Description

Potential double in 3 years driven by growth of recurring revenue and modest margin expansion.  Possible sale candidate with older CEO looking to exit.

Information Services Group (III) provides a range of products and advisory services in the IT space, with an increasing proportion of recurring revenues (>40% of revenue) helping the company drive top-line growth with operating leverage.  The company had a flat top-line for a long time and we believe that due to a lack of segment reporting obscuring exactly what has changed, an inflection over the last few years, combined with strong recent results, is still underappreciated by the market.

At prices in the low $5s, III trades at a low double digit multiple of after-tax, after-stock-comp earnings (i.e. a high single digit yield), and we believe that the company can drive at least modest (4-5%) revenue growth over the next three years, driven by strong growth (11% in our model) from a portfolio of recurring-revenue products and services.  These naturally come at higher margins, and combined with fixed cost leverage, we believe the company can achieve its goal of driving Adj. EBITDA margins higher by ~200bps over the next several years.  

Even assuming a longer timeframe to achieve these goals than the company’s target, and even assuming materially lower revenue growth, we think that in three years, the company will generate ~$57 million of Adj. EBITDA on $350M+ of revenue.  Subtracting our estimates for stock comp ($12M) and capex ($3.5M), pre-tax unlevered income would be about $42 million.  In our model, which assumes all FCF goes to debt repayment, the company should have minimal net debt by that time, so post-tax net income would be about $30 million.  At a reasonable multiple (16x), the implied market cap of ~$480 million would be in the $9.50 - $10 range, or roughly a double from recent prices and a 20 - 25%+ CAGR.  Share repurchases in excess of stock comp would boost this value.

While there are a few risks (which we will cover thoroughly), we believe these can be managed through position sizing.

The company pays an attractive dividend and has a large and active share repurchase program (although in fairness, the company also has elevated stock comp, so the sharecount is unlikely to reduce substantially.)  Nonetheless, the management team hasn’t done anything stupid.

Finally, a number of former employees expressed surprise that III was still a public company, and while there was some doubt about the right home for the business, there was little doubt that the likely endgame here is a sale.  While the company seems intent on executing its strategy over the next several years, CEO Michael Connors (who owns roughly 11% of the company) is 67, and the VP/President who runs a lot of things is 61 as well and owns 1.4%.  It seems unlikely to us that Connors will want to continue running the company well into his 70s, and given limited trading liquidity, a sale would be an efficient way for him to retire and monetize his stake at the same time.  

History: So What Would You Say… You Do Here?

This name was actually covered quite a lot on VIC a decade ago, with four writeups from 2008 - 2013 and one in 2017, so we’ll only hit the relevant high points of the history (please refer to those writeups for more details) and focus on what has changed in the past 3-5 years.  III came public through a SPAC prior to the GFC and ended up seeing a lost decade for the stock, which is still not back to where it was in 2007.  We note the SPAC because while Michael Connors is sometimes referred to as the “founder,” he didn’t actually found the business in the literal sense.  The SPAC acquired a business called TPI.

We like starting with a long-term chart because it helps set the stage.  You’ll see that until recently, the company really had very little organic growth in revenue or EBITDA.  Note that due to the large acquisition of Alsbridge in 2017 (which was somewhat distressed), the chart shows a jump, but in reality there wasn’t a whole lot of organic revenue growth.  Currency might have had some impact but basically, consolidated revenues flatlined.

Underneath that is a tale of multiple business lines, which helps explain the recent inflection point.  III does not provide segment disclosure, which is a shame from a public investor perspective because it has a hodgepodge of businesses with very different characteristics.  

In fact, the more of ISG’s 10-K I read, the less I understood.  The narrative section of their 10-K is an amalgamation of buzzwords with no substance or quantification - almost a caricature of all the worst elements of consultants.  It takes a little sleuthing to understand what the business really is, but perhaps therein lies the opportunity.

I felt reassured that I hadn’t suddenly developed some reading comprehension deficiency when I found a relatively recent Tegus quote - from a former director of digital strategy - that confirmed that not only are their disclosures opaque externally, but they’re even opaque internally.  This former did point to some general revenue buckets: 

• 50% sourcing advisory (down from the vast majority of the business at one point)

• 30% “digital” (up from less than 15% a few years ago)

• 10% RPA (non-core)

I am aware that the numbers above don’t sum to 100, but these are broad brushes.  The numbers are probably more favorable to digital now given that it has been a few years since that interview.

