Elevator Pitch

NEW to VIC:  Please meet Converge Technology (ticker: CTS:CN).  CTS is consolidating IT services providers serving mid-size clients.  To date, CTS has done 30+ acquisitions (2017 – 2022).  Unlike many unsuccessful roll-ups that rely purely on public-private market arbitrage (buy at 5x EBITDA while we are trading at 10x EBITDA => profit!), Converge also pursues cost synergies and – importantly – revenue synergies driven by cross-selling opportunities.  High-single digit organic growth reported by the company shows that the cross-selling strategy is working.  On the run rate numbers, CTS trades less than ~11x Adjusted EBITDA.  However, such run-rate multiples ignore M&A transactions that were completed during 2Q 2022 and acquisitions that were completed in 3Q 2022.  Hence, the “real” multiple is more attractive.  Converge would likely continue its growth via M&A over the next several years and could double in size in the next 3-4 years (measured by revenue).  Margins are likely to expand.  Importantly, I do not expect the need for Converge to raise more equity.  In fact, CTS annoucned a share buyback a few weeks ago.

Key Data Points / Key Statistics

Key Data Points (as of June 30, 2022, unless noted otherwise)

ü  Price = C$7.41 (as of August 15, 2022)

ü  F/D S/O = ~215M

ü  Market cap = C$1.593B. 

ü  Debt = C$194M

ü  Deferred consideration = C$43M; contingent consideration = C$24M.  Total = C$67M.

ü  Leases = C$24M.

ü  Cash = C$189M.

ü  EV = C$1.69B. 

NOTES re: Post 2Q 2022 Events

ü  Post 2Q 2022 CTS would need to pay ~C$191.35M for acquisitions.

ü  It also expanded its revolver up to C$500M with an additional accordion feature of C$100M. 

M&A Playbook

CTS does two types of M&A transactions:

(1)   Buying fairly unsophisticated IT services providers that derive the vast majority of their revenue from reselling hardware.  In these situations, CTS wants to buy access to the customer base.  

(2)   Buying niche IT services providers for particular capabilities that they possess (e.g., cyber security). 

Buying IT Services Providers for the Customer Base

Most M&A transactions completed to date fall into this category. 

This is a “typical” desired deal:

ü  Target has ~$100M of revenue, 3% EBITDA margin, and $3M of EBITDA. 

ü  The deal multiple is 5x EBITDA.

ü  Deal consideration = $3M of EBITDA * 5x = $15M. 

The secret sauce starts working its magic after that.  Here is what CTS does after:

ü  CTS would immediately renegotiate vendor discounts due to its scale. 

o   Given that CTS is already buying products from those sellers, it is actually very easy to do. 

o   That could generate 1.5% EBITDA margin uplift moving it from 3% to 4.5%. 

o   Not bad for starters!

ü  CTS would also integrate the acquired company and find cost savings. 

o   Management has used an example of moving a back-office employee dealing with accounts receivable from a high cost jurisdiction (think California) to a low cost jurisdiction (think of a state in the US with lower housing prices and lower costs of living). 

o   That could generate another 2% EBITDA margin uplift bringing it to 6.5%. 

o   This takes longer than getting vendor discounts.

This would bring EBITDA to ~$6.5M and acquisition multiple to less than 2.5x on this math.

However, that’s not the end of the story.  As a bigger purchaser of products, CTS also enjoys longer payment terms compared to smaller companies that CTS is acquiring.  Once those companies get under the CTS’ umbrella, extended payment terms apply to them too.  That could generate a one-time working capital release of ~$3M - $4M.  Getting a working capital release of $3M would cut consideration to $12M and the acquisition multiple to less than 2x. 

Finally, there are cross-selling opportunities.  CTS does not fire sales reps of the acquired company.  In fact, CTS tells them:

ü  Fellows, you can make more money, not less, now when you are with Converge! 

ü  Why?  Because we have more services that you could sell to your clients. 

ü  You do not need to become an expert on all our offerings (cloud, cyber security, etc.).  You just need to identify when offering such services may be appropriate and then you get out specialized sales rep / expert invovled in the sales pitch.  If the sales closes, you will get credit!  We want you to make more money!

Cross-selling effrots could generate another $3M from EBITDA which will bring the “final” EBTIDA to $9.5M and the “final” acquisition multiple to ~1.25x. 

It is possible that some of these assumptions on the M&A math are too optimistic.  We can cut them.  But even at 3x EBITDA, that’s a pretty amazing M&A playbook. 

See the illustrative M&A math below:

Buying Niche IT Services Providers for Particular Capabilities

Another type of M&A is buying IT services providers that possess a certain skillset (such as cyber security) that CTS wants to enhance and then cross-sell.  Multiples for these players tend to be higher. 

