Constellation Software's (CNSWF) Management on Q1 2016 Results - Earnings Call Transcript

Constellation Software, Inc. (OTCPK:CNSWF) Q1 2016 Results Earnings Conference Call April 28, 2016 8:00 AM ET

Executives

Mark Leonard - President and Chairman of the Board

Jamal Baksh - Chief Financial Officer

Analysts

Paul Steep - Scotia Capital

Thanos Moschopoulos - BMO Capital Markets

Stephanie Price - CIBC

Paul Treiber - RBC Capital Markets

Mayur Kenia - IWD Capital Management

Matt Pickering - Select Equity

Blair Abernethy - Industrial Alliance Securities

Operator

Good morning ladies and gentlemen. Welcome to Constellation Software, Inc.'s Q1 Results Conference Call. I would now like to turn the meeting over to Mr. Mark Leonard. Please go ahead, Mr. Leonard.

Mark Leonard

Thank you, Melanie. Good morning everyone. Welcome to the call. As you know we generally go directly to questions and so Melanie is going to tee up those questions. Go ahead Melanie.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] The first question is from Paul Steep of Scotia Capital. Please go ahead.

Paul Steep

Great, thanks. I guess, Jamal maybe the first question for you, if we look at the margins in the quarter, if the – are the full new bonus plan is on the full new bonus plan fully reflected in this current quarter's margins or is there still some extra cost that we should be thinking about?

Jamal Baksh

The impact of the new bonus program is not as material as we had originally expected. There is an amount that went through in Q1 and there will probably be some accruals around the rest of the year, but it is not the reasons for the decline in margins in this quarter. The decline is really because of the payroll taxes associated with the payment of our 2015 regular bonus.

Paul Steep

What happened last year was the bonus, the share purchases were made over Q1 and Q2 right? Which had a more – it spread out the cash flow and it was also spread out the payroll taxes or was that…?

Jamal Baksh

Yes, because yes, the payroll taxes maxed out when we paid bonuses for many of our employees and so if they maxed out in this year a lot of people maxed out in Q1 versus last year and that maxed out that has happened over Q1 and Q2.

Paul Steep

Okay, that helps. The other question just related to the quarter itself, the maintenance mix picked up, is there anything that's buried in that? Is there a more fundamental shift that's going on or that would be driving that or is this more just a quarterly anomaly and if so what sort of drove the shift there because it was meaningfully higher than prior periods?

Jamal Baksh

We do say Q1 there is seasonality in our Q1 versus Q4 numbers specifically. Q4 there is always a push, the sort of yes, some projects over the goal lines and then you'll see that in professional services so they'll go up in Q4 and then come down in Q1. And then you also had that large hardware sale or sales in Q4. And again so if you are just looking at percentage of gross revenue then those, that hardware sale is an anomaly and yes like in Q4 then you'd always expect excluding the impact of acquisitions that maintenance is going to be 100% in Q1 than it would have been in Q4.

Paul Steep

Great, I guess the last one from me Mark is related to your letter and if I take a look at table 3 on the maintenance revenues, a couple of things sort of lead to mind here, questions come up generally. One is the sustainability of the price increases that you've been able to drive across the base clearly over time, maybe some thoughts around that?

And then also the customer losses, if we look at the attrition from lost customers it sort of ticked up to sort of a 5% level and it has persistently been there for the last three years now, your thoughts around what you're seeing on that front and concerns or not on that?

Mark Leonard

Well first of all the normal preamble of whenever you look at aggregate numbers you don't really get the picture, you've got to drill down to the individual business units to understand what's going on which we can do in our data, but obviously don’t share with the shareholders and competitors.

Vis-à-vis customer loss, I think some of that is the fact that we are in some verticals where there is much higher attrition now than we were let's say five years ago. Many of the SaaS businesses that we're in have brutal first year attrition, infant mortalities that are in the SaaS space. And that's just a part and parcel of that particular business model. And other than that, as I think of an individual business unit I don’t think we are undergoing higher customer loss in most of our traditional businesses than we have in the past.

Then vis-à-vis price increases, this is really price increases and other. We used to have FX for instance in this bucket. We have in here a bunch of transactional business as well which has tended to be fairly significant grower for us and then prices in software are an odd thing.

One of the operating groups took one of their products and displayed all of the features and functions that they had added to that product over an extended period of time in a graph for the general managers' meeting yesterday. And what we could see is that the customers were getting enormously increased functionality and that's for long periods of time, five or six years and they will get no prices increases and then finally, you would come to a head and we put through a single price increase. And then over the next five or six years we didn't put through any price increase.

