All Consulting is IT Consulting
Software Ate the World - Now What?
If you have ever read any of my writing in the past, there’s a medium chance that you have heard me reference Marc Andreessen’s editorial article about Software Eating The World. It’s one of my favorite pieces of investment prognostication because (i) it’s written by someone who really knows what they are talking about (the inventor of Netscape), (ii) it came at an interesting time in software technology’s evolution (the beginning of the mobile revolution), and (iii) it’s right - software is eating the world. To continue the dietary metaphor: it has already taken a bunch of really large bites and has plenty of courses left in it’s full meal. Software’s voracious appetite is undeniable at this point.
But now that software has already gobbled up a lot of our economy, does that mean it will suck the oxygen out of the metaphorical room for every other form of business / innovation? Definitely, emphatically not. In fact, it is going to lead to further innovation and improved outcomes for non-software type businesses. I have written in the past about how every company is a “Tech Company”, but that gets more and more true every day. If you are a local cleaning services company, you better have a good online presence and customer reviews. If you are a restaurant, you better have a solid PoS system and reservation platform. Manufacturing firms are increasingly relying upon technology to bolster and improves processes and products. The financial services sector feels like it has gone completely digital even in the 5+ years since I joined it.
In an illustrative example, I remember joining Fifth Third Bank in 2015, meeting a lot of my peer new hires, and being completely blown away by how many of them were some variation of computer science major or digital product manager. Everywhere I turned, it seemed like a software engineer would pop up. They seemed to be recruiting more heavily for that role than even some of the bank’s main revenue centers (mainly, commercial banking - my track). And the thing is, it wasn’t too long ago (2008) that Fifth Third was considered the extremely stodgy, behind-on-the-times, conservative bank that would force its employees to wear a suit jacket at their desk (not an exaggeration).
And it’s not just Fifth Third - every large company has tech talent that it is constantly trying to hire to keep the corporate machine turning. GE had TV ads all the way back in 2015 specifically trying to recruit software engineers (and those ads worked, apparently).
The point is: every corporation has a tech stack, whether they know it or not. The big ones are hiring their own tech talent to manage and develop this technology in-house. But for the little guys, and even a lot of the mid-sized folks, that’s just not feasible. Maybe you can have an IT support function in-house, but rarely will you find a full engineering team in place. But still, tech-stack management has become an increasingly important business-critical issue as more and more of the world adopts various software solutions. Pretty soon, good managers will need to understand their technology functions as well as they understand their finance and marketing departments. MBA programs are going to be focused toward product managers and I predict that we will see more big tech product managers leave to work for more traditional industries in leadership roles as boards begin to realize how important tech fluency is.
If you are a manager, you might not be super deep on understanding your tech stack yet. If not, don’t worry - you certainly haven’t missed the boat. In fact, a somewhat recent business strategy trend has popped up that involves someone rolling up a legacy business (old-school services businesses, manufacturing, etc.) and wrapping it in technology to improve efficiency and performance. It is likely (though I can’t think of any examples) that entire private equity funds have been launched using this premise. While that may sound rudimentary for tech-focused people, there is still plenty of arbitrage available in that strategy as most companies have not embraced software technology to their fullest potential. We are a long way from every company achieving peak software optimization.
The problem with software and its rise, unfortunately, is that it is fickle and hard to understand. Tech solutions can solve a ton of problems, but they can cause some as well. We have all experienced something along these lines at some point - intranet goes down at the office, internet connectivity issues at a site visit, a restaurant is only accepting cash because their PoS system is experiencing a technical failure, etc. Tech breakdowns are common because all things that are created by humans are fallible.
Enter: IT Consultants. These are the wizards who solve all of your technical problems. Some companies have tech talent in house to avoid / shut down run-of-the-mill problems, but even the biggest players need outsourced consultants to solve the biggest problems. But IT Consultants aren’t just an IT Support Desk here to tell you “Did you try turning it off then on again?” They implement big new technology projects, update outdated systems, clean up existing architectural issues, and much more. IT Consulting firms are the tech experts that help companies best use IT to achieve their business objectives. As that tech becomes more abundant, it can also become increasingly complex and difficult to navigate. If you are a manager and reading that thinking “I don’t even know what I don’t know about this industry” - that’s okay. The good IT Consultants are used to that and can help you figure out where to begin.
