Description

Thesis:

We believe that Constellation Software (CSU CN) could have ~ 30% upside by YE17 from current prices and might be trading at ~13.5x 2018 Cash EPS.  The math to get this upside assumes CSU could trade for 17.5x forward Cash EPS by YE17 and assumes a 2018 Cash EPS figure of ~$29.50 USD, representing a ~22% EPS CAGR over this time frame.  Over the last 3 years the median forward PE using street estimates has been ~17.5x (Bloomberg figures).  The forward multiple was higher throughout 2015, but lower prior to mid-2013, likely because the name was less well understood and was less liquid in the past.

In our opinion, CSU has compounded cash earnings / free cash flow per share at very attractive rates of > 30% historically and may be a compounding machine for many years going forward just like it has been in the past.  The traits that have enabled the high compounding in the past seem to be in-tact for the future albeit the compounding will continue at a lower rate.  The TAM for CSU to continue buying VMS businesses is quite large and the historic ROICs are also outstanding.

Note. The headline numbers used in the VIC financial info are CAD. The company reports in USD, but is quoted in CAD.

Business Quality:

Constellation Software is a Vertical Market Software (VMS) provider that acquires mission critical, high market share, high switching cost, high recurring maintenance fee software platforms across more than 50 industries; typically focused on billing, administrative, and operational systems.  The key software platforms they manage provide the software backbone for transportation systems, education, home building, manufacturing, facilities maintenance, and healthcare systems.  These are extremely niche software offerings that are too critical to rip out while operating in mature markets and as a result are well insulated from competition.  Our research has shown that Constellation’s software offerings are typically a very small percent of the customers budget, but, critical to their operations, which leads to high pricing power.

The management team at CSU has been meeting with other management teams at various high performance conglomerates to better understand how they have scaled and to share best practices.  CSU actually spent time on their 4Q15 earnings call discussing how they recently met with the Transdigm (TDG) management team in this regard.  Both companies have annuity like aspects to their cash flow streams, possess significant pricing power, and are able to buy and improve assets within their markets given all of the free cash flow they generate.  Studying other “HPCs” shows that CSU may have plans to be much larger one day and wants to structure the business accordingly.  It also demonstrates how thoughtful the management team and senior leaders at CSU are considering their quest to learn and become better over time.

We’ve actually never heard about a public company studying other public companies with admirable track records to see what they can learn and it’s an efficient way to find solutions to the more complicated issue of compounding an increasing pool of capital at high rates of return.  The company expounded on this more in the 2015 President’s letter released in April and that is worth a read.

Management:

Mark Leonard is the Chairman, President, & Founder.  He is an extremely impressive capital allocator and runs the business in a conservative manner, historically, without much leverage, even though we believe that the assets and cash flows could likely handle much more leverage prudently.  If you bring up the term “deals” to him he’ll quickly counter with the fact that they don’t do deals - they acquire with the intent of holding the businesses forever.  This acquisition framework naturally creates discipline in the types of assets they are buying that they think can grow the value of over-time and that discipline has been passed down to much of the senior leaders, or division heads within the company, who also strike us as impressive capital allocators.  The senior leaders in the company and management team all have a lot of skin in the game with their equity ownership and bonuses go back into equity with a lock-up schedule that vests starting in year 3 and ending in year 5.  Many of the senior leaders have been with Constellation for > 15 years.

You can read about Mark Leonard online in news articles and various business school periodicals where he has presented over the years.  But, perhaps the best way to learn about Mark and the company he has built is by reading the last ~10 years of Annual Shareholder Letters.  These letters are unique in transparency and insight into the business and operations.  The earnings call transcripts are also helpful.    

Historic Compounding:

Via organic top line growth and high incremental EBITDA margins combined with inorganic growth the company has grown adjusted cash earnings per share at the following rates each of the last 5 years.

2015: 35% y/y

2014: 36%

2013: 17%

2012: 22%

2011: 42%

The company is much larger now than it was 7 years ago, but the worst year of earnings growth was 2009 at 15% (Bloomberg figures) as the company was able to continue buying assets relatively cheaply and had acquired assets in 2008.  In our opinion the business performed well during the GFC overall, shrinking organically by a relatively small amount in overall revenue, but growing dramatically via acquisition.   

We believe that one of the key items investors should focus on is the percent of revenue that comes from maintenance revenue, which is high margin.  This revenue line continues to become a higher % of revenue over time and margins should benefit as a result if CSU does not need to overly reinvest this into expenses such as R&D or S&M.  Organic growth more recently excluding FX has been light, isolated in particular to lower margin revenue lines and some shrinkage from assets they bought recently.

Variant Perception:

The key investment debate to consider seems to be a) can CSU continues finding businesses to acquire at attractive rates to deploy their FCF while b) growing their top line organically from the existing asset base.  Our view is given all of the measures the company is taking to scale their acquisition process, the size of their acquisition pipeline, which is currently ~30K companies and growing, and the fact that some geographies such as Europe may be in the early innings for CSU to map out and apply their acquisition process alongside TSS that we think the company could prove successful over time at deploying a healthy amount of their FCF into M&A.  Management has not given explicit guidance on the hurdle rate, but, they have insinuated that they would likely return capital to shareholders over time below a reasonable threshold.  It is our hope that CSU is building the processes and systems to continue scaling cash deployment at attractive rates.

