Converge Technology Solutions Corp

TSX:CTS

Earnings Call Transcript 2020-Q2

[Operator]

Good afternoon. My name is Sylvie, and I will be your conference operator today. At this time, I would like to welcome everyone to the Converge Technology Solutions Corp. Second Quarter 2020 Results Conference Call. [Operator Instructions] Your hosts today are Shaun Maine, Chief Executive Officer; and Carl Smith, Chief Financial Officer. Before we begin, I am required to provide the following statement respecting forward-looking information, which is made on behalf of Converge and all 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 a conclusion, forecast or projection in the forward-looking information. Certain material factors or assumptions were 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's filings in 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 also refers to adjusted EBITDA, which is a non-IFRS measure, has no standardized meaning. Please refer to the Converge's filings with Canadian provincial securities regulators for an explanation and reconciliation to IFRS measures. Thank you. Mr. Shaun Maine, you may now begin the conference.

[Shaun Peter Maine, CEO & Director]

Thank you, Sylvie. Good evening, everyone, and thank you for taking the time to participate on tonight's call, which we'll discuss Converge's second quarter 2020 financial results and provide an operational update on the business. As the world continues to manage the implications of the COVID-19 pandemic, many businesses have had to reassess their business strategies while adapting to new standards and business requirements. Due in part to our hard work over the last 2.5 years and as a result of our positioning within the market, I am proud to confirm that Converge continues to execute on our phased approach to growth without incurring significant negative impacts on our quarterly results. Similar to our Q1 results, Q2 2020 remains strong and is a testament to the business we have built and the incredible team we have assembled. As I have said throughout this challenging time, looking at our financial results, you wouldn't know that we are operating during a pandemic. Now let's take some time to explore why we witnessed the level of success we have this past quarter. Given the national platform we have built comprising our 12 acquisitions to date, Converge is well positioned to effectively meet the needs of its customers across North America during this challenging time. As a national business with extensive reach across the U.S. and Canadian markets, equipped with talented teams experienced in offering adaptive and responsive hybrid IT solutions, we help drive and lead our customers' digital transformation journeys, which have largely accelerated due to COVID-19. Not only have we assisted businesses with enabling remote work, but I am extremely proud of the teams who have gone above and beyond their regular duties to customers and suppliers to help foster work environments where employees feel comfortable to effectively execute on their responsibilities. A large contributing factor to our success this past quarter is the majority of our revenue comes from pandemic-resistant sectors. In the first half of the year, 22% of our revenue came from the finance sector, 20% from the governments and state, local and education, 20% from technology, 12% from health care and 6% from manufacturing. Of the remaining 20%, no one sector made up more than 4% of our revenue. We are very fortunate to have little to no exposure to the other sectors that have been heavily impacted such as oil and gas, travel, luxury retail and hospitality. Our diverse mid-market customer base helps insulate us from the impacts that individual customers might experience due to COVID-19. In the first half of 2020, 104 of Converge's customers bought at least $1 million of our products and services, and no one customer accounts for more than 10% of our revenue. As mentioned, as we continue to assist companies navigating through their digital transformation journey, we have witnessed an increase in sales of our public cloud, private cloud and managed services. This reality is demonstrated by the 81% year-over-year growth in our gross annualized recurring revenue base, or ARR, which now totals approximately $205 million, and on a net revenue basis in excess of $100 million. As a reminder, our ARR base consists of private cloud or managed services monthly recurring revenue, which are typically on a 3-year contract, public cloud monthly recurring revenue, which are usually on a 3-year contract and software subscriptions, which are annual. With all this in mind, let's take a further look into the operations of our business and some recent developments this quarter. As impressive as our sales growth is, I must admit to being in awe of our back-office integration team. During Q2, a quarter in which we were completely operating in a work-from-home mode, the team kept to the original schedule and integrated 4 back offices, making it now 7 of the 12 acquisitions that have had their back offices integrated. The team will have the next 2 companies integrated at the end of this month, with the remaining companies integrated by December 1. This integration will result in a savings of approximately $9 million annually. In addition to the back-office integrations as part of our Phase III plan, the team removed $11 million of annualized cost from the front office at the beginning of Q2. When you buy 12 companies, there are duplicate management, sales, marketing and engineering personnel. When you combine the front and back-office synergies, that equates to approximately $20 million in annual savings or $5 million a quarter, which will be fully realized at the end of the year. Also, as we do additional acquisitions, we