Constellation Software's (CNSWF) Management on Q2 2016 Results - Earnings Call Transcript

Constellation Software, Inc. (OTCPK:CNSWF) Q2 2016 Results Earnings Conference Call July 28, 2016 8:30 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

Paul Treiber - RBC Capital Markets

Andrej Krneta - Euro Pacific

Operator

Ladies and gentlemen good morning, and thank you for standing by. Welcome to Constellation Software, Incorporated Q2 Results Conference Call. During the presentation all lines are in listen only mode. Afterwards we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded on July 28, 2016.

I will now turn the conference over to Mark Leonard, Constellation Software, Incorporated's Chief Executive Officer. Please go ahead.

Mark Leonard

Good morning. Thank you, Dan. As you folks know on our regular quarterly calls we go directly to questions. So, thank you for joining us this morning and Dan is going to queue up for any questions you may have.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Paul Steep from Scotia Capital. Please go ahead.

Paul Steep

Hey good morning. Mark it might be worth talking a little bit about how and where you've been sourcing deals from lately, I'd be curious to hear your view as to what you've seen in terms of the mix of the pipeline coming in from various sources?

Mark Leonard

You know, I haven't done that analysis recently Paul. Historically we've had about two thirds direct and one thirds through brokers and historically the majority of our leads have come out of this space. It is a very large market for us, but increasingly we've been generating deal flow out of Europe as well and it is time to get a few in the follow on geographies over time.

Paul Steep

Great, if we think about executing more deals or acquisitions over time here, what are the constraints in terms of you moving forward, if you are already constrained by capital, ideal flow or just a broader valuation environment?

Mark Leonard

I would say it's letting people know the availability of ourselves as a buyer and so there are tens of thousands of suspects out there, it's reaching out and letting them know that whenever the time is right we would love to chat with them about being the new homes of their business.

Paul Steep

Great, and the last one I'll toss in here this morning is, we saw good organic growth across both segments in the year, the quarter again which was nice. Where - which underlying business segments have seen the highest rates of sort of organic growth over the last quarter or two?

Mark Leonard

You know, quarterly organic growth I'm not sure is a particularly good metric because we don't actually look to drive license revenues unlike a lot of other software businesses. We are more interested in recurring revenue. So I don't really focus on quarter-to-quarter organic growth. What I will do from time to time is look back on longer-term organic growth trends inside of businesses, because there are so many it is a very thing to track on a regular basis. But obviously the general managers of the 200 odd or actually it is 212 business units this quarter that we were looking at, stay abreast of that stuff. Jamal, did you have any further sense for which…?

Jamal Baksh

Yes, I mean, I sort of look at it by all different business units and it is fairly evenly spread in that the couple or the large verticals are still a little bit troubled like U.S. Healthcare. But there is a general positive organic growth across the companies. We knew these comments about hardware driving organic growth. I mean if you look at private which does not have any hardware. I mean they clearly strong organic growth as well and the impact of hardware is like 1% [indiscernible]. And I'd say it is fairly even as opposed to one specifically driving.

Paul Steep

Okay, that helps. The last one I guess is, on the cloud side of the business have you seen any shift in the tone in acquisitions there? And you know, obviously we saw a massive deal with NetSuite announced just before we got on his call, but if we look at the smaller end of the market, Mark we've been able to start to pick away at people who built an interesting cloud application, but unfortunately the business is uneconomic at basically acquiring customers on a sustained basis. Have you been able to - I know you had bought some in the past in that realm, has there been any more start to come into the fold?

Mark Leonard

We probably wouldn’t be very interested in buying one that was totally uneconomic at bringing in new customers because it means that you're buying an asset that is eventually going to liquidate itself. So, one would hope that there is a way of selling the software that generates value.

I think the biggest challenge in the cloud or SAS market is the amount of money chasing deals and driving them towards uneconomic behavior. And when one company in a space starts behaving irrationally, you don't have a whole lot of choice but to follow to some extent. And one of things we track is the sort of SAS index to get a feeling for how much dumb money is going into the industry.

And unfortunately that index has rebounded. From the beginning of 2016 it was starting to cool off and we were starting to get enthusiastic, but irrational behavior in this sector would taper off. But the stocks have popped right back up and I imagine they will be raising more money and spending it on acquiring clients. So I think it is as tough as it was late last year.

Paul Steep

Great, thanks guys.

Operator

Your next question comes from line of Thanos Moschopoulos from BMO Capital Markets. Please go ahead.

