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Mastech Digital: Growth, Value, And Momentum At An Attractive Price

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About: Mastech Digital, Inc. (MHH)
by: Mitchell Rosenthal
Mitchell Rosenthal
Long/short equity, macro, value, Growth
Summary

Mastech is a small, under-followed provider of IT Staffing and data/analytics services.

The company offers impressive sales, operating income, earnings, cash flow, and margin growth.

It reduced its debt reliance by 55% since Q3:17, and its valuations are near the bottom of their post-2010 trading ranges.

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Elevator Pitch

Mastech (NYSEMKT:MHH) boasts impressive sales, earnings, and FCF growth, an attractive valuation, improving share price momentum, an optimistic growth outlook, and strong insider ownership. Its success strongly correlates with U.S. economic conditions. Thus, its stock will likely interest investors looking to bet on the U.S. economic expansion by investing in lesser-known growth stocks with attractive valuations and healthy cash flows.

About

Mastech Digital, Inc. provides IT Staffing, data and analytics, and digital learning services to medium and large companies. Its staffing segment supports businesses with substantial IT-spend and onerous staffing needs, as well as smaller organizations with sporadic staffing needs. Its data and analytics segment offers project-based consulting services under the brand name "InfoTrellis," helping businesses around the world with data management and analytics, enterprise data Integration, and Big Data. Mastech also offers education and training to help businesses master tools like Salesforce.com.

Several key acquisitions have helped Mastech expand its services. It acquired Hudson Global Resources Management, Inc.’s U.S. IT staffing business in June, 2015, along with a digital learning services practice. Later, the data and analytics segment was born when the company acquired InfoTrellis, Inc.'s services business in July, 2017. Interestingly, the company tried to expand into healthcare staffing by acquiring Curastat, Inc. in 2010, but in 2013 decided to sell that division and focus on IT staffing.

Mastech's recruitment centers are located in the U.S. and India, allowing them to respond quickly and frequently to customers and provide staffing services 24/7. The company employs 200 recruiters who focus on finding high-quality U.S.-based talent. To reduce costs, it delivers its staffing and training services by hiring account executives who use a telesales model supplemented with client visits. The company markets its data and analytics services using account executives to acquire new customers and technical relationship managers to strengthen existing client relationships.

With a $120mil market cap, Mastech is small and fairly under-followed. In fact, its most recent earnings call lacked any questions from analysts.

Long-Term Fundamentals

According to data from StockRow, sales, operating income, and earnings (TTM) have reached new highs. Revenue growth (TTM) is a solid 8.6%, and Mastech's gross margin has been rising since Q1:15 and has reached a new high at 24.4%. Sales, Operating Income, Earnings (NYSE:<a href='https://seekingalpha.com/symbol/TTM' title='Tata Motors Limited'>TTM</a>) - charts provided by StockRow

Both operating segments have shown impressive growth since Q3:17, with staffing revenues up 20% and data and analytics revenues up 73% since then, based on data from prior 10-Q filings.

Revenues by Segment: Image created by author with data from SEC filingsGross, net, and FCF margins (TTM) are the highest they’ve been since 2010.

Gross, Net, and FCF Margins (<a href='https://seekingalpha.com/symbol/TTM' title='Tata Motors Limited'>TTM</a>) - charts provided by StockRowOperating and free cash flow (TTM) have been generally positive since 2010 and have also recently reached new highs.

Operating and Free Cash Flow (<a href='https://seekingalpha.com/symbol/TTM' title='Tata Motors Limited'>TTM</a>) - charts provided by StockRowSince 2013, book value per share (TTM) has quadrupled.

Book Value per Share - chart provided by ZacksMastech’s quarterly Debt/Equity ratio has fallen 55% since Q3:17 and now stands at 0.74.

Debt to Equity (Quarterly) - chart provided by StockRow

ROE and ROIC (TTM) have more than doubled since Q1:18 and now stand at 25% and 13% respectively.

