Converge Technology Solutions
(CTS-T) C$2.90
Q2/F23: Margin/ERP Migration Concerns; Downgrading to HOLD Event
Converge reported its Q2/F23 results. Click here for our initial take and here for our conference call takeaways.
Impact: NEGATIVE
Concerns about the cost structure and ERP migration. Despite LTM gross margins (% of gross revenue) trending upward in recent years, Adjusted EBITDA (% of gross revenue) has deteriorated over the same time period (see Exhibit 3), potentially indicating that corporate overhead expenses are more than offsetting acquisition synergies, acquisition synergies are taking longer to realize, and/or certain acquisitions may have required additional investment to improve operational performance.
Meanwhile, we are concerned about the potential disruptions to Converge's operations, particularly on the sales front, from its ERP migration that is expected to occur over the next year in North America and in Europe afterwards. We note that this new ERP migration is the second ERP migration in just the last few years for most of its >30 acquired companies, with the switch due to scaling issues with its current ERP system.
Debt covenants could restrict buyback activity. Converge's Revolver Credit Facility agreement limits dividend and share repurchases to a total of $40mm per fiscal year. Based on its $0.01/share quarterly dividend, Converge would be restricted to spending ~$32mm-$34mm annually to buy back its stock. At its current share price, that would imply Converge could repurchase ~11mm-12mm shares (~55%-60% of the NCIB maximum repurchase). However, proceeds from a potential Portage share sale are not subject to these share buyback restrictions.
TD Investment Conclusion
We are downgrading Converge to HOLD (from Buy), with our target price moving to C$3.50 (from C$5.50), based on 5.5x (was 6.5x) our F2024 Adjusted EBITDA estimate. Our downgrade is driven by our view that evidence of a sustainable and material expansion in Adjusted EBITDA margins is likely at least a few quarters away, our concerns over the potential disruption from its ERP migration, and our belief that the restriction on its share buyback activity is likely to prevent it from being a key catalyst.