So, I think what tends to happen a lot of the time in our businesses is you add incrementally to the product. You don’t necessarily breakout new modules and sell them separately, but then at some point the economics of supporting a much larger product, such that you put through price increase. And so it isn't just straight price, it's really you've created something much newer and better than they had five or 10 years ago.

So as to the sustainability of that, I think that's always going to be there. I think people will always want new integration and then features and then functions, whatever the shiny new toy is, they will want built into the software.

Paul Steep

Great, I'll pass on, thank you.

Operator

Thank you. The following question is from Thanos Moschopoulos of BMO Capital Markets. Please go ahead.

Thanos Moschopoulos

Hi good morning. I know you don’t provide guidance, but as we look out towards the rest of 2016 are there any are any structural reasons that you're aware of that would cause full year margins for 2016 to be any weaker than what we saw last year?

Jamal Baksh

I don’t know of any structural reasons, no.

Thanos Moschopoulos

Okay, and Mark, historically you've provided some disclosure I think annually in terms of your mix of SaaS revenue, would you have that metric for 2015?

Mark Leonard

We didn't do it. It is a bit of a pain and the distinction between SaaS and non-SaaS is fuzzy because frequently the add-on products we generate are SaaS products even though we may have on-premise core systems. And so I'm afraid we just didn’t go through the exercises here and it's not that meaningful to us. We run all of our businesses that try and make money and grow and service our customers irrespective of whether they are hosted or SaaS or cloud or whatever the term is that you want to use.

Thanos Moschopoulos

Okay and then finally in the shareholders letter you talk about the notion of having the business unit managers more actively involved with M&A and so I wanted to get your thoughts as to how much of a challenge that may or may not be as far as training them to do that. Based on your very expensive experience is M&A primarily an art which might be a little challenging to teach or is it really a science based on a very well established play book that you've developed over the years?

Mark Leonard

I think it is a bit of both, but you can like most things use base rates to refine your forecast. And so if you have extensive experience in buying companies, you can look at that experience and go organic growth, consistent organic growth above 10% happens very, very infrequently. Therefore if you are forecasting it and everyone you bring to me you are probably wrong. EBITDA margins above X happen very infrequently. It looks to me like you are being optimistic, et cetera, et cetera, et cetera.

So as long as we provide those base rates to our managers and then give them the opportunity to explain why they are going to be top decile versus the base rate, I think we give them a terrific tool. And then their level of commitment to actually delivering top decile performance will be enormous. And so I don't think it's that tough and then the underlying decision-making tool is IRR and that's a wonderful thing to teach because it teaches people how to think about cash and all of the things that affect cash inside of a business which is the essence of business.

So no, I don’t think it is going to be a problem. I think it's something that anyone with mathematical ability can pick up and I think if we provide them with the tools, I think they will embrace it.

Thanos Moschopoulos

Great, thanks a lot. I'll pass it on.

Operator

Thank you. The following question is from Andrej Krneta of Shawn [ph] Partners. Please go ahead.

Unidentified Analyst

Good morning. Thank you for letting me on. My question is on cash deployed on acquisitions. Mark, last year cash deployed on acquisitions is vastly upstaged that of any prior year, bar 2013 when you acquired TSS. Would you say or maybe you can offer your thoughts what the key reason here would be and is it sort of, can we assign that to the lowering of the hurdle rate on bigger transactions and should that hurdle rate remain where it is through 2016? Do you think that's the new normal for the opportunities that exist out there for you?

Mark Leonard

I have a feeling that competition is probably our toughest metric to forecast. We saw I think roughly 10 large VMS transactions in Q1. We got to participate in zero of them even though we followed roughly 70% of them, seven of them before they went into the process. What that tells me is that there's lots of people out there with lots of money pitching for these larger transactions.

So I don't see right now that that market is as attractive as we would prefer and we have to wait for very special situations within that market to come along, good companies that perhaps are underperforming or have something about them that doesn't fit the normal model that the PE firms in particular are looking for.

This quarter we were looking at a couple of larger transactions where they came with enormous debt staples and maybe these PE firms can operate vastly better than we can, but when we model out the numbers we just cannot make them work. They must be targeting assuming they are like us fairly low rates of return. And as long as they are willing to do that, we'll probably get outbid on these larger transactions.

The baseline however, are smaller transactions where the PE firms generally don’t play is a place where we should be able to consistently deploy capital and then occasionally we'll get a troubled situation where we'll be ideally able to deploy significant dollars.