now have a platform that will enable us to realize front and back-office synergies in the first year after new acquisitions. As you recall, we buy companies that typically have approximately 3% EBITDA margins. When we add the impact of volume rebates and both front and back-office cost reductions, it means that we can transform acquisitions from 3% EBITDA margins at the time of acquisition to 6.5% EBITDA margins once integration is complete. During Q2, we took advantage of our pause in acquisitions to focus on getting our story out to the marketplace, having demonstrated the impact of what we've created through our Q4 and Q1 results. Throughout the first half of 2020, we have talked with many institutional and retail investors and analysts, and the interest in our company and our strategy has been strong. On July 31, we announced a $15 million financing that was upsized to over $17 million; and just last week, on August 7, the underwriters exercised the overallotment, bringing the total to $20.1 million. This financing, co-led by Canaccord and Desjardins and a syndicate including Echelon, Eight Capital, Raymond James and Paradigm, not only added additional key institutional shareholders to our existing shareholder base but strengthens our balance sheet and positions us for continued growth. While our investors have noticed our progress, we have also received tremendous recognition from the industry, illustrated by our recent partnership awards and accolades that we have received. I am incredibly proud to top the CRN 2020 Fast Growth 150 List as the fastest-growing IT service provider in North America. To be at the pinnacle of this prestigious list is a testament to all the hard work the Converge management team has put in. As the 50th largest IT service provider, we also now have a meaningful platform as we look to be the dominant hybrid IT service provider in North America. In addition to the Red Hat Rising Star North American Partner of the Year award that Converge received in April, Converge won the 2020 IBM Business Unit Excellent award for data and AI. This truly was an honor to be recognized by top executives from IBM's analytics brand and to have IBM endorse the Converge advanced analytics practice areas, including business intelligence, data management, data science and AI. Additionally, Converge was announced as the 2020 Ingram Micro Cloud Reseller Partner of the Year for North America, confirming the powerful commitment Converge has to advancing cloud practices and providing adaptive solutions in an ever-changing and challenging ecosystem. These awards spotlight partners worldwide who deliver platform solutions that drive digital transformation while demonstrating an outstanding level of innovation, sales success, performance and best-in-class utilization of Ingram Micro's cloud marketplace. The Converge team has worked methodically to improve its practice areas surrounding advanced analytics and hybrid cloud solutions, and I'm particularly proud of the innovative Becker-Carroll-based technology marketed as Converge's TrustBuilder platform, which we'll utilize for digital transformation of public sector entities. This paired with our investment in the Digital Identity Laboratory of Canada encapsulates Converge's dedication to and active participation in driving innovative solutions while advancing digital identity initiatives across North America. We continue to believe that this solution has the potential to drive significant growth and value for Converge moving forward as providing this level of transparency and security to our managed services offerings will be a key differentiator for us. As stated on our Q1 call, after pausing acquisitions activity in Q2 as a result of COVID-19, we have now resumed activity on our acquisition pipeline as we look to get back to our typical acquisition pace. On that note, I would like to pass the call to our Chief Financial Officer, Carl Smith, to discuss our financials from the quarter.

[Carl Smith, Chief Financial Officer]

Thank you, Shaun. Second quarter revenue increased 44% to $227.8 million compared to $158 million last year. By industry, the breakdown for the quarter was approximately 20% banking and financial, 19% technology, 18% government, 14% health care and 8% manufacturing. For the 6 months ended June 30, revenue increased 43% to $469 million from $328 million last year. Our gross profit for Q2 increased 52% to $54.8 million from $36 million last year. Gross profit margin also increased to 24.1% compared to 22.9% last year. And for the 6 months ended June 30, gross profit increased 50% to $109.7 million from $73.3 million last year. The increase in our gross profit margin for both the 3 and the 6-month periods is primarily due to the company's focus on selling higher-margin software and cloud services. SG&A for the 3 and 6 months ended June 30 was $44.1 million and $89.6 million, increasing from $31.6 million and $61.3 million last year. The increase in SG&A reflects the increased headcount and overhead costs related to the acquisitions of companies purchase subsequent to June 30, 2019. As Shaun discussed earlier, during the quarter, we consolidated several back-office and front-office operations, and we will continue to consolidate some functions and it will result in an annualized cost savings by the end of the year of $20 million. Adjusted EBITDA for Q2 increased to $11.7 million compared to $5.5 million last year, an increase of 112%. For the 6 months to date, adjusted EBITDA increased 61% to $22.5 million from $14 million last year. At the end of the quarter, our cash balance was $36.4 million compared to $20.6 million at December 31, and our borrowings were $151.2 million compared to $156.7 million at December 31. And with that, I would like to now open the floor to questions.

