| 2022 | 2023 | ||||||
| Price: | 16.30 | EPS | 0 | 0 | |||
| Shares Out. (in M): | 11 | P/E | 0 | 0 | |||
| Market Cap (in $M): | 186 | P/FCF | 0 | 0 | |||
| Net Debt (in $M): | 9 | EBIT | 0 | 0 | |||
| TEV (in $M): | 195 | TEV/EBIT | 0 | 0 | |||
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Mastech Digital is a provider of IT staffing, digital transformation, and data & analytics solutions. The company has two business units that have dramatically different economics:
*Note that discussion of EBITDA in the write up deducts SBC (EBITDA primarily refers to EBIT + amortization of intangibles). As such, EBITDA largely represents pre-tax cash flow.
Cash flow from both segments is largely organically growing at double digit rates and yet the business trades for just 10-13x cash flow (depending on how it is measured, described below). This is also despite significant insider alignment with individuals who have a history of value creation, IT staffing (e.g. the "bad business") top line growth rates that are faster than the industry, and a good long term track record of execution.
In short, I suspect that one is likely purchasing this business for just ~50-60% of intrinsic value (roughly $30-36 per share) come 2024 based on conservative multiples, providing investors with an attractive IRR from the current price of $16.3 per share. In my view, this investment also promises superior risk adjusted returns: downside should be very limited in the event the thesis does not work out.
For those familiar with Computer Task Group (see Andreas947's May 17, 2021 write up), the Mastech story is similar. Over time, Mastech is transforming itself into a higher value digital consultancy vs. what was previously known as a pure staffing company. I also estimate that around 40-50% of maintenance cash flow comes from the Data and Analytics segment, despite it being roughly 20% of consolidated revenues. In all, legacy IT staffing is becoming much less important to Mastech's fundamentals as the transformation continues, which should allow for a much higher valuation for the company.
Of note, performance of the business is less dependent on the path of Covid than the average business, so there is some added protection in this regard given the current Covid case surge (operating income in 2020 grew relative to 2019) and the marginal investor reaction that comes with it.
The following are the main arguments for the investment:
(1) Low valuation -
While the company trades around 13-14x free cash flow on the surface, this free cash flow figure is temporarily depressed due to discretionary investments. The company actually trades closer to 10-11x maintenance free cash flow and ~7.5x EV / EBITDA. I think this is much too cheap as this free cash flow should meaningfully grow over the next few years as a result of (1) investments in the company's Data & Analytics segment, (2) the continued transformation of the company's IT Staffing segment (discussed more in (3) below), and (3) a larger portion of the free cash flow should be generated from the Data & Analytics segment, which sports significantly better margins and a better business model than the legacy IT staffing business.
For a quick frame of reference on valuation, legacy IT staffing revenues have largely organically grown at an ~8-9% CAGR since 2011, with an acceleration post 2017/2018 as a result of a new management focus on digital solutions (operating income in this segment has grown at a 20% CAGR since 2018); top line growth in the company's higher margin data and analytics business is faster. The company's end markets / the industry are also likely to grow faster than pre-pandemic as the pandemic has accelerated digital / digital transformation adoption.
I see 3 ways to value this business (I use #1 for transparency):
At the current price and under varying assumptions given historical performance and execution, one is likely purchasing this business for 50-60% of 2024 intrinsic value, at which point I think it should trade for anywhere from $30-36 per share based on ~13-14x free cash flow (~10-11x EBITDA). A $30-36 share price would provide investors an attractive IRR from the ~$16.3 per share today.
Importantly, since the D&A segment was created in 2018, the company traded at an EV/EBITDA of roughly 12x, so this doesn't seem out of line with history. While I usually don't rely on comp valuations, 10-11x EBITDA is also a notable discount to other IT services peers (Tata Consultancy, Wipro, Infosys, Cognizant, Capgemini), all of which trade for anywhere from ~13x EBITDA (Cognizant) to high teens / low twenties EBITDA. Pure staffing / BPO companies (Sykes, TTEC, Teleperformance, Concentrix) trade for anywhere from 8-13x EBITDA (roughly). Of note, Mastech's EBITDA includes significant non-cash intangible amortization, and Mastech's capex as a % of D&A is considerably less than nearly all of these comps, making 10-11x EBITDA even more conservative as an exit multiple.