Unidentified Analyst

That's helpful, thanks. And the second question is something you brought up in your letter. It seems that you are warming up to ceding some more autonomy to your PUs in pursuing organic growth and we know that that organic growth has been gradually declining. Is it if you do decide to move on that, would that sort of phase in gradually across PU units or would that be more a sweeping change across the corporation?

Mark Leonard

Yes, you know the way I described it, it sounds like it was some master plan, but what happens inside of Constellation is we gradually drift and so we gradually drift it in the direction of pushing more and more autonomy down, first to the operating groups and subsequently to the business units. And some of those business units have been consistent, strong organic growers for years and years, sometimes decades.

And so it's not like something dramatic has changed. A switch has not been flipped, plus our expectations of business unit managers are now being raised. It used to be you could run your business unit, generate a good IRR cruise along. Now we’re saying, well you know, you've got to deploy some capital too if you’ve shown capability for running a business unit well, and you've got to do some organic growth, if you’ve shown the capability for running the core of your business.

Well you’ve also got to run initiatives on top of the core. And so that is going to put more pressure on some of the BU managers who may not have been doing that in the past. But it’s not like everyone suddenly is going to have to start doing it. Some will obviously have been doing it, others will just do more and others will be learning for the first time.

Unidentified Analyst

That's helpful, thanks. And maybe a follow-up to that is do you think that those units where you envision that for, do you think they have enough capacity to change that balance and have the capital allocation balance out more towards initiative for organic growth because, as I said, it's been on a declining trend?

Mark Leonard

Yes, what I tried to explain in the letter is, we have a bunch of businesses that do not have a declining trend and then we have a bunch of businesses that we bought that were, that we knew were shrinking businesses, contracting businesses, but that we thought were really good rates of return, so we bought them.

And so I think what you’re seeing is a mix shift as much as anything else. It’s not like we decreed at any point, thou shalt not invest in initiatives. We did show after tracking for four or five years, the general managers that the rates of return that they were generating on initiatives weren’t great and therefore they had to get better at generating good rates of return on initiatives.

And I think that discouraged them from embarking on a whole pile of new ones, but I still think there is something inherent in our business when you’re close to your clients, you’re servicing them every day, they ask you for stuff and so you build add-on products all the time. It’s just part of the business and so all of our guys are practicing initiatives all the time. They may not be formal ones that are broken out, but they're implicit.

Unidentified Analyst

Thanks for answering my questions.

Operator

Thank you. The following question is from Stephanie Price of CIBC. Please go ahead.

Stephanie Price

Good morning.

Mark Leonard

Good morning.

Stephanie Price

In your President's letter, you talked about hurdle rates and the fact that lowering them in 2015 was a bit more expensive than you thought. Can you talk about – just expand on that and talk a bit about your thoughts on hurdle rates at this point?

Mark Leonard

Yes, I didn’t mean to suggest that lowering them in 2015 was more expensive than we thought and what I was trying to suggest was when we lowered them twice before, it was more expensive than we thought and in 2015, we tried to be clever and say we’re not lowering the hurdle rates on these classes of acquisitions, but we are lowering it on large and leveraged transactions. So hopefully that’s what I wrote and it just wasn’t as clear as it might have been.

Stephanie Price

And then when you look out at these large transactions, I mean, as you mentioned in terms of the PE firms, it's tough to compete. Like, would you consider lowering the hurdle rate again, or do you think this is a good level you're at right now?

Mark Leonard

I think it’s pretty good level that we’re at right now.

Stephanie Price

All right. And then just in terms – going back to the KPO [ph] capital in the previous question – organic growth, obviously, has been relatively flat for the last couple of quarters. I mean, where do you think a good organic growth level would be for Constellation? Or where do you think that Constellation is going to get to in, sort of, the medium term?

Mark Leonard

I’ve always wanted to do two or three points better than GNP. That has always been my objective. We’re a fairly diversified business across many sectors of the economy and I would hope that we can do that. Obviously because we are in essence a capital goods business, it’s going to be volatile and so in good times, it should be better than that and in rough times, it will be worse.

Stephanie Price

Okay, great. Thank you.

Operator

Thank you. The following question is from Paul Treiber of RBC Capital Markets. Please go ahead.

Paul Treiber

Oh, thanks very much. I just was curious about the study that you've done high performance conglomerates, particularly in regards to the, how Constellation's hurdle rate or IRR investments compare against the conglomerates, over time?

Mark Leonard

So it’s impossible to get at the individual investments of the conglomerates because they usually don’t break out individual amounts and financials associated with them. What you can see is sort of what their incremental return on incremental capital has been and it has been in the on shareholders investments, most part has been in the mid to high teens. There are some outliers, obviously, where they use lots and lots of financial leverage, when you break it down to EBITDA type numbers, I would say it’s in the, again in that sort of mid to high teens kind of area.

