Converge Technology Solutions Corp. (CTS) Earnings Call Transcript & Summary

Good morning. Welcome to the Converge Technology Solutions Corp. First Quarter 2023 Results Conference Call. [Operator Instructions] Before we begin, I am required to provide the forward-looking statement, respecting forward-looking information, which is made on behalf of Converge and all of its representatives that are on this call. All statements made on this call will contain forward-looking information. The actual results could differ materially from conclusion, forecast or production in the forward-looking information. Certain material factors or assumptions are applied in drawing a conclusion or making a forecast or a projection, as reflected in the forward-looking information. Additional information about the material factors that could cause actual results to differ materially from the conclusion, forecast or projection in the forward-looking information and material factors or assumptions that were applied in drawing a conclusion or making a forecast or projection, as reflected in the forward-looking information are contained in Converge filings with the Canadian provincial securities regulators. Converge does not undertake to update any forward-looking statements. Such statements only speak, as of the date made. Today's discussion may also refer to gross revenue, adjusted EBITDA and organic growth and adjusted free cash flow and adjusted free cash flow conversion, which are non-IFRS measures and has no standardized meaning. Please refer to the Converge's filing of Canadian provincial securities regulators for an explanation and reconciliation to IFRS measures. And I would like to turn the meeting over to Shaun Maine, Group CEO. Please go ahead, sir.

Thank you, Sylvie. Good morning, everyone, and good afternoon to those listening overseas. Thank you for attending today's Q1 earnings call. For those of you, who recently participated on the 2022 full year financial results call, we discussed being well positioned for a strong Q1 that would be comparable to Q4 despite typically being 20% to 25% sequentially lighter seasonally than Q4, which is traditionally our strongest quarter of the year. We are now pleased to deliver these record first quarter results to you today, where we achieved gross sales of $965.3 million, gross profits of $171.6 million, growing by 8.5 and $3.4 million, respectively, from our reported Q4 numbers. We also demonstrated very strong cash from operations, generating $28.8 million from operations compared to using $30.2 million last year, a change of $59 million and pointing to very strong cash generation in 2023. Despite current macro economic uncertainties and recent disruptions in the market that some believe may point to declining IT spend in certain sectors, our Q1 performance demonstrates the resiliency of our business model and the continued strong demand we are witnessing from our mid-market customers. We are confident that Converge continues to be well positioned to navigate current market conditions and we generally expect to outpace market growth rates for hardware, software and services powered by our cross-sell strategy and strength and breadth of our practice areas and capabilities. Before I continue expanding on the quarter and outlining the remaining road map of our 2023 corporate objectives, I'd like to pass the call to Thomas Volk to make a statement on behalf of the Board of Directors.

Thank you, Shaun. Good morning, everybody. Over the recent 6 months, the dedicated special committee has been working deliberately through the different strategic alternatives for the company. While there was no shortage of interest, all different alternatives were reviewed and several transaction opportunities were evaluated. Finally, the special committee concluded none of these alternatives offered the valuation for the company, which reflects our true potential. In cooperation with the financial advisors, the special committee recommended to the Board to have the company continue to execute the business plan, demonstrating the operating leverage afforded by the full integration of all acquisitions, prioritizing organic growth, improving our cash-generating ability. Based on this recommendation, the Board endorsed the conclusion of the special committee and approved the termination of the strategic review process and hence dissolved the special committee. The Board of Directors is fully supportive and confident in management's ability to deliver this plan successfully for the benefit of the company and its shareholders. I will now pass back the call to Shaun Maine. Thank you.