Other soft signals from management’s ability to scale the model exist as well: a recently expanded credit facility, the long-term debentures management successfully created they could issue more of in the future, discussion of cutting the dividend if the right acquisition came along, and the potential to partner with existing owners, or private equity firms to find, buy, and improve larger size assets.  They’ve discussed some of the latter points in their recent earnings calls.  Most interesting perhaps was the comment in the 2015 shareholder letter about scaling their tuck-in acquisitions to 100 per year if they are successful at teaching capital allocation below the division head level.    

For what it is worth - it’s interesting to do a case study on how much CSU was able to improve the margins at TSS before they stopped breaking it out on a standalone entity, as it is now consolidated.  CSU may be in the early stages of creating a “Berkshire” like effect in the VMS space, whereby owners of assets may want to sell, or partner with CSU for reasons that are not entirely valuation based.  It’s of course not lost on us that this isn’t always the case and valuation will play a vital role in the majority of acquisitions.  However, CSU’s reputation is one of improving assets under their ownership and owning the assets forever, rather than running them with a private equity like mindset of short term ownership and certain exit.  Often owners selling out prefer the former.    

2018 Earning / Valuation:

The below metrics are measured in $USD.  The company’s stock is quoted in CAD, but reports in USD.  CSU was written up in 2014 by author “ima” and we refer readers to that write-up for information on IRRs achieved with acquisitions, historically.  We don’t think much has changed since this time, although, mid-size acquisitions would likely have lower cash on cash IRRs and larger acquisitions, those greater than 100m or more in size, could be closer to a low teens, or low double digit unlevered ROIC.  The company has discussed in their conference calls a new tiered IRR hurdle for acquisitions depending on size, versus their original framework of a one IRR “must fit all” threshold.

The management team does not provide annual guidance, but the historic compounding algorithm serves as a reference to how CSU may be able to grow now through 2018E.  The company does say however that they expect organic growth over time to approach a MSD CAGR.

If CSU is able to grow organically top line LSD measured in constant currency, improve consolidated EBITDA margins by ~225bps in total, spends ~50% of FCF per annum on tuck-in and mid-size acquisitions, and spends an additional ~325m in total on a large acquisition that follows a partial/majority standalone financing framework similar to their 2013YE acquisition of TSS (TSS was ~325m in USD spend at the time) then 2018 Cash EPS could be ~$29.50 per share.  These larger acquisitions are harder to forecast, may not occur till later in the forecast period, or at all, but we do believe remain a key goal for the company to execute upon as outlined in conference calls.

At a ~525 CAD stock price and using a 1.31 CAD exchange rate to USD Constellation is currently trading at ~$400 USD per share, which would imply a 2018 P/E of ~13.5x Cash EPS if the company is able to execute as described above.   Of course, M&A is inherently hard to forecast.

On the Q4 earnings call, in a somewhat uncharacteristic manner, the Chairman, Mark Leonard, pointed out that if a $1B acquisition presented itself, and had all of the characteristics that CSU requires to make an acquisition, that they’d pull the trigger.  Of course, CSU has many prerequisites to satisfy before making an acquisition, so it’s hard to say how likely it is they’ll find the right candidate.  He was quick to point out that they did not have anything like this currently in their sights.  The Chairman noted in the most recent shareholder letter that they will also re-start their public equity investing strategy in other VMS businesses, which represents another avenue for the company to attempt to deploy all of the excess capital they generate over time into attractive IRRs.

Risks:

CSU in some ways has counter cyclical properties.  If markets continue to melt up they may not be able to find acquisitions that fit their high IRR hurdles, which would hurt their ability to compound earnings and could cause them to begin returning capital.

CSU may be unsuccessful in bidding for larger assets over time to chew up all of the free cash flow they generate as larger assets are often more competitive deals with multiple bidders, lower IRRs, and are often being levered at ratios that are far higher than CSU is willing to attempt.

Organic growth could continue to come in lighter than expectations.  If this persists management might need to spend more on R&D and S&M to drive organic top-line initiatives, which could depress margins.

Mark Leonard has a deep talent bench below him, but he’s been running the business a long time and could decide to step back from his duties over the next few years, which might depress the multiple if this occurred, or worse, disrupt the culture of discipline within the company.  CSU at the end of the day is a remarkable case study in discipline.

Technology research risks:  CSU is synonymous to a hyrdra with dozens of heads representing various markets and product lines, making it resilient and diversified often with high market share in each vertical.  However, it is also tough to diligence each vertical and the particular dynamics within each given how small these businesses are.    

Conclusion:

CSU may have a long run-way to continue compounding given the size of the TAM and we admire what the management team has achieved, so far.  We believe that we are at an inflection point in their strategy of shifting more time and energy into larger acquisitions while simultaneously pushing smaller tuck-in acquisitions down to the business unit level.  With high insider ownership, a remarkable culture and a track record of compounding, along with a large acquisition pipeline it makes sense to us to continue betting on the platform to scale over time via a combination or organic and inorganic growth.

Disclosure:

We and our affiliates are long Constellation Software (CSU CN) and may buy additional shares or sell some or all of our securities, at any time. We have no obligation to inform anybody of any changes in our views of CSU. This is not a recommendation to buy or sell securities. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusion.

Catalyst

Earnings.  M&A.