How to invest

Previously we looked at the business valuation of Mastech Holdings (MHH). To summarize, MHH is an IT staffing company in a competitive yet profitable industry. The macro environment has punished all staffing companies to the floor as companies continue to lay off people. MHH is a spinoff, a contrarian pick and a cheap stock all in one.

View the first stock analysis post on MHH. This post is all about analyzing numbers and valuation.

Spider Graph and Business Valuation Overview

Some opinions on the graph above

• Low risk: With a strong and healthy balance sheet, the risk of MHH going bankrupt and investors losing their money is very small. Current national unemployment rate is at 9.4% and I believe the jobless rate will decline more than it will increase in the future. Note that I did not say in a couple of months or this year. I’m talking over 1 year to be safe.
• High growth: Growth is dependent on the economy. Growth of job rates is the max it will be able to grow.
• Undervalued: Big margin of safety from different valuations. Continue reading.
• Well managed: In operation since 1986. Plenty of experience with the founders still running the company.
• Good financial health: Very healthy. Strong balance sheet.
• Strong moat: Shallow moat. Lots of competition. Anyone can enter the industry.

Financial Statement Analysis

Balance Sheet Analysis

• Mastech has a healthy balance sheet
• $1.55 in cash per share. i.e. 53% of share price is cash.
• No intangibles (WOW! I like)
• No long term debt
• Current debt not a problem. Current ratio of 2.51
• Net net value is $1.80 which means the company has lots of tangible assets making up the stock price
• No drastic changes in cash, accounts receivables or other balance sheet items from the past 5 quarters to set off any alarms.

Income Statement Analysis

• Gross profit margins in the 19% range. Good for a staffing company.
• Cost of Goods Sold (COGS) is very high at 80+% but other competitors around the same size is also in this range. Obviously has to spend to attract employees and earn business. Visa processing and legal fees obviously costs a substantial amount per employee.
• Small net profit margin of less than 4% average and 2.4% in the latest quarter makes it tough in bad economies.
• No new issuance of shares

Statement of Cash Flows Analysis

• Cash flow statement is clean
• Has a bad debt of $258k from not being able to collect receivables. Some of its financial clients went bankrupt.
• Generates positive cash from its operations. No need for debt. (Excellent)
• Organically creates FCF. No need to use EBITDA to try and inflate their numbers (Excellent)

Overall the financial statements are very clean, the business looks to be running smoothly without risk of going bankrupt in this tough environment.

Fair Value Calculations

Discounted Cash Flow (DCF) Fair Value

First using the discounted cash flow method. We see that MHH has been able to generate FCF for the first time as a standalone company in one of the worst years ever. Their history also shows how they have been able to generate cash while being a wholly owned subsidiary of iGate. With this, I’m confident that they will be able to generate more FCF in the future as well.

So to make some assumptions, I’ll use my FCF value of $3.8 million, assume 0% growth rate for the next 10 years and then a terminal rate of 3%. These are very conservative figures. Apply a 15% discount rate, I could use 20% as well but I don’t need to fiddle with the numbers.

• The DCF method gives me a fair intrinsic value of $9.40.
• 50% margin of safety means the buy price is $4.70
• 69% discount to current price of $2.90

Benjamin Graham’s Formula Valuation

This formula uses normalized earnings and with a 0% earnings growth rate, Ben Graham tells me that MHH is worth $3.77. If I were to apply a growth rate of 3.5%, which is basically the 10 year treasury rate;

• the fair value would be $6.21
• 53% discount to current price of $2.90

Net Net Working Capital Valuation

As I mentioned above, the net net value is $1.80.

When I calculate the net net value, I ignore property and all other assets except 100% cash, 75% of accounts receivables and 50% of inventories.

Multiples Valuation and Competitor Comparison

Competitors I am comparing that were mentioned in the annual reports:

• Analysts International Corporation (ANLY)
• Computer Task Group (CTGX)
• TSR Inc (TSRI)

Other value and Magic Formula staffing companies:

• Barrett Business Services (BBSI)
• Manpower (MAN)

Looking at all these companies side by side, I can’t help but see how much better MHH is.

• MHH PE is is at 3.6 while the average is 18
• Price to cash flow is a low 3.26 compared to average of 12
• Price to FCF is 1.86 compared to average of 5
• EV/Revenue (TTM) is 0.06 compared to average of 0.13
• Less of a decline in growth compared to all its competitors except CTGX
• Financially stronger than most
• Profitability is in line with competitors but profit margins are the best
• Excellent ROA, ROE, ROIC. Much better than competition

On ALL counts MHH performs and executes better than its competitors yet it is trading at a PE of 3.6 and this is even after it ran up 50% or so following its 1st quarter results.

If I was to assume a multiple of 10, which is still conservative, the fair value comes out to $8. Note that I am using their latest EPS with this multiple. I didn’t even bother factoring in how their earnings will definitely increase.

Also, the spinoff price was at $9 which is in line with everything I’ve written here.

See all the numbers for yourself in the spreadsheet below.
MHH Competitor Comparison Spreadsheet

Summary

No brainer.

Disclosure

I hold MHH at the time of writing.

