By Cristian Anastasiu and Michael Schwerdtfeger
In previous columns we reviewed the state of M&As in the IT services sector and examined the factors driving consolidation. With that backdrop in place, let’s shift from macro to micro and look at value drivers inside the IT services firm. In the next few months, we’ll delve into tactical decisions you can make to derive maximum value from your company. First up: IT delivered as a service.
Historically, IT services were largely one-time-cost projects, whether due to the purchase of equipment or software or engaging consulting services for a finite span. While often profitable for providers, sales and services needed to be recreated from scratch each time the IT firm completed a project. Sold a system or software? Time to start over. Finished the consulting project? Time to look for a new client.
In contrast, over the last few years, the landscape has rapidly morphed into a repeating business model, with firms providing software-, infrastructure-, and platform-as-a-service offerings. MSPs have flourished, and even relatively stodgy IT companies such as Microsoft have moved aggressively to SaaS offerings like Office 365.
While these IT-as-a-service offerings obviously fill customer need, they also drive significant value to IT providers.
Why ITaaS Creates Value
In the middle market, companies derive value from sustainability. The continuity of cash flow with low risk drives valuations.
In looking at historic operations in the IT services sector, the most appropriate analogy is to the construction sector, a market that continues to have low values relative to participants’ revenues and profit. Why is that? During periods of economic growth, capital spending booms, and large amounts are spent on construction, equipment and infrastructure. In contrast, in downturns such as during the late 2000s, capital is tight, and both construction companies and IT services firms that relied on project-based revenue saw business dry up.
Also, in both construction and project-based IT services, providers are often reliant on bid-based work, with significant contracts being awarded to low bidders. These sorts of fluctuations of revenue and lack of repeat business create an inferior value proposition for IT providers looking to participate in market consolidation.
In contrast, ITaaS has turned this historical model on its head, creating stickiness and sustainability where none previously existed. Looking at my own personal use of Microsoft Office over time is actually a very good example. While I have been a longtime user of Microsoft Office, I did my best to milk every last drop of utility from Office 2003. Then, when it became obvious that Office 2003 had run its course, I did my best to explore other options, including the “low-cost” leader, OpenOffice. Under this model, Microsoft derived very chunky revenue from me, and ultimately hoped that one day I would make another purchase.
Then, Office 365 arrived, and I bit. It provided a value proposition that I appreciated, but from Microsoft’s perspective, something wonderful happened: It took a chunky and unreliable revenue stream and turned it into a sticky and repeating cash flow.
Unlike the “construction company” model, this type of sustainable and sticky cash flow creates unbelievable value for firms.
In our first article, we pointed out the influx of institutional capital (such as private equity) into the IT services sector. These professional middle market investors are easy to understand. They’re bean counters who don’t like risk. They hire teams of MBA analysts to create models to explain risk and leverage deals with debt obtained from banks (the same banks that don’t loan to middle market companies without securing the loan with the owner’s first born). The “construction company” model is anathema to them. Work that can be lost to low bidders? Unprotectable profit margins? Chunky cash flow?
None of these are easy to model or to invest in.
Consequently, much of the institutional investment that has gone into the IT services sector has done so despite the historical model, and investors have had to get comfortable converting revenue into more sustainable forms. As an example, a local private equity firm acquired a telecommunications infrastructure company a few years ago and quickly converted its revenue stream from project-based to lease-based, financing customers’ installations and creating longer-term leases that generated stable cash flow over a multi-year period.
Not surprisingly, in today’s marketplace, buyers are clamoring for opportunities to acquire IT service companies that have already made this transition to foreseeable — and repeatable — cash flow.
Cristian Anastasiu and Michael Schwerdtfeger are managing directors at Chapman Associates, a national mergers and acquisitions firm providing middle-market companies across various industries with the same resources, expertise and representation that is usually available only to much larger companies. Michael’s e-book “The Inner Workings of a Deal: Tips for a Successful Transaction” is now available for free download. Follow him on Twitter at MBSMergers.