Investment Thesis

Information Services Group or ISG, (Ticker “III”, $3.70 NASDAQ, 11/15/2013) is an Information Technology (“IT”) Consulting and Advisory firm in the fast-growing information-based services industry.  Based on strong operating fundamentals, including new contract wins and rapid growth in the recurring Managed Services business, I believe that ISG has the potential to more than double to $8.28 over the next year as investors recognize the strength of ISG’s businesses and the shares begin to trade at multiples comparable to its peers.

Furthermore, a near term buying opportunity exists due to the market’s overreaction to ISG’s recent stock compensation charge. In its recently reported 3^rd quarter results, SG&A expense was significantly higher than expected due to the “cliff” vesting of restricted employee shares. The share grants had been expected to vest gradually over 4 years but the rapid appreciation of ISG’s stock price triggered vesting during the quarter, resulting in an EPS miss. The company exceeded expectations on all other line items and is well positioned for a strong 2014 due to the following:

• Strong organic growth across multiple lines of business, particularly in the area of Managed Services, which is an entirely recurring revenue business.
• Fully integrated acquisitions leave the company poised for higher utilization rates and margin expansion which result from a combination of gross selling opportunities and back office efficiencies.
• Release the full benefit of past investments in European operations, particularly the United Kingdom (“UK”) that just began to contribute in the second half of 2013.
• Weakness in Asia, particularly Australia, has been a drag on 2013 results, but is expected to reverse in 2014 due to a strengthening economy and a change in government.
• New revenue from large contract wins in Managed Services will begin in Q4 of 2013 and will reach full contribution margins in late 2014. Note that the upfront cost of these agreements was being expensed in Q3 with no offsetting revenue.
• Refinanced debt lowers interest expense by 50 basis points (1/2%) and increases financial flexibility.
• Discount of over 50% compared to its peer group based on 2014 numbers.

Company Description

Information Services Group, Inc. was founded in 2006 by industry veteran Michael Connors, its CEO who still owns 8% of the company, to consolidate portions of the fast-growing information-based services consulting industry, capitalizing on the proven track record of its management team and board of directors who had successfully managed and built companies like Nielson Media Research, AC Nielson, Dun & Bradstreet, IMS Health and Gartner Group . The company was established as a single purpose acquisition company (“SPAC”). Post its IPO, in 2007 it acquired TPI Advisory Services (“TPI”), an advisory firm specializing in assessing, evaluating and negotiating IT contracts on behalf of its clients. ISG’s stock suffered mightily from the “Great Recession”, as many clients curtailed IT projects to conserve cash, and the stock bottomed out at $0.95 in December of 2012. In 2011, the company grew significantly through the acquisition of Compass (UK based business and IT benchmarking firm) and STA Consulting (IT advisory firm to the US public sector).   

Following the three major acquisitions, ISG today is a $200mm company servicing over 500 clients via its 800+ professionals with operations in the US (55% of Rev), Europe (34%) and Asia (11%). The integrated firm continues to advise corporate and government IT clients on project viability, sourcing, vendor search and tract negotiation and project oversight. ISG’s extensive library of benchmarking data on service delivery standards and costs informs its consulting business and is also a source of recurring revenue from subscription-based research on trends in IT services. The company’s consulting engagements usually tend to be not less than three months and often exceed nine months. The Managed Services group works on multiyear, renewable contracts and produces high margin recurring revenue. This gives ISG significant visibility into its next 12 months of performance.

The Roll-up

TPI, a leading data and advisory firm in global sourcing was ISG’s first acquisition, which occurred in 2007, and provided a platform to build ISG. The company's second acquisition, Compass, took place in January of 2011. Compass was an independent global provider of business and information technology benchmarking, performance improvement, data and analytics services. This helped consolidate ISG's industry position in the area of performance improvement data and analytics. The acquisition of STA Consulting (“STA”) occurred in February of 2011, and added expertise in the public sector where STA focuses on strategic planning and the acquisition and implementation of new Enterprise Resource Planning (“ERP”) systems.

ISG has stated that while it might acquire additional companies in related IT services, future acquisitions will be small, tuck-in purchases.  ISG has been focused on fully integrating its 2011 acquisition and making sure that all of its consultants can cross sell the expanded suite of products. With the integration work behind it, we expect that ISG will be able to increase its utilization rates and also increase its operating efficiencies among its back office departments resulting in stronger operating margins in 2014 and beyond.

