Description

Business Introduction

CAG Group (CAG ST) is one of the leading Swedish technology consultancies, focused primarily on IT and cyber security across both public and private sectors (50/50 revenue split). Owner/operator led (Chairman/Founder still owns 20% of equity), CAG has grown rapidly through acquisition by rolling-up consulting firms within the Nordic region. CAG is an interesting opportunity in that it (1) is decentralized and operates through an independent subsidiary model (10 subsidiaries today), (2) is focused today on growth via M&A and (3) has the opportunity for material margin expansion over time. On conservative assumptions around sales growth (+5% organic with bottom-end of mgmt. guidance for M&A) and modest margin expansion (14% from 10.8% today), I see a path for the equity to generate compelling IRRs on a 5-7 year view (~18-20% through 2030). 

Based on our research, few English-speaking investors have looked at CAG. All of their reporting is done in Swedish, which has limited the investor-pool. However, we believe this will change over the coming year as CAG looks to expand its investor base and invite in more global investors.

This opportunity is best suited for PA’s or smaller funds that focus on illiquid securities. The market cap (in USD$) is $68M and average daily trading volume averages ~$45K. As of 6/22/23, SEK/USD was 0.094.

Company Background

CAG’s beginning actually dates back to the early innings of the IT J curve. Started in 1987, Bo Lindstrom (now Chairman) founded ‘Contactor’ in the hope of riding the enormous growth within the IT services vertical. The evolution of CAG (merger between Contactor and 2 other IT consultancies) began out of the dot-com bust. In 2014, Bo promoted Michael Ekman to CEO. 2017-18 brough cost-control challenges, which required a change of leadership at which point Asa Landen Ericsson was appointed as CEO. Asa had a strong track record across the Swedish consulting landscape as CEO of Cygate (IT focused consultancy in Sweden) and on the board of Grant Thornton Sweden. Overall, she seems like a rational and capable leader, who has managed the business well since assuming the role of CEO.

Customer Value Proposition

The most challenging headwind for businesses today are: (1) How do we enhance our technology capabilities to remain differentiated vs. our peers and (2) how do we keep up with the increasing cyber security requirements as technology develops & evolves? 

CAG solves these problems in two ways (with incremental income from licenses—2% of sales): Consulting Services is the primary driver of business performance (2022: 709M/89%) with additional services through Operations & Management Services whereby CAG manage IT solutions for customers--essentially outsourced staffing (2022:72M/9%). 

Both consulting and managed services are aimed at building a stronger digital foundation for a business. Whether that be moving a customer to the cloud, harnessing data within the business to make better decisions (e.g. software engineering, data analysis/visualization, system capability exploration), or developing and deploying new ways of operating (i.e. general management consulting projects across integration support, technology, infrastructure, logistics), CAG’s ability to grow depends on the value delivered to customers. 

Why We Like the Business?

Consultancy business models are simple, sticky and highly cash generative. The cost base is largely labor with minimal capital requirements over time, while the services offered to customers can be largely recurring depending on the value provided. We can all joke about the actual “value” created by consultancies, but the good ones do tend to add value albeit at an a very high $/hour rate.

The best consultancies get the best opportunities from the best clients. They do this by providing the best reputation, which is dependent on being able to hire the best talent and having provided the best service historically. The best talent want to work for the best consultancy based on reputation and quality of work, thus creating a virtuous flywheel for the best firm. With labor being the bulk of the cost base, best-in-class consultancies are focused on managing voluntary attrition while driving labor utilization up (for reference, Accenture’s voluntary attrition is typically between 15-20%; CAG 2022 was 18% with a LT target of <10%).

Moreover, Consultancies that have a large public sector exposure (50% of CAG’s revenue is public sector) are especially attractive. After winning a government contract, the consultancy operates as an extension of the government agency itself. While not explicitly recurring in nature (i.e. the firm does have to win the contract back at each renewal period), the relationship cements itself within the agency and exhibits recurring-like characteristics. While we are not thrilled by the concentration of customer risk within Swedish government agencies, we see the offsetting benefit of the recurring-like nature of these relationships as offsetting the customer concentration risk.

Operationally, CAG was founded (and led through 2014) by Bo Lindstrom, now Chairman. He owns 20% of the equity. It is our understanding he is still intimately involved in ensuring the success of the business, while putting guardrails around how to grow and who to acquire. This ownership mentality has enabled significant growth both from organic and M&A (sales CAGR of 15% since 2017), while running a net cash balance sheet.

For a further deep-dive on why consultancies are good business models, I'd suggest reading the Accenture annual report.

Economics & Valuation

Over the LTM, CAG has done ~SEK846M in sales at 19% gross margins. Gross margins are impacted primarily by mix of end market revenue, which largely determines pricing. The key KPI for economic performance is EBITA. Because both COGS and SG&A are primarily built up of people costs, generating incremental earnings over time is largely dictated by the ability to drive higher revenue over a fixed employee base (KPI is Sales per Employee or “Utilization”). 

Management short-term targets for EBITA margins are ~10%, with Q123 exceeding this range at 10.8%. Best-in-class consultancies maintain ~12-16% EBITA margins. While management disclose that 20% of revenue is true “recurring” (Ops & Management Services + Banking end market where 3-year contracts are the norm), with the large public sector exposure, the recurring-like % is likely much higher (particularly as it relates to their Defense customers, which are also disclosed as their largest as a % of sales). Lastly, FCF conversion is high at around 90% of EBITA (taxes and interest are the primary delta).

At equity of ~SEK98/sh (as of 6/22/23), CAG has ~SEK7.4/sh of net cash on the balance sheet bringing EV to SEK90/sh. At current levels, CAG trades at a ~10% levered FCF yield. If management deliver on their 2025 targets, the equity has 40% upside, over the next year, from current levels without any multiple expansion (>14% forward FCF yield). At a current ~9x EV/EBITA multiple, the equity looks fairly protected (Comp: Accenture is >15x) with potential upside for outperforming or re-rating (which I assume is very unlikely based on the current size). On a 5-7 year view, I assumed one deal per year at SEK50M for M&A, with a 5% CAGR for organic growth on the base business (relative to mid-teens average historically; assumed no organic growth on M&A 2025+). By 2030, CAG would be doing ~SEK190M in normalized FCF. Assuming no multiple expansion and slight dilution, that provides an 18-20% IRR / 2.8x MOIC. If growth continues to remain in the mid-teens, it is not difficult to believe this re-rates to a more mature FCF yield of 7.5-8%, providing even further upside. This excludes the return from dividends which currently yields 3.5% and is targeted at 50% payout on earnings. See Appendix 1 for details on valuation and revenue bridge.

Appendix 1: Valuation Bridge (Revenue and EBITA in SEK)

Appendix 2: 2021 – Q1 2023 (Revenue and EBITA in SEK)

Appendix 3: CAG ST Share Price since inception (in SEK)

Appendix 4: CAG ST Equity Ownership (as of Q1 2023)

Catalyst

• Accelerated M&A
• Margin expansion to be in-line with global peers
• Re-rate to lower FCF yield