[Operator]

[Operator Instructions] And your first question will be from Kevin Krishnaratne at Eight Capital.

[Adhir Kadve, Research Analyst]

It's actually Adhir on for Kevin here. My first question, I just wanted to talk a little bit about the launch of TrustBuilder. I know it's early days, and you guys kind of touched on it in the opening remarks. But can you maybe elaborate on some of the projects that you have commenced in the quarter? And how can we kind of think about the opportunities in TrustBuilder over the coming quarters?

[Shaun Peter Maine, CEO & Director]

Great. Thank you for the question. So TrustBuilder is a set of 11 APIs that allow you to build trusted ecosystems. And so the way we like to illustrate it and the way the Becker-Carroll guys talk about it is it kind of compares to when you -- in the U.S., they had that admission scandal where prominent people pretended their kids were athletes. Well, the assertion that their child was an athlete was false, but that could have been a validated assumption. We have been doing these kind of things for supplier relationships with the federal government, where if you needed to be a certain size and scale, let's say, you need to be $100 million because the government wants to make sure that you have the capabilities to fulfill a contract, we could actually check with CRA and validate that assumption to let you bid on that contract. So what started with a lot of work that we've been really developing to the Canadian federal government we're now deploying to municipalities. And although we have nothing to announce quite yet, there is a pipeline of municipalities that we'll be going through. And we started off with -- there's different revenue models associated with this IP. There is a licensing model, but there's also a managed services model. And although we're starting with more of the supplier relationships as the first trust ecosystem, there are many use cases that are managed services deploy that we believe a better trust model with trust and transparency can influence. And where there is value, there is margin. And so over time, we'll look to introduce this technology as it further develops into additional trust ecosystems. So how you can kind of watch our progress around TrustBuilder is we'll have some announcements on customers. And then at our AGM, which has been delayed, we'll kind of be mapping out how you can kind of watch the progress as we go through quarter-by-quarter. Hopefully, that answers your question.

[Adhir Kadve, Research Analyst]

It does. Just anything you guys are willing to share or able to share on pricing and how to think about like revenue and EBITDA goals for the short term?

[Shaun Peter Maine, CEO & Director]

Let us wait until our AGM, we can kind of map it through a little more fully.

[Adhir Kadve, Research Analyst]

That's fair. And then just I think you touched on this as well in the opening remarks, but just on the recognition by both Ingram Micro and Red Hat, how does Converge kind of stand out versus competitors? And how did that lead to the award recognition? Is it only based kind of on spending orders? Or are there other considerations that you can kind of call out to us?

[Shaun Peter Maine, CEO & Director]

