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By John Helmer, Moscow

If the Union de Banques Suisses (UBS), Credit Suisse and Deutsche Bank decided to put their employees in uniform; contracted with a factory in Bangladesh to make the costumes as cheaply as possible; and then floated shares of the Bangladesh Uniform Company (BUC) on an international stock market, taking underwriting fees, capital gains, and dividends as large BUC’s annual profit, would that be a clever line of business? What independent investor would want to buy into such a scheme?

The question arises as a group of Russians spin out of their holding, an Isle of Man entity called IBS, their British Virgin Islands subsidiary called Luxoft, and sell brand new shares of the latter on the New York Stock Exchange at a valuation of between $500 million and $1 billion; and with better than 50% capital gain forecast in just six months. If IBS, with a market capitalization on the Frankfurt Stock Exchange of €419 million ($549 million) can double its money by getting UBS to flog off an outsource department, isn’t a share-buyer guaranteed his return so long as the banks renew their outsourcing contracts? Will they do that, though, if the graduate-degree Russians who do the work insist that Luxoft pay them better than grade-school wages?

A few days ago Luxoft published this prospectus. UBS is the lead underwriter, followed by Credit Suisse, JP Morgan, and VTB. The state-owned VTB is already a shareholder. According to the reports for financial years ending March 31, UBS and Deutsche Bank are the principal buyers of what Luxoft sells, representing between the two of them 47% of the company’s revenues each year. Unicredit, Rosbank (now VTB), Citi, and Amsterdam Trade Bank may be among the top-10 clients, which account for 80% of Luxoft’s $315 million annual sales. They are also listed in the prospectus as guarantors and security holders of loans issued between IBS and Luxoft and other Luxoft obligations.

In its financial report for the financial year ending March 31, 2012, IBS reports sales revenues of $870.5 million, two-thirds of which were generated in Russia and the CIS. No income figure has been released yet. Debt at the end of the period was $56.5 million.

Luxoft reports for the same financial period that its sales revenues came to $314.6 million, just 11% earned in Russia; US and Canadian sales amounted to 42%, UK and Europe sales, 46%.Net income, $37.5 million. Luxoft’s short-term borrowings total $16.6 million, total liabilities, $59.9 million. Related-party transactions include $12.2 million worth of services Luxoft provides to IBS, together with loans to IBS of $7.2 million, and guarantees and security pledges for borrowings by other IBS subsidiaries.

There are 195 pages of small print in the Luxoft prospectus. Exactly what Luxoft sells isn’t clear except that it’s information technology and computer processing of large volumes of data. “Examples of our solutions include an open-source car connectivity technology, called SmartPhoneLink, which we have developed with Ford; mobile financial information dashboards for risk management; smart-grid demand management systems; and open source-based test automation frameworks for network equipment.”

What does the Luxoft dashboard say about the risk of buying its shares, following the warning on page 1: “Investing in our Class A ordinary shares involves a high degree of risk.”

In the first place, the Class A share which Luxoft is selling buys only one-tenth of the influence in the company of its controlling shareholders, who already own Class B shares. Says the prospectus: “The rights of the holders of Class A and Class B ordinary shares are identical including dividend and liquidation rights, except with respect to voting and conversion. The holders of Class A ordinary shares are entitled to one vote per share, and the holders of Class B ordinary shares are entitled to 10 votes per share, on all matters that are subject to a shareholder vote.”

Then there is the problem that “we are a ‘controlled company’ under the corporate governance rules for NYSE-listed companies.” What this means is that with at least 50% of the Luxoft shareholding after IPO, the spinoff parent IBS will continue to dominate Luxoft, whatever the new shareholders have to say. Exactly how many shares Luxoft is selling has not yet been announced. “Our principal shareholder is IBS Group Holding Ltd. (“IBS Group”), a leading software development and information technology services provider in Eastern Europe founded in 1992. IBS Group’s global depositary receipts are listed on the Frankfurt Stock Exchange. Following the completion of this offering, IBS Group will beneficially own % of our outstanding Class B ordinary shares and will have control over % of our voting power.”

Filling in the blanks will help. Even so, IBS can be expected to control the company, its cashflow and accounts until the IBS shareholders decide to cut and run. That could come next May. According to the prospectus, “IBS Group has advised us [sic] that it may consider divesting all or a portion of its ownership interest in us through an exchange offer or other form of distribution. IBS Group has advised us that it has not made an affirmative decision to pursue any such transactions and the timing of any such transactions is undetermined, however, no such transaction will be consummated during the 365-day period following the date of this prospectus. There are many factors that could affect IBS Group’s decision to pursue such a transaction, and it may never pursue such a transaction at all.”