Let’s take each of these pieces in turn.

Sourcing Advisory

ISG has a high market share (estimated at half to two thirds) of the “outsourcing advisory” market.  Basically, when companies do outsourcing deals, TPI provides advice.  While there are others, they are the 800-lb gorilla in the space.

The problem with having dominant market share is that you can’t really do much except grow with the market - and this market has shrunk significantly over time.  Basically, when outsourcing was newer, companies did big outsourcing deals and needed a lot of advice, because they hadn’t done it before.  Over time, the deals got smaller, and as companies had more experience, they needed less advice.  There are some other dynamics but a number of calls with formers confirm that this is generally the sum of it.  As one put it:

The first problem with outsourcing advisory is over the years the market’s gotten a lot more mature and the deals have gotten a lot smaller. So back when I first joined TPI, I did two four- billion dollar deals with AT&T and IBM. You will never find another four-billion dollar deal again. People are in their second and third generation of outsourcing, with some exceptions, so there’s not that giant fee, giant year deal going on there. It’s lots of smaller deals, add-ons, renegotiations, that type of thing.

 So the dynamic in the market has changed. The second thing is that you’re booking the business every time. There’s no recurring revenue. You might have a client that you had for five years because you’re doing lots of different deals, but it’s really not recurring revenue. It’s just they’re big enough to sustain you for four or five years

So underneath the flattish top line, sourcing advisory was shrinking while other pieces of the business were growing.  (We’ll get to those.)  The good news is that formers generally seem to believe that the decline has stabilized, and the industry may see some growth (albeit not a ton) over the next decade.

FORMER DIRECTOR OF DIGITAL STRATEGY AND SOLUTIONS AT ISG

I would say the sourcing advisory piece is stable. I think over long periods of time, right? I think 20 years from now, 30 years from now, it may not exist. But I think over the next 5 years, it's going to continue to be stable and maybe a little bit of growth because companies are going to be doing more of it.

So just to make sure I encapsulate that correctly for you. I believe that the sourcing advisory business will increase because all outsourcing will increase. But if all outsourcing grew at 100%, sourcing advisory would grow at half of that, right?

So sourcing advisory is becoming less of a thing, but there should be so much growth in sourcing overall, that rising tide should lift that ship as well. So I think as long as outsourcing stays strong, which it should be strong and continue to be strong until the economy has completely recovered. So whenever you put that data out there, I think sourcing advisory will be good.

Digital

“Digital” is a catch-all term that encompasses a number of items.  It’s important to note here that III does not provide implementation / maintenance services like some of the other IT service provider companies written up on VIC (CTG, MHH, MGIC, and so on.)  They are more akin to say Gartner or McKinsey, providing higher-level strategy advice and generally not getting into the weeds.  One former discussed the growth of digital over the past several years:

But digital transformation is 30% of their business. And 3 years ago, it was less than 15% of their business. So it is the growth engine. And it is one of the more margin accretive offerings. And when you look at the dynamic of what's happening inside of companies, right?

Now they're dealing with a much more remote workforce, and they're going to have to reimagine how they engage all of their clients and their IT infrastructure and how they engage their internal folks and you hear CEOs at John Deere & Caterpillar traditionally product companies talking about becoming digital companies, there's just a lot of tailwinds in that to help push them up, and they do have strong leadership there.

TEGUS CLIENT

And if you can translate digital into English?

FORMER DIRECTOR OF DIGITAL STRATEGY AND SOLUTIONS AT ISG

Yes. I would put a lot of the cloud initiatives inside of that bucket, right? So you're taking and you're removing physical infrastructure and you're getting rid of that physical infrastructure to go into cloud, you're doing things like autonomous driving, developing cars that are connected, the car then becomes a software product more than a physical product.

So I did some work with them at Chrysler, where we were looking at how you turn the car into a platform, helping companies with strategies around product transformation. ISG being in the IT space has always been in the back office. But in digital, they get a chance to go out and get in between the company and their clients. So the value proposition is much higher, right?