We’ve done better historically as you can see from our ROIC type numbers that we report, but if we deploy lots of capital at lower rates of return and our hurdles are lower than our ROIC right now, then it will likely go down unless we use lots of financial leverage.

Paul Treiber

And just as a follow-on to that and maybe a little bit of a hypothetical question, but these conglomerates that you looked at, I mean, they've delivered fantastic performance over the years with probably lower return on invested capital. If you can't deploy capital at your existing hurdle rates, hypothetically speaking over time, would you rather lower the hurdle rate or would you rather return that capital to shareholders?

Mark Leonard

It’s a really good question and there is a diversity of opinion around the Board. I think what we do generating really high rates of return on capital is very, very special and I hate to undermine it by dropping hurdle rates and so I would rather personally return capital. Many of our investors wouldn’t like to see that, I admire what Jack Henry did, one of the companies I profiled in the letter.

In that they only deploy, roughly, a third of their free cash flow on acquisitions and they had the discipline to return two thirds of that capital to the shareholders via dividends and share buybacks. I love discipline on hurdle rates. Otherwise if you follow finance theory and race down the curve towards your weighted average cost of capital when you’re buying companies, it’s just a matter of time, if you believe the hurdle rates are magnetic, the whole company ends up down there not just the incremental acquisitions that you do.

Paul Treiber

Somewhat as a follow-up to that, the comment on making public company investments in the majority of cases you haven't ultimately acquired those companies, and so you do end up getting the capital back in the future now still at a high rate of return, but doesn't that really just kick the can down the road so to say in terms of pushing out too much capital to allocate challenge?

Mark Leonard

Sure. No, it's a byproduct of what we do, and like many byproduct businesses, if it has high margins it is very tempting to prosecute it and so I think we’ll do it. It isn’t going to come to dominate what we do unless we get the recession to end all recessions in which case it could well account for the bulk of the capital we deploy because no one wants to sells the business during a recession, but lots of people want to sell stuff during a recession.

Paul Treiber

Okay, thanks. Good to understand.

Operator

Thank you. [Operator Instructions] The following question is from Mayur Kenia of IWD Capital Management. Please go ahead.

Mayur Kenia

Hi. My question is if you could talk about the notary industry vertical that TSS has acquired some businesses in Q1, if you could give some color around what type of software this is used for?

Mark Leonard

It basically populates documents with publicly available information, so that the notaries can prepare them and present them to their clients. And then it does billing and all the other associated things that a notary would do, so think of it is the core system than notary would use.

Mayur Kenia

Okay, thanks.

Operator

Thank you. The following question is from Matt Pickering of Select Equity. Please go ahead.

Matt Pickering your line is now open. Please go ahead.

Matt Pickering

Sorry, I was on mute. Thank you for taking my questions. Can you quantify the payroll tax impact please, for the first quarter?

Jamal Baksh

It's matched within a few different accounts. So all I can say is we expected this dip and like Mark said, we don’t expect the margins through this year to be, different than last year, so you can read into that as you roll in.

Matt Pickering

Okay, and disproportionately, I mean, I'm not trying to hold you to a firm answer, but is it $2 million, $5 million, $15 million? I would presume it's obviously not that high. I'm just trying to get an idea of magnitude even if you can't give the precise number.

Jamal Baksh

I mean I would assume it is like a couple 100 basis points debt from so, that what the average would be is with this a lot of that has to do with payroll.

Matt Pickering

Okay, that's helpful. Thank you, Jamal. The last couple of years, you guys have not disclosed on the accounts the annual run rate of the acquisitions you've performed. And I appreciate that having met some statutory materiality hurdle, but that's always been useful I was just trying to gauge the revenue multiple of the capital that you're committing for shareholders.

Mark, can you give us a broad perspective of, kind of, how aggregate revenue multiples have moved from the actions that you've taken in light of the acquisition environment that you helped us understand better?

Mark Leonard

We put that graph together for our quarterly managers meeting and it looks like we are paying increasingly high multiples over time, over long periods of time individual years bounce around, but that there is an upward trend clearly.

Matt Pickering

And you still used to describe that trend relative to maintenance revenue. I presume that's still how you're thinking about it internally or has your thinking changed?

Mark Leonard

No, it applies to both maintenance and total revenues. The correlation of intrinsic value with maintenance we think is slightly better than with overall revenues.