Thank you, Thomas. With the special committee process concluding, I wanted to provide some commentary and outline a few corporate objectives our management team is now able to pursue over the upcoming fiscal year that we believe will help create value for our shareholders. After acquiring approximately $1.2 billion of gross sales through 10 acquisitions last year, we paused to focus on integration, cross-sell and cash generation. Listening to our quarterly business reviews last Friday, it is clear that the strategy is working, but it's also clear from our stock price that the value we are creating is not currently reflected in the market. Therefore, our Board and management team have decided to prioritize organic growth over acquisitions in the short term to really highlight the success we are having in growing particularly our gross profit organically, while continuing to gain efficiencies through integration. Our integration team has completed 20 -- over 20 integration projects in Q1, with 23 of our 30 non-Portage companies being fully integrated, and we are targeting to have all integrations complete by the end of the year. The combination of the growth of our services and managed services, combined with the operational efficiency results in strong cash flow. As stated in our earnings press release, we plan on returning capital to shareholders in 2 main ways. The Board of Directors has authorized a quarterly dividend starting with a first quarter dividend of $0.01 per share. Additionally, the company will resume purchases under the NCIB and actively buy back our own stock with Converge being the strongest acquisition the company can make today, especially with our stock price at its current levels. Joining us to assist with these matters, I would like to officially welcome Avjit Kamboj back to the Converge team, as our new Chief Financial Officer. Avjit is well known by many from his time at Dye & Durham, and we are pleased he's returning to Converge for the next stage of our evolution. Some of you may not know that Avjit was already a key member of our leadership team during the initial phase of our growth, as a private company in 2017 and '18. I will work closely with him in his new role, as we transform our finance organization and processes, as we look to align to best-in-class reporting, forecasting and disclosure. Avjit will assume overall responsibility for finance, accounting, tax, financial planning and analysis, along with Investor Relations, which I look forward to partnering with him on to further Converge along its growth and value creation path. Turning the conversation back to our earnings results, I'd like to discuss the supporting details that helped secure such strong first quarter results and substantial year-over-year growth. We try to provide transparency about our backlog management, as our teams continue to create and seize opportunities to land and expand into a global client base. As stated on our Q4 call, Converge witnessed strong demand in Q1, particularly for its managed and professional services, as mid-market customers continue to invest in their cloud and hybrid IT journeys. After receiving over 90% of our Q4 backlog invoiced in Q1, new product orders that did not invoice in Q1 added $479 million to our Q1 backlog for a total of $527 million in our product backlog entering Q2. Given that $234 million of orders that came in Q1 invoiced in Q1, this means we received $713 million in new orders in Q1, showing the strength of demand from our mid-market customers for analytics, cybersecurity, cloud and managed service and digital infrastructure and digital workplace offerings. Based on this backlog, at this point in the quarter, Q2 is looking very similar to Q4, with a similar net down since Q2 and Q4 traditionally have a higher mix of software compared to Q1 and Q3 under the new IFRS 15 guidelines. Although backlog have improved with some product categories like endpoint devices normalizing, network gear and some high-end computing platforms still have not normalized, and we conservatively suggest that backlog levels remain elevated for the remainder of the year. The key to our resiliency truly derives from our ability to constantly be bringing scarce capabilities to mid-market customers, the best technologies, the best advice and solutions and the highest level of service excellence. That's what builds loyalty, and we will continue to support profitable organic growth for Converge. Today, we service a diverse global and balanced customer base, as demonstrated by the makeup of our Q1 revenues, with 22% from healthcare, 16% from technology, 19% from government, 12% from financial services and the balance 31% spread across various other industries, such as manufacturing, retail and automotive. As government was the least prepared for the work from anywhere movement during the pandemic, they invested heavily, particularly in endpoint devices throughout. And although requires services like managing end user security, the refresh cycle for these devices is in the future, resulting in government hardware spend being down year-over-year. As endpoint devices tend to be lower margin, we have maintained strong gross profit through services into this sector. However, this is being offset on the commercial side with particular strength in the healthcare sector, and we have seen broad mid-market demand for our hybrid IT services across all sectors. Notably, our financial sector has remained strong, as we have not had exposure to companies affected by the recent regional bank difficulties in the U.S. It is an important differentiator and central to our strategy to understand the key profile differences of the mid-market customers. The reason we highlight how many practice areas our sales personnel are achieving is because it demonstrates strong cross-selling through over 90% of our sales reps selling more than 1 practice area and over 50% of them are selling 4 or more of our practice areas. Traditional VARs do not have these capabilities, especially around AI security and managed services, and mid-market customers are really struggling, as they try to train their internal IT teams to implement these projects, which are often unsuccessful. As a byproduct of our positioning, we have consistently displayed strong net new logo growth on a quarterly basis once again and having 103 net new logos this quarter. I would now like to pass the call over to Matt Smith to discuss our financial results in further detail.

