Article Thesis

The coronavirus crisis is having a devastating effect on employment and the tough situation will continue in the months to come. The drop in labor demand creates significant challenges for companies in the staffing sector. Amid the current uncertainty, investors have been avoiding stocks related to this industry – at least until there is more clarity in the economy. However, the pessimistic outlook has created interesting opportunities in the sector due to much lower valuations. I have (Source)

Mastech Digital is a provider of IT staffing services and data and analytics services across different industries such as, among others, financial services, government, healthcare and retail. It was established in 1986 and began operating as an independent public firm in 2008 after a spin-off from iGATE. The company is largely owned by Sunil Wadhwani and Ashok Trivedi, co-founders of MHH, who hold approximately 62% of the outstanding shares. Although MHH has different clients in Europe, the Middle East and the Asia-Pacific region, almost 99% of the company’s revenue is generated from customers located in North America. In 2019, its top ten clients accounted for approximately 45% of sales.

MHH business is composed of two segments

MHH’s revenue is generated from two business segments: IT staffing services and data and analytics services. Each segment has its separate sales and marketing organization.

  • The IT staffing segment delivers a range of services in digital and mainstream technologies – currently just in the US. The company works with businesses and institutions with significant IT staffing needs as well as smaller organizations with temporary IT staffing requirements. As is common in this sector, the company does not enjoy exclusivity concerning a client’s contractor needs and its service must be very efficient in terms of quality, time and price. The IT staffing is MHH’s most relevant segment in terms of sales – it represented 86.2% of revenue in 2019. Unfortunately, it is the least profitable of both segments due to the highly competitive environment in the industry. Although the gross margin has improved in recent years, it was only 21.3% in 2019.
  • The data and analytics services segment, known as Mastech InfoTrellis, offers project-based consulting services in the areas of Data Management, Data Engineering and Data Science, which can be delivered using onsite and offshore resources. The service aims to support clients in the realization of discontinuous business performance in areas such as revenue growth, operating costs, data management effectiveness and risk. The segment has been growing substantially in recent years as a percentage of MHH total sales – during the last fiscal year, it accounted for 13.8% of revenue. Management aims to continue growing this service due to its much higher profitability, which had a gross margin of 46.7% in 2019 and above 50% in the most recent quarter. Looking forward, the data and analytics market provides fertile ground to continue growing – it is estimated to be $275 billion by 2023, growing at a 12% CAGR.

MHH sales by segment

(Source: Mastech Digital annual report 2019)

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Competition

MHH operates in a highly competitive and fragmented industry with low barriers to entry. The company competes in the data and analytics services segment with significantly larger companies such as Cognizant (NASDAQ:CTSH), IBM Services (NYSE:IBM), Tata Consultancy Services (OTCPK:TTNQY), Deloitte and Accenture (NYSE:ACN). The IT staffing services segment competes mainly with providers of outsourcing services, system integrators and other staffing services firms.

However, MHH has proven to have some competitive advantages compared to peers that allowed it to grow while maintaining a stable balance sheet and increasing profitability. Some of these strengths include an established client base – large, medium-size and small companies – operational excellence, a lower operating cost structure, and expertise in certain advanced technology IT skills. Besides, the fact that the company is a large minority-owned staffing firm is attractive to certain clients in the government and public-sector segments, where project dollars are specifically earmarked for diversity spending.

Profitability of the overall company

Gross Margin

Gross Margin (5-yr avg)

Net Income Margin

Net Income Margin (5-yr avg)

Return on Equity

26.6%

22.1%

6.06%

3.28%

28.6%

(Source: Created by the author using data from Financial Times)

Despite the strong competition, the company has been able to increase its probability in recent years. However, due to the still high dependence on the IT staffing segment, MHH has a low gross margin and earnings margin. Management aims to continue to develop the data and analytics services business, which has strong growth potential and significantly wider margins. Capex has been historically low and the current return on equity of 28.6% looks interesting. Amid the current crisis, the gross margin of the overall company in the most recent quarter was 26.6%, being the third consecutive quarter of breaking the 25% gross margin barrier.