Margin Profile

Using the world of distributors, VARs, IT solutions companies as comps, CTS has strong margins which is driven by selling higher margin services. 

The gross profit margin has generally been 22% - 24%.  CTS says that it targets 22% to 30% GPM.  It is important to keep in mind that whenever CTS makes a big acquisition with a lot of hardware revenue, CTS’ GPM dips because it just acquired a big chunk of low-margin revenue, and it takes time to cross-sell higher margin services. 

Adjusted EBITDA margin has been around 6.0% - 6.5% - again fluctuating due to M&A transactions.  In a couple of quarters it hit 7.5% - 8% range which makes me think that 8% margin should be achievable over time.  I would not rule out 9% or event10% margin, but I am not necessarily underwriting that and would prefer being pleasantly surprised by management’s execution (which I have been over the last 2+ years after I got long CTS:CN). 

Capital Allocation

Smart capital allocation is as imporatnt for a successful roll-up as running operations well.  So far CTS management has done a super job on that front.

Issuing Shares

In 2018 – 2021 CTS did several stock offerings and as far as I recall each of them was at a higher price.  This is how much money CTS has raised via equity offerings:

o   2018 – ~C$12.2M

o   2019 – ~C$2.3M

o   2020 – $103.5M

o   2021 – C$494M.

In other words, CTS raised capital well because:

ü  It would raise capital, deploy it to M&A transactions, show results, get recognition from the public market.  Rinse and repeat.

ü  Again – every round (as far as I recall) was done at a higher valuation.  Well-done.

ü  CTS did it when the equity market was between “open” and “really-really wide open”.  Take advantage when you can!

CTS Does NOT Needs to Raise Equity Anymore

This is a very important point.  I would not be surprised that many investors think of CTS as a company that is reliant on public markets to continue its expansion via M&A.  In my opinion, it is not the case anymore. 

CTS should have ample internally generated FCF and can use debt to finance its M&A going forward. 

CTS targets ~C$1B of acquired revenue per year which – according to management on 2Q 2022 EC – would require C$250M to $300M of cash.  My understanding is that the implied multiple is higher than my illustrative math above because it could include (1) acquring skillset / capabilities and / or (2) buying a platform in another European country – for example, UK, since CTS has already bought such platform in Germany. 

My estimate is that CTS could generate C$100M+ of normalized internal FCF, which by the way should be growing over time.  I actually think that it can be as high as C$130M or even C$150M, but let’s be more conservative.  The shortage can be covered by debt. 

Buyback

In fact, a few weeks ago CTS announced a buyback of up to ~5% of shares outstanding. 

Dividends

Management also spoke that that BoD would be thinking about dividends in 2024. 

Insider Ownership and Insider Purchases

ü  CEO Shaun Maine is very sharp and very impressive and has been delivering on his vision very well since I started following the company and became a shareholder (via an affiliate).  CEO owns ~8M shares currently valued at C$50+.  So, he has a lot of skin in the game. 

ü  Over the last few months CEO and other insiders bought some shares. 

Valuation Based on Run-Rate Numbers

Valuing highly accretive companies is tricky. 

Below I show the valuation math based on run-rate numbers. 

If you are interested, you can run your own math what CTS could look like in a few years using these as core variables:

ü  How much revenue CTS would acquire each year.  I think C$1B is a reasonable expectation. 

ü  How much CTS would pay.  I have discussed it. 

ü  Organic growth.

ü  Margin expansion. 

ü  Future capital allocation decisions. 

Management talks about a path to C$5B in revenue in a few years and up to 10% EBITDA margin.  As I wrote, I am using more conservative margin assumptions, but I definitely think 10% as possible.  We shall see. 

Risks and Mitigating Factors

The main risk from my perspective is that CTS is still a roll-up.  I consider the following mitigating factors:

ü  Solid FCF generation

ü  Track record of success

ü  Aligned CEO

ü  Organic growth and cross-selling opportunities play an important role in the strategy as opposed to pure public-private multiple arbitrage.

Catalysts

ü  Buyback – though I do not consider it to be a major catalyst.

ü  Continous M&A.

ü  Market participants’ realization that CTS does not need to issue equity to continue its strategy.

ü  There is one more: potential IPO of Portage.  Portage was incubated within CTS and subsequently raised more money from outside investors.  Today CTS owns ~53%.  Management talks about a potential IPO.  I am not modeling any significant impact from Portage since available data points are limited to develop a view.  I’d rather be cautious here and if things play out, I would be happy to be pleasantly surprised.  

Disclaimers

I do not hold a position with the issuer such as employment, directorship, or consultancy.

I and/or others I advise hold a material investment in the issuer's securities.