We’re not into the Converge Technology story, this portfolio manager says

High-flying stock Converge Technology Solutions (Converge Technology Solutions Stock Quote, Charts, News, Analysts, Financials TSX:CTS) has certainly accumulated its share of admirers over the past couple of years, which has been comparable to the Canadian tech company’s habit of acquiring companies in the IT services and solutions space. 

But count investor James Telfser of Aventine Investment Counsel among the skeptics, both of the stock and Converge’s roll-up strategy.

“This is a name that we do not hold in our fund. We tend to be quite concentrated and we hold about 18 positions right now in our Canadian equity fund. But we did look at look at Converge,” said Telfser, partner at Aventine, who spoke on BNN Bloomberg on Friday. 

Converge made huge strides in 2020 where the stock went from basically a buck to $5 when it was all said and done and then CTS followed it up with more than a double so far in 2021, currently trading around $11 for the past few months.

The company has been growing by leaps and bounds as it consolidates in the fragmented value-added reseller (VAR) space. Converge started a multi-year strategic growth plan in 2018 pushing to make between four and six acquisitions per year. That’s in North America, while the company recently branched out to Europe where it hopes to continue the process with three to five more pickups per year. All told, Converge is in line for over $2 billion in revenue run-rate by the end of 2021and between $100 and $200 million in EBITDA, with the aim of hitting a whopping $5 billion in revenue by 2025.

Converge recently completed the acquisition of German IT solutions company Rednet AG, along with three more acquisitions since the start of its most-recently reported quarter, the company’s Q3 2021. There, CTS managed to grow its revenue by 93 per cent year-over-year to $367.3 million with adjusted EBITDA up 29 per cent to $18.9 million.

“Converge continues to execute on all aspects of its strategy and we are extremely enthusiastic to have closed our platform acquisition in Europe. The Company continues to invest in talent and expand its service capabilities to its customers across North America and Europe, as reflected in our very impressive recurring revenue managed services growth” said Shaun Maine, CEO of Converge, in a November 10 press release.

But for Telfser, both Converge’s share price appreciation and M&A strategy are not what they seem to be.

“We missed it,” said Telfser, speaking of the rise in Converge’s share price over the past 18 or so months. “We missed a big run up there in the stock.” 

“It’s a growth by acquisition story, so they’re acquiring service companies on the technology front to be able to provide all sorts of services or give them the Microsoft or the tools that businesses need to succeed on the technology front and in the cloud,” he said. 

“And so, as long as that keeps on rolling forward, they’re going to be generating cash and away they go,” he said “What deterred us from the stock was that they were issuing a lot of equity to be able to do that. And like any good roll-up, as long as you can keep your valuation elevated when you’re making acquisitions, it’s going to be accretive and if you get to a point where you’re generating free cash flow to fund those acquisitions, away you go,” Telfser said.

“We didn’t think it was a very high quality business on the actual the nuts and bolts. It’s not a business that we’d love. But if they continue to do acquisitions, the stock is going to continue to work as it has, so I think if you’re in it for that thesis it’s proved correct and you should continue to hold it,” he said.

Paradigm Capital analyst Daniel Rosenberg reviewed Converge’s latest quarter in a report to clients, saying the numbers came as expected although gross margin and profit were a little under estimates. But Rosenberg said the future looks bright for CTS as the IT Services industry has some strong tailwinds supporting it going forward, while the company’s roll-up strategy has so far proven successful.

“We believe a large opportunity to expand and cross-sell into Europe should drive continued share price appreciation over the long term. Industry tailwinds support organic growth and a well-capitalized balance sheet and proven M&A model point to a substantial growth opportunity. Early indications with new customer wins and sales accolades suggest the strategy is working and cash flow is beginning to increase,” said Rosenberg in a November 12 report.

With his update, Rosenberg trimmed his target for CTS from $13.75 to $13.50 and kept his “Buy” rating, with the target representing at press time a projected 12-month return of 22 per cent.