High-speed technology and connectivity are long-run business and consumer themes that have for several years attracted hefty investment, but there remain sub-sector niches that continue to emerge, many of them under the radar of many retail investors.

We all know that the internet has transformed the way we communicate, shop and even entertain ourselves.

We also know that super-fast broadband, the proliferation of wi-fi networks and a mountain of various on-the-go devices no longer bolt us to our homes or work desktop. But what some of us may not have understood is the convergence of basic IT services and communications networks under a single banner, and often outsourced to a specialist third-party supplier. Welcome to the world of managed services.

Concept explained

In simple terms, managed services is really about outsourced IT and communications (ICT) networks integration. A specialist supplier will take ownership for delivery of a defined set of ICT services to the customer. This is a global trend yet it is arguably more valuable to smaller and mid-sized enterprises (SMEs). The reasons are largely twofold.

First, the increasing breadth of technology solutions means that an SME’s in-house IT team often lack capacity, scale, experience, even knowledge of alternatives. Secondly, it’s cost efficient. An SME’s in-house team, perhaps one to half a dozen IT people, are a fixed cost with a skill-set not necessarily in demand on a daily basis.

Bring a specialist outsource supplier on board adds valuable expertise that can deliver best-of-breed combinations of networks, hardware and software with specialist support. It also lends flexibility to the cost base, an SME can crank up their outsourced service provision quickly and easily as the client business expands, or reduce demand and expenses in tougher trading climates dominated by contraction.

And it’s a win-win situation because there are benefits to a managed services supplier too, including the ‘appeasement of churn via the closer relationship with the provider of essential services, and typically longer service provision contracts,’ explains Andrew Darley, FinnCap’s respected technology analyst, in an extensive piece of research.

‘Increased complexity makes it far more difficult to churn all services away, albeit full cloud flexibility means flexing down as well as up is possible over contract periods, subject, typically, to minimum spend requirements or their equivalent.’

Changing landscape

This is a sub-sector niche that has, and continues to see, plenty of change. Darley admits that ‘when we first considered writing a piece on this topic, it was a much more heavily populated sector.’ He reminds us that there has been plenty going on the takeover front over the past 12 to 18 months or so. ‘We’ve seen a failed bid for Iomart (IOM:AIM), and we’ve waved goodbye to listings for Daisy, Accumuli, Advanced Computer Software, Phoenix and, most recently, COLT.’

Outside of the Accumuli acquisition, effectively a trade sale executed by escrow, ethical hacking and cyber security firm NCC (NCC), most of the buyers have come from the private equity world. This comes as no surprise. Managed services companies normally offer reliable and attractive levels of cash generation that helps support the typically higher levels of debt and gearing of companies that operate out of the gaze of public markets.

Daisy is a good example. Founded by Matthew Riley, Sir Alan Sugar’s one-time right-hand man on the BBC’s Apprentice show, his company found itself often criticised for its apparent unquenchable thirst for mergers and acquisitions (M&A), its level of cash generation and its limited dividends. That ultimately led a very progressive share price to become bogged-down, sparking the interest of private equity investors Toscafund and Penta, and ending up with their joint £494 million, 185p per share buyout.

Behind the veil of private equity ownership, Daisy has since been able to leverage its balance to, arguably, levels that would not easily be tolerated had the company remained on the stock market. The company launched a further SME ICT outsourcing consolidation raid on back-up and disaster recovery specialist Phoenix IT on 8 June, originally hinted at by Shares in our Griller interview with then CEO Stephen Vaughan nearly a year earlier, on 4 September 2014.

M&A hotspot

Investors can expect more of the same because M&A isn’t going away. ‘Among the varying profiles of indebtedness, cash generation, margin and yield, the only constant is acquisition,’ reveals FinnCap’s Darley. ‘M&A looms large in managed services with listed stocks as both acquirer and target.’

Companies such as current Shares Play of the Week Redcentric (RCN:AIM), former Play Iomart and buy and build minnow Castleton Technology (CTP:AIM) have all been consistent and busy acquirers. Elsewhere, the likes of KCOM (KCOM), Manx Telecom (MANX:AIM) and Shares pick for 2015 Gamma Communications (GAMA:AIM) all have scope to more aggressively add to sub-sector consolidation, in much the same way that Alternative Networks (AN.:AIM) did at the start of 2014, or fall prey to a buyer themselves.

Considered by many to be a genuine blue-chip company on AIM, Alternative Networks had earned its reputation thanks to consistent growth, cash generation and attractive dividends. Yet in January 2014 it pulled the M&A switch twice in the same month, buying Intercept IT and Control Circle, bolstering its otherwise reliable organic growth. That the share price has failed to match the 2012 and 2013 surge since is arguably as much down to the absence of a busy M&A strategy as the over-riding trading backcloth.

In the end, it’s growth that counts more than anything else in the managed services sub-sector, at least for now. ‘Yield is a splendid fillip to an investment case, supporting mature businesses with high levels of distributable cash, but also emphasising management confidence for smaller and less mature businesses,’ says FinnCap’s Darley. But, he adds the important caveat that, ‘where turnover growth is significant, the yield can be less punchy - the benefit of growth, whether acquired or otherwise, is key.’

‘None of the companies we have looked at will stay still, and the irony of all the detailed forecasting is that we know that our forecasts will not, for the most part, come to pass, being that each company will most likely either acquire or be acquired sometime in the next 12 months,’ Darley concludes.