Constellation Software: Cautious Approach To A Legendary Company

Summary

• Constellation Software recently released its annual report.
• At first look, results seem to be below what its shareholders are used to.
• Using my previous valuation of its subsidiary, Topicus, calculation of fair value of Constellation shows interesting results.
• Given current market volatility, Constellation is close to its buy point even for a conservative investor.

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Investment Thesis

Constellation Software Inc. (OTC: OTCPK:CNSWF), or Constellation, is one of the most successful holding companies in the recent corporate history of the western world. Since its founding, it adhered strictly to its philosophy of acquiring small vertical software companies in diversified areas. Always focusing on sustainability and historical and prospective profitability of their acquisitions, they had one of the longest streaks of value creative acquisitions. The only obstacle in their future growth is their past success. After 25 years and its incredible growth, Constellation is facing a challenge, albeit not immediate, of starting its expansion into new business areas. Analysis shown here will examine the risks of investing in Constellation at current prices and this analysis will explore.

Business Overview

Constellation is a holding company, which, through its branches, acquires, manages and develops vertical software business. Its current operations are mostly focused on Canada, the USA and the EU.

Previous articles on SA provided a good description of what Constellation focuses at. In brief, Constellation acquires small vertical market software companies (or VMS) with an intent of holding them for as long as there is a need for their services. Companies they acquire are small and regional. Usually, they have to be profitable, with good track record of revenue generation and net result. If you go through acquisitions stories on Constellation and its subsidiary websites, you will understand that these acquisitions are not hostile at all. This typically happens when companies volunteer to be taken over, either because their founder and owner wants to retire, or they would like to benefit from support and know-how that Constellation offers to its business. Once acquired, they are left alone, to exist as a rounded corporate entity as before. Much like, for example, Berkshire would do with its fully owned businesses.

The portfolio of businesses in which these VMSs operate is diversified. Constellation operates through six main daughter companies, which then in some cases own further companies that acquire small businesses across the world. Figure below shows the segment distribution of all the VMS companies acquired by all six Constellation subsidiaries.

Constellation Portfolio Industry Segmentation (Constellation Software Website)

Interestingly enough, there seems to be little overlap between them in sector segmentation.

Recent Developments

For the first time in a long period, net income decreased compared to last year. However, since Constellation reports also Topicus (OTCPK:TOITF ) results as a part of its annual report, it also included on net level the difference between income from conversion of its preferred shares in Topicus, and loss based on conversion of preferred shares of Topicus Coop by Joday Group and IJssel. It should also be mentioned that this extraordinary income caused one of increase in tax payment by Constellation, so the effective tax rate of 55% should not be a reason for concern. In the same time, this gave Topicus a tax shield, as discussed in my previous article.

Profitability Results (Author's Calculation)

Apart from that, Constellation actually had a remarkable year. Its businesses have grown organically, which does not happen every year. Also, the largest ever acquisitions were performed, with more than CAD 1.3 billion being invested.

Organic Revenue Growth (Constellation Annual Report)

As for the measure Constellation itself emphasizes, free cash flow to shareholders was at the levels below Q4 2020. However, as I mentioned multiple times, since this value was derived from net income, and accounting treatment of Topicus spin-off and subsequent preferred shares conversions, show distorted image.

Quarterly Result Overview (Constellation 2021 Results)

In order to evaluate Constellation, results of Topicus valuation cannot be ignored. This is why in the next section, I used both my valuation of Constellation on consolidated level, and previous Topicus valuation, to derive the final value of Constellation equity.

Intrinsic Valuation Assumptions and Considerations

To calculate the fair value of Constellation, I used a three-stage discounted free cash flow model, assuming the following stages of development:

1. Efficient high growth comparable to that of recent Constellation outcomes and currently expected revenues in next year.
2. Revenue growth slowdown due to size increase and limited options for further external growth, with high efficiency expressed through maintained margins.
3. Stable growth in line with the overall market in perpetuity, with maintained competitive advantage in asset management against the overall market.

The company's operating cash flows were valued as a going concern and discounted back at an estimated cost of capital. Cash and cash equivalents were added back, and the market value of debt and leased properties were taken out to arrive at a total value of equity. R&D and marketing expenses were not capitalized, as I considered them to be a part of regular spending for business maintenance and necessary expense to fund immediate organic growth. However, amortization of intangible assets was treated as a non-cash expense and part of the free cash flow to the firm. In addition, part of the estimated fair value of the non-controlling interest in Topicus, was then subtracted from the end result to derive the equity value belonging to the shareholders of Constellation. Total equity value was then divided by the current total number of Constellation shares outstanding to obtain an initial value per share.

The following are the assumptions I used in the intrinsic value calculation for them:

Revenue growth

For immediate, next year, growth I assumed 22%. This amount might seem high, but based on the disclosed deferred revenue (prepayment by its customers for goods or services that have yet to be delivered) in the latest annual report and by looking at the historical relationship between this number and future year growth we can see some regularity.