Exactly who are “us”? The principal shareholder is Anatoly Karachinsky (image left), 59, a computer engineer. The prospectus suggests he owns 43% of the shares of IBS, and with Sergei Matsotsky (centre), another 20.2% of IBS; Matsotsky is a group vice president. Altogether, IBS owns 86% of Luxoft. Dmitry Loschinin (right), Luxoft’s chief executive, holds stock and options amounting to another 5% of Luxoft. VTB’s stake in Luxoft hasn’t been disclosed; it is about 9%. Between the management group and VTB, at least two-thirds of Luxoft’s shares will be retained after the IPO.

The Russian labour force is Luxoft’s strategic asset; hanging on to it requires wage bidding against the rest of the IT world. Last October Karachinsky criticized the welcome mat rolled out by Prime Minister Dmitry Medvedev for Facebook owner, Mark Zuckerberg. He has lobbied against US company raids on Russian computer programmers and software designers, and advocated Kremlin countermeasures in support of Russia’s IT businesses. According to a lengthy interview Karachinsky gave to Vedomosti and ComNews.ru in March, “I have not found that there is a program to support high-tech exports by private companies, nor any particular people in the government who are responsible for it; especially I don’t feel there is the belief that Russian technology companies can become major players in the world.” In this interview, Karachinsky provided several examples of the type of software and computer system applications his group designs and sells. “We, as a public company, are always very careful talking about forecasts. But we believe that IBS is expected to grow by 6% to 12% per year, Luxoft by 18% to 23% — that would be optimum growth for us.”

According to an interview Matsotsky gave in 2007, dependence on client contracts is risky business. “Large long-term outsourcing contracts were in vogue in the West a few years ago when, for example, some tax authorities of Australia signed an agreement with an IT company for several hundred million dollars and a term of ten years. But if you look closely, in the West these days are over. Customers want to move from so-called strategic outsourcing to functional [contracting]. That is, they want to buy specific services, and have the opportunity at reasonable intervals to change contractors. In Russia no one at all was used to the idea of signing contracts for a period of, for example, five years. And from this point of view we have been more strongly hardened than many Western companies… That is, we are lean, are in constant readiness to fight.”

It is unclear what exactly Luxoft is offering as its competitive edge in the North American market over homegrown programmers or Indian outsource contractors, except that the Russians have to be smarter, and for the time being accept a lower multiple for their wages than Karachinsky wants for his shares. “We are strongly undervalued by the market as our company combines two investment cases, which are interesting for different investors,” Karachinsky told Bloomberg last November. “One is IT business in Russia, and the other one is the so-called offshore software development for large Western companies, under the Luxoft brand.” He conceded that the idea of extracting more capital from North America through an IPO was inspired by the example of Epam Systems Inc. (EPAM), the creation of Belarusian expatriates in the US. Since its IPO on the New York Stock Exchange at the beginning of 2012, EPAM has recorded an 83% gain in share price; UBS was one of the four underwriters for that issue. EPAM’s current market capitalization is $1. 2 billion. “It became easier for us to target the U.S. stock market once we’ve got a distinct peer from central Europe there,” Karachinsky said.

Uralsib Bank is the first major Moscow institution to value Luxoft for the share sale. According to analyst Konstantin Belov’s report, issued last Tuesday, “our DCF-based valuation of Luxoft resulted in a fair equity value estimate of $585 mln pre-money or $535/share based on the currently outstanding 1.1 mln shares (not accounting for the outstanding share option plans). We thus recommend participating in the IPO if there is a chance to enter into the name with a 10% discount to fair value or 20% to EPAM Systems’ valuation. This would correspond to a $530 mln pre-money valuation for Luxoft or $480/share (given the current number of shares). At the same time, we highlight risks for existing minorities of IBS Group. As a result of the placement they would reduce exposure to the best part of the group’s business. Furthermore, having an opportunity to gain direct exposure to Luxoft could reduce investors’ interest in IBS shares.”

This year and next, according to Belov’s calculations, Luxoft shares should be priced (price/earnings ratio) at a discount of about 20% to EPAM; 48% to a fuller list of global peers including Microsoft, Oracle, Symantec, and Citrix.

In his report to the market last week, Belov acknowledged that once Luxoft lists as a US stock, it may have to reduce its Russian workforce to support the profit line and share price. “We see risks of rising labor costs as a major operating concern. We see growth in the company’s labor costs as a major operating risk, as labor is estimated to have accounted for about 60% of total costs or 50% of revenues in 2012, and upward pressure on salaries in the sector was quite apparent. Luxoft has been seeking to mitigate this risk by opening new locations in regions where wage levels were lower, including both Russia and abroad.”

One additional caution for new sharebuyers. According to the prospectus, Luxoft isn’t planning to pay out any dividends, except for the controlling shareholders who have been running the company. They paid themselves $30.5 million in dividends for FY 2012, when according to the financial statements, the net income for the year was $36 million. “We do not intend to declare or pay any further dividends on our ordinary shares for the foreseeable future following this offering. Any future determination relating to our dividend policy will be made at the discretion of our board of directors, subject to the BVI Act, and will depend on a number of factors, including future earnings, capital requirements, contractual restrictions, financial condition and future prospects, and other factors our board of directors may deem relevant.”

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