Converge Technology Solutions: On Hold Pending Confirmatory Data Points (TSX:CTS:CA)

Summary

Converge Technology Solutions (TSX:CTS:CA) is an information technology services provider, providing integrated hardware and software solutions to mid-market enterprises. The majority of its revenue is generated from value added reselling of hardware and software solutions, with the remainder coming from professional services. CTS has achieved most of its incredible growth through acquisitions, but paused M&A activity this year to focus on profitability, cash flow generation, and integration of past acquisitions. The market has responded violently to these developments, offering a seemingly attractive entry price. However, risks remain and I give CTS a Hold rating pending confirmation that management can execute the necessary changes.

Company Overview

CTS is a North American and European software-enabled IT and cloud solutions provider. It helps enterprises in the underserved mid-market segment (n.b., 500-10,000 employees) design their IT infrastructure by procuring and integrating the requisite hardware and software for an integrated IT solution and providing ongoing IT support services.

Its solutions include advanced data analytics, application modernization, cloud, cybersecurity, digital infrastructure, and digital workplace offerings to clients in various industries. CTS supports these solutions with advisory, implementation, and managed services expertise across all major IT vendors, including VMware, Red Hat, Microsoft Azure, Amazon Web Services and Google.

It is critical to note that CTS operates predominantly as a value-added reseller (“VAR”), selling hardware from OEMs (e.g., Nvidia GPUs, Cisco routers, etc.) and software (e.g., Snowflake, AWS, etc.) to customers and charging a markup, which effectively becomes their gross margin. The lack of proprietary technology and relatively low barriers to entry make this a highly competitive, low-margin, and fundamentally unattractive business. VARs and related, low-quality information technology service providers (“ITSPs”) generally earn <20% gross margins, whereas global system integrators (e.g., Accenture, CGI) generally earn gross margins in the 30-40% range. CTS’ margins currently sit in the middle, reflecting its presence on both ends of the industry (n.b., ~25% average gross margin and ~6% EBITDA margin ‘20-’22). As a result, management is focused on shifting CTS into a predominantly higher value-added services business. They have made some progress in recent quarters, growing the Services segment from ~20% of revenue in Q2 ’22 to ~23% in Q2 ’23, but progress is slow. Part of the reason for this is the fact that many of the recent acquisitions were companies in low-value, high-volume (“LVHV”) businesses, which I note seems opposed to management’s stated strategy.

Recent Performance

CTS’ share price rallied significantly through 2020 and 2021 (n.b., average share price rose ~101% and ~379% from ’19 to ’20 and ’20 to ’21, respectively) on the back of accelerating M&A activity and COVID-driven increases in enterprise IT spend. In Q1 ’23, CTS concluded a strategic review process initiated in November ’22. Through the review process, the Company pivoted away from its aggressive M&A strategy to focus on integration, organic growth, and cash flow generation.

Organic growth in gross sales has decelerated markedly (n.b., ~4% vs. ~16% in the comparable period in ’22) due to declines in its Product segment driven by lower customer IT spending and supply chain challenges. Meanwhile, interest costs exploded from ~$3MM in H1 ’22 to ~$16MM in H1 ’23 as the all-in rate on the Company’s variable rate credit facility moved from ~5% to ~7%. These factors contributed to 3 consecutive quarters of negative EPS, something not seen since 2019, and a ~40% decline in its share price (n.b., ~80% off all-time highs).

Catalysts

Following this year’s brutal sell-off, the sell-side naturally believes the current pricing is attractive. The current narrative underpinning the bull case appears three-fold: 1) an acceleration of organic growth driven by increasing adoption of CTS’ AI and cybersecurity solutions, 2) potential monetization of the 51% stake in Portage, CTS’ cybersecurity platform, and 3) margin expansion driven by completing the integration of recent acquisitions (n.b., management believes front office synergies have been realized, while back-office integration is ongoing) combined with improving FCF conversion. One could also add the resumption of M&A and a potential takeover of CTS as potential catalysts; however, the outcome of the strategic review and high cost of capital (i.e., elevated base rates and depressed share price) makes me highly skeptical of these for now.

1. Organic Growth

On September 13, management held a special call for analysts in which it seemed to hope an in-depth conversation about the market opportunity AI presents for CTS would help change the narrative around its decelerating organic growth. Reading through the call, it is difficult to separate rhetoric from reality. My naïve opinion about the new generation of AI and its role in business applications is uncertain. At a minimum, AI will drive improvements in existing business intelligence software, and will likely foster new solutions. However, the impacts this will have on CTS’ core and emerging businesses is not clear. Based on the call, customers agree. Nvidia has become the Company’s 4^th biggest selling OEM (n.b., up from 20^th just months ago), generating ~$100MM in GPU hardware sales for CTS YTD. While I wouldn’t place much stock in growing hardware sales, as this is the least attractive component of the business, this surge in AI-related hardware was accompanied by a complementary increased utilization of the Company’s Services business. Management conveyed that its customers’ technology departments are scrambling to determine if and how they will integrate AI into their core operations. This in itself will be a boon for CTS’ Services business, until businesses get clarity on their AI plans. At that point, this could either become a sustainable growth market for CTS, or a will prove itself a fad. Either way, it seems likely that AI will drive both hardware and Services revenue for CTS in the short term