Revenue Generation

It is important to understand that the company is not an IT service provider; rather, it acts as an independent advisor who provides unbiased recommendations. In addition to the inherited skills of its personnel, ISG has developed an extensive data base of the cost and service implications of implementing transformative IT projects. This independence coupled with its benchmarking abilities constitutes a key differentiator for ISG.

For example, a fortune 500 company may be considering moving its data warehouse to India and upgrading its storage capabilities as part of the process. ISG would be brought in to 1) conduct an analysis of the existing systems and to determine if the projects appears viable, 2) develop a Request For Proposal “RFP” and project scope, 3) help in the selection process of all vendors and in negotiating the pricing of goods and services, 4) remain involved during the implementation process to ensure that the project proceeds on plan. Such a project may typically take 12-24 months with varying staffing needs during the different stages and might generate revenue for ISG in the low millions of dollars. This advisory cost is quite minor compared to both the total price of the project and to the cost savings that the client should realize over time once the project is completed. ISG estimates that its fees represent approximately 1/70^th of its clients’ savings and that its clients achieve significantly higher total savings than if ISG had not been engaged. The long term and impartial nature of ISG’s engagements also tend to develop into a strong bond of trust with the clients’ IT departments. As a result, approximately 75% of ISG’s business comes from repeat clients and referrals.

Recurring revenue businesses:  Managed Services and Research Library.

In addition to its consulting business, ISG generates revenue from providing research on trends in the IT industry to both corporate clients and investment firms. This service is generally charged on a subscription basis and is recurring in nature. I believe that this line of business is generally stable for ISG.

Of much greater value, is the rapidly growing Managed Services business which this quarter was up 34% compared to Q3 of 2012 and grew 28% year to date. This group manages vendor contract performance, financial and relationship management for its clients’ application data, data centers, networks and business processes. For example, if a client is working on a project to move to cloud computing, it might ask ISG to not only advise on the project but to remain involved and oversee all the vendors after implementation. ISG would then ensure that the vendors have met performance and quality targets as well as act as a proxy for the client in any billing disputes. Most companies have used members of their purchasing departments to handle this function in the past. However, ISG has had significant success in winning the business, particularly if it can do so before the project is fully implemented so that no client employees are disrupted. As a specialist in this area, ISG believes that it can save clients’ money over having this function done internally.

In June 2013, the company signed a 5 year, $14mm deal with Marriott. Despite having the cost associated with ramping up for this contact, ISG has not yet booked any revenue related to this deal. We expect some revenue from this contract in Q4, with full impact ramping throughout 2014. As with all its Managed Services agreements, once the contract is fully implemented, ISG expects operating margins from this business to be significantly higher than the operating margins in its base consulting business.

Recent events

ISG stock has come off significantly following its 3^rd quarter earnings release. I believe this was caused by the markets focusing on what was perceived to be weak EPS results and ignoring the very strong operating performance for the quarter.

Becoming a victim of its own success, ISG was required to take a $2.1mm charge related to stock-based compensation because of the rapid rise of its share price. $1.7mm of this expense was due to a restricted stock program put in place earlier in the year under which employees would normally vest in their stock grant over a four year period. However, to encourage heightened performance, there was also a “cliff” vesting that occurred if the company’s share price increased to $3.50 (from $1.90 at the date of grant).  As the stock price appreciated past this trigger point during Q3, the full expense of these grants had to be incurred on the P&L during that quarter. This non-cash charge was significantly higher than the $0.7mm charge in the prior year quarter and caused EPS to come in at $0.01, below analyst expectations of $0.03. Note that had the stock not appreciated, the company would only have incurred approximately 1/16^th of this charge. Absent this accelerated, non-cash charge, the company would have beaten estimates.  

Outlook

ISG is likely to benefit from both growing global IT spending and the perennial need of governments and large and mid-size companies to manage their cost structures. Currently the move to cloud computing is a hot topic among IT professionals. As this is a relatively new and rapidly developing field, many CIOs may lack the expertise to formulate and implement the best strategy for their firms. I believe this creates an excellent opportunity for ISG to add value for its current and future clients.

During 2012 and 2013 the company invested heavily in building up its capabilities in several new markets. These include the UK public sector and the Scandinavian countries as well as the US public sector and its Managed Services group. In the second half of 2013, ISG is starting to see the benefits of these investments, in particular from a large, multi-year contract in the UK and the Managed Services deal with Marriott. However, the full impact of these new contracts will not hit until well into 2014 when the company also expects to see results from its Scandinavian operations. Also in 2014, ISG is likely to benefit from a rebound in its Australian operations which have been a drag on 2013 results but now seem likely to benefit from an improving economy and new government leadership, which could use ISG’s services to help cut costs.

