Q3 MSP Trends: Revenue Insights, M&A Dynamics, AI Impact, and Future Predictions with Peter Kujawa

[00:00:03] Dave Sobel here at IT Nation Connect with my most frequent flyer, Peter Kujawa. Welcome back to the show.

[00:00:09] Hey Dave, nice to be with you once again.

[00:00:11] I know, with service leadership of course, and you are now my most frequent guest.

[00:00:16] Really?

[00:00:16] You are. You've now distinctly taken that out because you always come with such amazing data.

[00:00:21] I would be remiss if I didn't start right out with the tell me what you're reporting on the Q3 revenue and profitability data.

[00:00:29] A couple of things. Number one is for MSPs, what we've seen over the last about five to six quarters is a slowdown in organic managed service growth.

[00:00:39] So we started running a new chart a quarter ago based on hearing a lot of feedback in the peer group was about challenges of growing organically and specifically managed services.

[00:00:49] So we decided to do a four quarter over four quarter analysis on that on a trending basis back to 2018.

[00:00:55] What the data shows is pretty clear that starting in late 2020 during the second half of COVID year with the lockdowns and everything that you saw this tremendous lift of organic growth.

[00:01:09] Historically, in our industry, organic growth has been about 12% plus or minus 2%.

[00:01:16] Okay. And what we saw for about two and a half years was a lift up that peaked around 25%.

[00:01:22] And we've now seen that coming back down pretty dramatically.

[00:01:27] The good news is though, it's not a panic they do say,

[00:01:30] when MSPs look at the slide, it can cause a degree of panic.

[00:01:36] Right. And our advice is the world's not having, take a deep breath.

[00:01:40] We are back to historical norms.

[00:01:43] Okay.

[00:01:43] And in some respects, it's really good because a lot of that growth, organic growth was due to inflation or was due to price increases.

[00:01:52] And MSPs were putting through 6%, 8%, 10%, 12% price increases in some cases.

[00:01:57] And they were doing it because they had to.

[00:01:59] They had gone to their head in terms of wage inflation.

[00:02:02] Right.

[00:02:03] And then every MSP owner knows 75%, 80% of their cost of goods sold is their people.

[00:02:10] So when you're seeing wages go up like that, and you're increasing pricing on a chart, it looks really fun because you're seeing this really nice lift of revenue.

[00:02:22] But in reality, it created a lot of downward pressure on gross margin and on profitability.

[00:02:28] So the last three quarters, even though we're seeing a flapping out back to the 10%, the 10.5% growth rate, what we are, what we're also seeing is really good gross margins and we're seeing really good profitability.

[00:02:44] So everybody thinks about organic growth in terms of adding new logos, but the, the inflationary aspect of it's often forgot.

[00:02:52] It's price increases.

[00:02:54] It's price increases.

[00:02:54] And it's also when your customers are adding bodies, when your customers, if you've priced your managed services on a per user basis, and you certainly should have every MSP should.

[00:03:06] If you have, as they're adding employees, that's organic growth as well.

[00:03:10] And so we've seen some cooling in the job, in the labor market.

[00:03:13] So that probably has affected that downward a little bit.

[00:03:17] But again, it's not going negative.

[00:03:20] It's not.

[00:03:20] We don't, we think it's going to plane as landing in that historical normal growth range.

[00:03:25] Right.

[00:03:26] So focus in on that.

[00:03:28] If you're a VAR, if you're product centric, so 60% or more of your revenue comes from product recurring amount.

[00:03:36] Really different dynamic there.

[00:03:39] Key to three was off the charts, high growth for them because of product and because of projects.

[00:03:47] MSPs had a really lousy quarter for both of those things, but organic growth on managed services was okay.

[00:03:55] Okay.

[00:03:55] The VARs had a monster order for both product and for projects, but they had a lousy quarter with downward growth in managed services.

[00:04:04] And the reason for the product and project for VARs is Q3 is when all the government bids come in.

[00:04:10] Okay.

[00:04:11] So, you know, most of the VARs are doing a bunch of state-fed visits.

[00:04:16] They're doing public education visits.

[00:04:19] And so those budgets are locked in July 1.

[00:04:22] Bids come in and they start fulfilling that large measure in Q3.

[00:04:28] Great.

[00:04:29] So we're not worried.

[00:04:33] We think next year should be a good year.

[00:04:36] Okay.

[00:04:37] So it's interesting that we talk about that and I want to make sure that I'm hearing all that.