ROE and ROIC (<a href='https://seekingalpha.com/symbol/TTM' title='Tata Motors Limited'>TTM</a>) - charts provided by StockRowThe company’s financial health metrics are also strong. Its Altman Z-score of 4.65 indicates low default risk, and the company has a solid Piotroski Score (TTM) of 7 out of a possible 9, according to StockRow.

Insiders own 73% of total shares. Institutional ownership of shares has risen sharply to 13.7%, compared to 2.54% in early 2011. It has almost doubled since late February, 2018 (see below).

Institutional Ownership - chart provided by GuruFocusQ3:19 Performance

The most recent quarter’s sales, earnings, and free cash flow grew by 11.8%, 20.3%, and 243.5% YoY, respectively, according to StockRow data. Both the IT staffing and the data/analytics segments saw substantial growth, with sales increasing 10% and 22% YoY respectively.

During the Q3:19 earnings call, management said the staffing segment’s growth more than tripled that of the North American IT Staffing industry as a whole. That segment saw its operating income grow by 13% YoY thanks to the company increasing its focus on digital technologies.

During the call, management also noted that the data/analytics segment’s operating margin increased 15% YoY, even though the company continues to invest in this segment. Over the past nine months, Mastech was able to use its operating cash flow to reduce bank debt by $11.7m while increasing its cash balances by $700k.

Valuation Metrics

Mastech’s EV/EBITDA and P/FCF ratios are near the bottom of their post-2010 trading ranges. Though its P/S ratio of 0.64 is elevated compared to its historical (post-2010) range, that ratio is cheaper than the ratios of 93% of companies with similar revenue growth (TTM) growth in the same sector.

EV/EBITDA, P/FCF, and P/S - charts provided by StockRowSeeking low valuation multiples isn't enough. To avoid value traps, investors should study how shares behaved in past situations with similar valuation levels, and determine whether they should expect history to repeat itself. The last time Mastech's P/S ratio reached its current level was on September 24, 2018. Soon after, the stock fell 54% over the next 10 months.

Why expect a different result this time around? First, by reducing its debt use by 38% since then, Mastech will start off 2020 with more cash and lower interest expenses, letting it more easily invest in future growth areas. Management says advances in technologies like social, cloud, analytics, mobility and automation offer more opportunities for its IT segment (85% of total sales) to grow. That segment is already tripling the growth of its industry. With better access to capital, Mastech can more easily fuel the segment's strong momentum.

Also, fundamentals have strengthened substantially since last September (see table below). Mastech's net profit margin (TTM) is 77% higher and has held above 5% for the last two quarters, a first for the company. Yet, Mastech's P/FCF and EV/EBITDA have fallen 92% and 34% since then, respectively, and its P/S is unchanged. Overall, current fundamentals are healthier and valuation metrics are more attractive.

Present vs Past Fundamentals - image created by author with data from StockRow and GuruFocusOther Catalysts

In August 2019, Mastech launched a "Digital First" initiative that committed the company to forming specialized teams dedicated to finding talent with skills in data management, analytics and AI, cybersecurity, mobile tech, and digital learning. So far, customers have reacted positively. Mastech President and CEO Vivek Gupta said the company has on-boarded numerous new customers in the last three-months and is seeing an uptick in digital revenues. He also noted the past couple quarters' record revenue growth in the data and analytics segment, and said that Mastech has successfully transformed into a digital technologies company.

Since 85% of Mastech's Q3:19 revenues came from their IT Staffing segment, the company's success is closely tied to labor market conditions, which are highly cyclical. One useful proxy for labor market conditions is the Kansas City Fed's Market Conditions Index's Momentum Indicator, which compares current conditions to the long run average. Currently, this indicator has been downtrending since August 2018 and is 30% below its post-2010 trading range's median value (see image below). If labor conditions turn up and return to the median, Mastech's staffing segment could see additional growth.

Labor Conditions - chart provided by St. Louis Fed

Like many small growth stocks, Mastech has a concentrated customer base. In Q3:19, its top ten clients accounted for 45% of total sales, according to the 10-Q. This risk provides an opportunity: if Mastech can grow its customer base, it can grow earnings and revenue per share. All else equal, companies with fewer customers will see greater earnings growth when they acquire new customers. And as noted, the company has acquired numerous new customers in the last three-months.

