If you are looking for the best ideas for your portfolio you may want to consider some of Merion Road Capital Management’s top stock picks. Merion Road Capital Management, an investment management firm, is bullish on Mastech Digital Inc. (NYSE:MHH) stock. In its Q2 2019 investor letter – you can download a copy here – the firm discussed its investment thesis on Mastech Digital Inc. (NYSE:MHH) stock. Mastech Digital Inc. (NYSE:MHH) is a technology company.
In July 2019, Merion Road Capital Management had released its Q2 2019 investor letter. Mastech Digital Inc. (NYSE:MHH) stock has posted a return of 206.5% in the trailing one year period, outperforming the S&P 500 Index which returned 13.4% in the same period. This suggests that the investment firm was right in its decision. On a year-to-date basis, Mastech Digital Inc. (NYSE:MHH) stock has risen by 60.5%.
In Q2 2019 investor letter, Merion Road Capital Management said the Long Only fund posted a return of 4.6% in the second quarter of 2019, outperforming the S&P 500 Index which returned 4.30% in the same period. Let’s take a look at comments made by Merion Road Capital Management about Mastech Digital Inc. (NYSE:MHH) stock in the Q2 2019 investor letter.
“Mastech Digital (“MHH”) was the largest driver of negative returns as it fell 23% during the period. MHH is an IT staffing company that was spun-off from iGate, an IT outsourcing company, back in 2008. iGate subsequently made the transformative acquisition of Patni in 2011 and sold the entire company to Capgemini in 2016 for $4bn. Following this sale, the two co-founders turned their attention to growing MHH. In 2016 they brought in a new CEO, Vivek Gupta, to help reposition the company toward a higher valued product and in 2017 they provided the equity funding for the acquisition of Infotrellis, a data and analytics company (thereby increasing their joint ownership from 50% to 60% of the company). I built an initial position in early 2018 at roughly current prices and it was the source of significant positive performance last year as I made sales at higher levels. Mr. Market has provided us with another bite at the apple, and I have been adding to our position on recent weakness.
With regards to IT staffing, MHH provides temporary employees on a wholesale basis to system integrators and other IT staffing firms as well as on a retail basis directly to consumers. While this is a competitive, economically sensitive, and lower margin business, execution has been very encouraging.
Vivek has focused on serving higher-growth digital needs like cloud, mobility, and social over traditional IT services such as Oracle mainframe. Employees addressing digital needs typically generate a 2-3% higher margin for MHH, which is significant given that operating margins are in the mid-single digits. Today 30% of their staffing work is digital versus less than 20% when Vivek took over as CEO, and this trend should continue. The industry has been growing in the mid-single digits and is forecasted to grow 4% in 2019. MHH has surpassed this level, growing 11% in 2018 and 7% in Q1 2019. Margins have expanded despite the additional long-term investments the company has made in upgrading its systems and expanding its offices. Industry participants I have spoken with have given positive reviews of the company.
The data and analytics business provides project-based consulting services solely focused on digital technologies such as master data management, enterprise data integration and digital transformation (i.e. implementation of Salesforce.com CRM). When MHH acquired this business a large part of the consideration came in the form of contingent payments based upon one and two year segment EBIT. The first year hurdle was not met, meaning that MHH was not required to make an additional payment to prior management. The second year concludes in July of this year and it is still too close to call. I doubt MHH specifically throttled the business, but it is clear that they would not have benefited from any outperformance. These disincentives will go away once the testing period concludes. Of note, in the last few quarters the company has begun to make investments that will improve segment sales and offshore delivery services. The industry as a whole is forecasted to grow at a 12% CAGR from now until 2023. Senior management incentive compensation is tied to achieving 25% segment growth annually from 2020-2023.
MHH is currently trading at a little less than 6.0x my estimate of 2020 EBITDA and around 5.5x free cash flow (after adjusting for one-off expenses related to office relocation and expansion). Most IT staffing companies trade at 7-9x EBITDA while data and analytics companies are typically valued at 9-11x. At 8.5x MHH would be worth $8.50 or 75% above the current price. So the question remains, why has the stock traded down so much and what is going to change?
Ignoring the prior point with regards to the contingent consideration, there is a more obvious explanation for the stock underperformance and a potential catalyst. Upon closing the Infotrellis acquisition MHH’s goal was to pay down debt and subsequently pursue additional acquisitions. While the company has generated strong earnings since then, earnings have not been converted into cash as their accounts receivables balance and unbilled receivables balance have ballooned by $10mm. I believe this has been the biggest factor weighing on the stock. Over the last several quarters MHH has implemented a new ERP system which wreaked havoc on their billing processes. This type of upgrade can be very complicated and they are not the first company I have seen have issues. Fortunately, the cash conversion problem should be a temporary setback; and through my conversations with the management I believe that the worst is behind them. If working capital normalizes not only will we see earnings turn into cash, but we should also see a release of excess working capital that is currently on the balance sheet (allowing them to quickly de-lever). Once this occurs it will be hard for investors to ignore the almost 20% free cash flow yield that the company will generate.”
In Q1 2020, the number of bullish hedge fund positions on Mastech Digital Inc. (NYSE:MHH) stock increased by about 100% from the previous quarter (see the chart here), so a number of other hedge fund managers seem to agree with Mastech Digital’s growth potential. Our calculations showed that Mastech Digital Inc. (NYSE:MHH) isn’t ranked among the 30 most popular stocks among hedge funds.
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Disclosure: None. This article is originally published at Insider Monkey.