Matt Pickering

And so if the acquisition multiple is increasing as a proportion of total or maintenance revenue, are you buying more profitable day one businesses, or implicitly is the IRR trending inversely?

Mark Leonard

I would say the IRR is coming down yes, as we got hurdle rates and people stretch a little more and little more optimistic the IRRs I think are coming down.

Matt Pickering

Okay and you've done a good job building up a very strong vertical market software position across a variety of public sector verticals, in particular. At the margin, more of your incremental acquisitions have occurred in the private vertical. Does that reflect an opportunity sense to randomness? I'm just curious, when we think about the evolution of the network of businesses, going forward, if there’s a trend there that we should appreciate?

Mark Leonard

Yes, it’s a contrarian philosophy evident in the numbers. In the Internet boom era the government sector was for the most part thoroughly disliked because it didn’t move quickly and so the private sector stuff had higher multiples and we ended up buying a lot of stuff in the government sector. Once you should have a footprint there, you tend to find other things and hence we ended up with a big public sector business.

We do have a preference for businesses where the clients are not spending their own money when you are dealing with an entrepreneurs' buyer of systems they tend to be more careful, more frugal than if they're spending their employer’s money. So and the larger the client base and the more public sector it is, the more likely you are to have better economics.

Matt Pickering

Yes. Are there any clear pockets of opportunity like that public sector observations that you benefited from in the early 2000s that you hope to exploit further today?

Mark Leonard

Think of any sector where the stock prices have come down 30%, 40%, 50% and that there will be a little Constellation fellow attending the conferences.

Matt Pickering

Yes. And, lastly, I know you've commented that TSS has worked well relative to their expectations, but just to be clear here, how should we judge success there?

Mark Leonard

It’s pretty easy to tease out the numbers from the increases in the value of the minority interest and things of that nature, so I don’t think you’ll have any trouble judging it.

Matt Pickering

Oh, I don't mean judging on a short-term basis. I'm saying when you think about why you did the deal and what you hoped to accomplish from a longer-term perspective? What is success given the way TSS has progressed?

Mark Leonard

Well, it was good deployment of a big chuck of capital with people that we liked and whom we've come to trust over an extended period of time who are now in turn deploying capital. It’s a unique situation in that we have significant third party shareholder involved, so that requires some different thinking than we have had previously.

Kind of like it and that it creates a discipline and a tension and attention to what one does and so we would hope to duplicate it elsewhere. So if there are the opportunities to buy significant positions in larger vertical markets, software companies or conglomerates, often when they get big they tend to be conglomerates, we would welcome them.

Matt Pickering

That’s helpful. Thank you.

Operator

Thank you. [Operator Instructions] The following question is from Blair Abernethy of Industrial Alliance. Please go ahead.

Blair Abernethy

Thank you. Mark just I wanted to get your thinking around the transaction processing space. How has that been performing for you? What sort of opportunities do you see there for growth or for consolidating and leveraging up your platform?

Mark Leonard

We have a number of businesses where transaction processing is an important part of what they do, both from the point of view of straight up incremental margin, but also from the point of view of making the business sticker and lowering the attrition rates. Often with small ticket software the switching costs are fairly low when you add in transaction processing just as you know, there are switching costs which is sometimes good.

The whole payment area to me is a mystery. There is a ton of stuff going on. I have no idea who is going to win. It’s clearly going to be huge. At some stage I think there is going to be massive amounts of margin compression in portions of it as the market shakes out and the major players emerge.

And so it's something that makes me nervous, on top of which there are all kinds of security concerns about being in the transaction processing business. So, I’d say it’s one of the most comfortable pieces of our business, but it is an important part of few of our verticals.

Blair Abernethy

Okay, and would you understand that, it seems like there's a fair bit of competition to acquire those kinds of established businesses. Is it something that you're seeing in your M&A pipeline that you think you could do or is it – is the pricing too far out right now?

Mark Leonard

It’s varies by vertical a lot. There are some businesses where software is 90% of solution payment is 10% and then there is some where it’s the flip of that. Obviously the payment companies like the ones were its 10% software, 90% payments and so they tend to compete for those vigorously, whereas we prefer the ones where software is a bigger chuck of value added.

Blair Abernethy

Okay, great. Thanks very much.

Operator

Thank you. There are no further questions registered at this time. I’d like to turn the meeting back over to Mr. Leonard.

Mark Leonard

Thank you, Melanie. Thank you all for joining the call. We will be holding the AGM at 10:30 and look forward to seeing some of you there. Thank you.

Operator

Thank you. The conference has now ended. Please disconnect your lines at this time. We thank you for your participation.

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