2. Portage

CTS owns a 51% stake in Portage, a cybersecurity company that offers a government-grade digital identity platform for e-signatures, customer relationship management and digital content management. In ‘21, Portage raised $35MM in a private placement at a valuation of $75MM. In the Q2 ’23 earnings call, management outlined its intent for Portage: “we have a significant stake in the Portage business that we’ll look to monetize in the future.” Additionally, they guided to $17MM full year ’23 ARR for Portage after posting ~99% YoY growth with gross margins of ~65%. Paradigm Capital analyst Daniel Rosenberg believes Portage could fetch 5-6x revenue on $24-29MM of ARR (n.b., ~$74MM EV at CTS’ share assuming 5.5x revenue of $26.5MM, implying $0.36 per CTS share, or ~13% of the current share price, assuming no debt at Portage). A sale of Portage would also be ~100bps accretive to core CTS EBITDA margins, as Portage currently runs at an EBITDA loss. I note that these potential proceeds would provide more than enough cash to fulfill the Company’s entire NCIB (n.b., ~19MM shares authorized).

3. Margin Expansion / FCF Conversion

In my estimation, margin expansion and a return to historical FCF conversion rates is the key to the investment thesis in CTS. Management is targeting adjusted EBITDA margins of 30% on gross profit (n.b., the preferred metric due to the resale-heavy nature of the business) driven by cost efficiencies and mix shift. Given that most of the synergies of past M&A have already been realized, I expect most of the expansion to come from mix shift. As a result, margin expansion will be a symptom of the increasing focus on the higher quality Services business, a necessary condition for potential multiple expansion.

While I see margin expansion as critical, FCF conversion may be more important in CTS’ valuation. Per management, CTS has historically seen FCF conversion of 85-90% (n.b., ~12% in FY22, per Scotiabank, and ~85% on a Company adjusted basis). As discussed below, this is a critical assumption for the bull case. FCF conversion was depressed on a reported basis in ’22 due to a lengthening of CTS’ cash conversion cycle as customers delayed payments, a trend which has continued into this year, and elevated capex. I am not too concerned about the elevated capex, as it seems predominantly growth oriented and success-based, but the working capital trends are somewhat worrisome. In such a competitive industry, it is not surprising that customers have this much bargaining power, and it remains an open question if, when, and how CTS can resolve these issues. I believe this, along with organic growth, are the key bets one needs to be willing to make to underwrite the bull case.

Risks

1. Potential Value Trap

As discussed above, much of CTS’ revenue is still generated in its low-quality Product segment, which is comprised of numerous VARs of hardware and software. While the higher quality Services segment is growing organically and gradually gaining revenue share, it will take a long time to meaningfully pivot the business.

2. Negative Feedback of Declining Share Price

Stock based compensation is a major component of CTS’ compensation strategy, and its depressed share price may require it to give employees more shares, or frustrate employees, causing them to leave to a competitor.

3. Debt

As discussed earlier, the Company carries a lot of variable rate debt. Interest costs have more than quintupled as rates have risen over the past two years. The overall leverage picture does not look existentially threatening, but it is certainly something to watch.

Valuation

For valuation, I created a What You Need To Believe (“WYNTB”) case based primarily on broker consensus estimates (n.b., Scotiabank and Paradigm). Note that only Scotiabank disclosed FCF estimates in the reports I was able to access. They forecast FCF conversion recovering from ~12% in ’22 to ~78% by ’25. The case assumes the following:

• Revenue CAGR: 9.6% ‘22A-‘25E / 3.6% ‘23E-‘25E
• Gross Margins: 26.3% average ‘23E-‘25E (n.b., 25.4% ‘22A)
• EBITDA Margins: 6.8% / 25.9% average ‘23E-‘25E on revenue / gross profit (n.b., 6.3% / 24.9% ‘22A)
• FCF Conversion: recovering to 78.2% by ‘25E (n.b., ~12% ‘22A)

Assuming entry at the current share price and a 9x LTM EBITDA multiple (n.b., average of Scotia and Paradigm) in ’25 results in an IRR / MOIC of ~38% / ~2.0x. With the same exit multiple and a 12% discount rate, these assumptions imply a share price of ~$5.6 per share, or +102% higher than the current price.

I also constructed a bear case to assess what is currently baked into the current market valuation. Assuming a 7.7x exit multiple (vs. 9x WYNTB, 7.7x current), flat revenue (but WYNTB margin profile), and flat 50.5%% FCF conversion (n.b., in-line with consensus ‘23E), I arrive at an implied price of $2.64, ~5% below the current market price.

Conclusion

Given the seemingly apocalyptic assumptions reflected in the current market price, and presence of several credible catalysts, I am tempted to give CTS a Buy rating. However, given the generally low-quality of the business and the necessity of a near flawless execution of the growth and cost efficiency strategy, I will be watching the next few quarters closely for confirmation that the Company is executing on its cost and cash efficiencies. If I see notable EBITDA margin expansion, continued organic growth (particularly in the Services segment), and, most importantly, improving FCF conversion, I will likely pivot to a Buy rating. If this were to happen, I would keep my position sizing small given the risks and low business quality.

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