Thank you, Shaun. Shaun highlighted, Converge continues to see robust demand for its products and services, which has translated to strong year-over-year revenue, gross profit and adjusted EBITDA growth. Beginning with our revenues. Q1 gross sales was $965.3 million, growing 43% from Q1 last year, which was driven both by acquisitions and organically from companies we've owned in the current and prior periods. Dollar terms, gross sales organic growth contributed $45.7 million to our Q1 results, equating to 6.8% year-over-year organic growth. On a net revenue basis, the company reported $678.2 million for Q1 2023, increasing by $184.2 million or 37% from 2022. Q1 product revenue, which includes hardware and software, increased 35% to $536.7 million from Q1 last year. Q1 professional and other services, which includes the net revenue from public cloud resale and product support, increased 51% to $106.1 million over Q1 last year, reflecting the benefit of our ongoing investment in our key consulting practice areas, including analytics, cloud and cybersecurity. Managed services revenue increased 34% to $35.4 million from Q1 last year, implying annual recurring net revenue today of $141.6 million. Including all third-party maintenance and cloud services, our peer services business for Q1 was $117.2 million in revenue terms. We are poised to continue growing this organically in 2023. Looking at our gross profit. Gross profit performance was stronger in Q1, growing by 57% from Q1 last year. While our acquisition strategy was a key driver behind reported GP growth, organic GP growth was a significant contributor as well with organic growth of 16.5% in Q1 behind strong software and services growth, meaning that our existing portfolio of companies has generated an incremental $17.9 million of GP compared to prior year. Reported gross margin increased to 25.3% compared to a margin of 22.1% in Q1 last year, largely driven by a decrease in device sales to the Canadian government, which are high volume, but low margin that was replaced by higher-margin software and service revenue in the quarter. In the near term, gross margin still reflects the impact of recent acquisitions that sell proportionally more hardware when we acquired them, but as we go forward and execute on cross-selling higher-margin services, we expect to see margin expansion. Adjusted EBITDA, as a percentage of reported net revenue was 6.1% in Q1 compared to 6% last year. Adjusted EBITDA, as a percentage of GP, which removes the noise of the net down of certain software and services, which we believe is a more meaningful measure of how effectively we turn gross profit into bottom line profit was 24% for Q1, as compared to 27.2% last year. As a reminder, between Q4 and Q1, we've executed on cost takeout that will result in approximately $15 million in annualized SG&A savings with the benefits to be realized throughout 2023. Despite these significant savings in the interim, this metric also reflects the investments made in our services organization, which we expect to yield higher margins in future quarters, as we grow revenue organically and services makes up a greater portion of our overall revenue. Finally, looking at our balance sheet. We finished Q1 with a strong cash position of $139 million. February, we announced the exercise of our accordion feature under existing credit terms, increasing our revolver credit facility by $100 million for a total borrowing capacity of $600 million. As a result, with our cash on hand plus excess capacity on our revolver, we exited Q1 with approximately $280 million in available funds. In terms of cash flow, we generated cash from operations of $28.8 million in Q1, increasing from cash used in operations of $30.2 million in Q1 last year, representing an increase of $59 million year-over-year. In what is seasonally a lower cash from working capital quarter, we are pleased with the fact that cash from working capital sources increased $46 million from Q1, 2022 on the strength of especially strong cash collection from our U.S. companies. We noted on our Q4 call that we expect cash from operating activities to revert closer to levels we saw in 2021, and as expected, our Q1 results reinforce that we're on track to do so. With that, I'll turn the call back over to Shaun.

Thank you, Matt. As promised last quarter, we have broken out financial information on Portage CyberTech to offer a better indication to investors of its scale, its rapid growth trajectory and ultimately, the untapped value of this asset gem. To illustrate its Q1 revenues are $4.7 million, on track for its next phase of rapid growth. Portage exited Q1 with $16.6 million annualized recurring revenue, up from $15.2 million at the end of Q4, an increase of 9% in 1 quarter. Portage has been helping Canadian municipal and provincial government organizations responsibly accelerate digital services to citizens across Canada, and it looks forward to expanding these services to the U.S. during its expansion phase. In this regard, Converge will be an excellent channel partner for a growing product company like Portage. Portage targets at least 25% annual recurring revenue growth. As many of you are aware, we concluded 2022 with strong run rate financials on a pro forma basis and delivered Q1, as predicted. We will continue to integrate and gain efficiencies, as we focus on organically growing by helping mid-market customers on their digital transformation journey. With the conclusion of the special process, I look forward to engaging with investors at our upcoming Investor Day and our Annual General Meeting to provide further details on the success we are having with our strategy and our plans to reward shareholders based on operating cash flow. In particular, I will aim to expand on our integration achievements and outline the ESG road map opportunities that lie ahead of us. I will now open the floor up to questions.