When you're talking about the infrastructure and the applications and the strategy for Chryslers and products, the value proposition is much higher and you can charge more for that, and you'll get a much stronger margin if you can deliver it.

RPA

The company has a non-core RPA segment that might be disposed of sometime and would likely fetch a higher value.  There are a number of reasons it might make more sense in the hands of another buyer including some conflicts - generally, III isn’t competing against IT suppliers in the industry, but in RPA it sort of is.

Recurring Revenue

The more helpful way to think about the business is recurring and non-recurring.  As noted by the former above, one of the big problems with the sourcing advisory business is that each sale cannibalizes future revenue and shrinks the market, which makes it hard to grow.  The company has therefore focused on growing recurring revenue streams, and been quite successful in doing so:

The company doesn’t break down exactly what comprises this recurring revenue, but areas include research, benchmarking, and what I consider to be the crown jewel - GovernX, a contract lifecycle management SaaS platform.  Here is some commentary from management on the buckets:

Essentially three or four buckets.  Bucket one is research - so think about subscription based, emerging technology - it’s $50, $75, $150K subscription - recurring - 

Second part is our platform business - consists of GovernX - it’s the vendor risk management piece we manage based on SaaS governX software - charge them half a million, million bucks over three years on a recurring - those two represent a majority

The other components consist of our long term public sector contracts - multi-year contract with state of louisiana where we provide technology advisory work - or our automation software licenses - where we provide - UIpath, Nice, blue prism - that’s what comprises the portfolio of recurring

Most of our research, like IDC - they have 85% of their client base is vendors - roughly 85% of our research - maybe it’s 80% of our research business - comes from the vendor/provider side 

Unlike somebody like IDC that might track the market share of iPhones etc, our work expands and the research and GovernX both are growing at double digits, have been for a number years - expect it to continue in a double digit area - there is a proliferation of providers and vendors in the community and they buy a series of products from us - we have a probenchmark product which is a black box where we load in a lot of our engagement data - clients like accenture, cognizant, british telecom would buy that - we charge $250K or more per year - and they might use that to go in and pitch Barclays in London, we need to determine - what is the pricing range we can do to take applications from 1,000 to 250 and how does ISG data help inform us when we actually pitch Barclays…

Another bucket not mentioned above is training-as-a-service - something in the neighborhood of Skillsoft, with recurring multi-year contracts that appears to be growing nicely (albeit off a small base):

There's another example, a large bank, a large bank does a lot of training on regulatory and on compliance. We have a new service we launched last year called Training-as-a-Service, TaaS. And we're taking one of the top four banks in the world, and we are basically going to operate their Training-as-a-Service on a fixed-fee multiyear contract. Why? Because of the number of people, the turnover, the costs associated with it, and we could do it more efficiently for them. So there's another flip of that. 

It is worth noting that this recurring revenue (other than GovernX) is lower-quality than true software revenue but higher-quality than standard consulting services.  My calls with formers highlighted that their research/benchmarking sales are more constrained than, say, Gartner’s, because they are mostly selling to vendors and not to clients (i.e. a smaller TAM).  They appear to be growing nonetheless.  There are also other types of revenue (such as event revenue) that get bundled into “research.”  

I think VIC is a better place when people present ideas honestly rather than dressing them up, so I’m not going to sit here and try to convince you that this is world-class quality recurring revenue - most of this revenue is not as good as say Gartner, or Franklin Covey, let alone a true software asset.  But I think it’s underappreciated by the market given the company’s history, and it’s good enough to create a base to drive growth, which we don’t think is priced into the stock today.

GovernX

GovernX is the crown jewel.  They don’t provide an exact revenue number, but my guess from talking to them and formers is that it is likely at least 20 - 25% of the recurring revenue figure, or perhaps $25 - $30 million in ARR (~10% of total company revenue).  It could be higher, but it’s probably at least this much.  Per management, client retention is over 90% and dollar retention is over 100%.  The business has a demonstrably double-digit growth rate, suggesting that as a standalone software asset it would likely be worth $100 million plus (or a third of the current EV, despite being merely 10% of revenues.)  