Competitive Positioning

The data and analytics segment mostly competes with IBM Services, Cognizant, Tata Consultancy Services, Deloitte, and Accenture, while the IT staffing segment mostly competes with providers of outsourcing services, systems integrators, computer systems consultants, and other staffing services firms, according to the company's 10-K.

Mastech believes its experienced management team, low and flexible-cost business models, minority-owned status, and established client base will help the company outperform its peers.

Management Team

Its team includes executives with extensive experience working at Mastech and/or other companies (see below).

Management - image created by author with data from Mastech DigitalLow and Flexible Cost Business Models

Compared to industry peers, Mastech has historically had a cheaper operating cost structure thanks to the low cost telesales model in its IT Staffing Services segment and the offshore delivery models in both of its operating segments. Its investments in sourcing and recruiting processes and leading technologies and recruitment tools have resulted in a highly scalable offshore recruiting model.

Minority-Owned Status

As its 10-K notes, Mastech has been certified as a minority-owned business by the National Minority Supplier Development Council. This certification is attractive to many existing and potential clients, especially those in the government and public-sector, who set aside project funds for diversity spending.

Established Client Base

Its 10-K also notes that Mastech's blue-chip client base spans multiple industry verticals and delivers a high quality accounts receivable and consistently strong cash flow conversion metric. Mastech also has many long-standing relationships with corporate clients, blue-chip IT integrators, and managed service providers (MSPs). The company's consistently low customer attrition rate suggests that these relationships are healthy.

Competitive Performance

The table below shows how Mastech's EPS growth, ROE, and operating margin rank among its 27 industry peers, which includes 24 companies in the staffing and outsourcing industry along with IBM, Cognizant, and Accenture. Mastech consistently falls into at least the top 40% of this group.

Mastech vs Competitors - image created by author with data from FinvizRisks

Mastech's 10-K notes several risks. If more large users of staffing services use MSPs to reduce costs, Mastech may be forced to lower its prices, and thus its gross margin, to stay competitive. But so far, gross margins have actually been rising since Q2:15.

As noted, Mastech has a concentrated customer base. This means the loss of one key client could cause a substantial revenue loss. Nearly all revenues come from clients in North America, so Mastech's success is highly sensitive to U.S. economic conditions.

The company's Indian operations face risks typically associated with foreign business activities: currency fluctuations, regulatory changes, tariffs, and wage increases.

Changes in the H1-B visa program could hurt operating results. Nearly 37% of Mastech's workforce worked under company-sponsored H1-B temporary work permits as of Q4:18. If the law changes, the company may face higher recruitment costs and struggle to maintain its workforce.

Demand for Mastech's services may suffer if more companies outsource their IT solutions.

Management warns that technologies such as social, cloud, analytics, mobility and automation face acute supply side challenges.

Company co-founders Sunil Wadhwani and Ashok Trivedi owned 62% of shares and had sufficient voting power to elect all Board of Directors members as of Q4:18. Their interests may diverge from those of management or from your own.

Potential Entry Points

After identifying a company that offers strong value, prudent investors should wait to go long until price action turns bullish. This suggests that the rest of the market is starting to recognize the company's potential.

Mastech's price action turned positive on October 29, 2019, when the price gapped 18% above a four month long trading range (first arrow). Soon after on November 4 (second arrow), the share price continued to climb, and its 50-day exponential moving average (EMA) crossed above its 200-day EMA, indicating that recent price momentum exceeded the longer-term average (see below).

Price Action - chart provided by TradingViewStill, the price remains slightly below the previous high set on September 5, 2018 and has been unable to break that key level.

If they desire to go long, investors may want to wait for the price to break above its previous high from September. They may also want to wait for Mastech's P/S ratio to break above the 0.73 level, the upper bound of its post-2012 range (see below).

Mastech P/S Trading Range - chart provided by StockRowBoth of these signs would increase the odds that Mastech has entered a new stage of growth, as the CEO suggests, and that investor sentiment has changed materially from its prior range-bound behavior.

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.