So this whole industry doesn't target mid-markets very well. So we're the 50th largest, but I believe we're the only one who's solely targeted at the mid-market. It requires a different sales force, and we have a very unique presales model. When you talk to a lot of the classic private equity guys, they'll say, you can't make money on the mid-market. Well, in Europe, they have been able to. So if you look at Cancom, which I quote quite often, and Bechtle and Softcat and Atea in Europe, they have executed this strategy very well. You need a different kind of sales force, they're younger, they're hunters. They go after multiple customers. When you look at large enterprise, there's fewer farmers who farm one account, but you're 1 of 3 to procurement. But also, Greg Berard, our President, came up with this really unique presales model. In this industry, the way that people have customer engagements is they hold happy hours or invite customers to baseball games. And they have salespeople talk to customers about their capabilities. What Converge does is we hold workshops in the various cities that we operate in, and we invite our mid-market customers to come to us and which started as inviting 25 to 40 customers to a Red Hat Ansible or OpenShift workshop, where our world-class experts are demonstrating the technology for a day or our cybersecurity guys, our analytics guys are holding a workshop with our customers. That is such a better way one to validate your company. But when you buy companies through acquisition, it's hard and takes a long time to train salespeople and engineers on these very deep offerings. And so if they know enough to bring their customers to these events, which we ended up getting 65 to the one in Costa Mesa, which is 65 customers, think how efficient that is when you bring 65 customers to you, which now during COVID-19, we turn into online workshops. It is the most efficient net new logo presales model that I'm aware of that also the vendors recognize. We are the fastest-growing IT service provider in North America, partially because of the way we acquire companies, but also because of the way we attack the mid-market in a pre-sales motion with unique capabilities, bringing our world-class people to bear. And so this, we have been incredibly successful where others in North America haven't, but people in Europe have at going after the mid-market showcasing our capabilities. So when people talk about -- if I had to send out a salesperson and an engineer to 65 customers, it would take months, and yes, it is not an efficient process, the way we do it is. So I think we do a great job, and the vendors fund this because they recognize this growth in a market where IBM, I think, got rid of all their kind of SMB sales force because they couldn't do it efficiently. So we have a very efficient model. Our vendor partners recognize that, so hence, the awards and also the funding of these initiatives.

[Adhir Kadve, Research Analyst]

That's really helpful. Really appreciate that. Just 1 more question here. In terms of the quarter, did you experience any sort of supply shortage constraint in any parts of their business -- any parts of your business, for example, maybe like PC, laptops?

[Shaun Peter Maine, CEO & Director]

So there was -- we're not heavily a device business and, say, the hardware component is kind of just a little over half of our business, but tends to be more network-centric as part of our cloud-based solutions. The partners that did experience supply chain tended to be the heavy HP partners. We tend to be more Dell because of VMware on the hardware side and then the network guys like Cisco. And their supply chain did not experience those kind of disruptions. We also -- this is where size and scale does matter, where we have the ability to work effectively, look ahead with our partnering of Micro on the distribution side, but also our vendors. But we did not experience product rush -- at the end of Q1, there was a kind of rush for end point devices. But in Q2, it was much more about delivering our cloud-based solutions. So I don't believe that in our ecosystem, and again, we have a great national footprint with our vendors and partners, we did not experience that.

[Adhir Kadve, Research Analyst]

Okay. Great. And just one last one, if I could, and then I'll pass the line. How do we think about the opportunity within cybersecurity? And what's the portion of your gross spending attributable to cybersecurity software? And how has that kind of evolved with the whole work-from-home dynamic?

[Shaun Peter Maine, CEO & Director]

So let's start with every solution in the cloud that involves our cybersecurity team. We have a world-class team led by Sean Colicchio that is part of every solution. It's not just hardware. So there is software intelligence event management software like IBM's QRadar or Splunk that will do monitoring. But it's a lot as much about the security architecture. As you're aware that during COVID-19, there's been a 14,000% increase in cybersecurity attacks. Because the way you used to validate yourself was by logging into your email, you would be validated through a 2-factor authentication and then you have an access control is to say access these applications. When you dial in from home over VPN, it bypasses that normal mechanism. So you don't have that. And the IT folks who are kind of struck said if people want to access applications, we'll just open everything up. Well, that's been a disaster. So the way that we provide access to applications through our managed services, that I mentioned one of our big sellers is our VMC on AWS offering as a managed service, it provides a secure access to these applications that we used to offer as disaster recovery but has worked very well in working from home. But every solution involves our cybersecurity team. We do have strong cybersecurity software products, as I mentioned. We also -- every network piece, so whether it be from the Cisco side, which is our dominant security vendor partner, there's Palo Alto and Juniper as well, that we are providing the network piece, which guards your hybrid IT solution. So it is a very strong practice area we have, but it goes through our software products, our hardware products and our architectures.

[Operator]

Next question will be from Rob Goff at Echelon.

[Robert Goff, MD & Head of Research]

My question would be on the software side -- or sorry, the services, where a year ago it went 35.8% to 23.4% and then back up to 30.5%. How do you see the seasonality this year, where Q2 was up from Q1? Was that an acceleration of orders? Was that underlying growth? How can you sort of help us with our expectations?

