Description

Summary – Constellation offers mission critical software to very niche verticals. The CEO is the Warren Buffett of software, having acquired 200 small software companies and generating high 20s IRR on deals. The business should grow revenues MSD organically, and if the company deploys all its FCF to acquisitions they will generate another 20% or more in growth. Management is also willing to do large deals funded with debt which raise growth to a 30% CAGR.

Best in class management – 1) amazing capital allocator. IRR approaches 30%. 2) Amazing operator. He has setup a simple process for identifying, evaluating and integrating acquisitions. Every employee is molded after him and properly incented. The company is setup so that it can scale into another 2-3 business units and do more deals going forward. 3) He is completely transparent. His shareholder letters read like Buffett’s letters; His focus is to maximize long term shareholder value without sacrificing the sustainability of his business. 4) He owns $500M of stock and has never sold.

Acquisitions are extremely accretive– Their internal hurdle rate is > 20%, possibly 25%. Between 2009 and 2013, I estimate that they paid 0.7x sales and generated a 29% IRR on their investment. They paid 0.73x sales in 2013 and 0.55x in 2012/2011. They buy at 4-5x EBITA. The high IRR is available for structural reasons: 1) the software industry tends to focus on growth whereas Constellation focuses on FCF and pricing power. 2) the typical acquired company is poorly run and often loses money. The average deal is $7M with sales < $10M. The businesses are run by mom and pops that do not take advantage of their pricing power and often spend too much to grow the business. In the typical scenario, constellation raises prices 20% and cuts significant opex. 3) There is minimal competition on their deals; < 20% of the time.

We are at an inflection point as the Company will look to do large acquisition like the recent TSS acquisition. Since 2004, they have spent 127% of FCF on acquisitions. It was 85% through 2012 but they recently did a large acquisition funded with debt. I expect them to cut the dividend; they are clearly signaling this and this action will allow them to spend 100% of FCF on acquisitions. They will spend more than that by using debt. They are ready to grow aggressively in Europe which will help them find attractive targets. This is a new area of growth for them. They have a pipeline of 17k companies and employees are assigned to each company and mandated to ask them every 6 months if they are ready to sell. The pipeline was 11k 12 months ago and is now 17k as they expand in Europe. there are other signals they are looking to make acquisitions: 1) issued unsecured subordinated debt with a 20 year life. 2) added the former CFO of open text to the board. he was responsible for open text's successful acquisitions. 3) hinted at their desire to cut the dividend. 4) they are executing faster than expecting on raising margins at TSS which gives them confidence they can repeat this process on future deals.

Valuation – LSD organic growth peers trade in line with constellation on FWD EPS and FCF despite Constellation compounding at a 35% historical CAGR due to acquisitions. Constellation deserves a premium for demonstrating a record of deploying all FCF towards acquisitions and achieving extremely high IRRs and because they have a more sustainable franchise (mission critical, niche verticals).

Forecasts vs Consensus – Consensus models the base business correctly. they are a little low on margins. consensus assumes half of FCF gets deployed at approximately 20% IRR. right now the company is deploying about 50% of FCF. the key differentiating view is that i believe the company will step up their acquisition pace and deploy over 100% of FCF. a large deal would offer a 20% IRR and smaller deals will be 30% in my view. that gets me to $19.50 EPS in 2016 ($19.50 USD, $22.25 CAD) and $26.00 in 2017 ($29.50 CAD).

Risks

• They do not spend as much as I expect on acquisitions.
  • They used to spend < $100M a year on acquisitions, or < 20 acquisitions at $5M each.
  • Going forward they will have to spend ~$200M on tuck-in acquisitions. Average deal size is approaching $7M which means they need to do 30 deals. Their expansion into Europe will allow them to do 1/3 more deals.
  • They have a pipeline of 17k companies, up from 10k 6 months ago as they expand into Europe. At $5M per company that is $85B in TAM. At $7M that is $120B. VAR indicates they will not be short on deals and recent history shows that deal economics haven’t changed.
  • the risk is that in a web 2.0 environment, targets demand higher multiples. Constellation will not budge on its hurdle rate. they prefer to hold on to cash and buy up companies in a downturn if necessary.
• Organic growth slows
  • They grow organically MSD and it is intentional that they don’t grow faster. The CEO invests just enough to maintain market share and ensure the franchise is sustainable. He prefers acquisitions to spending on opex and driving HSD organic growth because of the higher IRR that acquisitions offer.
  • I believe that only 20% to 25% of revenue is meaningfully at risk of SaaS competition. The rest of revenues are in small mature verticals with high barriers to entry. churn is LSD and entirely due to bankruptcies and mergers, not switching to the competition. Of the 20% to 25% of revenue that I believe is at risk, I see no near term threats but the potential is always there. The most likely threat is that a big player acquires a niche competitor and expands their product offering.

Catalyst

Catalysts – 1) dividend cut. 2) Acquisitions. Especially in Europe, or a large deal next year. 3) Earnings.