Thanos Moschopoulos

Hi good morning. Mark, can you comment on the competitive environment for deals? And I'm sure it is extremely competitive given the availability of cheap capital, but specifically I was wondering on small deals which historically haven’t been very competitive, has there been any change in that regard or are there typically few you buyers for smaller assets that you look at?

Mark Leonard

You know, there is always buyers for nice businesses and so there are always buyers out there. And I don’t see it having changed a lot. We look at the ratio of those that we participate into those we closed and it is not decreasing over time in any significant way.

Thanos Moschopoulos

Okay, that's encouraging. And then on your revenue mix, the mix of recurring revenue keeps growing which is certainly good to see. As you pointed out you are focused on driving your maintenance revenue. Just curious is there sort of a natural limit in terms of how high that can go, I mean I know that to some extent you cannot completely do away with license and hardware and services revenue and so what do you think of the natural limit might be for maintenance as a percentage of revenue?

Mark Leonard

If I had my druthers I would get rid of the license revenue and just have professional service revenue and recurring revenue. The professional services reflecting the amount of effort spent installing, customizing, et cetera the products, by vertical the amount of PS required varies enormously.

There are some verticals that require much more than others which can just operate out of the box. There tends to be a correlation with client size there as well. the larger the client, the more likely they are to one customization and modifications of their product and interfaces to other systems, and the smaller the client, the less they can afford those things, no matter how much they want them.

And so we're always going to have PS as a significant piece of our business. We tend to view it as something that makes our bigger clients stickier and happier and so it is something we are happy to do. So I don't know what the limit is Thanos, but it will vary by the different kind of businesses that we are in.

Thanos Moschopoulos

Okay, fair enough. And one for Jamal, the tax rate was higher this quarter due to the intercompany dividend withholding tax. Just to clarify, I would imagine that to be an annual recurring item, and if so, should the magnitude proportionately be self consistent to your year-by-year or would there be any change on that front?

Jamal Baksh

I mean as we grow in various jurisdictions and want to repatriate cash then the number will likely grow. I mean in the short term I would assume it would be something so.

Thanos Moschopoulos

And again just so once a year event?

Jamal Baksh

Yes.

Thanos Moschopoulos

And then aside from that, should we still be thinking about taxes in the mid teens otherwise near-term?

Jamal Baksh

Yes, I mean, our sense though has been that taxes are going to go up over time Thanos and it's a constant battle. If we happen to do a pile of acquisitions that have structures that are tax affective in a particular year that really helps. If we do some that are not then we're going to slip faster so to speak.

Thanos Moschopoulos

Fair enough. Thanks Mark and Jamal.

Operator

Your next question comes from the line of Paul Treiber from RBC Capital Markets. Please go ahead.

Paul Treiber

Thanks very much. Mark, I just want to go down memory lane a little bit and just thinking about the growth of the company since the IPO, if you could just recall maybe using rough numbers, what was the number of M&A targets in your database at the time of the IPO and how does that compare to the current number? And then what do you attribute from an organizational point of view the growth, the biggest drivers of the growth in that database to?

Mark Leonard

The IPO is a bit of a blur Paul. So, I don’t recall what the number was. It's been obviously very rapid. We have been working on it hard. If you ask me next time I’ll have a number handy. And so what drove the growth was basically a process whereby we asked each of the operating groups to stake out the suspects that they wanted to pursue. So, was pushing down a bunch of the capital allocation to the operating groups, and that drove the significant growth in the suspect funnel.

Paul Treiber

And then in regards to that funnel, what is the proportion of those, I think the last count you gave was 30,000 in that funnel, what was the proportion of those that are typically sold in a given year?

Mark Leonard

Hey, that’s a great question, which we had enormous debate over at both the board and the managers meeting level yesterday. So we believe it’s very, very significant and we are not seeing enough of them and we need to improve our coverage, so that’s a comfortable thing.

Paul Treiber

Are you comfortable with saying, in what ways you're looking to improve the coverage going forward?

Mark Leonard

Obviously, more resources is one of the answers. It is not like we have any easy solutions to this. We are experimenting with a host of different ways of communicating with business owners that we like these kinds of businesses and that we're a good place for them to place those businesses for the long term, when they are looking to exit.

Paul Treiber

Okay. Just want to shift over to organic growth and not focusing on the quarter itself, but just only at 2015, you did give a breakdown of organic maintenance growth, and we can compare that against the organic growth of the total revenue line. How should we think about the organic growth of the other revenue lines in 2015?

