TIXT - Converge Technology To Focus On Organic Growth As It Digests Acquisitions

2023-08-15 16:06:43 ET

Summary

• Converge Technology Solutions Corp. provides technology and IT consulting services and related hardware & software solutions.
• The company needs to prove that its AI GPU hardware sales and services can generate profitable growth.
• I remain Neutral [Hold] on Converge Technology Solutions stock for the near term.

A Quick Take On Converge Technology Solutions

Converge Technology Solutions Corp. ( CTSDF ) provides businesses with an array of technology and IT consulting services and related hardware & software solutions.

I previously wrote about the company with a Neutral outlook.

Converge needs to "digest" its recent acquisitions and prove that its foray into AI GPU hardware sales coupled with a services component can produce profitable growth with good margins.

I remain Neutral [Hold] on CTSDF for the near term.

Converge Overview And Market

Gatineau, Canada-based Converge Technology Solutions was founded in 2016 to provide organizations with IT, cloud software and related hardware solutions for their information requirements.

The firm is headed by Group Chief Executive Officer Shaun Maine, who was previously Chief Operating Officer at Pivot Technology Solutions and COO at ProSys Information Systems.

The company’s primary offerings include the following:

• Advanced analytics

• Application modernization

• Cloud platforms

• Cybersecurity

• Digital infrastructure

• Digital workplace

• Managed services

• Talent services.

The company acquires customers via its direct sales, marketing and business development efforts as well as through strategic alliances and partner referrals.

It also acquires various complementary businesses through an active acquisition program.

According to a 2021 market research report by 360 Market Updates, the global market for digital transformation strategy consulting was an estimated $58.2 billion in 2019 and is forecast to reach $143 billion by 2025.

This represents a forecast CAGR of 16.2% from 2020 to 2025.

The main drivers for this expected growth in IT consulting are a large transition from on-premises, legacy systems to cloud-based environments with complex architectures.

There is also expected growth in the number of industries adopting digital transformation strategies, such as manufacturing, finance, and retail, as well as a growing demand for improved customer experience.

IT consulting firms can also leverage their expertise to help companies develop and maintain new or better business models which are better suited to the digital world.

Also, the COVID-19 pandemic likely pulled forward significant demand to modernize enterprise systems resulting in increased growth prospects for digital transformation consultancies.

The growth of IT consulting is expected to continue due to the evolving digital landscape, increased demand for improved customer experience, the need to develop and maintain new or better business models, and the accelerated demand for modernization due to the pandemic.

Major competitive or other industry participants include:

• Globant

• Thoughtworks

• EPAM

• Slalom

• Accenture

• Deloitte Digital

• McKinsey

• BCG

• Ideo

• Cognizant Technology Solutions

• Capgemini

• Computer Task Group

• Company in-house development efforts.

Converge’s Recent Financial Trends

• Total revenue by quarter has been volatile in recent quarters; Operating income by quarter has varied within a somewhat narrow range.

• Gross profit margin by quarter has fluctuated seasonally; Selling, G&A expenses as a percentage of total revenue by quarter have trended slightly higher in recent quarters.

• Earnings per share (Diluted) have dropped into negative territory more recently.

(All data in the above charts is GAAP.)

In the past 12 months, CTSDF’s stock price has fallen 66.34% vs. that of the SPDR S&P Software & Services ETF’s ( XSW ) rise of 0.8%, as the chart indicates below:

For the balance sheet , the firm ended the quarter with $59.2 million in cash and equivalents and $326.2 million in total debt, of which $0.4 million was categorized as the current portion due within 12 months.

Over the trailing twelve months, free cash flow was $36.1 million, during which capital expenditures were $12.6 million. The company paid only $3.5 million in stock-based compensation in the last four quarters.

Valuation And Other Metrics For Converge

Below is a table of relevant capitalization and valuation figures for the company:

(Source - Seeking Alpha.)

As a reference, a relevant partial public comparable would be TELUS International (TIXT); shown below is a comparison of their primary valuation metrics:

(Source - Seeking Alpha.)

Commentary On Converge

In its last earnings call ( Source - Seeking Alpha ), covering Q2 2023’s results , management highlighted the ‘persistent demand for our products and services’ as the firm finished the quarter with a backlog of $447 million.

Leadership continues to pursue what it calls a "advise, implement and manage" strategy which it believes has kept its revenue streams growing despite macroeconomic headwinds.

The firm has shifted its focus to "driving accelerated time to value for its customers."

Other consulting companies have noted that customers are looking for cost-takeout activities more than just "digital transformation" for its own sake, as macro pressures dictate the need for increasing operational efficiencies.

Recently, the Board of Directors had created a Special Committee to review the firm's potential options due to various expressions of interest in the company.

In May 2023, the Board concluded that the company would remain as an independent, publicly-held company under the leadership of Group CEO Shaun Maine.

Management didn’t disclose any company, customer, revenue or employee retention or attrition rates.

Total revenue for Q2 2023 rose 25.6% year-over-year and gross profit margin increased by 0.5%.

Selling, G&A expenses as a percentage of revenue grew by 1.9% YoY while operating income dropped sharply by 42%.

The company's financial position is moderate, with ample liquidity, some long-term debt and reasonably robust positive free cash flow.

However, management "noticed a number of our long-standing creditworthy clients simply slowing payment cycles leading to negative cash from working capital."

Looking ahead, consensus revenue estimates for full-year 2023 are $1.97 billion, or 28.1% growth over 2022.

If achieved, this would represent a drop in revenue growth versus 2022’s growth rate of 89.64% over 2021, due in part to inorganic acquisition activity.

From management’s most recent earnings call, I prepared a chart showing the frequency of key terms mentioned (or not) in the call, as shown below:

I’m most interested in the frequency of potentially negative terms, so management or analyst questions cited "Challeng[es][ing]" once and "Macro" twice.

Analysts questioned company leadership about capital allocation and M&A activities. Leadership responded that with the stock so low, it makes more sense to purchase shares than to go after more deals.

Management also prioritized organic growth generation followed by debt reduction for its capital allocation strategy.

Regarding valuation, in the past twelve months, the firm's EV/EBITDA valuation multiple has dropped by 54.3%, as the chart from Seeking Alpha shows below:

The primary business risk to the company’s outlook is the industry-wide trend of clients slowing or canceling discretionary projects and deferring existing projects as they exert greater scrutiny on their IT spending.

Also, the firm’s recent acquisitions have reduced its margin profile and it will take well into 2024 to begin to see higher margins from those high-volume, low-margin segments.

For the time being, I remain Neutral [Hold] on Converge as it seeks to ‘digest’ its recent acquisitions and improve its operating results and margins.

For further details see: