- Constellation Software has a history of shareholder wealth creation delivering returns over 13,000% since IPO'ing on the Toronto Stock Exchange in 2006.
- With a focus on acquiring good or excellent vertical market software companies, I believe Constellation has a diverse moat because of the broad range of niche segments they operate in.
- By coupling potential organic portfolio company growth with possible future accretive acquisitions, Constellation has the ability to continue delivering shareholders' value, in my opinion.
I believe Constellation Software, Inc. (OTCPK:CNSWF) [CSI] will continue to deliver long-term returns supported mainly by three points.
I believe CSI has a diversified moat through the portfolio companies under their umbrella. With a focus on acquiring leading vertical market software companies across an array of different industries, they are currently diversified across 113 different vertical markets while specifically targeting leaders in those markets. Because companies may find industry-specific software that works and continue using it, vertical software can be very sticky potentially proving that moat for CSI.
Management has an excellent historical track record and focuses intensely on the best ways to achieve high returns on capital, in my opinion. Through decades of acquisition experience, high profitability metrics, and performance-driven bonus structures I believe management has shareholders' best interests in mind when making decisions.
While corporate acquisitions can be hostile, CSI focuses only on non-hostile takeovers. By using a decentralized strategy, portfolio companies can leverage CSI management teams for expertise regarding capital allocation, acquisitions, finance, tax, and compensation while focusing on growing their business.
Constellation Software was founded in 1995 with the intent of creating a portfolio of vertical market software [VMS] companies. CSI looks for leading (or those with leader potential) companies within their respective niche. As of March 26, 2021, CSI operated in 113 different vertical markets overseen by their six different operating groups.
Vertical Market Software
Just to give the reader a better understanding, VMS is software developed for a specific industry, niche, or unique clientele. Contrasted from horizontal market software that can purpose an array of different industries (example: Microsoft (MSFT) Office), VMS is customized to specifically serve individual industries.
When it comes to acquiring new VMS companies, CSI focuses specifically on growing businesses with a diversified customer base, high relative market share, and capital-constrained competitors. While CSI seeks to acquire good VMS companies, now and again they purchase an exceptional one. Exceptional companies are those with an outstanding manager, consistent profitability, and above-average growth. Below shows their specific criteria between exceptional and good businesses:
Between CSI's six operating groups they work in over 100 different VMS markets. By diversifying so greatly among industries, CSI may not be heavily influenced by a specific sector. Along with market diversification, CSI only looks to acquire companies with hundreds of thousands of customers. Through their diverse customer base, CSI didn't have a single customer account for more than 1% of total revenues in 2020. Similar to industry exposure, the potential volatility of certain customers will not massively inhibit earnings in my opinion.
With no country making up more than 50% of total revenues I believe geographical revenue diversification also provides another layer of protection for CSI.
I believe at the heart of CSI's success is its management team. Mark Leonard founded CSI in 1995 after working in venture capital for eleven years. Other top management members, Jamal Baksh, Mark Miller, Bernard Anzarouth, and Farley Noble have extensive experience and between the four have an average tenure at CSI of 22 years. CSI believes that if their acquisitions aren't already leaders in their respective niches, many of them have the potential to become so. Because VMS software serves a specific purpose for a business or industry, leaders in their focus areas tend to have sticky customers. I believe this stickiness effect is represented through consistent long-term top-line growth as well as margin expansion over time.
Since being founded, CSI has acquired 47 companies of which the majority they're the sole owners. Not only has management been able to continually make deals over the past few decades, but they have also created immense shareholder value through acquisition-related growth, in my opinion.
I also believe management's long-term focus is the key to potentially driving future wealth creation for shareholders. In my opinion, this focus becomes very apparent with how they structure bonuses for employees at CSI. Because management believes shareholder wealth is created by managing a company's profitability and growth, they base employee compensation structure off both profitability and revenue growth of the operating group or individual business overseen. The way their compensation package is structured is by mandating a minimum of 25% of senior employees' compensation structure to be reinvested in shares of the company that is being acquired. Restrictions on this reinvested compensation can last anywhere between 3 - 10 years. Senior executives are also required to invest 75% of their bonuses into the company and are subject to the same restrictions. I believe by requiring senior employees to have skin in the game, future growth will be more attainable.