[Shaun Peter Maine, CEO & Director]

So as a percentage, our services this quarter was 23%, which I think is, again, a continuation. I think you were kind of in that range again. But our -- very clearly, what we're trying to grow is our software and services revenue over time. And as we haven't acquired any company in Q2, you're going to see that. When you acquire new companies, that also blends into the mix, which makes it a little more difficult to get the real numbers. But what you're seeing here, as our gross profit also increases, it's an indication of us selling more services and cloud services. So I think the general mix of higher-margin software and services, you'll see where we're not doing acquisitions in a quarter, you'll always see that growth.

[Robert Goff, MD & Head of Research]

Okay. And you mentioned that you're looking to get your M&A back on trend. Could you perhaps tell us a little bit about the landscape and what you're seeing and how COVID-19 may have impacted that pipeline?

[Shaun Peter Maine, CEO & Director]

So we already had a very strong pipeline. There are some good companies, as I've mentioned, that have been impacted by sectors that did poorly during the pandemic. There's also some people that realize that they don't have the size and scale as people move to cloud to need this and this has provided some more incentive for them to become part of a consolidation. So we have a very good pipeline. And I think we've been able to assess the impact that COVID-19 had on companies. Again, before we buy these companies, they don't have the cloud-based services that we add to them once they become integrated into the Converge platform. So without those, some of them have had more difficulty during COVID-19. We can only buy them on the trailing 12 months whether it's been impacted or not. What we can do is if they reach those levels again, add it to their earnout. So when we acquire companies, we'll be explaining to you how it has shifted the acquisition prices down and that turns some more into contingent. I hope that answers your question, Bob.

[Robert Goff, MD & Head of Research]

And one last, if I may. Are there any particular opportunities that you're seeing open up in the marketplace with Red Hat or VMware or AWS?

[Shaun Peter Maine, CEO & Director]

Well, all the above, right? So when you've got -- the cloud space is healthy double digit, and those are the explosive areas. And really, as everyone looks to move, this is an accelerated people's digital transformation. So as applications and even horizontal applications move to the cloud, our ability to, one, enable that; and two, provide managed services around that is a key growth area for us. So also, there are companies that are dropping by the wayside who do not have our size, scale and breadth. As I mentioned, you look at our financials, you can't tell a pandemic is going on. We are not the same as everyone in the industry. And therefore, I think customers are also drawn to stronger partners. They like the fact that we are the fastest-growing IT service provider in North America. And therefore, there is safety in with a partner with our capabilities and our scale, and so there is more opportunity for us to grow at the incredible rate that we've been growing. So yes, all of the above with Red Hat and VMware kind of being the operating system business multicloud environment, with Microsoft, Google and Amazon experiencing such healthy growth around digital transformation, we're in the sweet spot of that.

[Operator]

[Operator Instructions] And your next question will be from Anja Soderstrom at Sidoti & Company.

[Anja Marie Theresa Soderstrom, Senior Equity Research Analyst]

So for the second quarter, how was the cadence in terms of revenue? Was there any part of the quarter that was stronger? And how was the sort of the momentum building into the third quarter? And how should we think about the momentum going into the rest of the second half of the year?

[Shaun Peter Maine, CEO & Director]

So we started April was very strong, May typically kind of drops off and then we had an incredibly strong June. We tend to, as you move a product sales company, its revenue tends to be split 30% in the first month of the quarter, 30% in the second month of the quarter and 40% in the third month, with a more software company where you tend to have quarterly subscriptions that tends to be much more weighted to the quarter end. And so we -- as we kind of experienced that, I think 45% of our revenue in the quarter came in June. So you'll continue to see that as we move to more software sales in addition to our cloud services that you'll have more of that skew towards the end of quarter. We continue to see strong demand. Again, we start off these quarters with not -- COVID-19 provides all kinds of uncertainty. All we know is what's in front of us, we continue to see strong demand for our products and services. And the sectors that we support, as we kind of go into detail, have been quite resilient. The one that was -- you'll notice from last quarter that grew a lot was manufacturing. Our Advanced Analytics group has done a super job of providing automated analytics around video to manufacturing force. A security guard watching a video is not going to know someone breaches a 2-meter rule. But an automated program that's analyzing the -- a whole 8-hour, 12-hour shift can provide a report to the shift lead that here was the violations that here's the people need training on social distancing. So we did see our analytics practice really benefit from some of these trends, solutions specific to COVID-19.