[Operator Instructions] And your first question will be from Robert Young at Canaccord.

In the release and the comments, you said you received a number of proposals for transactions through the strategic process. I understand you may not be able to divulge any specific bids or that sort of thing, but any color here would be helpful? Can you give us a sense of where the interest was coming from, what type of valuations, what was the range of multiples that they were looking at? What type of investor was it? Any type of color to give investors a better understanding of what happened through this process?

Pass that one over to Thomas.

Good morning, Rob. How are you? So -- as we stated, we have had several interested parties from the beginning. We also had several proposals from interested parties, different type of alternatives in terms of how we want to move and structure the company going forward. But based on that -- those proposals and -- then the evaluation, the strategic committee went through together with the financial advisors, it actually led to this conclusion, as we described that we believe the company has a better potential going forward, as a public company. Now getting to your question in terms of we can't give you ranges or obviously data points because it's all confidential, but we can clearly state that we went on exhaustive process, which included different ways of analyzing the proposals versus the potential of the company. And we also had, obviously, feedback from several shareholders on their expectations. And at the same time, as we all know, the macroeconomic environment created some challenges also for the interested parties, especially the financial crisis in North America with some of the banks. And also with our stock price being under so much pressure, obviously, that also was not helping in the overall process of getting proposals in at the level, where we wanted or where shareholders wanted to see that. So based on that, we came to the conclusion that at this point, the best -- it's the best interest of all stakeholders that we continue, as a public company that we execute our plans. And I think what we saw with the Q1 results and the way we -- how much cash we generate now and how we actually are able to turn our business plan into success, we feel that we evaluate and came to the conclusion that this is the best -- in the best interest of everybody.

Okay. Maybe if there's -- if you're going to pause M&A for a longer period, I think you said short term, Shaun, so maybe give us a sense of what that is? And then what does a slowdown in M&A imply on your longer-term targets? And what are your plans for the cash balance going to be if you're not doing M&A?

Yes. So with our stock at these prices, the only acquisition that makes sense is buying our own stock. It doesn't make sense for us to look at any other M&A targets with our stock price here. So we've been definitely investing in our own organic growth. That's something that was already in place, and we'll be focusing -- prioritizing that organic growth, and we'll aggressively buy our own stock back.

What does short-term mean like a pause? I mean, are you just going to evaluate in the context of the market? Or are you just setting a frame?

No, no, no. Actually is if our stock price was materially to change, we would reevaluate those decisions. We are exceptional at buying and integrating and cross-selling with companies, but at these stock price, it makes no sense to do that.

And then the cash, are you going to pay down debt in addition to buy back? Or would you consider a large one-time buyback or a CIB like there's more cash here, I think, the new NCIB would have?

Yes. So again, the first step is to continue on the NCIB that we had paused previously. Obviously, with such a strong cash generation, we'll be looking at how we can provide benefits back to shareholders. Also, there's the Portage asset that we have as well that can also contribute to that. So definitely, we're going to be focusing on -- you've got a small dividend, which allows access to the income investor. We'll be executing the NCIB and then look for other ways of giving back to shareholders.

Next question will be from Christian Sgro at 8 Capital.

At the enterprise part of the market, peers have called out more bureaucracy or red tape maybe in purchasing decisions, but you've expressed some confidence in what you're seeing in the mid-market. Is there any comments there you could offer on their buying habits, who's making the decisions there? And it sounds like you see no slowdown or uphill battle this year so far, which is good.