One reason I believe CSI will continue to succeed moving forward is that they are only involved in non-hostile takeovers. This allows for CSI to operate with a decentralized management structure, meaning CSI will not take over the day-to-day operations of an acquired business and instead rely on managers and employees of the subsidiaries to continue running their businesses.
While CSI may not run the day-to-day for subsidiaries, they do offer an operating and corporate infrastructure for portfolio companies to take advantage of. This infrastructure provides capital allocation expertise, acquisitions, finance, tax, and compensation policy with the goal of acquired companies to share best practices of CSI.
By acquiring companies in a non-hostile fashion while offering operating and corporate infrastructure, I believe portfolio companies are able to grow more organically over the long term. By coupling the potential organic growth of portfolio companies with further acquisition earnings accretion to CSI overall, I believe the long-term growth runway for Constellation Software is excellent.
Price Action History
Since the IPO in 2006, I believe CSI has had one of the most impressive runs in terms of price action globally. Below is a monthly chart of CSI since IPO followed by a table showing metrics compared to the S&P 500:
(CAGR calculated using excel '=RRI' function. Alpha calculated using equation Alpha = R – Rf – beta (Rm-Rf). The risk-free rate [rfr, Rf] is an estimated average of the 10-year U.S. Treasury yield from 5/18/2006 - 10/1/2021. Beta is calculated by finding the covariance ('=covariance.p') of returns between CSU.TO and SPY and dividing that by the variance ('=var.p') of returns for the SPY.)
Constellation Software's (Toronto Exchange) monthly stock chart is truly incredible in my opinion. Since the IPO, CSI has experienced mild drawdowns relative to the S&P 500 which has helped keep its beta below 0.30. Because of the minimal volatility measure and incredible compound annualized growth rate [CAGR], CSI has delivered annualized alpha over 30% since 2006.
I believe one of the key reasons CSI has performed so well over time is because of its excellent profitability metrics.
Return On Invested Capital [ROIC] has expanded drastically since 2015 mostly due to rapid growth in Net Operating Profit After Tax [NOPAT] and considerable growth in cash on the balance sheet. Return On Equity [ROE] has consistently stayed above 35% for the last five years as net income growth has been substantial in my opinion.
Free cash flow growth has also been in the double digits annualized which I believe will be vital for supporting further acquisitions for CSI.
Below are the financial highlights from my CSI model:
I believe CSI's earnings will continue to expand over time through organic portfolio company growth coupled with future acquisitions powered by high free cash flow generation. In 2025, I project revenues to reach $8.5 billion, operating profits to expand over 18%, and EPS to break $45.
Lowering Hurdle Rates
According to the most recent letter to shareholders, Mark Leonard mentioned that CSI was looking to pursue large VMS transactions. Because in the last 5 years brokers only invited CSI to participate in 16% of large VMS sales processes, Mark mentioned dropping hurdle rates for these transactions would lead to more auction invites. While the large VMS business may be an excellent way to continue the growth trajectory especially as CSI scales, dropping hurdle rates for future acquisitions may inhibit profitability metrics.
Inability to Acquire
The potential lack of VMS businesses that fit CSI's acquisition criteria could hurt future growth for the company. While organic growth may still drive top-line, a potential drop in acquisition-driven growth may lead to potential multiple compression if growth rates slowed.
Since the IPO in 2006, Constellation Software has generated shareholders impeccable returns in my opinion. Excellent acquisitions, stemming from what I believe is a great management team, have driven growth for the past few decades in my opinion. By allowing portfolio companies to continue to grow organically in a non-hostile environment and combining that with potential future acquisitions, I believe Constellation Software will continue generating shareholders' returns.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of MSFT either through stock ownership, options, or other derivatives. 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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