Name That Trade – Lux on, $LXFT

by CC August 27, 2015 11:36 am • Commentary

Dan discussed Luxoft back in a MorningWord post in March:

Last night on CNBC’s Fast Money we had the CEO, Dmitry Loschinin, of Swiss software company, Luxoft (LXFT) on the program.  To be 100% honest I have never even heard of the company prior to him stepping foot on the set but considering the stock’s 28% year to date gains and the fact that the stock is up 100% from the 52 week lows, it’s obvious that some investors are familiar with the LXFT story.  Watch the interview here:

What struck me as interesting was the differences in the company’s software development as they seem to be attacking two big growth areas, autonomous cars and regulatory reporting for financial companies like Deutsche Bank (DB).  It seems like these two verticals could be the gift that keeps on giving considering how nascent the driver-less car segment is, and what seems to be a never ending regulation of large financial institutions.

LXFT recently broke out to new all time highs, and I am not sure chasing it up here makes a ton of sense, but a pull back to the mid to low $40s could be an ideal long entry for a high growth stock that trades at a very reasonable earnings multiple (trades 19x expected fiscal 2016 earnings growth of 19%).  This one is on my radar.

Since that post, LXFT has traded remarkably well.  Even after the past week’s selloff, the stock is back above its its rising 50 day moving average around $60:

Screen Shot 2015-08-27 at 9.24.34 AM

The rising 200 day ma is around $50, still more than 15% lower.  $50 is an important support level with many bounces in the stock from that level throughout the spring and “printed” there on Monday’s panic open.

Digging a little deeper on the fundamentals of Luxoft, an interesting picture emerges.  It’s basically a software company with a broad focus on growing sectors of the global economy.  Since it relies on outsourced labor to remain cheaper than the competition, and has strict management principles around efficiency and productivity, it has achieved better results than the majority of software outsourcing industry.

Here are the main positives of the fundamental story:

CEO Dmitry Loschinin is the founder and owns about 10% of the company. He has assembled a strong technical team of Russians and Eastern Europeans to manage the company.  That likely leads to significant recruitment of cheap engineering talent to complete their software outsourcing projects, a key source of competitive advantage compared to Western peers.  From the conference call:

We have made significant headway with global delivery pillar, decreasing consideration for our engineering workforce by about 5% in Ukraine to 43.9% in and Russia for 25.2%.

To remind you, our business model is built on driving virtually all revenues from the developed economies while having a cost base supporting those revenues in the emerging economies.

  • 20-30% sales and earnings growth for a $1.75 billion market cap with plenty of runway in software outsourcing (41% of revenues from U.S., 67% from financial services); extrapolation of those growth rates can make the model look quite big in 5 years.

  • Keen focus on productivity: Luxoft finished the first nine months of this financial year with 8,689 employees, of which 7,333 were delivery professionals, who continued to drive average productivity during this period to another record — in excess of $74,500 per engineer or 6.9% annual growth.

  • We view this as a testament to our strong positioning in the competitive IT services landscape as a “different kind” of provider.   All key geographies posted strong performance, with the U.K. and Germany growing above the Company’s average at 37% and 54% respectively for the first nine months of the year on year over year basis.  Additionally, the past quarter has been extremely beneficial in terms of currency weakness, predominantly in the Russian ruble, which created a significant tailwind on margin levels.

Against these positives, the biggest negative is valuation.  The valuation is very rich. While the clean balance sheet is a positive, and the low tax rate helps (almost all earnings flow to free cash flow), an operating free cash flow of around $75 million vs. a market cap of $1.75 billion implies a free cash flow multiple of around 25x. Even if LXFT gets to $200 million in free cash flow in 2018, the stock still might be flat over the next 2 years.

In addition, while the breadth of the client base is very impressive, it also leads to the question of whether Luxoft is stretched too thin. Its high cost base from covering so many sectors and geographies could be a major problem in a global downturn.

Finally, the CEO seems unduly focused on the stock price.  From the third quarter conference call in the spring:

Therefore, the extreme weakness of the Russian ruble…is generating a measureable tail wind to our margins. Because of this non-recurring driver our net income margin expended to 16.4% in the third quarter with cumulative nine months figure standing at just about 14%. I just wanted to emphasize since during the weakest ruble performance our stock has been proportionally weak, which is counter intuitive.

– I have also a question to Dmitry. There are reports about you filing to sell 150,000 shares. Given that the outlook for your business is good and as far as I understand, that you believe in the stock price to recover. So what was the reason if these reports are correct?

With all of this in mind, LXFT doesn’t seem like a great buy outside of its positive momentum.  The stock is 20% more expensive than when Dan looked at it in the spring, making the valuation even more unattractive.  The stock probably still only looks interesting in the $40’s from our standpoint. But with momentum seemingly recovered from the selling this past week it’d be a difficult entry on the short side. And of course there are no options so this is strictly a stock call. But we’re keeping an eye on it.