Converge Technology Solutions Corp

TSX:CTS

Earnings Call Transcript 2018-Q4

[Operator]

Good morning. 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's Q4 and Fiscal Year 2018 Conference Call. [Operator Instructions]Mr. Maine, you may now begin your conference.

[Mary Anne Palangio;Chief Financial Officer]

Thank you, Sylvie. It's Mary Anne Palangio, and good morning, everyone, and thank you for joining the call. Your main hosts today are Shaun Maine, President and Chief Executive Officer and myself. Before we begin, I'll take care of the housekeeping to provide the following 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 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 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 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 also refers to adjusted EBITDA, which is a non-IFRS measure and has no standardized meaning. Please refer to Converge's filings with Canadian provincial securities regulators for an explanation and reconciliation to the IFRS measures.I will now turn the call over to your host, Mr. Shaun Maine, CEO of Converge.

[Shaun Peter Maine, CEO & Director]

Thank you, Mary Anne. Good morning, everyone, and thank you for joining us this morning. I'd like to take this opportunity to speak about our great Q4 results and provide an overview of what we've accomplished over the course of 2018. Finally, I'd like to provide some commentary on what we are looking forward to during 2019 and why we are more excited than ever about Converge. Historically, we have seen that Q4 has been the strongest period for our U.S. operations, and we saw this trend continue this year. The now 8 companies we have completed transactions with continue to be an integral part of their client's IT spend, providing critical resources that allow them to effectively and efficiently run their companies. Furthermore, we are seeing an increase in spend from same account clients across the board, reflecting the operational leverage we are able to create through adding companies each with their own unique specialty.During the quarter, we entered into an agreement with Essex Technologies. We are extremely excited about this opportunity as Essex is a key partner of IBM and offering their cloud services technology in addition to a variety of AI, artificial intelligence solutions. In addition, Essex is one of the industry's leading cybersecurity providers, and by working alongside them, we bolster that segment of our service offerings. The cloud component of Essex is significant to our long-term strategy moving forward and which I have talked about in the past. I will speak more to developments on cloud and managed services later on.Our second transaction of the quarter was Lighthouse Computer Services, which is one of IBM and Red Hat's top partners. This is truly a transformation acquisition for Converge. With USD 82 million of revenue and approximately $4.7 million of adjusted EBITDA for the trailing 12 months prior to the acquisition, the company immediately contributes to our long-term goal of reaching $3 billion in revenue with over $100 million of adjusted EBITDA. However, the opportunity with Red Hat's applications is truly once in a lifetime opportunity. As many of you are aware, IBM has a bid to acquire Red Hat for $34 billion. Lighthouse is one of the leading providers of Red Hat technology and a long-term partner of IBM. As we anticipate the closing of the Red Hat acquisition, our already very strong partnership with IBM will strengthen even further as one of their top resellers of Red Hat and Converge should benefit from this relationship greatly.Beyond these 2 transactions, we continue to grow organically. We were pleased to announce this quarter that Becker-Carroll was awarded a contract by the government of Canada related to digital identity and authentication frameworks. This was another step forward in our blockchain strategy, and I continue to maintain that we will see meaningful recurring revenue and EBITDA from this segment of our business beginning in 2020. This contract validates our commitment to transformation technologies, and we will play an important role in the implementation of true enterprise blockchain strategies for large organizations in the future.Looking at the year as a whole, I couldn't be more proud of the Converge team and what we've accomplished in 2018 and the early parts of 2019. We've now completed 7 acquisitions to date and 1 strategic investment, and we are firing on all cylinders as we continue this strategy. With fiscal revenue of $459 million and adjusted EBITDA of $16.5 million for 2018, I am proud to say that we've accomplished Phase 1 of our 3-phase strategy and are moving into the second stage, which aims to continue growing revenue to north of $1 billion and achieving at least $50 million of EBITDA. While Phase 1 was a broad stroke approach of acquiring strategic companies in key target areas, Phase 2 is targeted towards regionalization and realizing cross-selling opportunities between our family of companies. The goal remains to enable our outstanding sales teams to execute and take advantage of entirely new suites of products. Our pipeline of acquisitions remain incredibly strong as we continue to see good acquisitions that are able to add value from day 1, and we have a long list of companies that we are confident will be able to do so. As many of you will recognize, cloud and managed services will play a key role in development as a business going forward. To illustrate the developments we have achieved in the services space, we've focused on monthly and annual recurring revenue and the continuing organic growth we expect. Cloud and managed services revenue was relatively insignificant compared to our total revenue in Q4 of 2017 and the acquisitions in 2018 have set this foundation for ongoing growth. Recurring revenue for the year amounted to approximately $75 million of which a significant portion comprised of public cloud sales rounding out our in-house offerings.Most importantly, this growth shows that we are well on track to drive meaningful revenue from cloud and managed services going forward, and more importantly, that we are delivering on our strategy of converting our acquisitions into hybrid IT cloud providers, ensuring that they remain integral parts of their client's IT strategies for the foreseeable future.On that note, one of our largest clients, a DNA genetics testing and analytics companies have -- in addition to the $7.5 million that they provided in revenue of cloud services this year, have an additional $22.5 million of MRR going forward, a great example of our continued customer loyalty. Our cross-selling opportunities continue to develop, and we are incredibly excited about that as well. While subsequent to the quarter, we recently saw one company from the Converge family of companies sell $4.9 million in Red Hat applications enabled by our Lighthouse acquisition. This type of integration and cross-sell shows the true value we are able to bring to the table by providing an umbrella for our operating companies to operate and thrive under. While this is only one example, we are beginning to see more and more types of these deals, making us extremely excited for what lies ahead.Prior to the acquisition of Lighthouse, they had seen 25% annual growth rate, and we've already seen a dramatic increase in that since that time. Further to our strategy of implementing increased rebates for the companies we've acquired, we have already seen an increase of 350% growth year-on-year in rebates, all falling -- dropping to the bottom line. As well, we continued to unlock trapped working capital by extending payment terms in our agreements with our suppliers. And recently, we had an extension to 70-day terms for our IBM business units, immediately freeing up significant working capital to the balance sheets of our companies.Over the course of this year, we will continue to roll out acquisition strategies and grow our revenue base as well as our adjusted EBITDA. We remain well on track to achieve our targets for Phase 3, consisting of $3 billion in revenue with over $100 million of EBITDA. As I've mentioned, our pipeline remains strong of acquisitions as we stay committed to our target of 4 to 6 acquisitions per year. We firmly believe that we will execute on the strategy we outlined when we first began in late 2017. With that, I would now like to turn the call over to our Chief Financial Officer, Mary Anne Palangio, to provide the financial update.

