group, have been ignoring the worsening fundamentals. Stocks, so far, have managed well to avoid the mounting concerns related to slowing growth, management issues, visa issues and failure to move up the value chain. Stock performance has been helped by the market-friendly outcome of the recent elections in the country, which promises to accelerate business reforms. But, this temporary political reprieve for the stocks may not be enough to ward off investor concerns, and any strength in the Indian rupee may actually make matters worse for these companies.

Luxoft, compared to the Indian IT companies, is better placed due to its focus on the higher end of the value offerings. The company has focused on the middle office engagements, compared to outsourcing back office that is dominated by the Indian companies. Almost 80% of Luxoft's employees have a master's degree or higher, and the company uses only a handful of work visas for its customers in the U.S. Growth and profitability, in the IT services industry, is also shifting towards relatively high-end "managed services" businesses, which offer fixed price and full project ownership to the vendor.

Source: IBS Group presentation

Price target and Financials

The price target of $45-50 is based on 18-20 times next year's earnings, at which level the company will be trading more attuned with its growth profile and similar to the trading multiples of the Indian IT stocks, as the worksheet below shows.

Relative Valuation

Rev. growth (Est. 2014)

Rev. growth (Est. 2015)

P/E 2015

P/Sales

P/Book

EV/EBITDA (TTM)

LXFT

22%

21%

13

3

7

15

INFY

9%

9%

14

4

4

11

WIT

9%

9%

18

4

5

15

CTSH

17%

16%

18

3

4

13

Discount, relative to the Indian IT stocks, can mostly be attributed to the recent political concerns. There is significant room for improvement, since the trading discount, even after providing more than twice the growth rate, can be easily quantified from the traditional valuation metrics, but the valuation premium for better visibility is harder to quantify. Typically, Luxoft has more than 90% of the expected revenue as backlog at the start of the year.

Besides catching up with the relative valuation discount, there is ample room for earnings upside, especially if the present operational trends stay put. Margins usually benefit from more fixed price contracts, especially in the second and third year of the contracts, and fixed price contracts have been growing for the company. Revenues have been growing faster than the headcount, which is a good sign for any service company. Improving Europe, the largest market for the company, should also help.

Risks

Some of the risks that can derail the long thesis

Political risk: The situation is as unpredictable as ever, even for any political scientist to comprehend completely. Any major flare-up can affect the stock negatively.

Float: The stock has a small float, and a majority of the outstanding stock is owned by the IBS Group. A small float can increase the volatility, while IBS Group ownership does create an additional layer of uncertainty.

Attrition rates and wage inflation are a constant threat to the IT service sector. Even though the company has been able to manage them well, but the trend can change quickly.

Scale: There are concerns around the size of the available talent pool in some of the geographies where the company operates, considering the number of students graduating, which questions the long-term growth potential of the company.

Conclusion

Political events have overshadowed fundamentals of Luxoft and Indian IT service sector stocks. In Luxoft's case, bad political news flow is offering a good opportunity, as some elements of the recent political disturbance, like weak currency, may work in favor of the business. The discount on offer is an opportunity, and its fundamentals deserve a premium to the Indian IT stocks, which may be the case in the coming months as negative news flow fade and improving fundamentals take center stage. The sector is more or less immune from the political events, unlike maybe other sectors like commodities. Fundamentally, the business is strong, with growth drivers in place to accelerate growth in the coming quarters.

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.

Additional disclosure: I'm long RS Software India Ltd. (listed in India), which may be impacted by some of the stocks mentioned in the report.