[00:04:40] Essentially the, hey, we got the sugar high for COVID.

[00:04:43] There's a lot of that coming back down.

[00:04:45] It's not plummeting.

[00:04:46] It's helping.

[00:04:47] It's settling into, as you said, historic norms so that we can, you're anticipating some more of the same with, you know, solid 2025 potentially ahead.

[00:04:55] We are, yeah.

[00:04:57] And we also had the impact of the election this year.

[00:04:59] Mm-hmm.

[00:05:00] So we ran a data set that correlated total revenue growth for MSPs, litany, managed services, product, projects, all of it.

[00:05:09] And we looked at is there a correlation between U.S. presidential electioneers and growth?

[00:05:15] Okay.

[00:05:16] And I would love to take credit for the idea.

[00:05:19] In reality, we were asked for by an industry reporter.

[00:05:24] And at first we thought, this is crazy.

[00:05:26] There's no possible way there's a correlation.

[00:05:29] In fact, what we found was that in 2012, 2016, and 2020, there was a definite correlation.

[00:05:36] Growth came way down during the presidential election cycle.

[00:05:40] And the following year was a really nice bounce back here.

[00:05:44] We now are far enough into 2024 to run the data and make some predictions on this year.

[00:05:51] And we think this will be the fourth straight presidential cycle correlation that will show the same thing for the downwards then.

[00:05:58] Hmm.

[00:05:59] Barring some unbelievable piece here.

[00:06:02] Sure.

[00:06:04] But it's likely it'll show the same thing whether next year will or not.

[00:06:08] I don't know, but I think there's a re-invitation at this point that next year should be a bit bounce back here.

[00:06:13] I'll give you another data point to layer on top of that.

[00:06:15] Those of us that track marketing spend, as you might guess on my media business,

[00:06:19] have actually can also correlate a drop in marketing spend to election years.

[00:06:24] As organizations pull back on marketing spend, they then resurge post based on the uncertainty of the upcoming election.

[00:06:30] Yeah.

[00:06:30] So another data point to layer on that.

[00:06:32] The other thing I was really intrigued to ask you about was is an area that we haven't talked about, but I wanted to get a little bit of sense of what market data that you're looking at beyond the managed services space that you're using to correlate.

[00:06:45] I'll give you an example.

[00:06:46] One of the things I report a ton on the show is those labor trends that you're talking about.

[00:06:50] I highly track the jobs report.

[00:06:52] I highly track wage, you know, overall wage growth.

[00:06:55] I look at the industries that MSP serve in order to try and get a sense of that.

[00:07:00] What are those larger market data points that you're keeping an eye on that you find are related to managed services help?

[00:07:08] Well, we look certainly we look at multiples.

[00:07:10] So we look at three track the M&A market pretty closely and every year at the end of the year, we come out with our opinion on where multiples have gone.

[00:07:19] So even though that's not directly service leadership data per se entered into our system.

[00:07:23] We have other sources for that data that we collect from and we use that to publish our opinion on that.

[00:07:29] So we're looking at some external sources, but most of what we talk about is coming straight out of our benchmark and fulfilling.

[00:07:38] Because we're benchmarking 10 different business models, because that data is collected worldwide,

[00:07:43] and because everybody who benchmarks uses a common chart of accounts or our chart of accounts, the national or the normalized solution provider chart of accounts in this PCOA.

[00:07:54] Because everybody uses that, we're able to look at apples to apples across 10 different technology business models.

[00:08:01] We're able, we're doing a lot of data trimming on the differences between the market in Europe and the market in the US and the market in Australia, New Zealand.

[00:08:11] So we're really starting to carve the data up in different ways.

[00:08:15] But there are some things that we look at externally.

[00:08:18] Okay.

[00:08:19] So then I'm going to ask you a different way, just to get a little bit of sense.

[00:08:22] You trying to stay informed of all the trends that you might want to think about, any larger economic sense?

[00:08:27] Are there particular indicators that you just generally as a, not as service leadership, but you as Peter, the analyst,

[00:08:32] trying to get a sense of that are your favorites to keep an eye on the market?

[00:08:35] Well, I watch CNBC religiously every morning.

[00:08:38] So get a close eye on the US market and what's happening.

[00:08:41] We watch labor trends in this market, certainly.

[00:08:45] There's a bunch of folks that we like to talk to that we find that good input on what's going on.

[00:08:50] So it's a variety of different sources.