So what you see in the -- and when I say enterprise, I'm really speaking to Fortune 500, the way that they purchase is not -- in the mid-market you're buying through the business, in large enterprise, you buy into procurement and they have a network procurement group. They have a storage procurement group. They've got a services procurement group. It's done. You're 1 out of 3 into procurement. It's a very different buying environment that you go versus the mid-market, where they're looking for solutions. We have multiple areas, all part of one solution. And so when you're decoupled like that in the large enterprise in the Fortune 500, they make decisions to slow down spending. They'll have refresh rates or projects that during tougher economic times they'll slow down. A 3-year renewal they'll make it to a 1-year renewal. So there's different ways. And when you have customer concentration, that's a real issue. Our top 10 customers make up less than 20% of our revenue. Most of our customers are $1 million to $10 million in size. That's kind of our sweet spot. So you really -- that well-diversified customer base by sector as well, really kind of -- it insulated us during the pandemic, and you really see that's where the strength is coming from. And these mid-market companies are really struggling to deal with these new technologies. They can't find the resources in cybersecurity that CBI provided to us or in the 5 analytics companies we bought. These are resources. They send their internal IT staff on courses, and then we'll come by with the Red Hat workshop, where they're coming to see our experts in the field, like, why are we trying to do this ourselves, why don't we let Converge help us with these problems. So that's where our success has really come and really the structure that Greg has put into place around the practice areas and embedding the solution specialists into the regions, we're seeing tremendous success with it, both as they move to the cloud and then realize, wait, some of those workflows might come back from the cloud, but in those journeys and being their partner it to the business, as opposed to the large enterprise to procurement.

And one more question from my end. On the Q2, you called out it will be similar to the Q4 and those are the 2 strong software quarters. Just wondering what other color you could provide around maybe how it will be similar in terms of revenue and margin composition? And then on the product backlog, you gave some good color in the opening remarks, but I know crystal ball, tough to say, how it unwinds, but do you see all of this giving good visibility into the June quarter end year?

So first off, I was too optimistic last year about the supply chain normalizing. So I want to be really cautious when we look forward. What I see at this point in the quarter and realize this is much earlier in the quarter than last quarter, we had did a call in March, where you're pretty near the end of the quarter. And it's not about demand, it's about timing of shipment and things like that. When I say it's looking like Q4, I mean from both a revenue perspective and a net down perspective. You will see our revenue in Q4 and Q1 were remarkably similar, but the net down was very different because now under the new IFRS 15 guidelines, we had, I think it was $30 million more of net revenue in Q1 than we did in Q4, even though gross revenue only was up by $8 million. So the net down in Q4, we see similar revenue levels to Q4 with the net down being more similar and similar gross profit and EBITDA. So that's a general indication of what we see at this point in the quarter.

Next question will be from Deepak Kaushal at BMO Capital Markets.

I've got a couple, if I may. First on the M&A environment, I know that you're pausing M&A and you said that for a while, but I know you guys have relationships throughout the industry with lots of companies and you were actively looking in Europe. What are you seeing in terms of private company valuations, what are those management teams saying? And how has that environment changed in Q1 with the macro?

We've got a very robust pipeline of acquisitions. There's no shortage of companies to buy. But right now, the prices of those acquisitions make no sense compared to our stock price. So yes, we're very good. I think we've done a wonderful job in the last 5.5 years of showing how we can go through acquisition. Now we believe the market will reward us more if we focus on organic growth, and then the best acquisition we can make is our own stock. So all the acquisitions that are out there in a very fragmented market don't make sense for us right now.

So is that to say that the valuations of private companies haven't changed in the last 6 months?

They definitely have. So you have seen some trends there, but we're not -- we're never going to be the top bidder. I don't want to say we're the consolation of the VAR world, but we're not far off. And so let the -- but so -- when we go in -- we usually do not take part in processes. We're usually -- these are people we know that are -- we're kind of negotiating one-on-one, and we buy more hardware-centric VARs we're buying for customers, and we turn them into and we add the capabilities to turn them into cloud and hybrid IT providers. When we buy for capabilities, that's a different kind of story. But this hasn't been something that we've been a part of a lot of processes I can talk about how those are running. And again, we haven't done any acquisitions since -- for us, that's a long time since Q4. But yes, we've maintained discussions when we go around to industry conferences, we constantly are seeing companies that are in the space and always have very good relationships with them. And so at some point, if it does make sense, we absolutely have the capabilities to go back on that trail, but at these stock levels, that don't make sense.

And then I know in your prepared remarks, you called out resilience in the financial services vertical through this regional banking crisis. But when you step back and you talk to your SMB customers, as a whole across the board, what are they saying about the regional banking crisis? Are they concerned about rising credit constraints? And what are your expectations here on the impact of that through the balance of the year beyond Q2?