[Mary Anne Palangio;Chief Financial Officer]

Thanks, Shaun. And good morning, again, everyone. Before I begin the financial review, as a quick note of reference, the company was inactive operationally until the fourth quarter of 2017. Accordingly, we will provide a year-over-year analysis for the 3-month period ended December 31, 2018, where permitted. However, we will not provide a full year comparison between 2017 and 2018.As we announced last evening, revenues for the 3 months and 12 months ended December 31, 2018, were $136.1 million and $459.2 million, respectively. Revenue increased 158% for the quarter ended December 31, 2018, as compared to the same period the prior year. This is primarily attributable to the 5 successful transactions completed over the course of 2018 as well as the implementation of our cross-selling strategies that Shaun spoke about earlier between our operating companies.Resulting gross profit was $30.3 million for Q4 and $90 million for fiscal year 2018, generating gross margins of 22.3% and 19.6% for each respective period. Gross margin of 22.3% for Q4 2018 is an increase compared to 20.2% in Q4 2017. This is reflective of the strategic focus on cross selling, vendor partnerships and higher-margin sales revenue. We anticipate further improved margin as we secure additional sales from high recurring revenue components of our business, such as managed services and public cloud offerings.Selling, general and administrative expenses for the 3 months ended December 31, 2018, were $25.2 million, an increase from $10.8 million in the year prior. The increase in SG&A is reflective of our strategy to identify and acquire high-quality ITSPs we believe present long-term growth prospects in conjunction with our existing portfolio companies.As Shaun had mentioned, in Q4, we capitalized on 2 opportunities, which involved both Essextech and Lighthouse. Adjusted EBITDA, a non-IFRS measure, for Q4 was a positive of $5.8 million, and for fiscal 2018 was $16.5 million. In line with the prior year and expectations, Q4 saw strong performance from our U.S. operators. As of December 31, 2018, the outstanding balance on our loan facility was $73.3 million. As of December 31, 2018, Converge had a cash balance of $10.8 million on hand compared to $7.8 million at December 31, 2017, reflective of the seasonal trends in our business. Subsequent to the quarter end, we announced the acquisition of Software Information Services, LLC, for USD 11.5 million in cash, plus the issuance of a right for the vendors to exchange specific membership units in SIS for an aggregate of 8 million common shares of Converge over a 3- year period. While we typically adhere to our strategy of non-dilutive acquisitions, the company's large recurring revenue component warranted consideration for a partial share payment, of which we agreed to.Subsequently, as of March 2019, the issued and outstanding shares are 75.8 million with the total fully diluted amounting to about 97 million shares. I will now turn it back to Shaun for his closing comments.