Expect more growth and acquisitions in the future

Revenue (5-yr growth rate)

Net income (5-yr growth rate)

Capital expenditure (5-yr growth rate)

11.3%

26.3%

8.35%

(Source: Created by the author using data from Financial Times)

MHH has grown its revenue and net income at an average 5-year rate of 11.3% and 26.3%, respectively. The strong results obtained in the first half of the year despite the substantial drop in labor demand demonstrate the efficient working way of management through the crisis and the resilience of MHH business – the company has beaten EPS estimates for the third quarter in a row. Capex is relatively low in this kind of company and has grown at an average rate of 8.35% during the same period. However, most of the free cash flow generated has been deployed on acquisitions – one of the main sources of growth for the company. The last significant investment was in 2017, with the acquisition of InfoTrellis for approximately $35 million.

USD Million

2015

2016

2017

2018

2019

2020 E

2021 E

Net Sales

124

132

148

177

194

200

227

Growth

6.9%

12.0%

19.8%

9.3%

3.1%

13.9%

Diluted EPS

0.31

0.28

0.16

0.60

0.99

1.10

1.24

Growth

-9.7%

-42.9%

275.0%

65.0%

11.1%

12.7%

(Source: Created by the author using data from Seeking Alpha)

Looking forward, analysts are optimistic about sales and EPS in 2020 and 2021. Due to the uncertainty created by the current crisis, MHH has put some planned investments on hold. Management has come up with an austerity plan guided by four main principles; minimize the essential expenditure, eliminate or defer discretionary spending, defer all investments for future growth, and more importantly, protect the top-notch talent. The austerity measures allowed MHH to reduce SG&A expenses in Q2 by $1.2 million from its previous quarter. Nonetheless, management does not want to hinder the company’s ability to scale quickly once the economy starts to recover. MHH will make a significant effort to retain all its A and B players since management expects a significant rise in demand when the economic activity resumes.

On the other hand, the financial situation of the company looks solid to go through the current crisis and capitalize on M&A opportunities when they present themselves. MHH has $10 million of outstanding bank debt net of cash balances on hand and borrowing availability of over $17 million under its existing revolving credit line.

Risks

The current coronavirus pandemic has weakened the economic conditions in North America and consequently, negatively affected MHH clients in heavy-hit industries such as travel, energy and manufacturing. The overall demand for IT professionals has been reduced in the first half of the year. MHH saw around 50 to 60 early terminations of the 1,100 billable consultants that the company has in North America. On the other hand, the data and analytics services demand remained robust during the same period; but most decisions in this segment are getting delayed into the later part of the year. However, the current crisis has not significantly affected the MHH business, whose sales are even expected to increase by 3% in 2020.

On the other hand, during 2019, 41% of MHH’s workforce was working under the sponsored H1-B temporary work permits. Since the company’s success depends upon finding qualified professionals at a low cost, a change in government regulation – presumably due to the coronavirus pandemic – may limit the supply of professionals and can have a material adverse effect on the business. Nonetheless, according to management, the current legislation does not affect the company significantly since MHH is not bringing people in from overseas but looking at H1-B people within the US.

Valuation

Price (USD)

EPS (TTM)

EPS (FWD)

Price/ earnings

Price/ earnings (FWD)

Price/ book value

Price/ cash flow

Price/ sales

EV/ EBITDA (TTM)

22.26

1.07

1.10

20.80

20.23

4.60

13.95

1.22

16.35

(Source: Created by the author using data from Seeking Alpha)

Although MHH does not look undervalued by the current standard metrics, its valuation ratios are reasonable for a growing business. The stock currently trades at $22.26 and estimated EPS for 2020 and 2021 are 1.10 and 1.24, respectively, which gives a forward PE ratio of 20.23 and 17.95, respectively, for the following two years. Besides, analyzing MHH valuation through a discounted cash flow valuation, I got the stock is still undervalued by more than 20%. I used a discount rate of 9% and a terminal value of 14 times earnings. Observe that I substantially inflated Capex as of 2021 to include an approximation of the capital that is expected to be deployed in future acquisitions.

MHH FCFMHH Valuation(Source: Created by the author using data from MHH annual report 2019)

Conclusion

Despite the recent rise in price, according to my valuation, MHH stock still has a +20% upside potential. Nonetheless, the main argument of my bullish thesis is not valuation, but the company’s ability to continue growing and increasing earnings despite the tough challenges in the industry and the high competition. Amid the current crisis, MHH has been beating earnings estimates in recent quarters and its sales and net income are even expected to grow this year. The company maintains a solid financial position and the growing data and analytics services segment seems well-positioned to be a significant catalyst to increase MHH sales and profitability in the years to come. My recommendation is a “Buy” below $23.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MHH over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.