This has taken a long time to build.  In an interview all the way back in 2017, a former describes the value proposition:

Then at the very tail end of the process, is a newer offering. ISG has had that for a bit. I helped get it going at Alsbridge as well. They call it vendor management and governance. A lot of organizations will try to sell it as a service. ISG had pretty decent luck with it early on. Alsbridge has struggled a little bit with it. But it’s how you manage the vendor in an ongoing relationship. And part of that, both of these guys have set up offshore upsource centers, so to speak, to help clients manage these contracts. These contracts can be hundreds of pages long with lots of service levels, ARCs and RRCs and covenance, obligations that need to be tracked and managed against to ensure everything is performing well. The challenge is to manage that. Some customers have built that competency, the vendor management and governance group. I’m helping a client build that right now 0n their site because they don’t have it, but it’s one of the skills to hire. They’ll sell that as a service. The best part about all those services that I just mentioned, why they like the last one the best is because it’s recurring revenue. But it’s also harder to sell at the same time, too. That one runs a longer duration. 

Formers I spoke to recently suggested that GovernX delivers significant cost savings to clients and is in the early innings of adoption, with few / limited competitors and a large potential TAM.  There is a real value proposition here because when you have SLAs (service level agreements) from vendors, you are entitled to compensation if those terms are not met, and/or it helps you renegotiate the contract more favorably in future.  

But it has historically been a very manual, inefficient process to keep on top of monitoring this (i.e. it’s often not done very well, or at all, because it’s easy to just miss or forget things that are buried in thousand-page legal documents.)  One former I spoke to stated that in addition to these benefits, there are direct cost savings, i.e. a client might be able to have only 1-2 FTEs instead of 5-7 managing this process.  So GovernX pays for itself.

One of the things that makes it really sticky is that setup is hard and switching costs are high, because you have to populate the database with the terms.  This has historically been done manually by ISG using offshore labor, but they are increasingly finding ways to utilize AI tools for the extraction process.  Nonetheless, it seems like a business where once you’re in, you’re in, and though there is an initial cost, the margins on it should be quite high once a contract is set up.

This business is demonstrably growing double digits.  Management says it, but there is also proof.  If we assume that I am roughly in the correct neighborhood of ARR, then the fact that management cites new million or multi-million dollar contracts on each earnings call suggests that growth rate in this business is well into the teens and perhaps 20s (even if the stated contract value is for a multi-year period). For example, on the Q2 call:

 In a very positive development, we recently were awarded the largest GovernX engagement to date in Asia Pacific, a multimillion-dollar contract with one of the largest independent payment solution providers for the Australian financial services sector. This contract begins in the second half of this year. 

Margins - ISG Next, Recurring Revenue

The final piece of the story is margins.  Margins inflected during COVID due to the firm’s “ISG Next” operating model.  Basically, they started providing a lot of advisory services remotely rather than on-site, saving T&E for clients but more importantly, allowing for higher utilization of consultants (who are now wasting less time in airplanes, and could potentially service other clients during downtime for one client.)  Utilization rates for consultants rose from the 60s into the 70s and are staying there despite some return to in-person interaction.

Meanwhile, recurring revenue is also boosting margins.  Management has a target of reaching 17% Adj. EBITDA margins by the end of 2025; this seems quite achievable given that they did EBITDA margins of 15.6% in Q3 2022 as well as 15% margins in the prior and subsequent quarter.  Margins dipped into the 13% range in the last few quarters and are expected to be close to 15% in Q3, but I believe this is a temporary rather than structural phenomenon as they did a lot of hiring to support growth (9% constant-currency consolidated revenue growth in H1) and are a bit underutilized at the moment (pretty common phenomenon for professional services firms).  As they utilize (or fire) these individuals, and higher-margin recurring revenue continues to ramp, a 200 bps of EBITDA margin expansion vs 2H 2022 levels hardly seems aggressive (although for conservatism, my model only has them getting to 16.5% by mid-2026.)