[00:08:53] So the other thing I'd like to get a little sense of, one of the things that happens a lot at this space is that there's a lot of the M&A initial discussions, right?

[00:09:00] This is, this has been discussed as a little bit of a seller's market for managed services providers, that there's lots of buyers looking here.

[00:09:07] I want to get your little sense of, of, you know, and I know you've been digging into this, both the data point, as well as the anecdotal evidence.

[00:09:13] Give me a sense of the, the kind of distribution of how much this is a seller's market versus a buyer's market.

[00:09:20] When I think about it from a size perspective, I'll elaborate a little bit more to help you out.

[00:09:24] One of the things I keep hearing, but I'm not sure I have data on is that there's a lot of small MSPs.

[00:09:31] There's a lots of larger platform MSPs and a bit of a dearth in the middle.

[00:09:35] And so a lot of M&A people that are interested in buying are trying to help the smaller ones get up there because there's less of a market in there.

[00:09:43] How much of that are you seeing either in the data or in the conversations you're involved?

[00:09:47] I think it's highly accurate.

[00:09:49] Okay.

[00:09:49] So there's a large supply.

[00:09:51] When you look at valuations, if you're looking at it based on the biggest, the biggest valuation mover is going to be the size of output of EBITDA.

[00:10:00] How many, what's your EBITDA dollars?

[00:10:02] Okay.

[00:10:02] Are you generating 300,000 or are you generating 3 million?

[00:10:06] Um, and based on the amount of output, there's certainly other factors that come into bearing.

[00:10:12] How profitable are you as a percentage of revenue?

[00:10:15] What's your revenue mix?

[00:10:16] How well run is your MSP?

[00:10:18] How fast are you growing your business?

[00:10:20] Do you have an effective sales engine?

[00:10:22] All of these things are ultimately going to be, I am, to the range you're going to get on that multiple.

[00:10:27] Well, let's say, let's say the range is a 6 to an 8.

[00:10:32] If I'm doing everything right based on the size of EBITDA and tuning out, then I'm going to hope for the 8, not the 6.

[00:10:40] Um, but I'm not getting a 12 or a 14 or, right?

[00:10:45] Um, in order to get that, I'm going to have to be much larger.

[00:10:50] I'm going to have to generate another level of output of EBITDA dollars, et cetera.

[00:10:54] So what you're, what we're seeing in the market is, uh, so that, that is the case.

[00:10:59] Um, you have a lot of buyers, uh, who are only looking for a certain size of MSP, particularly private equity buyers.

[00:11:07] They ask, and if you think about it, let's say I have a hundred million to deploy into space as a private equity fund.

[00:11:14] Would you rather buy $25 million MSPs or $520 million MSPs?

[00:11:20] Assuming all else is e-

[00:11:21] Assuming profitability, per se, and ch, et cetera.

[00:11:24] Obviously you'd rather buy five $20 million MSPs.

[00:11:28] It's going to be a lot less integration.

[00:11:30] It's going to be a lot less deal costs.

[00:11:32] It's also going to be a lot less risk.

[00:11:34] Every deal I do presents a degree of risk.

[00:11:37] As a result, I'm going to pay more for those $20 million MSPs.

[00:11:41] And that factors into the multiple that they're going to get.

[00:11:46] So, um, so what's the advice to a smaller MSP?

[00:11:50] A, it depends on your timeline.

[00:11:52] Um, if, if you have a longer timeline, you should be planning what you're, what you need to sell your business for, what you ultimately are going to want to get.

[00:12:02] And you should be building a value creation strategy that looks at every year.

[00:12:06] What do I need to do in my business to get from here to there?

[00:12:09] We have tools and service leadership, uh, that will help them do that.

[00:12:14] The evolved community is really great at doing that and helping teach that.

[00:12:18] But what do I need to do within my business to, to get that?

[00:12:22] Second, if it's some much larger number that I'm going to be able to get to organically, well, then I'm going to need to look at M and A.

[00:12:29] Uh, so maybe I'm going to have to buy their business to get there.

[00:12:33] Or we're also seeing some MSPs merge.

[00:12:35] And so if we, if we want to get to be a $3 million, uh, EBITDA per year MSP, and I need, and we want to do it next year, not in five or 10 years, then maybe I'm doing a million.

[00:12:50] And I know two other MSPs in my care group or I know them that are also doing a million.

[00:12:55] Well, if we merge, uh, we now have an MSP that is doing a million of users.

[00:13:00] Right.

