1 Main Capital, an investment management firm, published its second-quarter 2021 investor letter – a copy of which can be downloaded here. A quarterly net return of 18.6% was delivered by the fund for the Q2 of 2021, ahead of its S&P 500 and Russell 2000 benchmark that delivered a 15.2% and 17.5% return respectively for the same period. You can view the fund’s top 5 holdings to have a peek at their top bets for 2021.
In the Q2 2021 investor letter of 1 Main Capital, the fund mentioned Mastech Digital, Inc. (NYSE: MHH) and discussed its stance on the firm. Mastech Digital, Inc. is a Pittsburgh, Pennsylvania-based digital transformation and information technology services company with a $198.7 million market capitalization. MHH delivered a 10.06% return since the beginning of the year, while its 12-month returns are down by -10.35%. The stock closed at $17.44 per share on August 31, 2021.
Here is what 1 Main Capital has to say about Mastech Digital, Inc. in its Q2 2021 investor letter:
“During the quarter, the fund re-initiated an investment in MHH after its stock price was cut in half from its 2020 highs, driven by (i) a COVID-related slowdown and (ii) its removal from the Russell 2000 Index, causing significant uneconomic selling. I previously wrote about the company in the Q2’18 letter.
Mastech is an off-the-radar, closely held IT services company that is in the process of transforming itself from a legacy IT staffing business into a higher margin IT consulting and services business.
The company’s co-founders, who together own ~60% of the company, turned their attention to value creation at Mastech after selling iGate to Capgemini for $4 billion in 2015. A new CEO with significantly more industry experience was hired for MHH in early 2016. This CEO made organic investments in the staffing segment and deployed capital into two strategic acquisitions over the last several years to help transition the business into higher margin, higher growth consulting and services businesses (the “Data & Analytics” or “D&A” segment).
The staffing segment is boring (2/3 of adjusted operating income). It generates low margins, though it has low capital requirements and grows well above GDP, in-line with the growth in global IT spend. From 2011 to 2019, the staffing business grew revenue at an average annual rate of approximately 10%. However, in 2020 the staffing business had its first down year since the financial crisis – obviously due to COVID. This business should recover nicely this year and return to growth going forward. The best evidence of this is that the number of billable consultants finally inflected positively in Q1, which is a good forward indicator of revenue. Below is a table of YoY growth in billable consultants for the staffing segment: (See table at Pg.2)
The D&A segment is less boring (1/3 of adjusted operating income). It manages high-value IT projects and implementations for blue chip customers globally. This segment should grow revenue mid-teens or higher organically and generate 20%+ EBIT margins at maturity.
However, the leader of the D&A segment has made some significant organic investments over the last 3 years to i) enhance the capabilities of the business and ii) increase the sales team in order to better sell those capabilities. As such, the adjusted operating margins of this segment compressed from 28.8% in Q4’17 to 4.5% in Q1’21. However, we will likely see meaningful operating leverage in the coming years.
Additionally, management is seeking to continue growing the D&A segment through accretive M&A, which they have done skillfully in an environment where anything tech has traded at high valuations.
For example, when MHH acquired InfoTrellis in 2017, they paid $55 million, of which only $36 million was paid in cash and $19 million was structured as a contingent earn-out with some aggressive growth targets for the acquired business. The growth targets were missed so the earn-out was never paid, which led to an effective purchase multiple of 5x 2018 EBIT.
In late 2020, MHH acquired AmberLeaf for $14 million, of which only $9 million was paid in cash with the remainder deferred. The 2021/22 EBITDA targets that need to be hit to get the earn-out would make the effective purchase price 5x EBITDA.
As the business continues to mix towards D&A via M&A and organic growth, and as the D&A margins inflect upwards after a period of investment, I believe the overall operating margins of MHH will materially inflect as well.
Between now and 2025, I believe adjusted EPS can triple to $3 per share, up from $1 currently, and by then the operating profit contribution from Data & Analytics will exceed the contribution from the Staffing segment, likely allowing us to benefit from multiple expansion along the way.
Eventually, I believe that the company will be sold, as the co-founders have shown a willingness to part with their assets (when paid a good price) and are 68 and 71 years old.”
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Based on our calculations, Mastech Digital, Inc. (NYSE: MHH) was not able to clinch a spot in our list of the 30 Most Popular Stocks Among Hedge Funds. MHH was in 2 hedge fund portfolios at the end of the first half of 2021, compared to 3 funds in the previous quarter. Mastech Digital, Inc. (NYSE: MHH) delivered an 8.02% return in the past 3 months.
Hedge funds’ reputation as shrewd investors has been tarnished in the last decade as their hedged returns couldn’t keep up with the unhedged returns of the market indices. Our research has shown that hedge funds’ small-cap stock picks managed to beat the market by double digits annually between 1999 and 2016, but the margin of outperformance has been declining in recent years. Nevertheless, we were still able to identify in advance a select group of hedge fund holdings that outperformed the S&P 500 ETFs by 115 percentage points since March 2017 (see the details here). We were also able to identify in advance a select group of hedge fund holdings that underperformed the market by 10 percentage points annually between 2006 and 2017. Interestingly the margin of underperformance of these stocks has been increasing in recent years. Investors who are long the market and short these stocks would have returned more than 27% annually between 2015 and 2017. We have been tracking and sharing the list of these stocks since February 2017 in our quarterly newsletter.
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Disclosure: None. This article is originally published at Insider Monkey.
