Constellation Software Continues To Shine

by: Implied Value

Summary

Blowout quarters are becoming pedestrian as CSI has been so consistently good.

Skeptics overlook alignment of management interests and long track record of success.

Valuation is still reasonable despite good run in 2014.

Constellation Software (OTCPK:CNSWF) or "CSI" reported Q2 earnings on August 1. As usual, the company put up excellent results for the quarter as revenue grew 39%, adjusted EBITDA grew 37%, and adjusted net income (ANI) grew 30%. While most of the growth were driven by acquisitions, organic growth was healthy at 5%.

The big TSS acquisition that CSI did in late last year also showed good progress. In Q1, Leonard (CSI's president) admitted they were not pleased with the margin at TSS. In just one quarter, the company was able to improve adj. EBITDA margins from 5% to 10%. More improvement should be on the way as TSS margin is still significantly below rest of CSI's margin of high teens.

As I discussed in a previous article (link), Leonard and his team have an outsider-like mentality and through numerous acquisitions grew the company to a vertical market software juggernaut. Having followed the company for a few month now, I've learned a few more things about their business and their worldview:

Giving guidance

  • Does not give any guidance
  • Does not mange to street expectations

Acquisitions

  • "Buying and holding forever businesses"
  • Ramp up to 50 acquisitions is a challenge
  • Large transactions proceed very quickly because of broker deadlines
  • Smaller transactions have longer process => "We contact companies, we start to engage in conversation, hopefully a decade later, we have a transaction."
  • Prefer to do numerous smaller transaction vs. large transactions
  • Use IRR as metric for acquisitions. Multiple scenarios are built into the models. The bar is very high
  • Most acquired businesses tend to be better after 1 to 2 years
  • Organic growth may suffer as managers integrate acquisitions

Dividend policy

  • "Torn" on dividend
  • Will consider sacrificing the dividend if an attractive acquisition comes up

SAAS vs. traditional on premise

  • Sells monthly/annual subscriptions vs. perpetual licenses
  • Higher attrition
  • Lower sales and marketing expenses
  • Like a drop in price

I find higher attrition a little surprising. The reason seems to be low switching cost (literally price is low due to competition). Leonard believes economics of perpetual licenses is more attractive due to negative working capital of upfront payments. He noted that subscription period are becoming longer and even Salesforce.com is starting to bill annually. Overall, he believes CSI's business model will become less attractive as higher revenue shifts to SAAS, but longer subscriptions will help alleviate some pressure.

Skepticism

For years, CSI has traded at a discount (relative to hyper growth companies) due to, what I believe, skepticism over sustainability of its performance. The complex structures makes it hard to evaluate the business. Unless you are an expert every vertical that CSI operates in (CSI has hundreds of subsidiaries), you really need to have faith in management. I certainly don't know exactly what is goes on. The volume of acquisitions also give management opportunity to do accounting shenanigans.

What makes me comfortable though is the alignment of interest by management team. Significant component of compensation is the annual incentive bonus. 75% of after-tax bonus must be invested into common shares. Those share must be held for 2 years and only one third can be sold in years 3, 4 and 5. This incentivize employees to reap the fruits of their labor and helps to ensure that transactions are done to grow intrinsic value, not just making the company bigger.

Valuation

Shares have enjoyed a nice run since my first article, gaining 26% to CAD$273. This compares with earnings growth of 42% in the first half. Previously my estimate for 2014 EPS is USD$11.8 (though based on H1 results it looks like that is too low). Given appreciation of USD relative to CAD (shares trade in CAD but presentation currency is in USD), shares still trade around 21x 2014 P/E. Essentially there has been little multiple expansion the shares have merely kept pace with earnings growth and currency fluctuation.

To repeat my previous article: "the attractiveness of Constellation Software's stock is primarily a function of your view of future growth prospects". Right now the story seems well understood and a decent "deal premium" has been built into the share price. Short term, it's probably not the most ideal time to be an aggressive buyer. My approach after the first article was to take a half position and to add on pullbacks (which I would aggressively do). If the price runs higher (as it has) then I'll happily take my gains, albeit lower than if I had taken a bigger position. But that's not terrible either.

Disclosure: The author is long CNSWF. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I bought CSU shares on the TSX