Constellation Software Part 2: Where Do We Go From Here?


Explores cash generated and return on invested capital.

Discusses the unique operating mentality and process.

Highlights key risks including some recent questions surrounding acquisition quality.

This is Part 2 in a short series on Constellation Software (OTCPK:CNSWF). This report covers (1) The Q4 conference call (2) free cash flow generation (3) growth by capital allocation. (4) the balance sheet (5) challenges as they grow (6) changing software dynamics (7) accounting siscussion and (8) concluding thoughts

Part 1 discussed the recent quarter, rise in operating margins and slowing organic growth. Part 3 will discuss valuation.

(1) Q4 Conference Call

On the conference call, management gave investors plenty to chew on for the upcoming year:

  • The hunt for elephants continues. And while they looked at upwards of 20 large acquisitions last year, as investors are well aware, none closed.
  • TSS was impacted by a 15% swing on FX and delivered "fairly positive" organic growth in Europe. In general, European organic growth is better than when reported in U.S. Dollars
  • Continues to reaffirm lower hurdle rate on larger transactions
  • They seem to remind listeners every conference call that the focus of business managers is not just management. It includes being capital allocators and thinking like a long-term owner:

And when you start talking about most of them as acquisitions [and] completely involve in these things is that you hold forever, [then] what's happening in the very short term in the macro world hopefully doesn't have a profound impact on your thinking.

(2) Free Cash Flow Generation

The foundation of Constellation's operating model is a disciplined process, which I reviewed in Part 1. Perhaps the second most important piece is found in the cash flow statement.

Constellation has a history of generating a lot of cash from operations and spending little on capital expenditures.

The amount of cash reinvested in the business is a tiny percentage of CFO and substantially lower than reported depreciation and amortization (more later). The company is finding it is far cheaper to buy a mature company, invest in R&D and try to run it well than to try to build one from scratch.

The result is that the company generates a large amount of cash each year and with modest reinvestment needs, management has a large amount of capital for acquisitions.

With that said, the availability of capital is only one part of the equation. Many business empires have been destroyed by poor capital allocation. Constellations success is found in its disciplined capital allocation process that has generated high returns on invested capital - ROIC.

(3) Growth by Capital Allocation

Some would simply describe Constellation's strategy as "growth by acquisition". I would describe it as "growth by capital allocation". Very successful capital allocation at that. Whether acquiring or reinvesting in the business, good returns on capital are at the heart of every company's decision. Or should be.

Acquisitions have been a very good use of shareholder capital. One need look no further than ROIC to see as much. Management has successfully deployed capital year after year by adhering to a very strict operating and acquisition process. Consider that the company's reported Return on Invested Capital figures is now above 35%.

Not only is ROIC exceptionally high but its grown as the company has become larger.

So what is behind the magic?

The capital allocation process is very decentralized and responsibility for most acquisitions are downloaded to the operating divisions. While head office is often involved, decentralization has allowed them to scale without becoming top heavy.

On the Q3 conference call, Mark Leonard provided some insight into how decentralization works at Constellation and why he believes it can continue to grow the business:

What we really want are a collection of small teams that are self-managing, run by trusted individuals with experience and integrity….

And if they can buy an equivalent business in the next three to five years and coach it to perform as well as the one that they're currently running, then all my M&A problems go away, all my integration problems go away. And it becomes an organization where you just need the ability to reach into the occasional faltering business unit and provide coaching or sometimes replacement managers.

He repeatedly emphasizes that individual business managers are required to not only manage the business but also allocate capital. This culture permeates throughout the entire organization. The responsibility of the head office is to continue to teach and cultivate good capital allocators, whether for acquisitions or organic growth.

(4) The Balance Sheet

The company has adopted a strategy of over-capitalizing the balance sheet with excess cash. The 2014 letter to shareholders details the rationale. First, more capital is required to compete with Private Equity for larger vertical market software acquisitions. It is a much bigger market than the $5-$20 million acquisitions Constellation built itself upon. Second, cash raising initiatives help prepare the balance for the next recession. It is often recessions that create opportunities to buy great businesses at really cheap prices.