Constellation Software Current Liabilities (2021 Shareholders Report)

Although past performance is not indicative of the future, balance sheet information can give us some insight to what to expect in the short term. In case of Constellation historical revenue levels are closely correlated with one year lagged revenue increased for the same lagged period deferred current and non-current revenue, as shown in the figure below. This is no surprise given that Constellation has historically had organic revenue growth just above 0% on average and that any revenues from 2022 acquisitions will only partially enter the consolidated reporting by 2022 year-end. Figure below shows how this relationship held in the past.

Revenue vs Prior Year Implied Revenue (Author's Calculations)

Since according to this we can expect close to CAD 6.3 billion in revenue by year-end 2022, I applied the growth rate of 22% for next year.

My revenue growth in midterm assumptions was based on average prior revenue growth achieved by Constellation Software. Some cyclically can be observed in the historical figures, due to which I formed simulation around my baseline 20% growth assumption between years 2 and 5. This is a guess on my side, but it is based on the Constellations cash-generating ability, which in theory will give them enough buying power to fund this growth through acquisitions.

Constellation Software Revenue Development (2011-2021) (TIRK.com)

After year 5 from now, I assumed that the growth will start to slow down to a more sustainable level in perpetuity. For the latter, I tied this to the long-term expectation for risk-free rate in Canada, which for me now is 3%.

Although this might seem like a low estimate for growth at the final stage, with this, as it is seen in outcomes section, I have effectively assumed that Constellation will increase its recurring revenue by 4 times, by 2031.

Target operating margins

I kept operating margins constant at 15%, both in the short term and long term, as this is close to the levels Constellation seems to have been able to achieve in recent periods. Risk here is that in the longer term these might change as they change their focus to other types of acquisitions. Due to this, I will include the sensitivity to operating margin I would use to perpetuity in my scenario analysis.

Operating Income Development (TIKR.com)

Reinvestment assumptions

Capital needs to fund future growth, measured through sales to capital ratio, are increasing for Constellation which is understandable since the size and number of companies it needs to acquire to utilize its free cash flow is growing. As per 2021 year-end results, the relationship between revenues and sum of total equity and interest-bearing debt was 2.43, which is well below the last 5-year median value. In my forecasts, I allowed this ratio to increase once more to 2.7 in midterm, before decreasing again to 2.5 in perpetuity.

Sales to Capital and Amortization Rate (Author's Calculations)

One important assumption I made is that Constellation will not need to reinvest the costs of intangible assets' amortization. In the latest report, this was CAD 518 million which was reported as a cost, but caused no cash outflow. In order to derive free cash flow to the firm, I would add this amount to after tax operating income, corrected for capital funding needs to be measured through sales to capital ratio. To forecast future amortization cost, I assumed that the relationship between intangible amortization and invested capital will remain constant. I deliberately decreased the future value of this ratio to 0.23, exactly for the value of global corporate tax rate. With this, I assumed that as Constellation decreases the amount of its future acquisitions, so will the goodwill amortization decrease. However, I kept this effect to free cash flow to acknowledge that this item also will disappear from operating results over time. Hence, I would add it back instead of modifying the operating margin assumption itself. The outcome on the FCFF at the end is the same.

Cost of capital

For cost of capital, I estimated cost of equity from the market-implied equity risk premium and I added a regional risk spread (largely based on CDS spreads) based on where revenues were earned. Constellation is a global company with the majority of its revenue generated in the USA, Western Europe and Canada. I used an average bottom-up business beta from software companies and levered the beta to Constellation's own adjusted debt/equity ratio. Multiplying the equity risk premium by the computed beta and adding it to the risk-free rate sums to a total cost of equity. The estimation was performed using February 27, 2022, values.

Cost of Equity (Author's Calculation)

Cost of capital is then derived as the weighted average of cost of equity and cost of borrowing net of tax, based on Constellation's 'BBB+' credit rating:

Cost of Capital (Author's Calculations)

Terminal cash flow value

For value of the terminal cash flow, the following assumptions were used:

Terminal Value Assumptions (Author's Calculations)

Valuation results

Similar to what I did in Topicus' valuation, I have to assume that Constellations revenue growth has to decrease to the level of growth of the overall economy. For some, this assumption is unreasonable, but assuming anything more in perpetuity, and using this calculation approach, would effectively imply that Constellation would outgrow the world as a whole. Due to this, over time, I assume the period of high growth will end as the company enters a more mature stage of its corporate lifecycle. As we advance in the future, I too will accept that the high growth period might last longer, but again, only until some point.

Even with the last point, I consider my estimates of future growth result in revenue increase to more than CAD 20 billion in year 10. To put this into perspective, currently, out of more than 67.5 thousand listed companies globally, only 804 has reported revenues above CAD 20 billion. This is just shy of 1.2% of all listed companies today.