Valuation

If you assume their recurring revenue base (currently ~$125MM per annum) grows at 11% per year, that’s enough to drive ~5% growth for the consolidated enterprise assuming zero growth in their non-recurring revenues.  I think this is reasonably conservative, considering that the growth rate in recurring revenue (on an LTM basis) has been 20% for the past three quarters, and has grown at a 13% CAGR since the end of 2019.

Add in a little bit of EBITDA margin expansion and you get a pretty nice outcome.  Since I’m lazy, my model simplistically assumes that all earnings are used to pay down debt (and keep in mind that my model treats SBC as a real cost.)  Of course, a decent chunk of FCF will be used to pay the dividend, and much of the rest will be used to buy back shares, but the latter should be accretive so it sort of offsets.

The point here is that not a lot has to go right for this to work out nicely for shareholders.  Of course, management is shooting for higher figures, i.e. high single digit total revenue growth (vs. my mid single digit) and 17% EBITDA margins by year-end 2025 (vs. my 16.5% by mid-2026).  So it could go even better than this.  Of course, it could go worse.  About that…

Risks

1. Stock comp / mgmt comp in general

One potential risk factor here is that rain or shine, management will get paid.  Management seems to be compensated very generously.  III mgmt is paid more than that of Charles River (CRAI), which has double the revenue and EBITDA. 

Stock comp is running at about $10MM/yr, or ~22% of run-rate EBITDA (Q3 annualized).  I’ve seen too many situations recently where stock comp is treated as fixed even when EBITDA declines, so with a high percentage of stock comp going to EBITDA, if there are any hiccups, real returns to shareholders could be dramatically impacted.  Similarly, it is my expectation that some portion of the growth in EBITDA will accrue to management through higher payouts.  Model as you wish.

The flip side of this is that in a takeout scenario, one zero-risk, day-1 synergy is having a more reasonable compensation structure - either a PE firm or a strategic would have internal resources at a much lower cost.  So perhaps you can add back $3 - $4MM of stock comp to EBITDA in the event of a buyout, which would support a significantly higher valuation than my public-company valuation (which is burdened by these real and ongoing costs.)  

While I don’t wish to make light of this risk, I think there are mitigants.  The first is that there is no indication here of empire building.  There is certainly the setup (if they wanted) to do a big dumb deal to make the company larger, but there is no evidence that they would ever do so.  Alsbridge was done at a cheap multiple (albeit it was a distressed situation), and that was in 2017 - since then, they have only done a few very small/tuck-in deals which by all accounts seem to be pretty sensible.

Meanwhile, they pay a large dividend, and are buying back stock - hardly a sign of bad corporate behavior.

2. Further declines in sourcing advisory / slowing of growth in research…

As I’ve tried to make clear throughout the writeup, this is not the highest-quality asset out there.  I think it’s safe to assume sourcing advisory is not a growth market at this point, and it does still comprise perhaps 40% of their business.  Were this market to take a steep downturn - or were other competitors to start eating into their market share - and it would still make a dent, despite the recurring revenues.

I think it’s also worth noting some elements related to the research business.  As I mentioned, this mostly sells to vendors and not clients, i.e. it is not Gartner and cannot grow indefinitely.  Similarly, formers pointed out that much of their research and benchmarking data is related to / gathered from their sourcing advisory work, and as such, if the sourcing advisory market were to slump and/or they were to lose market share, this would obviously weaken that part of their research business as well.

I would ultimately describe this business as good, not great.  I don’t think any pieces of it are terrible or at risk of imminent destruction, but I like to look beyond the currently-reported numbers to assess the durability of growth, and I’m not convinced that current growth levels are sustainable.  GovernX is the only piece of the business that I think is stellar, but if my estimates of its size are in the ballpark, it is way too small alone to drive large top-line growth no matter what else happens - other pieces of the business need to stay at least stable and/or grow for this to work.

Ultimately, I think the risk here is more “dead money” rather than losing a lot… consulting firms can be profitable at different levels via restructuring and ISG clearly has a focus on margin.  Recurring revenue provides some support and, with all the reservations that I’ve pointed out, it is worth noting that the business is growing strongly in an environment that is clearly challenging for the IT sector (see recent results from ALYA, MHH, CTG, CTSH all demonstrating a soft market.) 

Catalyst

Cash flow / growth / potential sale down the line