Commenting on recent attempts to improve their line of credit:

With room and flexibility enough to allow us to buy significant businesses (or pieces of businesses) during a recession. We are hopeful that our existing banks and perhaps some new ones will find the proposal attractive.

I will emphasize the following. One of the key attribute to Constellation's acquisition strategy is that it relies on very little debt and no equity issues. As opposed to empire building that often comes at the expense of shareholders and per share value, management is finely focused on building value without incurring excessive financial risk.

With the balance sheet at ~1x debt to EBITDA, I would argue investors have some degree of protection from (potentially) declining organic growth. Perhaps the bigger risk is poor capital allocation underpinned by poor decision making, which I'll explore next.

(5) Challenges as they Grow

Up to this point, this report has been positively biased. From now on, I will attempt to balance the positives with a few negatives.

The first is challenge is a very conventional opinion: the larger they get, the harder it will be for them to grow. While true for almost every company, the details are especially pertinent for an acquisitive company like Constellation. In order to sustain a high level of growth, two scenarios could potentially occur.

In Scenario 1, the company continues to acquire small software companies (<$20 million) but in order to sustain a particular level of growth, they must acquire more. The risk is that quality of decision making becomes diluted as more individuals make decisions and over time ROIC suffers. With ROIC declining, the multiple likely declines and so doe the share price.

In Scenario 2 Constellation could choose to acquire larger companies but in order to do so, must pay more. There is often more competition for larger businesses and sometimes you are even buying better quality ones. The risk here is in order to, say, meet investor expectations, management pays too much or lowers quality criteria. Further, mistakes are magnified with larger acquisitions. Much like in Scenario 1, paying more without subsequent operational improvements also likely results in a lower ROIC.

This, in my view, is conventional wisdom. And, arguably, this conventional opinion is partially due to laziness. It is far easier to dismiss the strategy as simply "growth by acquisitions" that will eventually fail than to investigate the process oneself.

But it's also partially due to history. When a growth by acquisition company fails, it often does so spectacularly leading many of us to be skeptical. Further, few news agencies highlight the successful growth by acquisition firm but everyone covers the failure. This mental error is akin to the availability heuristic and influences our opinions of (and decisions around) companies like Constellation Software.

It is important to note that the company has in fact reduced its hurdle rate on larger acquisitions. With debt financing, management believes it can achieve similar rates of return than with using internally generated cash and a higher hurdle rate.

No doubt the line they are walking is fine.

(6) Changing Software Dynamics

The second negative is the growing presence of the cottage software industry. Competition from new entrepreneurs developing better products is fierce and ever increasing. While it likely isn't a huge risk of losing a sticky, existing customer, it presents challenges with respect to winning new business and increasing organic growth.

It could also make the incremental revenue dollar slightly less sticky - or recurring. Consider this from the 2014 President's Letter:

The SaaS'y businesses also have higher organic growth rates in recurring revenues than do our traditional businesses. Unfortunately, our SaaS'y businesses have higher average attrition, lower profitability and require a far higher percentage of new name client acquisition per annum to maintain their revenues. We continue to buy and invest in SaaS businesses and products. We'll either learn to run them better, or they will prove to be less financially attractive than our traditional businesses - I expect the former, but suspect that the latter will also prove to be true.

So in addition to being arguably more competitive, they are potentially less stable for shareholders.

(7) Accounting Discussion

The definition of Adjusted Net Incomes is one of the biggest curiosities with Constellation Software's reported financials. They essentially present a number more akin to cash from operations than GAAP EPS.

Specifically, while the company does not adjust for restructuring or other oddities like many companies, they do add back amortization of acquisition related intangibles. Consider the following from the Q4 Shareholder report, which details the outsized impact of amortization of intangibles.

Managements justification is that so long as maintenance revenues are growing, the business isn't impaired. Accounting rules, however, require your write down the value of part of the acquired business annually. And over time, maintenance revenue of the combined business continues to increase:

It has some funny outcomes, such as depressing book value and inflating ROE. It is worth noting that, using Adjusted Net Income ($17.51), ROE would be over 100%. But even so, ROE without the amortization add back is still impressive. The following is courtesy of Morningstar:

The adjustments reduce the value of the income statement for investors forcing one to increase scrutiny of the cash flow statement and the sources of cash flow of operations.

