Transcom - Waiting for the Turnaround - Initiation | Positioning
Dear All,
Please find our initiation note on Transcom, here.
Transcom is suffering from lower customer volumes (in eComm & Tech) which started in Q2 2023 and continues at the present, the business has also had management turnover with a new CEO and a structural shift in the market with the adoption of new AI related products which is creating uncertainty in the sector and leading to a valuation re-rating with Transcom and its sector peers (as reflected in the secondary trading prices of the debt and equity).
Investment Rationale:
-We are inclined to take a starter 2% of NAV long position in the Senior Secured Notes at the current trading level of 66.
-We are constructive on the notes because of the current trading price (and the implied valuation multiple through the notes), the levers around the cost structure, (70% + variable cost), capex cuts and no acquisitions going forward as well as implied shareholder support. Additional tailwinds which have not been priced in yet including resumption in growth in the higher margin eCommerce & Tech segments, winning new contracts (especially in the key US market) and better execution from a newly appointed CEO (from Transcom's biggest competitor).
-The key unknowns include will AI lead to a loss of customer contracts, will the new contracts be priced at lower margins and when will growth accelerate leading to free cash generation and de-leveraging?
-Our initial position sizing reflects our cautious yet constructive stance on the situation. If we see progress in an operational turnaround in the subsequent quarters, we may be inclined to increase our exposure to the notes.
AI headlines - more noise than substance
-We think the headlines (which have caused the bonds to fall from par at the beginning of the year to the mid-60s) from the growth in AI are not as disruptive to the business as market participants expect. In their recent quarterly numbers, management emphasized that 41% of their existing customers already use a form of AI product.
-Our view is that there will be a short-term churn or mix shift towards new contracts and AI friendly products which may or may not be accretive to margins however that should be offset by the ability to cut costs given its variable nature.
Recent Results - lots of noise around a repositioning
-Growing topline: Q2 revenues grew by 3.4% (mostly through its "buy and built" strategy). Organic growth was low with the exit of a low margin Spanish contract.
-Leading indicators of growth remain strong: NPS scores remain high at 73, new clients, strong sales pipeline and better capacity optimization actions.
- Is the margin drag temporary?: Q1 EBITDA was €16.8 million (9.3% margin) vs. €20 million (11.4% margin) in Q2 2023 due to challenges in EMEA with reducing and repositioning of volumes as well as short-term investment in building a sales team in the US.
-Cash burn due to high debt service: Operating cash flow has halved to €6.1 million with capex remaining low at €2.8 million. However, the business burnt cash by €11.8 million due to high cash interest & lease payments of €15.1 million.
-Meanwhile liquidity remains strong with the cash balance at €39.6 million and undrawn RCF to total €67 million. Net leverage remains elevated at 6.4x. on an pre-IFRS basis.
-Still investing in growth: building a sales team in the US which will be a drag to margins.
-Slight growth in end market offset by margin declines: While revenues increased by 2% + in two of its biggest verticals (eCommerce & Tech and Services & Utilities), EBITDA margins declined from 16.5% to 11% (eCommerce & Tech) and from 10.4% to 9.2% (Services & Utilities).
Near-term guidance points to gradual improvement but we remain conservative
-Management expects positive free cash flow by the end of 2024 with target leverage expected to be 4.0x and deleveraging to continue into 2025. However, Sarria’s projections assume trough EBITDA and elevated leverage in 2024 and improving credit metrics starting in H2 2025 with some help from the existing shareholder to facilitate a refinancing.
We look forward to following what could be an interesting turnaround situation.
Happy to discuss
Saahil
T: +44 203 192 0200
www.sarria.co.uk