I first mentioned Mastech Holdings (MHH) when I updated the results of the negative enterprise value screen. Mastech is not a net net value stock but after briefly analyzing the financial statements, I believe it to be within my circle of competence and margin of safety. There is also a limit to the downside. In other words, this is a cheap value stock idea.

Nevertheless, all fundamental analysis requires more reading and analysis to come up with a conclusion and fair value estimate. Like previous stock analyses, it will be broken to two parts. This one looking at the business, industry, risks and advantages and the second post will go over the various numbers.

I’ll start with a quick overview.

Spider Graph Overview

Business Summary

Mastech Holdings, Inc (MHH) is a provider of IT and brokerage operations staffing and consulting services to Fortune 1000 companies.

Mastech delivers a broad range of services within business intelligence / data warehousing, service oriented architecture, web services, enterprise resource planning & customer resource management and eBusiness solutions segments.

Mastech was established in 1986, has more than 2o years of operating history and was a wholly-owned subsidiary of iGATE but spun off from its parent on September 30, 2008.

The company managed to survive the dot com bust and retooled its recruiting model to focus on the recruitment of U.S. based IT talent which has allowed the company to access to a larger and differentiated recruiting pool compared to many of their competitors.

Growth Strategy and Competitive Advantage

The staffing industry as a whole is very fragmented with low barriers of entry and high competition. This means that there is no clear leader dominating the industry like Cola and Pepsi. The pie is big enough for everyone i.e. everyone has the potential to profit and stay in business although a moat does not exist.

In this type of industry, regardless of size, a company can steal or lose market share.

As for growth, I see it being dependent on a couple of things.

1. Stealing market share and contracts – Staffing is a service. It isn’t a product that can be sold internationally. An H1-B visa is useless outside the United States and a US staffing company isn’t likely to send their contractors to other countries.
2. Growth is entirely dependent on the economy - This is an investment that should be monitored along with the economy. When the economy is good, companies increase their business which will require additional employees whether they be permanent or temporary. With the nationwide unemployment rate being 10% at the moment, it is safe to say that the probability of economic growth is  higher than a depression.
3. Acquisition of companies – MHH has a healthy balance sheet and has the ability to acquire other companies.

One competitive advantage that MHH states in their 10-K is the following:

“Unlike most staffing firms that have a high concentration of either H1-B workers or W-2 hourly U.S. citizens, we have approximately a 50/50 composition of H1-B and W-2 hourly employees. As such, this balanced mix allows us to tap a broad candidate pool.”

I’m not quite sure how much of an advantage this is, since it should be easily replicated.

However, if you look at the numbers that I will go through later, MHH compares to a company 4-5 times its size. Their margins and profitability are higher than a number of their competitors which does prove they have an advantage. I just can’t see or pinpoint it.

Sales and Marketing

Mastech focuses their marketing primarily on large businesses with spending power and recurring staffing and software development needs.

MHH tends to spend “much of our marketing efforts are focused on increasing business with our existing accounts.” As you can see already, MHH is not a growth company.

The company does business through two business channels – wholesale and retail with most of the strategic relationships in this channel are established vice presidents and sales director.

“Wholesale channel consists of system integrators and other IT staffing firm customers …  Revenues from this channel represented 48% of total revenues in 2008.

IT retail channel focuses on customers that are end-users of IT staffing services.

Within the retail channel, many end-users of IT staffing services have retained a third party to provide vendor management services to centralize the consultant hiring process. Under this arrangement, the third-party managed service provider (“MSP”) retains control of the vendor selection and vendor evaluation process, which acts to weaken the relationship built with client contacts.”

Risks

1. Concentrated customers

IBM, Tek Systems and Wachovia Securities are the top three clients representing 14.9%, 12.7% and 10.7% of total 2008 revenues, respectively. If they lose even one of these clients, MHH will suffer huge setbacks.

However, with their history, expertise, broad talent pool and client relationship, this possibility seems to be small.

2. No Pricing Power

Because the industry is highly fragmented, MHH do not have the luxury of increasing prices without jeopardizing their business.

3. Immigration law

Immigration law is also another issue. There is a quota limit to how many H1-B visa’s can be issued each year and it fills up very rapidly. The good thing is that Mastech focuses on employing people in the US already with a H1-B visa.

4. Dependent on Economy

Mastech’s business is directly correlated to the economy. i.e. buy the stock when the economy is bad and sell when things are doing well.

5. Margins and profits will suffer if the trend towards Managed Service Providers (MSP) continues. Managed Service Providers are employed by bigger companies and act as the middle man to handle the negotiation and hiring of contractors. More companies have been using this business model which means that a direct and close relationship will be hard to maintain.

6. MHH also operates internationally to recruit talent which introduces currency risk.

7. Mastech hold several “preferred vendor” contracts which provides business volume although the margins are smaller. If they were to lose their preferred status, they would see a drop is revenue.

8. Co-founders of iGate, Sunil Wadhwani and Ashok Trivedi, hold 57% of MHH common stock. If they are shareholder orientated, great, if not, even an wolf activist Bill Ackman won’t be able to do anything.

To be continued

The next post will focus on the financial statements, fair value calculations and other number discussions. Stay tuned.

Disclosure

I hold MHH at the time of writing.