Yes. So Deepak, I want to be careful about how we define what SMB is. We're selling into mid-market, which are not the smaller guys. So mid-market kind of for us in the U.S. goes from 500 to 10,000 seats. And we went and asked this to all -- we did the QBRs last Friday. We asked all the regional sales leaders, have you seen an exposure impact? And the answer is no.

And then I just wanted to clarify, if I may, one last question, maybe for Matt. What was the targeted annualized cost savings in SG&A this year? And what can we expect from non-recurring costs, the cash drag on that for the calendar year for the fiscal year this year, just to set out our EBITDA versus cash flow expectations?

Yes. Deepak, we saw some non-recurring costs in Q1 in our special charges related to the amending our credit facility in Q1 and obviously, some costs associated with buying back 25% of REDNET. So you will see the non-recurring costs kind of taper off in Q2 to Q4, as we focus on organic growth. We did realize savings from the SG&A takeout in Q1. Some of that is offset, as I mentioned in my remarks, with the investment in our services organization. But you will see that savings kind of spread out through the balance of the year.

And did you say in your prepared remarks, $50 million in annualized SG&A savings that's the target?

Yes. $15 million cumulatively between Q4 takeout and Q1 takeout.

Okay. That's 5-0, right?

15, 1-5, sorry.

1-5, sorry, apologies. I'm mishearing everything this morning.

Next question will be from Rob Goff at Echelon.

My question would be, given your focus on organic growth, how might that influence your capital allocation perspective? And in turn, how does that impact your outlook on dividends or potential or prospective share repurchases beyond the current NCIB?

Well, first, maybe I can -- Avjit, can you handle like -- just our philosophy on the dividend.

Yes. Absolutely. Maybe I want to talk about the capital allocation as well. I think what you're hearing about the acquisitions the company is really playing to its strength, what we're good at and what our skill set is. We're great capital allocators. We're making the capital decisions based on what we see in the market. And as Shaun mentioned, the best allocation of our capital today is organic growth, so investing in ourselves and investing in our shareholders, and that's where you're seeing the dividends come in.

There's a few reasons for the dividend we -- as we initiated, one was to provide some returns back to the shareholders; and number 2 was to large, broaden our investor base for value investors or investment investors that only invest in dividend stock. As we move forward, as we prove out our cash flow from our operating activities prove out our organic growth, we will continue to evaluate growth of our dividend as well. So capital allocation from our perspective, it's not a set in stone decision today. We will continue to evaluate, where our best capitalists in the universe invested.

And as a follow-up, you did discuss the $15 million of annualized savings, how should we look at the Q-on-Q progression of net savings, as we go through the year? And to what extent should the integration onto one platform realize additional savings?

So as we've mentioned, we've got 23 of our 30 non-Portage acquisitions that are fully integrated. We've got some big ones that we acquired last year that are still to be integrated. And as we go through and have that completed before the end of the year, that will provide additional synergies. Again, as Matt mentioned in his remarks, we've also invested in our services going to a growth model, where you're adding salespeople and more particularly engineers, means you're making those investments. We now have growth reps, where as before, we buy -- basically buy companies for the sales people and engineers, you're buying sales reps. Now we're looking at a growth model for their, and both to our services organization. So there is some offset. As you -- part of the not buying additional companies means it provides much more clarity on that cross-sell and growth. And so there is the synergies you're getting from your integration, and then the investment getting to the higher growth, particularly you see that strength in the higher gross profit growth, and then you see the synergies happen later on in the year, as those resources become fully utilized.

Next question will be from Jerome Dubreuil at Desjardins.

So just to continue on this $15 million synergy savings, how should we approach that? I'm guessing it's not just taking the current SG&A annualize it and do minus 15. Is this some sort of same percentage throughout the year and then removing $15 million, just so we take into account the growing scale of the business. So if you can just walk us through the mechanic of the $15 million.

Yes. So that is headcount savings that you've seen in that reduction based on the synergies from our integration efforts. You'll continue to see those. But I think we'll fully elaborate these more on the Investor Day and at the AGM, where we can provide a more robust model because you see there are a lot of moving parts, and we'd like to provide more clarity on that. So if you give us sort of a chance to come back to you, it is out just first day as well, so.