Newsletter
The Game is (Finally) Afoot

(Full disclosure: both All Covered and MindSHIFT have been Service Leadership clients. However, S-L was not a party to either of the transactions discussed below, and only publicly available information has been used in this discussion.)

With the recent purchase of All Covered by Konica/Minolta and of MindSHIFT by Best Buy, the game is (finally) afoot. When billion-dollar players start making acquisitions in a given space, it is likely that not only will they themselves keep acquiring, but others will join them. Professional investors love to be second to any great idea. (Being first is too risky.)

The parenthetical “finally” is deliberate. It has been a long while – since the mid-1990’s – that anyone large has attempted to perform a consolidation in the infrastructure-centric Solution Provider space. The last was Ikon Office Systems, who purchased some 120+ Solution Providers in an attempt to leverage the convergence of office equipment and computer technologies. The convergence was real; the leverage was not, though this was not helped by Ikon putting the 120 former owners on differing earn-outs, making them as easy to herd as proverbial cats.

Therefore it is ironic that Konica/Minolta, another office equipment company, has sparked this apparent resurgence of interest. Hopefully they will have learned from Ikon about the need for standard earn-outs.

Several other factors have conspired to create the conditions for the current mini-boom and may fuel a real boom.

First, Managed Services created the necessary foundation for Solution Provider scalability, including the ability to sell outsourcing and remote services, the art and science of process development and discipline, and the focus on self-branding versus vendor branding. Together, these enable some if not all Solution Providers to mature into scalable businesses with some mass and consistent profit potential.

However, Managed Services as a business model is essentially unknown outside the industry. Customers by and large do not ask for “Managed Services” and certainly Wall Street has little awareness of it in the SMB space. Hence, the advent of Managed Services was not in itself enough to garner outside investment of any significance.

It took a second factor, a catalyst: the Cloud.

The Cloud is the latest in a long and semi-honorable series of IT miracles which were to save the computing industry from its costly self by “changing the computing paradigm”. As such, it is not only noticed by Wall Street but promoted there, by players representing every part of the IT value chain, from vendors to pundits and analysts to global consulting houses.

Especially, it is viewed as an opportunity to make efficient that notoriously inefficient market segment, the SMBs. Indeed, some major technology vendors are attempting to use the Cloud to disintermediate the SMB channel, primarily because they have failed to convince Wall Street that a sustainable scalable business model can be built on the shoulders of the SMB channel.

(A tip of the hat here to Ingram Micro – also an S-L client – and its founding of a Services division in 2006, to help the channel accelerate its Managed Services growth. They really were the first big player to see all this coming, and to their credit, they chose to back the channel.)

A third factor has contributed to the incipient M&A fray: excess cash on balance sheets of big companies and the availability of cheap debt. After nearly four years of investments first constrained by risk then frustrated by lack of opportunity, big company coffers are bubbling over with cash looking for any decent excuse to escape into productive use.

Taken together, these three factors – the skills learned in Managed Services, the high profile emergence of Cloud, and the excess of cash – have catalyzed what may be the start of a sell-side boom in the infrastructure MSP space.

The boom, if it continues, will not be evenly distributed. In a typical consolidation environment, the big players each first secure a “platform”, a large-ish high quality company which has all the sophistication needed to ensure and support additional growth. They are willing to pay higher multiples and more cash for this critical first piece. Then they seek out lower quality “add-ons” for which they can pay lower multiple and less cash. The buyer gains two arbitrage opportunities: one from the jump in multiple the add-ons take when “bolted on” to the platform, and another as the combined mass continues to grow.

However, that does not appear to be what is happening, at least from early indications. After paying a likely-hefty multiple for All Covered, Konica/Minolta is busily snapping up prime, platform-quality MSPs in major markets, apparently paying equally hefty multiples for them as well. They appear to be ignoring lower quality, lower cost add-ons.

The likely reason for this is available mass. Those who follow our opinions, know that we divide the MSP community into five Operational Maturity Levels© (OML©): 1 Beginning, 2 Emerging, 3 Scaling, 4 Optimizing and 5 Innovating. There are a number of objective criteria which, taken together, determine a given MSP’s OML, but one of them is simply the number of fully managed accounts.

The repeated act of finding, winning, on-boarding and running a sequence of fully managed accounts, itself creates operational maturity that can’t readily be gained any other way. This experience in turn enables the MSP to win and keep more accounts, and the reinforcement cycle repeats. OML 1’s generally have about 10 fully managed accounts, OML 2’s about 20, OML 3’s about 30 – and here it gets interesting – OLM 4’s have about 80 fully managed accounts and OML 5’s have about 160.

Konica/Minolta is likely buying high quality MSPs – that is, OML 4’s and 5’s – not because it needs the skills, but because these MSPs are the only ones of any material size. OML 1’s, 2’s and 3’s are simply not big enough to be material to them. While it’s no doubt a benefit to get the additional skilled managers that come with purchasing OML 4’s and 5’s, it’s doubtful that this would outweigh the potentially much lower multiples that would apply to purchases of OML 3’s for example.

On the other hand, it’s possible that Konica/Minolta has figured out what virtually every other consolidator in the IT infrastructure space to their eventual peril has missed: the essential ingredient for success in multi-branch infrastructure companies is strong management in each local market. Perhaps Konica/Minolta has uniquely figured this out and is intent on keeping top former owners on, even past the initial earn-out.