After Tax Operating Income Forecast (Author's Calculation)

On the other hand, I did assume that they will be an efficient business (high EBIT margin), good acquirers with excellent track in finding good businesses (high sales to capital and stable goodwill amortization).

Free Cash Flow to the Firm Forecast (Author's Calculation)

Having the FCFF forecasted, and by discounting it with the cost of capital, we obtain the total value of the operating assets.

Discounted Cash Flows (Author's Calculation)

From this value, I then subtracted my estimate of the value of debt of CAD 1,387 million, 39.35% of non-controlling interest in Topicus (based on the CAD value of equity I calculated previously) in amount of CAD 2,201.87 million, and I added back available cash of CAD 803 million. As a result, I estimated Constellation's fair value of equity to be CAD 52,323.73 million.

Using Constellation share count as of February 27, 2022, this equates to approximately CAD 2,469, while the shares were trading at CAD 2,105.

Since my baseline valuation is sensitive to my assumptions, I ran simulations around those I am most unsure of. The following assumption ranges and distributions were used:

Assumption Ranges Used in Simulations (Author's Calculation)

The following results were obtained (results are in CAD).

Simulation Results (Author's Calculation)

This results in a median present value per one share of CAD 2,496.18. Which is above current market price. However, only by some 15%. To put it in a different perspective, if you agree with my FCFF estimates, current price would yield an implied return of 7,65%.

Simulation Summary (Author's Calculation)

As in the case of Topicus, I have belief in Constellation as a business, but at this price, I am willing to wait a bit more before I start building my position. Especially given the current market volatility, it would not be unimaginable that we see at least intraday decrease of share price by additional 5%. In that case, I would invest.

Risks

Just like everyone, corporations age, slow down and in time disappear either by ending their operations, becoming part of other systems or reinventing themselves and giving second youth to their corporate lifecycle. The unknown of what the future will bring for Constellation is probably what is weighed down on its price right now.

The obvious risk many are stating is the question of succession of Mark Leonard and the rest of the current management team, of which the majority were a part of Constellation success from the start in 1995. My personal opinion is that focusing on this question is futile as no real answer can be given. One should always take into consideration that Constellation is now more than a small team of people and has a history of recognizing smart and dependable business operators and managers. Just as it was able to find businesses that could grow organically as a part of their network, they should be able to identify a person or two who would replace, in time, people heading the current top management.

The biggest risk for Constellation is actually the risk of changing investment focus. That was mentioned last time in President's letter issued on February 15, 2021 (more than a year ago). There, reference was made related to the suspension of future extraordinary dividends, limitations that would be imposed on distribution of cash to shareholders and shift in focus towards larger acquisitions outside the Constellations historical area of competence. Since then, we have not received any update on how or when this shift will start to be implemented.

This, tied with their traditional and legendary minimalistic approach to disclosing financial information, brings a lot of uncertainty around future development.

I would assume that each next large acquisition out of the area of competence would be tied to high volatility in Constellation stock, until results of that acquisition are show in financial statements. This would usually mean waiting for a year or two until enough evidence is collected that the acquisition could be value creative. If initially successful at this, Constellation would be viewed as a different company afterwards. However, if initial new investments turn to be mistakes, narrative around Constellation growth story could be destroyed, and growth expectations built into its price could cause less than average returns or even losses. One should always remember, that one of the most destructive forces in corporate world are in fact acquisitions, as they at the end tend to lead to more value destruction than creation on average.

I do rely primarily on my analysis, but I am not ignorant to price movements and other opinions. Figure below shows recent price development relative to the existing one-year analysis targets. As always, Constellation seems overvalued, and the only justification I can see is in fact in the unknowns the future will bring and lack of more precise disclosure from Constellation.

Constellation Software Analyst Targets (TIKR.com)

Summary

My baseline estimates are above even the most optimistic analyst estimates, and you should be aware of that just as much as I am. I do not believe that I am any smarter than people who provide these estimates as a part of their daily job, but at the end, I am certain that none of us can truly estimate the true fair value. At the end, all of us will be wrong. What I do have faith in, is the process I use to value the company and that at least it will give me a peace of mind in times the market might be telling me that I am wrong. I do not own Constellation, yes, but I am waiting for the right moment to buy it that would give me enough of a margin of safety that I can sleep at night. My portfolio is relatively small, and currently, I could afford to purchase only a few shares. For this, I am waiting to wait still and benefit from any further negative market pull on Constellation price. I believe, Constellation will continue to grow, and I will regularly reassess it to try to guess how far ahead this exceptional growth path could be sustained.

Call For Comments

What is your view on the future development of Constellation? Do you know of any recent acquisitions that are unusual when compared to their historical area of competence? Express your opinion, provide alternative assumptions and different opinions in the comment section below, and I will happily rerun my analysis using your inputs.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in CNSWF, TOITF over the next 72 hours. 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.