[Shaun Peter Maine, CEO & Director]

Thank you, Mary Anne. Q4 was truly a phenomenal quarter for Converge, and we continued to deliver on the milestones we've outlined since we embarked on this journey. We have one goal in mind, establishing an industry-leading company that effectively transforms traditional VARs into hybrid IT providers, and all signs point to us having been successful so far. Ultimately, this is about delivering value to shareholders. And despite the success we've seen so far, we are only at the beginning of our strategy and will continue along the path we are on.On that note, I will open the floor to questions.

[Operator]

[Operator Instructions] And your first question will be from Kevin Krishnaratne of Paradigm Capital.

[Kevin Krishnaratne, Former Equity Analyst of Technology]

So on the quarter, you mentioned strength in the U.S. I'm wondering if there were any particular unit steps stood out to you above what you may have been expecting heading into the quarter? And maybe related, you also mentioned, Shaun, that you're continuing to see same account spend going up. Is that dynamic mainly related to cross-selling opportunities? And so just your thoughts on particular businesses that stood out and how they benefited?

[Shaun Peter Maine, CEO & Director]

Yes. Great question. So the real rock star of our Q4, even though there's only one month of the results is Lighthouse. Corus saw tremendous growth. I mean, Corus year-on-year grew by 27%, but Lighthouse, it has been an absolutely phenomenal acquisition with the software aspect. They sell more software than they do hardware and maintenance and the relationship with IBM and Red Hat being truly transformative. And we're -- I think we're almost at the end of Q1, and we're seeing that very strong growth into Q1 as well. As far as the sales, absolutely, the cross-sell of -- again, when we buy companies -- so I remember the analysis, the President of the West did on Key Information Systems when they acquired them, that they had only 1% of their client's IT spend. And so by cross-selling things such as our Microsoft Azure practice -- so we can basically -- we take e-mail to the cloud for our customers. That's a great example of cross-sell. I mean we -- again, with Key, we did 30 of those projects that -- to their existing customer base. So it is truly impressive to see 2 in 3 of our operating companies working together on deals and taking a larger share of the wallet of the existing customer relationships that their salespeople have.

[Kevin Krishnaratne, Former Equity Analyst of Technology]

Great. So again, just to kind of like summarize, you would have -- would you say that Q4, the standout was Lighthouse and just -- generally on its own, just that the Red Hat and the IBM kind of product offering has helped them there. And so as we head into Q1, is that when you start to see some incremental cross-selling opportunities from Lighthouse into some of the other areas in Converge?

[Shaun Peter Maine, CEO & Director]

Yes. And so again, Cisco has been very strong for us as well. We -- but the cross-selling -- so Lighthouse is doing a road show to all of our different companies. And as the Red Hat acquisition will be closing around the end of Q2 or beginning of Q3, we believe that, like, IBM will be putting a lot of focus and attention behind it. Again, in a multi-cloud environment, what Red Hat does through -- they allow you to share data in a multi-cloud environment. So all of our customers who are deploying things in the cloud require that. So the ability for the Lighthouse team to enable through their practice areas, all of our 145 sellers to be able to offer these solutions to our customers is meaningful, and you'll see it in our numbers.

[Kevin Krishnaratne, Former Equity Analyst of Technology]

And what are you seeing at -- just to pick again on Lighthouse as well. The Red Hat offering, it's Linux but it's also container and DevOps tools, and I think that those are seeing a strong pace of growth or acceleration just at the industry level. So can you just comment on how those elements are helping?

[Shaun Peter Maine, CEO & Director]

So one of the kind of neat things about our company is that we focus heavily on small and medium-sized enterprises. Large enterprises don't need help getting to the cloud, but a lot of smaller -- medium size, and so the state of small -- medium-sized company is up to 10,000 seats. They need help. And so usually, we will be the ones who will have installed their network. And when you move to the cloud, your cybersecurity team -- so we have great ones at Essex and Lighthouse -- open up your network and allow you to have traffic at Microsoft or AWS or Amazon or Google's Cloud, allowing traffic to go back and forth. And so what the Red Hat, Kubernetes allows you to do is share data across all those platforms with your on-prem and your off-prem ones. And so that enablement -- and again, Greg Berard, the President of Lighthouse took over in 2014. At the time, they really weren't a software partner. He has transformed them in over -- little over 4.5, 5 years into a major software provider, and now he's doing that across our platform. And this also speaks into annual recurring revenue. So we have monthly recurring revenue on our managed service and cloud practice, but the software deals, they have an annual recurring revenue piece as well. And we now have $200 million of backlog of recurring revenue, both on MRR and annual through software subscriptions. And some of the margins on the software side, especially into that segment of the market are very profitable.So as you see, our -- when we buy companies, we say usually they're around 3% EBITDA. Our blended rates are getting near to 4%, and they will continue to rise as we become more MRR and software focused.