[Anja Marie Theresa Soderstrom, Senior Equity Research Analyst]

Okay. That's interesting. And then it seems like the COVID pandemic have more or less just helped you accelerate this digital transformation and demand to your solutions. Is there any way that this -- you have seen any challenges across because of COVID and -- that might build the couple of coming quarters and that should help you accelerate even more?

[Shaun Peter Maine, CEO & Director]

So just because our financials are superb does not mean -- this is one of the most challenging environments to be able to operate in. And I got to take my hat off. Our people are truly amazing. I think the way that we bought smaller companies, they tend to be more adaptive, but we've had closures, restrictions. Our people have found a way. Some people have just been during the headlights, not working for us, but our competitors, have just had -- have not known how to deal with, how do I get supply from somewhere else, how do I provide solutions when everyone is remote. Like look at us integrating 4 back offices in Q2 when everyone is remote. It's -- I mean the team is incredible. And so just because we make it look easy doesn't mean that it is. So I take my hat off to the team, they've done an incredible job. It is an incredibly difficult environment that we are really thriving in. And that's a testament to the leadership, but to all the people and the kind of mentality we have on solving our customers' problems, but it is a very challenging environment.

[Anja Marie Theresa Soderstrom, Senior Equity Research Analyst]

Okay. And also, Carl, in terms of the gross margin, is that improvement a product of their revenue mix? And are there now other puts and takes that help that? How should we think about that? You mentioned when you have -- when you make acquisitions, your hardware sales tends to become a bigger part of the pie. So that might then affect the gross margin a little bit negatively? Or how should we think about that in the coming quarters?

[Carl Smith, Chief Financial Officer]

So our gross margin has steadily increased. I think it's probably a record this quarter, over 24%. As more of our business is coming from managed services, our gross margin will continue to increase. As we do add acquisitions, again, depending on the size of the acquisition and maybe the mix, then it could have an impact on the gross margin. But generally, when you look forward, you should probably be thinking about gross margin sort of on a steady-state basis, trending up closer to the 30%. So as more and more of our revenue is coming from managed services and software, which is much higher margin than, say, hardware, our gross margin will trend up, and it might be impacted periodically as we do acquisitions, but the trend should be up.

[Anja Marie Theresa Soderstrom, Senior Equity Research Analyst]

Okay. And then lastly, just congrats on being named the fastest-growing company by CRN. I looked at that list and you were significantly above everyone else on that list. What you allude that to, Shaun?

[Shaun Peter Maine, CEO & Director]

So again, this speaks to, one, our ability to acquire and integrate companies this successfully. We are batting 1,000% in integrations. Everyone will tell you, "Oh, consolidations are difficult. You have ones that fail." We haven't. So part of that is the culture fit of the companies that we've chosen. The second one is Greg Berard's presales model and the practice areas. That has been something that has really driven the ability to cross-sell cloud-based services, managed services in a way that is really difficult to people, especially to the mid-tier. So really the way that we go and cross-sell, the kind of companies we buy, our ability to attract companies with similar cultures that have been collaborating together, that is a path which is difficult. That is -- a lot of people have tried that and have not been successful. And as a small-cap in Canada, to be on the top of that list, I'm extremely proud.

[Operator]

And at this time, Mr. Maine, we have no other questions. Please proceed.

[Shaun Peter Maine, CEO & Director]

Thank you. Well, I just wanted to thank you all for taking the time to join us today. As previously mentioned, we are on track for this being our strongest year yet despite the global and economic conditions businesses are finding themselves in. And as demonstrated by our strong performance during the first half of 2020, I look forward to updating our shareholders again when we announce our third quarter results. Thank you all for joining.

[Operator]

Thank you, sir. Ladies and gentlemen, this does indeed conclude your conference call for today. Once again, thank you for attending. And at this time, we do ask that you please disconnect your lines.