Mark Leonard

I suppose we could go back and do that analysis is not something I worry about. We concentrate on building the recurring revenues in the business, both organically and by acquisition because we think that is the driver of intrinsic value in these businesses.

Jamal Baksh

Clearly the - like professional services there was decline in 2015. I mean, the maintenance is growing at 8% and we only grew at 2% or 3% whatever it was overall and clearly the other lines we are down, but there were reasons for that. Right? I mean, when you are acquiring these large companies and we are focusing upon the specific portion of the market and they came with legacy large contracts and we're declining them now that was what was driving the sort of negative organic growth there, yes.

Paul Treiber

Okay. That's clear to me. Just lastly, just one more for you, Jamal, you mentioned in the MD&A that you purchased shares of two power companies this year, that's in available for sale securities. Where would you include on the balance sheet Bond International, this is the ownership in that? And then, do you own shares of any other public companies other than those three?

Jamal Baksh

Yes, the bond is, there are lot of other long term assets and we breakdown the amount in the note to the financials because we equity account for it because of our percentage ownership and no we don’t own any other at this time.

Paul Treiber

Okay, thanks so much. I’ll pass the line.

Operator

[Operator Instructions] Your next question comes from the line of Andrej Krneta. Please go ahead.

Andrej Krneta

Yes, good morning, gentlemen. Thank you for letting me ask a question. Mark, you talked about professional services revenues. We saw a bit of a recovery in those this quarter, they were up 17% year-on-year, just up 3% a quarter ago and actually contracted as we just heard in 2015. Any particular drivers this quarter? They were attributable to what you just talked about what drives typically your professional services side and sort of any part of that sort of new customers going live in the second half?

Mark Leonard

We have 60,000 odd customers, I couldn’t even hazard a guess as to how many go live in any particular quarter. There are as I said 212 business units and so what drove the professional services in each of them will vary. So it's a difficult question to ask at the aggregate or at least to answer of the aggregate levels, it's pretty easy to ask.

So the general themes are, we go to our largest clients and we try to do PS for them. With the small clients we recognize that they are much more price conscious and we try to be as efficient on PS as possible and to try and reduce the amount of PS required to install and configure the product. And so your R&D has a quite different focus for each of those two sort of segments of the market and then Austin over time as you build the business and you get to a certain size, there is a strong case to be made to fork the code and to have a version for the large clients that gets customized, highly customized for their particular elections [ph] and a version for the low-end clients that goes in flick and doesn’t have as many features and functions.

Andrej Krneta

I appreciate the color and was just such a large delta that warrants to be asked. Thank you for that. Maybe my second question is on the FX. It seems like FX this quarter was a bit of a less of a headwind than we saw in prior quarters. Jamal, do you have any view, sort of, what FX impact will be for the second half should the rates stay where they are? I know you provided that in the past, I appreciate any color there. Thank you.

Jamal Baksh

The decline in the Pounds right after Brexit really didn’t impact us in Q2. So, I haven’t analyzed where it may show off yet, but I mean the UK operations are, I think on an EBIT perspective aren't material. From a revenue perspective there maybe some headwinds there, but I will on that and calculate it out. From a Euro perspective, I think there shouldn’t be much of an impact in Q3 if things stay as they are.

Andrej Krneta

Thanks and the final question may be along the same lines. I noticed amortization was a bit volatile over the last few quarters, particularly dropped Q-on-Q this quarter. Anything there that we should be aware of, any write-downs or such things?

Jamal Baksh

The amortization is like what is flowing through there right now, which is pure accounting amortization, it depends on the timing of when we buy businesses and the valuation that we have and we write it down accordingly.

Mark Leonard

There is some quarter-to-quarter adjustments of a couple of million.

Jamal Baksh

Yes, so there was an adjustment, but we did a clean-up in Q1 and there was an immaterial, what we consider immaterial adjustments that might have some impact on that. And then also changes in FX also do impact, since it is they are booked in their native currencies, but there is no write-downs or impairment that is going to be that number.

Mark Leonard

If you look at H1 this year versus H1 last year, I think you will be looking at apples-to-apples is that fair to say? The adjustment was relatively short-term adjustment.

Andrej Krneta

Got it. Thanks for the color. Thank you.

Operator

And we have no further questions in the queue at this time. I will turn the call back over to the presenters.

Mark Leonard

Okay, then thank you everyone for joining the call. We appreciate it and look forward to chatting with you next quarter. Bye-bye now.

Operator

This concludes today's conference call. You may now disconnect.

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