This would be well-advised, as the former All Covered team has a formidable new competitor: Best Buy’s MindSHIFT. All Covered was likely profitable and easily the second-largest SMB MSP; either of which is no mean feat. It’s clear that MindSHIFT was substantively profitable and was yet bigger revenue-wise. Paul Chisholm and his management team including corporate development exec Joe Croft, along with the former owners they bought out, built a company which we hope many will seek to emulate. Significantly, one of MindSHIFT’s success strategies was leaving strong former owners in place in the local markets, such as Gary Pica.

Best Buy itself has exhibited better than average intelligence in its handling of Geek Squad (which we first visited in 2000 when it was a single location shop in Minneapolis owned by Robert Stephens). Many corporate giants would have crushed the life out of an entity as creative and fast-moving as Geek Squad, but once again it is a tribute to both Best Buy management and Stephens for making Geek Squad a household name and a success.

If whatever sensitivities the Best Buy executive team applied to their deft nurturing of Geek Squad can be applied to Paul Chisholm and his team, we may see a very successful outcome…a paradigm shift in its own right.

It is likely that Konica/Minolta and Best Buy both paid multiples the likes of which we will not see again for some time. That’s because the two acquisition targets were, by a large margin, the biggest of their kind, and the only SMB MSPs to have the heft to attract the attention of billion dollars players who must “deploy” $100mm or so on the first purchase, to even justify getting into a market.

However, even if these high multiples are not seen again, they create “headroom” for the smaller MSPs being acquired to add to them. It’s likely that Konica/Minolta is paying EBITDA multiples in the 6 to 8 range for their add-ons, which is a full 2 points or so above what the market was paying before they began their spree.

This is precisely the divergence we predicted in 2007: that top performing, mature MSPs would command much higher multiples while the valuation of less mature MSPs would decline in comparison. We have not yet seen the decline but it is to be expected…the delta in operational efficiency and existing scale between an OML 3 and an OML 4 is considerable and therefore so is the attractiveness and safety for the buyer.

As a result, the race to reach OML 4 has now begun in earnest. By our objective criteria, some 4% of MSPs are OML 5, another 12% are OML 4, while 44% are OML3. The keys to the transition to OML 4 are: strict standardization of the technologies clients are allowed to buy and use, an almost exclusive focus on the “all you can eat” fully managed approach rather than the hybrid flat fee plus T&M approach, and higher prices based on value-selling as opposed to lower prices based on pricing to “market”. Together these strategies yield the quality and efficiency needed to scale, as well as the margin to thrive. Most at OML 3 know or have a gut feeling they need to do these things, but either the prospects of executing are daunting or the methods unclear to them.

It’s important to understand the gap between the buyer’s expectations of Cloud and the reality of converting an MSP into a Cloud purveyor. This gap is likely to lead to severe challenges, and we bring it up because many MSPs selling their businesses will be held to earn-outs which span the time in which the supposed conversion to Cloud will occur.

Our interactive Cloud Business Model Transition Simulator© tool (available on our website) shows our expectations for the gross margins of resold Cloud services, whether white label or vendor branded: about 35% for white label Cloud and 14% for vendor branded Cloud.

That’s a far cry from the average 44% gross margin on Managed Services currently earned by median-performing MSPs, and even farther from the 56% of the Best-in-Class MSPs.

However, the fact that Cloud contracts can likely be more easily rolled-up or consolidated, means that Cloud revenue may have higher valuation multiples to a buyer than higher margin Managed Services. Meaning, whatever margin Cloud purveyor X is getting from their $100mm investment, Cloud purveyor Y can greatly exceed with an investment of, say, $500mm.

This means there are four likely strategies for maximizing value if the current situation indeed turns into something of a boom:

  1. For OML 4’s and 5’s, judiciously add Cloud without degrading differentiation or margin,
  2. For OML 3’s, shoot for OML 4 while adding just enough Cloud to demonstrate Cloud sales and integration capability without gutting the core operational capabilities you’re working furiously to develop, or
  3. Ditch efforts to get more mature at Managed Services and rush to add full-bore Cloud resale capabilities and grow your contract base while keeping a close eye on cutting SG&A costs as margins drop,
  4. For OML 2’s and 1’s, abandon efforts to get to OML 3 and “simply” learn how to sell and integrate Cloud as quickly as you can.

For OML 4’s and 5’s, this will be a particularly hard choice, especially if the owners are within 5 years or so of desired retirement. Risking a known good – usually excellent – stream of cash by engaging in yet another business model transition is a thorny proposition.

For OML 3’s, the challenge is likely to be different but equal: knowing how to split your attention between continuing to evolve your core operational (MSP) skills and integrating Cloud which will not improve your operational skills.

If we sound somewhat skeptical about Cloud in general, remember that we benchmark more SP/MSP companies than anyone else, in more detail. In addition, we’re advising several of the global IT vendors on their cloud channel strategy and enablement. Cloud resale revenue remains a small, though fast-growing, portion of SP/MSP revenue. In addition, there has yet to be a successful transition to a mostly-Cloud model. Not that there can’t be…there just isn’t yet, and so the course is uncharted even if its contours are clear. There are still too few “born in the cloud” Solution Providers to see this model as anything other than a reprise of the manufacturer’s rep model.

Lastly, it remains to be seen if clients en masse want Cloud. There’s no question of current, hype-driven demand, but the IT history of the last 30 years is littered with heavily promoted “paradigm shifts” that were supposed to make computing significantly less costly and more user friendly. We are very early in the Cloud lifecycle, if there is one.

The key change that Cloud has indeed made has occurred in the last few months with the acquisition of All Covered and MindSHIFT: big players are once again interested in our space. That is good news for multiples and for liquidity.

How you choose to play it, and whether you choose to play it at all, is up to you. And that, as always, is the joy of being an owner.

© 2012 Service Leadership, Inc. All Rights Reserved