So now that we have established why IT consultants exists, the question I ask myself as a middle market investor is: are these good businesses to be in? It’s an especially cogent question because a lot of these firms sit in the lower middle market ($1 - $5 million of EBITDA) where I invest.
Investment Thesis
The basic bull thesis for this industry is that as software continues to eat the world, IT Consultants are just going to become more and more important, fetching more and better business. And while it might seem silly to hire consultants when you could potentially bring this talent in-house (it is extremely important, after all), the reality is that the pace of tech talent supply just can’t keep up with demand.
As a result of this tech-talent gap, companies will continue to need outside consultants to come in and solve their problems. On top of that, even if you could find the talent, sometimes it’s difficult to know how to speak their language and find the right areas of focus for that talent. In theory, IT consultants should help businesses focus on what they do best - service their customers - by freeing them up from worrying about an ever complicating tech-stack. Of course, it doesn’t always work out perfectly, but when it does, it can be a work of art.
The industry, while still relatively nascent when compared to other consulting professions, has grown to a significant size, with nearly 2.4 million employed IT consultants in the U.S. and a $484 billion market size, up nearly $100 billion in size over the past ten years. As previously stated, IT consultants are more than just your outsourced IT help desk. There are a handful of subsectors within IT Consulting / Services that I am interested in, but two areas that have my fullest attention at the moment are Cybersecurity and Managed Service Providers.
You have invariably heard a story recently about a large corporation or government entity (or in the case of December 2020, almost every federal government entity) getting hacked and losing a bunch of their data. There are a variety of reasons this has become so prevalent as of late, but a main driver is the same reason why IT consulting is so popular. As we become more reliant upon software and technology to do our jobs, there are more opportunities for malicious actors to try and steal and scam. Since the dawn of time, theft has existed - the only thing that has changed as been the means and the players.
Cybersecurity threats don’t just happen to massive companies with tons of valuable data, it occurs to little guys as well. A study performed in 2019 found that 15% of middle market companies experienced some level of data breach in the prior year, up 3% from 2018. What’s more, that 15% doesn’t even take in to account the amount of cyber threats that occurred that were not data breaches or went undiscovered - as a result, it is likely that cyber crime in the middle market is an extremely prevalent issue. So while you might think it only happens to large banks and hotel chains, that’s simply not true. Middle market companies are prime targets precisely because of their size - they are less likely to have the infrastructure in place to prevent attacks of this nature. IT Consultants that can help companies prepare for, prevent and clean up these problems have a huge window of opportunity, as every company needs this more and more moving forward.
While Cybersecurity focused firms are attractive because of the importance of their work, managed service providers (MSPs) are attractive because of the business model, as they can really be focused on a variety of IT consulting functions, including cybersecurity. MSP’s are effectively IT Consultants-as-a-Service, (ITCaaS doesn’t roll off the tongue as well as MSP) - so they act as the outsourced provider affiliated with a company for a recurring fee. They have sometimes been affiliated with single manufacturers or technology providers, but are increasingly focused on providing a variety of services so they can be a one-stop-shop for their clients.
However, I am not the only person who has come a bull thesis on these companies and that they are increasingly valuable. This comes to bare in the valuation multiples for IT Services Businesses. While it is always difficult to nail down multiples in the middle market, you can see some folks who believe the EBITDA multiple range for these companies to be anywhere from 5.0x - 10.0x, depending on size and other variables. Of course, there are always outliers on both ends of the spectrum, but for services industries on the lower end of the middle market, that’s fairly expensive (and most of these numbers are pre-pandemic, which has only increased the price of these firms).
And it’s not just because this space is hot and investors like me are chasing deals - these companies tend to have pretty healthy, attractive profiles. I previously mentioned the recurring nature of some of their revenues. They also have strong gross margins (~50%), EBITDA margins (~25%) and growth rates (~10%). These are all, including the EBITDA multiples, generally considered to be on the high end of professional services firms.
In sum, the IT Services / Consulting industry is very attractive right now, and I anticipate it is only going to get more attractive over the next 10-20 years. There are certainly risks inherent in what they do that I didn’t cover in this post, but overall I am extremely bullish. If you know of anybody working in this space, I would love a connection to them to get their thoughts on the sector.
Additional Links
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