The second comment on accounting relates to a Veritas Research report that questions Constellation's definition of organic growth. The company includes the organic growth of acquired companies owned for less than one year as opposed to after a year of results. One can naturally draw their own conclusions as to the perils of such decisions.

On one hand, if you buy a company that is growing quickly, it makes your organic growth look higher. If you buy a company that declining (as Constellation often does), it depresses organic growth.

On the conference call, management said the difference isn't material and will present data in the Presidents letter:

There's not a whole lot of difference.

I think our method is more sensitive and gets you an answer quicker on whether the acquired business has organic growth or not. I think a method that Veritas prefers. It is less likely to get played with because the run rate that you pick for the business when you acquire it, you can't play games with it if you just don't include it for the first year. It's a much more audible kind of number and they take great comfort in quality of earnings, quality of numbers that kind of stuff.

In addition, Veritas argued the quest for growth is forcing them into lower quality acquisitions - and lower organic growth is impairing their decision making ability. This is from the Globe and Mail:

Howard Leung of Veritas Investment Research, in a late January report named Fading Star Power,"argues that slowing organic growth is forcing Constellation into lower-quality acquisitions. Specifically, Veritas says, the mining software company Datamine has profit margins 10 percentage points lower than Constellation's existing margins; real estate-software seller Market Leader was described as a "declining franchise" by previous owner Zillow; and Springer-Miller Systems, a provider of software for hotels and spas, had an EBITDA (earnings before interest, taxes depreciation and amortization) margin of negative 20 per cent prior to Constellation's acquisition.

In response, management had this to say on the call:

[W]hen they see us buying larger troubled businesses that aren't generating the kind of margins we're generating and in some instances are undergoing fairly significant revenue shrinkage, their concern obviously is that the historical financial results that they can see through the internet, through various sources will continue under our ownership.

It isn't magic, we just try and share best practices with the businesses that are required and work with the management teams, existing teams to implement some of the things that will work better elsewhere inside the organization.

So I understand why they are concerned, I understand their natural cynicism they've been burned before by acquisitive companies and the best I can suggest is look at the track records and continue to monitor the working capital account to see if they are ballooning

These are challenges with a company that is acquisitive. With respect to the former, investors must take management at their word regarding organic growth because it is nearly impossible to calculate the figure oneself. And the answer for latter? Well, in my view, it will eventually be told in the ROIC number.

In the meantime, it has naturally created some nervousness among investors. The stock at one point was underperforming the TSX by ~20%:

Click to enlarge

Note: The CEO has a very unconventional way of thinking about the stock price. In recent years, he's occasionally chimed in on conference calls or in shareholder reports often stating bluntly the shares were overvalued. How many CEO's do that?

I'll leave you with this from the 2013 Shareholder letter:

Ideally, we'd like CSI's stock price to appreciate in tandem with our fundamental economics. At any point in time, we'd prefer the price to be high enough to discourage a takeover bid and low enough so that our sophisticated long term oriented investors are not tempted to sell. It takes lots of time and effort to attract and educate competent shareholder/partners. The last thing we want them to do, is sell.

If a stock is over-priced and sophisticated investors sell, they are generally replaced by unsophisticated investors who are ultimately disappointed.

(8) Concluding Thoughts

In addition to the preceding "negatives," I'd argue some of my own conclusions warrant skepticism, particularly the aura building around the CEO. While it is impossible to say a negative thing about his track record, what are the probabilities he becomes a capital allocation legend? One of the few "outsiders?" We all remember Bill Ackman's recent attempt to crown a new "outsider."

So where do we go from here? Well I'd argue not much has changed - Constellation's path forward remains inherently positive. Yes he business is bigger, it is no longer under-the-radar, and investor scrutiny is growing but the balance sheet is good, cash flow generation is strong, and the acquisition discipline does not yet appear impaired.

Once again, this report is far from being all-encompassing and I welcome any comments and/ or suggestions. Part 3 is up next and will go through the valuation.

Disclosure: I am/we are long CNSWF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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