[00:13:00] There's a bit of financial engineering that's going into that.

[00:13:03] Yeah.

[00:13:03] Are you going to truly integrate and some other factors, but you're seeing some of those kinds of things becoming more common to help bridge the gap that you're describing.

[00:13:12] Okay.

[00:13:12] So last question, cause I want to get your insight and this is a bit of a forward thinking looking question and I've been thinking about it a lot recently.

[00:13:19] So we're, we're all talking AI, it's all the buzz, right?

[00:13:21] Again, my clip these days is I managed to make it 10 minutes into an interview before I have to bring it up.

[00:13:26] Right.

[00:13:27] Thank you.

[00:13:27] I made it the 10 minutes, but what we're, what I'm thinking about here is, is that if we think that AI is going to start having productivity gains, and if we think AI is going to start having labor cost address, what in the data,

[00:13:42] that you're looking at, should we be able to see impact besides just the EBITDA?

[00:13:47] What can we look at to understand if AI is actually having an impact in MSP services businesses to tell if that's working?

[00:13:56] Like what are the, the, the indicators that we should be looking for?

[00:13:59] Well, we're tracking a few.

[00:14:01] Uh, number one, it is one of the most important KPI that we teach is service multiple of wages.

[00:14:07] Okay.

[00:14:07] What's the ratio of your service labor to the service revenue your, your factory, if you will, is generating.

[00:14:15] And so that should be at least a 2.5 relationship.

[00:14:18] So if you have a million, million dollars of service labor and that includes not just your techs, but your service managers, uh, your project managers, your VCIOs or TAMs, anybody who's doing post signature service of your accounts should go into the, that, into that bucket.

[00:14:36] And they should be generating at least 2.5 million of services revenue cut, including managed services project and, uh, break fix.

[00:14:45] So, uh, so at least 2.5 to get a decent profit.

[00:14:50] Right.

[00:14:50] What we're seeing in the data is that the best in class, the top quartile, most profitable companies are improving that every year.

[00:14:57] And in fact, today they're doing about 2.9.

[00:14:59] I think with hyper automation and a couple of years, they'll be doing a 3.2 or 3.4, uh, ratio bottom quartile, just because the, the opportunity exists to become more efficient.

[00:15:11] It doesn't mean everybody out there is grasping it.

[00:15:14] Right.

[00:15:14] Um, we are seeing that, uh, that already happening in the best of class, bottom quartiles actually flat to negative.

[00:15:20] They're not taking advantage of any of this and staffing accordingly and all the things that you need to focus on.

[00:15:26] So it's not just enough to build efficiency of your operation.

[00:15:29] You have to change the ratio that you're adding people and that, how you're looking at your, your model.

[00:15:34] So where else you'll see it?

[00:15:36] Well, you'll see some things like, uh, endpoints per engineer.

[00:15:40] Okay.

[00:15:41] So if you look at all your techs in your managed service organization, best in class today is, there is about 450.

[00:15:48] Bottom quartiles about 150 to a hundred.

[00:15:52] Hey, well with hyper automation, is that going to, where's that going to go?

[00:15:56] It's going to go up.

[00:15:57] The best in class probably goes next couple of years to 550 or 600.

[00:16:02] Right.

[00:16:02] But you'll see these kinds of incremental improvements that are, that will be very quantifiable.

[00:16:07] We're already seeing it, uh, with the best in class.

[00:16:10] Okay.

[00:16:10] Well, I look forward to asking you about that.

[00:16:12] The next time I have you on, I think what's the next report that we're looking for?

[00:16:15] Uh, we will have a fall.

[00:16:17] We'll have a look at predictions on, we have our compensation, uh, report coming out in

[00:16:23] March.

[00:16:24] We'll have a brief report on expected wage inflation that'll come out in December.

[00:16:29] Um, anybody who wants to get a copy of the compensation report for free, uh, it's a $2,000 report.

[00:16:36] It's a really incredible value.

[00:16:38] Even at 2000, if you enter your data now, before the end of November, you'll get a free copy of that report.

[00:16:46] And you'll get the wage inflation opinion when it comes out this summer.

[00:16:50] Well, there's your value from the show.

[00:16:52] And so you got a free access to that.

[00:16:53] And Peter, I know what we'll be talking about next time.

[00:16:55] Thanks for joining me today.

[00:16:56] Thanks Dave.

[00:16:57] Appreciate it.

[00:16:57] Always enjoy it.

[00:16:58] Me too.

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