I suspect that 13-14x free cash flow is also a conservative multiple since the % of free cash flow that comes from the higher margin / higher operating leverage D&A segment should grow over time (at present ~45% comes from this segment on a maintenance basis), and this segment also generates recurring revenue from its new services offering which should result in a comparatively higher cash flow multiple. Similarly, a larger percent of cash flow should also come from the digital transformation solutions side of the IT staffing segment. A 13-14x multiple also strikes me as conservative given the company's organic growth profile (at least GDP+ ex investments for growth, perhaps higher as cash flow from the D&A segment grows as a proportion of free cash flow) and the current / likely future interest rate environment.
(2) Low downside -
What is particularly attractive here is that nearly all of the growth is free: downside should be limited even without growth given the current valuation on free cash flow, and consequently the investment is fairly asymmetric.
If management were to strip away the discretionary investments, you would be buying the company for a ~10% unlevered yield that (1) should organically grow at GDP+ with the industry/end markets and (2) should be relatively less cyclical than history given that the new D&A segment partly generates revenue from recurring multi-year agreements which should grow as a % of revenue over time; revenues during Q1-Q3 2020 also remained quite stable, as an example. The portion of operating income generated from this segment should also expand over time.
Importantly, 10x cash flow multiples are usually reserved for businesses that have relatively uncertain cash flows. So, I would highlight that from 2005 to today, the company has never reported negative operating income; CFFO during the same period has only seen one year of negative figures. Plus, this is all relating to the relatively worse legacy IT staffing business.
In the IT Staffing segment, the company also has one of the lowest cost operating structures of most peers. Operating expenses as a % of revenues are quite low at ~15% when other NAM competitors have these expenses at 17-18%+. This is important in an industry where some services are fungible as it allows them to better compete on cost - whether it be in the acquisition of talent (e.g. offering higher salaries to attract talent and reduce attrition) or in the pricing of client engagements. The company also has a good portion of its delivery centers overseas, which should help to further insulate it from competition. The company's variable cost structure in its IT staffing segment should also limit downside and impacts to operating income if revenues do begin to falter, as evidenced by IT staffing operating income growth during 2020 despite a small decline in revenues.
Stepping back, if one wants to play devils advocate on valuation and assume that the maintenance cash flow margins are no longer achievable (e.g. the investments for growth are necessary to sustain the business today), then ~13-14x cash flow (the multiple on the reported cash flow today) still doesn't strike me as overvalued given the growth profile of the company and the make-up of its operating income, so downside in this case should still be quite limited.
That said, I believe this case to be unlikely: the company achieved the maintenance EBITDA margins until 2019 (when investments for growth were telegraphed and accelerated). Further, in the most recent quarter, margins picked up substantially as a result of successful forward SG&A investment (D&A EBITDA margins were ~18% in the most recent quarter vs. a mere 7% in the prior 6 months). I suspect margins would have been higher this quarter if some large orders were not pushed to Q4 (as mentioned in the most recent call), plus once those orders come through in the next quarter or two, margins should pick up.
While the company does have some customer concentration, it is with very blue chip clients who have been clients for a long time. The company's two largest clients are CGI group (a $20 billion Canadian consulting firm) and Accenture, which combined account for 20-25% of the company's revenues. The other 80% of revenues is fairly diversified. Both blue chip relationships have expanded over the years (Accenture has been a client since at least 2011, and CGI has been a client since 2012/2013).
(3) History of growth -
The company has grown its IT Staffing top line, largely organically, 8% per year since 2010. Operating income in this segment is likely to outpace top line growth for the next few years as the company is simultaneously transitioning to higher margin digital transformation services, much like peer Computer Task Group. This is especially evident from 2018-2021, during which period IT Staffing operating income growth exceeded a 15% CAGR, significantly outpacing top line growth. Importantly, the company remains early in the transformation of its IT Staffing segment as only ~40% of its revenues come from the higher margin digital transformation services (growing it from ~18% in 2016), which should result in a long runway for both continued top line growth and gross margin expansion as management continues to execute. Consistent with this transformation, gross margins have expanded from around 19.8% in 2017 to 22.8% in the most recent quarter.