[Kevin Krishnaratne, Former Equity Analyst of Technology]

That's great to hear. And so that did bring me to my next question then. You mentioned the $75 million in kind of cloud spending. And I did wonder how you think about the margin difference as your mix changes and certainly through some of the integrations and kind of the understanding of the network, you're able to extract some incremental margins as well through consulting type work?

[Shaun Peter Maine, CEO & Director]

Yes. Some of the public cloud margins aren't that great. It's the services that you provide around them which are key. Also, SIS, which we acquired January 15th of this year, has a fantastic managed service offering based on VMware called VMC on AWS, where if you want to move a workload to the cloud, you can basically just point and click from vSphere. So having those kind of offerings, which are high -- well, so kind of 18%, 20% kind of margins as opposed to some of just the -- if you're just putting someone on AWS, the margins are single digit. It's all the services around it. Our services average in the 30% to 40% range. And so you'll see in the numbers as that mix of MRR, the software side, those numbers are reflected as you see are -- we all say the numbers don't lie, and that's what you'll see.

[Kevin Krishnaratne, Former Equity Analyst of Technology]

Got it. Maybe switching gears into Q1. Can you talk about Q4 seasonally strong for the U.S. Can you remind us on how Q1 looks? And then remind us in Q1 of last year, there was strength out of Northern Micro. So how do we think about the comp as we think about modeling for the next quarter out?

[Shaun Peter Maine, CEO & Director]

Thank you. So as you know, the Canadian federal government's year-end is March 31. And so Northern Micro provides over half of its revenue into the Canadian -- sorry, in Q1. So they have a very strong quarter. The interesting thing we're finding is it's -- and you'll see our Q1 results, I think we're announcing on May 22, not just having Northern Micro having a phenomenal year, but it's all the U.S. companies as well. The cross-selling is -- it is tremendous to see the growth. And I will say Lighthouse has been transformative. Corus, our first acquisition, has been growing at, as I mentioned, 27%, 28% year-on-year. And they're now on top of that, able to leverage some of the Lighthouse services into their platform. On the West Coast, we're seeing it as well. So I'm very excited by our Q1 results as well.

[Kevin Krishnaratne, Former Equity Analyst of Technology]

Great to hear. Final question then for you just on the M&A front. You talked about a pretty good pipeline. And as you head into Phase 2, you mentioned targets focusing on more regionalization and cross-selling opportunities. So I'm wondering if you can give us a little bit more color on what you're thinking in terms of regions, any gaps in terms of services or product offerings that we might be thinking about filling as you look at your next few targets?

[Shaun Peter Maine, CEO & Director]

So we're -- I'm thrilled by -- with the acquisition of Lighthouse and SIS, our offerings, I'm very happy with. The one thing we'll be investing in, as we did in Q4, is sales enablement of those offerings on a regional basis. And then also, if you look at the map, we're light in the center. So we've got great East Coast coverage, great West coast coverage. But in the center of the U.S., we -- Texas has got 4 of the top 10 population cities in the U.S. And so that's a major focus for us. Toronto, we've got great coverage up in Ottawa. Toronto has been a gap that we're looking to fill as well. So I think in this year and some of the offerings, you'll see more acquisitions around the center. And up in Canada, we want to cover the Canadian banks, obviously, and insurance companies in Toronto are a great target market for us as well.

[Operator]

Next question will be from Ralph Garcea at Focus Merchant Group.

[Unknown]

Just following up on Kevin's last question there on the M&A pipeline. Are you looking at smaller guys if you find someone where you can leverage some of their cross-sell -- some of their IP through our cross-sell strategy? Or they would be similar to Lighthouse and SIS, so in the $100 million to $200 million range in revenue?

[Shaun Peter Maine, CEO & Director]

Yes. So out of the 13 companies that are currently in our pipeline, there's 2 that are, I would say, larger in the kind of $175 million U.S. size. A lot of them tend to be around that kind of $100 million of the Canadian size, range from $70 million U.S. to $130 million is kind of a sweet spot. There are a couple of smaller ones that provide coverage. As we've stated, the NFL is pretty clever. They cover all of the major population centers in the States, and that's where our customers are. So if we need regional coverage in a certain area that someone's specialized in that city, we'd go and acquire them as well. But as for the most part, the kind of $100 million size, as we get bigger, we can consume larger and larger companies without risking our culture. So we'll look for some of the larger ones as well, which is -- you wouldn't want to have one that was a, say, $500 million, $600 million in size that would swallow your culture. So we've been targeting -- say, about $100 million to $250 million has been kind of the sweet spot, and I think we'll continue -- most of them seem to be in that spot as well.

