Hidden Value Stocks issue for the third quarter ended September 30, 2021, featuring an interview with Bedford Park Capital Corporation’s President and CEO Jordan Zinberg, in which he shares his stock idea, Converge Technology Solutions Corp (TSE:CTS).
Bedford Park Capital – Stock Idea One: Converge Technology Solutions Corp (CTS)
One of your favorite stocks is Converge Technology Solutions. Can you start by giving us a brief overview of what this company does?
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Converge provides IT services across several verticals including data analytics, cloud migration, cybersecurity, digital infrastructure, and managed solutions. The company is growing rapidly, and just recently announced their first acquisition outside of North America with the purchase of 75% of Rednet AG based in Germany.
You’ve mentioned that you first came across the company in 2018. What did you think about the business then and what stopped you from pulling the trigger at the time?
I first met with Converge CEO Shaun Maine in late 2018 and I believe the stock was around $0.80 at the time. At that meeting, Shaun outlined a roadmap to $1 billion in revenue within 3 years. My initial impression was that the growth strategy was too aggressive and would be difficult to achieve. As a result, I decided to put the company in my database and monitor their progress but did not invest. After seeing that management was successfully executing their initial plan, we ultimately ended up investing about two years later around the $2.00 level.
What is management’s background, and do they have skin in the game?
The majority of the senior management team worked together at a public company called Pivot Technologies. I had been an investor in Pivot in the past and it was acquired by Computacenter PLC in 2020. Notably, Converge has been adding bench strength in Europe recently, with the addition of two high profile European tech executives, one of whom is now chairman of the board. According to Bloomberg, insiders currently own just under 10% of the company.
The company’s growth strategy is based on acquisitions. It has completed 22 deals since 2017. Some companies that have followed a similar roll-up strategy in the past have eventually fallen back to earth. What makes you think Converge is different?
Given our fund’s focus on high growth businesses, we invest in and evaluate roll-up strategies on a very regular basis. The mere fact that a company is pursuing a “roll-up strategy” is not unique and that fact alone does not make any company an attractive investment to us. Where these types of companies typically fail is in their inability to source and close transactions or buying companies that don’t fit, taking on too much debt, or failure to properly integrate the acquired companies.
Converge has proven their ability in all the above areas and is not simply pursuing valuation arbitrage. Converge is buying low margin businesses that other players don’t want and turning them into higher margin businesses that generate a ton of cash flow. For any company that is growing predominantly by acquisition, what we look at is the types of companies they buy, the subsequent steps taken to optimize those businesses once acquired, and the potential repeatability of that process in a systematic way. Converge checks all those boxes.
The firm uses an acquisition strategy template. Can you talk us through that approach?
Management at CTS has often cited the following acquisition template, which contemplates the acquisition of a $100 million revenue business with a 3% EBITDA margin that is acquired for 5x EBITDA. This $15 million acquisition would typically be structured as $9 million of cash up front with a $6 million earn out:
Can you walk us through the company’s three steps to increase sales, profits and reduce costs after an acquisition?
The first step is cost reduction. Post acquisition, target companies qualify for Converge’s volume discounts with suppliers, resulting in significant cost savings and expansion in gross profit margins. Also, in functional areas where there is overlap (i.e. Accounting, HR, etc.), the company is able to rationalize headcount, further reducing costs. In a short period of time, these initiatives can result in lowering the effective purchase multiple of the target company from 5x EBITDA to 2.5x EBITDA.
The second step is working capital optimization. Converge has secured favourable payment terms with its suppliers. Pre-acquisition, payment terms in effect at target companies are typically 45 days. Post acquisition, Converge can increase these terms to 75 days, resulting in increased cash flow to the business. This optimization and extraction of working capital is later used to help offset the purchase price of the business. Notably, in the example above you will see that $3 million of the $9 million initial purchase price is extracted from the target company themselves.
Finally, all the above noted synergies are further enhanced through the third step: cross selling Converge’s existing products and managed services to the target company’s customers. The ability to cross sell managed services is a major priority for CTS management. Managed service revenues are higher margin and recurring in nature, which enhances the company’s profitability while adding predictability and stability to its top line.
Do you think there are any signs the company is growing too fast?
Given how quickly the company is growing this is something I think about often, however I’m not seeing any areas of concern currently.