In 2017, the company created its Data and Analytics segment with the acquisition of Infotrellis, a data and analytics consulting company. Specifically, Infotrellis focuses on master data management consulting - essentially helping companies modify and create their own data sets on which to perform analytics to improve business decisions. This is a relatively high priced service, but it is somewhat essential - without the right data structure, companies are effectively unable to perform any useful analytics and improve business decisions (e.g. "garbage in, garbage out"). The goal with the acquisition was to provide an anchor investment for the company to be able to provide more dedicated, higher value data management consulting, as well as to accelerate the digital transformation service offerings on the IT staffing side of the business.
In my opinion, this has been a very successful investment, despite its relatively lower growth vs. management's pro-forma post acquisition -- digital transformation adoption in IT staffing has significantly accelerated, and while operating income in the D&A segment has been rather stagnant, this has been a result of significant income statement investments (the company has to front load SG&A investments); if one were to adjust for some of the SG&A investments, EBITDA margins in this segment remain around 25%, plus margins were ~25% when the company was first acquired per the 2017 filings, as well as during 2018 and partly 2019. There is also a transparent discussion re: margin degradation as a result of investments in the most recent earnings call.
Within the Data & Analytics segment, management expects that growth will exceed 20% for the next few years (while the industry is expected to grow at a 12% CAGR), but nonetheless the segment has grown at a 10-12%+ CAGR since the segment was created (ex 2020). While I haven't relied on a 20%+ growth case in establishing the base case valuation (this would put the share price in the >$35-36 per share range), the company's recent investments in SG&A and a new acquisition at the end of 2020 should help the acceleration (plus, the most recent quarter, described briefly below, shows that growth has significantly picked up toward management's 20% goal).
The increasing revenues derived from Center of Excellence contracts should also continue to improve the segment's economics, as once contracts are won, SG&A efficiency should significantly expand. Importantly, the company has won a number of these contracts this year, and apparently may be on track to win a couple more in Q4 / Q1 2021. While I suspect the current contract value of these engagements is small relative to total segment revenues, the percent of revenue represented by such engagements should grow over time.
The company's most recent quarter shows continued evidence of growth in both segments, but especially in the Data & Analytics segment. This segment is on track to grow mid to high double digits relative to 2020 (Q3 2021 organic revenue growth was 19% YoY), when revenue was actually quite stable so there isn’t much of a base effect. The IT Staffing segment continues to expand its top line, as well as gross margins, to new records as a larger portion of its revenue is derived from digital transformation services. Of note, the recent acquisition in the D&A segment and the continued expansion of the D&A business should accelerate digital transformation services in the IT staffing segment, as cross selling has been one of the main avenues for growth.
(4) Capital Allocation -
Mastech management has a history of purchasing assets at highly attractive and accretive multiples and is likely to continue doing so.
In 2017, management purchased Infotrellis for $36 million in cash, plus an earn out of $19 million. In 2017, Infotrellis had revenues of ~$21 million, and EBITDA margins of 25-27%. Management set very aggressive criteria for the earn outs (20%+ organic growth), but they were not achieved. As a result, management effectively purchased Infotrellis for just ~6x current EBITDA (note that there is essentially no capex at Infotrellis, and so EBITDA is representative of pre-tax cash flow).
In 2019, Infotrellis (at maintenance margins, ex growth investments) generated around $7-7.5 million in EBITDA, bringing the purchase multiple to ~5x 2019 pre tax cash flow. Including growth investments (e.g. reported EBITDA), the purchase price is still ~6-6.5x pre tax cash flow. Infotrellis has continued to grow since then.
In October 2020, management purchased Amberleaf, a CX data & analytics firm. The plan is to cross-sell Amberleaf's service offerings with Infotrellis, and at the same time expand its EBITDA margins (Amberleaf had 2018-2020 EBITDA margins of ~18%). This seems like a reasonable plan as well -- Infotrellis brings expertise in the creation / maintenance of entity master data sets, which are the building blocks of any data & analytics service (e.g. if customers don't have good data, they won't have good analytics), and Amberleaf brings expertise in the actual customer analysis using such data sets.
Mastech can now offer both services in one offering (e.g. "we'll help you build and maintain your business's data sets, and then we can help you perform analytics on those same data sets"). There are recent signs of success here: as of the most recent quarter, the D&A segment has experienced accelerated growth. For those interested in digging more, this page provides a brief overview of one of the combined service offerings: https://mastechinfotrellis.com/intelligence/enterprise-intelligence-hub/
The purchase price for Amberleaf was $9.6 million in cash, plus earn outs (initial earn outs were not met, so the remaining liability is just $900k). From 2018-2020, Amberleaf generated around $1.5-2 million in annual EBITDA (again, representative of pre-tax cash flow given the lack of capex), so the purchase price (without improvement to EBITDA) was 5.5x pre tax cash flow. Should the margin targets eventually improve toward management's goal, the effective purchase price will be ~4x pre tax cash flow, assuming no revenue growth.
Of note, the vast majority of these acquisitions was funded with debt (along with some cash from the company's chairmen), which has since largely been paid down. Given the purchase multiples (and now current cash flows of the businesses), the end result has been exceptional accretion to the equity value. Notably, management has mentioned that they expect more acquisitions to occur over the next few years, which should continue to be highly accretive (both because of likely purchase multiples as well as through growth in the higher value D&A business line).
(5) High insider alignment -
Insiders own 62.6% of the company.
The two co-founders (Ashok Trivedi and Sunil Wadhwani) of the company are co-chairmen of the board and each own 30% of the shares outstanding. In 1996, the same co-chairmen took Mastech/iGate public, which was an IT Staffing and BPO company. The company then had a market cap of ~$80 million. iGate was eventually sold in 2014 for $3.9 billion. Gerhard Watzinger, the chairman of Crowdstrike (the $43 billion company) is also on the board of Mastech. Importantly, Ashok and Sunil had net worths of ~$500 million after the iGate transaction, so at 30% of the market cap today, their investments in Mastech (now valued at ~$60 million) are not necessarily trivial.
Vivek Gupta, the company's CEO, owns 2.7% of the company. Vivek also has a history in the industry. For much of his career, Vivek worked at Zensar Technologies, an Indian IT Staffing / BPO company. He reportedly built the company's UK business from inception (which was later expanded to include other European and Asian countries), was instrumental in growing the company's APM & BPO business, and later was head of the company's Infrastructure Management services segment where he led an acquisition integration and a post acquisition turn around. Admittedly, the acquisition / turn around stint was relatively less successful (you can find some info on this via Zensar Technologies filings - it is publicly listed in India). In late 2015, once the acquisition integration stabilized, Vivek was made the head of the Americas segment of Zensar's parent company (RPG Group), which at the time reportedly had roughly $3.4 billion in revenue.
He stayed there until 2016 when Sunil and Ashok replaced the then Mastech CEO (presumably because of stagnant growth during an industry downturn from 2014/15 - 2016) with Vivek. Since taking over in early 2016, Vivek has grown the company both organically and inorganically from a market cap of $31 million to ~$195 million today. Reported operating profit has also more than tripled during this time. I would encourage those interested to read some of the transcripts from 2016/2017 - Vivek laid out his vision for the company, and has largely successfully executed against it.
(6) Low float and almost no coverage -
Given the insider ownership, the company has relatively low public float. As such, the investment is rather illiquid. Average daily volume is less than 10,000 shares a day. I suspect this turns off a significant number of potential investors. In a similar vein, the company has just two analysts covering it (Sidoti and Zacks). As recently as Q3 2019, there were no analysts.
Risks:
The below are the current risks I foresee that should be tracked:
Customer concentration with Accenture and CGI could be an issue -- fair, but these have been long-standing relationships and thus far I have not seen cause for concern in losing one of them
DISCLAIMER: The Author currently holds a long investment in the securities of Mastech Digital (Ticker: MHH) and stands to benefit should the price of the security rise. The Author may buy or sell long or short securities of this issuer and makes no representation or undertaking that Author will inform the reader or anyone else prior to or after making such transactions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note and disclaims any obligation to update such information. The views expressed in this note are the sole opinion of the Author, which may change at any time. The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the above note. This written note should not be construed as a recommendation to buy or sell any security or as investment advice.
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