[Unknown]

And are those guys active -- in active sales processes? Or they've seen what you guys have done within IBM and Red Hat, and they're just calling you up out of the blue looking for a home?

[Shaun Peter Maine, CEO & Director]

I joked that IBM thinks -- it felt like speed dating -- with a lot of companies that are very attracted to our model where a lot of the strategics wipe out the management teams and obviously, the people that are there, they've built the company over 25 years, they want to participate in it. And yet, they tend to be one-trick ponies of the smaller side because they can't invest in all this public cloud infrastructure. So when we buy someone and add the ability to cross-sell the various services in the public cloud and the software side and the managed services side, that allows them to, one, stay with their company, but experience this growth. So it's a hybrid model. There are a couple that are running processes. We tend to not go for ones that are processes. We're fortunate enough that we have -- again, our target is 4 to 6 a year, and I've got 13 in the pipeline. So we're not in any shortage, and we've been very disciplined about how we buy them and the prices we buy them. So long may that continue.

[Unknown]

Okay. That's great. Just on the margins for Q4. I mean, it looked pretty good that you mentioned the software subscriptions in Red Hat and IBM. On the IBM side, I mean, do you have access to sell their full cognitive solutions? Or are you selling their middle-worth products? What's sort of a high-growth area there in their software side for you?

[Shaun Peter Maine, CEO & Director]

Yes. So the high-growth areas, you're absolutely right, like Watson, their cognitive solutions or AI things are the software side of their process. We still have a very healthy product business, but the key growth areas are much around the software side. And obviously, with the Red Hat acquisition, I mean, they're spending $34 billion on Red Hat. We are their top partner. So we're the #3 IBM VAR worldwide and a top Red Hat partner. And we have -- I think we were put on stage with IBM to explain how this strategy works and why it's so important. And for us, enabling the channel the way we are, we're doing exactly what IBM wants us to do around the Red Hat acquisition. Because of the transaction going through, they can't deal with Red Hat directly. So we're able to provide a really useful function for them. So we're going to see -- we're tremendously excited by Q3 and Q4, once the Red Hat acquisition is done, about the opportunities it means for our companies.

[Unknown]

Okay. And then just a clarification. On the DNA Genetics example you gave, can you just go through the numbers again for this year?

[Shaun Peter Maine, CEO & Director]

So we signed a $30 million deal of monthly recurring revenue AWS deal. $7.5 million of that was in the first year. There's $22.5 million of it still to go, and that's all MRR. And so that's an example of a company who has massive data requirements that has outsourced that to the cloud. We provide that service for them and analyze the spend on -- you should put this workload here, this application here. But it's just an example of one of our customers using us to have a public cloud offering for their data that they're using in their business.

[Unknown]

And over time, I mean, would the Azure contracts be a similar size or similar stuff you're doing with Red Hat just from a dollar value?

[Shaun Peter Maine, CEO & Director]

No. So that tends to -- the Silicon Valley one, so BCTs are kind of in Silicon Valley. They tend to be more hyperscale. Most of our accounts tend to be more of the small and medium size. So I mentioned our Microsoft practice grew by 400% last year. I think everybody is putting their e-mail in the cloud on Azure. So we're seeing a lot of that growth, but it's on a smaller bite size, not on those massive contracts. The BCT guys tend to get the [ whales ] but they're indicative of what customers are doing. So that's why I highlighted.

[Unknown]

Okay. And then just lastly on the payables comment you made. I mean, what sort of leverage do you get as sort of cash flow, even an approximate number from those extra 10 days? And how has that helped your liquidity in the quarter?

[Shaun Peter Maine, CEO & Director]

Well, so as you know, the whole model around acquiring companies is by -- our secret sauce is higher rebates, cross-selling and moving our terms, and sourcing capital. So the example that we usually use is per 100 days of -- sorry, per $100 million of acquisition, that additional 10 days is approximately $2 million. So that's meaningful.

[Operator]

[Operator Instructions] And currently, Mr. Maine, it appears we have no other questions. So I would like to turn the call back over to you for additional comments.

[Shaun Peter Maine, CEO & Director]

Great. Thanks, Sylvie. And thank you, everyone, for joining our call. Our AGM will be on May 9 and our Q1 call will be on May 22. We look forward to sharing our updates with you then. Thank you very much.

[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. Have yourselves a great weekend.