Description

Despite the recent run in the equity over the last 12 months I believe Constellation continues to offer compelling value.  The equity could have 30-40% upside by YE 2018 from current prices and might be trading at 15x 2019 Cash EPS, assuming 20x 2019 cash EPS of $47.  Cash has been building, and at historical returns, Constellation could deploy >$1 billion of cash in the next year and add $7 EPS (more if they use some debt).  Constellation could continue to compound at attractive rates beyond this forecast period.

Business

Constellation Software sells mission critical, high switching cost, high recurring maintenance fee software platforms across many niche verticals, and acquires vertical market software companies.  Constellation's 50+ verticals include education, home building, manufacturing, facilities maintenance, and healthcare.  These are extremely niche software systems that are too critical to rip out, and as a result are well insulated from competition.  Constellation’s software offerings are typically a very small percent of the customers’ budget but critical to their operations.  For this reason I believe Constellation will have no trouble growing at GDP-like rates over the long term due to superior pricing power.

I do not believe that a shift to a cloud model would present a risk to Constellation, because these verticals are less competitive than larger enterprise verticals.  They are smaller verticals that are uneconomical to build to suit for larger competitors.  And even so, many software vendors have shown that economics can be maintained or improved in a cloud model.

Management

Mark Leonard is the chairman, president, & founder.  He writes an intelligent and frank shareholder letter that is useful for learning about his strategy.  Mark has a very strict capital allocation framework that has created 20% returns on past acquisitions.  Mark runs the business very conservatively, with no net debt, and I heard you guys like conservative balance sheets.  Mark doesn’t think of himself as a “dealmaker”, he is looking for businesses that he wants to own forever.  Constellation’s M&A model seeks to radically improve the acquired businesses for the long term.

Unit managers are given a lot of autonomy to run their units, and the top management and 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 three and ending in year five.  The senior managers have an unusually long average tenure with the company, some more than 20 years.  Unit managers have recently been given more autonomy to deploy capital into bolt-on acquisitions as well.

M&A

I believe TAM is perhaps much bigger than the market believes.  The acquisition pipeline is vast, possibly as large as 30,000 companies.  I don’t think the quantity of good target companies is the bottleneck as much as valuations, and valuations aren’t a permanent condition.  In some ways, Constellation’s intrinsic value is counter-cyclical inasmuch as the verticals that they serve are only mildly cyclical, the vast majority of revenue is recurring and fixed in nature, and acquisition opportunities are counter-cyclical.  The worst year of earnings growth was 2009 at 15% as the company was able to continue buying assets relatively cheaply and had acquired assets in 2008.  The business performed well during the GFC overall, shrinking organically by a relatively small amount in overall revenue, but growing dramatically via acquisition.  Also the Japanese JV indicates that Mark is willing to get creative in finding new ways to deploy larger amounts of capital. 

Though Mark has conceded that returns can’t be as high on larger acquisitions as they were on earlier ones, he still intends to keep returns on capital above the rate of S&P companies.  Even so, the IRR on TSS was >20% in what was not a buyer’s market. 

Constellation has compounded cash earnings 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.  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.  

Organic Growth

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.  Many naysayers I suspect put undue weight on this metric.  Mark focuses intensely on the cost of growth, whereas many traditional tech investors ignore these costs and focus entirely on growth rates.  Mark believes that if the growth comes at a low ROI, then it’s not a worthy goal to have. 

Conclusion

I believe that Constellation trades at a market multiple, and you get S&P-type organic growth, above average business quality, above average returns on capital with Mark and business unit managers doing acquisitions at 15-20% returns on capital, and well above average management and capital deployment discipline.  These factors should produce above S&P returns with less risk.

Risks

-The supply of good acquisition targets available at reasonable valuations continues to be dismal

-Law of large numbers.  Constellation has gotten large, so it’s going to be hard to get larger at the same rate as prior largening happened.

-Amazon

-It’s become a hedge fund hotel, and a lot of the new owners are just looking for a good story

-Mark Leonard retires.  Though, Constellation has a deep bench and Mark has cultivated many unit managers in his mold.

Catalyst

-M&A