Last month, a pair of formerly high-flying public companies dedicated to consolidating their sectors threw in the towel.
Dentalcorp Holdings Ltd. DNTL-T and Converge Technology Solutions Corp. CTS-T kicked off strategic reviews, which are the investment banking equivalent of sticking a “For Sale” sign in the front lawn. Both companies grew by rolling up smaller rivals – in dentistry and IT consulting, respectively. Both saw their share prices drop by more than 60 per cent over the past year, triggering November’s board reviews.
Dentalcorp and Converge are far from the only fallen angels in public markets. There are scores of companies, particularly in the domestic tech sector, with acquisition-focused expansion plans and declining valuations. Former market darlings such as Nuvei Corp. and Lightspeed Commerce Inc. face similar challenges, and their boards may reach the same conclusions on the best paths forward.
No one is calling the roll-up growth strategy into question. It’s a proven way to build a business in a fragmented sector, an approach that has created billionaire founders such as Mark Leonard, at Constellation Software Inc., and Alain Bouchard at convenience store giant Alimentation Couche-Tard Inc.
Market leaders such as Constellation and Couche-Tard continue to expand through ever-larger acquisitions. But smaller roll-ups stop rolling when their share prices tank and cheap capital, in the form of low-interest-rate loans, dries up.
That’s what’s undermining Converge. A year ago, when investors gravitated to growth stock stories, the Toronto-based company could fund acquisitions with shares that traded for 11 times its earnings before interest, taxes, depreciation and amortization (EBITDA). After this year’s sell-off in tech stocks and the company’s internal issues, analyst Robert Young at Canaccord Genuity Group Inc. said in a report that Converge stock was trading at five times its forecast EBITDA, half the valuation of North American and European rivals.
The shift in valuation reflects a change in market sentiment. A year ago, investors were willing to put faith in management of growth plays as they searched for the next Amazon or Apple. Now, there is zero tolerance for missed financial targets or perceived performance shortfalls.
Mr. Young said Converge had failed to meet investors’ expectations when it came to integrating acquisitions and striking new contracts with clients.
With its shares at current levels, Converge faces a daunting challenge in paying for acquisitions. Its stock is too cheap to be used as currency in a takeover. Mr. Young reviewed 19 deals in the IT consulting sector over the past two years and found the average price paid for a company was 11.8 times its forecast EBITDA. At current valuations, Converge is dinner, not diner.
“We believe that there are a wide range of logical buyers of Converge, from strategic to financial, who may look at the gap to peers and under-levered balance sheet as an opportunity,” Mr. Young said. He highlighted European companies looking to bulk up their North American IT operations as potential bidders, along with CDW Corp., a Chicago-based company with significant Canadian operations. He said private equity funds are also likely buyers.
Dentalcorp faces the same valuation challenges. Shares in the Toronto-based company, backed by private equity fund L Catterton, currently trade at 8.5 times its forecast EBITDA, according to analyst Douglas Miehm at RBC Capital Markets. Comparable U.S. companies command a valuation of 18 times EBITDA. “The decision to conduct a strategic review process is likely due to the significant decline of the stock, and de-rating of the stock versus peers,” Mr. Miehm said in a report.
If Dentalcorp ends up being sold, analyst Gary Ho at Desjardins said in a report, the logical buyer is privately owned rival 123Dentist Inc., a Burnaby, B.C.-based company whose backers include Peloton Capital Management, KKR & Co. Inc., Sentinel Capital Partners and U.S. giant Heartland Dental.
Private equity funds have long been patient backers of entrepreneurs with roll-up expansion strategies. Unlike public investors, their affection for cash-spinning growth companies stays constant across market cycles. These fund managers were sellers of businesses in the last IPO boom. They will be buyers if more companies follow Dentalcorp and Converge’s lead, and put up “For Sale” signs.
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Andrew Willis