ISG has publically guided to 2013 revenue growth of 6% to 10% and Adjusted EBTIDA growth of 30% to 40%. ISG has also stated an internal goal of further growing Adjusted EBITDA to $30mm by 2015, an increase of 30% to 40% over 2013 levels. Considering its many tailwinds, I believe that these expectations are conservative. 

The company, which generates strong cash flow, is expecting to reduce debt by $5mm in 2013 and will continue to de-lever in 2014. Earlier this year, the company was able to refinance its debt and extend its maturity until May of 2018 from November of 2014 and reduced its interest expense to LIBOR plus 3% from LIBOR plus 3.5%, providing additional operational flexibility to the management team. 

Challenges

While weak economic conditions can favor ISG as companies and governments seek ways to lower costs by increasing efficiencies, truly terrible conditions do hurt the firm. This is because there are up upfront costs associated with any IT project, including running duplicative systems for some time as well as severance payments and (of course) consulting fees. This was particularly true in the European market (which accounts for 34% of 2013 revenues), where the countries at the center of the debt crisis (Italy, Spain, Greece) have recently contributed little to ISG’s revenues. By contrast, Germany and even France have continued to demonstrate strong demand, as well as the Scandinavian countries, which are expected to provide additional revenue growth in 2014.

We note that the international component of ISG’s business (only 55% of revenue was generated in the US during 2013) does leave the company open to the impact of currency fluctuations. However, because ISG pays its employees in local currency, the company feels that it is naturally match funding and it does not need to utilize a hedging program. This can cause some top line fluctuation, but it is offset by equivalent movements in expenses, such that only the profits are actually at risk from currency movements.

Valuation

Based on the first three quarters and the company’s guidance for the full year, it appears that ISG will grow revenues by 8.6% or $16.5mm in 2013. EBITDA (“earnings before interest depreciation taxes and amortization”) will increase 35% or $4.7mm and Adjusted EBITDA (excluding non-cash stock compensation) will increase 39% or $6.3mm. ISG has not yet provided guidance for 2014, but considering the many initiatives that are just starting to generate revenues for the company I believe it is appropriate to grow sales by at least a similar dollar amount as in 2013. This results in forecasted revenue of $225mm, a 7.5% increase. It also yields a $4.6mm increase in Adjusted EBITDA and a $6.9mm increase in EBITDA; the smaller change in Adjusted EBITDA dollars is due the negative impact of the cliff vesting of stock grants discussed above which depressed 2013 EBITDA. I have assumed a 1.3% increase in Adjusted EBITDA margins to reflect the positive impact of the Marriott Managed Services contract generating revenue as well as the full year impact of the UK government contracts, both of which incurred startup costs in 2013.

With a current enterprise value (“EV”) of $173mm ($137mm market capitalization + $59mm debt -$24mm cash) ISG is trading at about 0.8x 2013 EV/sales and 8.34 EV/EBITDA. If we look out to 2014, using today’s share price but 2014 year end cash and debt levels, the enterprise value would be $153mm ($137mm market capitalization + $55mm debt  - $39mm cash) and ISG would currently be trading at .7x next year’s EV/sales and 6.1x next year’s EV/EBITDA.  By way of comparison, Bloomberg shows its peer group (see table below) as trading at 1.7x next year’s EV/sales and 10.2x next year’s EV/EBITDA.  Due to its strong growth and higher margins associated with the Managed Services business, I would argue that ISG deserves to trade above the group’s average. If ISG were to trade at the average multiple, ISG would (based on EV/Sales) trade at $10.07, a 172% increase over current levels, or $6.48 (based on EV/EBITDA), a 75% increase. Of these two metrics, I believe that the sales multiple more accurately reflects valuations in this sector. However, to be conservative I will use the midpoint between the two which yields a value of $8.28 for ISG shares, a 124% increase from current levels.

Conclusion

As ISG begins to fully realize the benefits of having integrated its acquisitions and to achieve revenue growth from increased global IT spending and the impact of generating revenues from recent contract wins, it is positioned to materially increase its earnings. It will also generate significantly more free cash flow which will allow it to continue de-levering the balance sheet. While its earnings growth probably deserves an above average valuation multiple, ISG only needs to get the same multiples as its peers in order for its share price to more than double.