Value Investors Club / Constellation Software (CSU)

Description

Following Mark Leonard’s latest shareholder letter, we are laying out some updated thinking on

Constellation Software (CSU CN) given the new focus on deploying a greater percentage of FCF on M&A

and plans for expanding beyond VMS. A lot has changed over the past few years, but please refer to VIC

pitches from May 2017 and May 2016 on CSU for further thoughts on the company. A list of Mark

Leonard’s shareholder letters can be found on the CSU website:

https://www.csisoftware.com/category/pres-letters.

Elevator Pitch:

CSU is a high quality vertical market software (VMS) business and is a compelling long because in our

view their unique, distributed operations and fragmented M&A approach takes advantage of 1)

microcap/midcap valuation spreads, 2) non-economic seller interests like business continuity, and 3) a

playbook for streamlining inefficient operations, which historically resulted in average acquisition

multiples of ~1x revenue and ~4x PF post-synergy NOPAT. CSU CN has historically focused on high

quality VMS companies that are deeply entrenched in their customer base and have substantial pricing

power, making them resilient to disruption and recession. We believe VMS will comprise the majority of

Constellation’s M&A spend, but management will likely diversify into adjacent spaces over time, which

has unproven ROICs and is thus a risk (both upside and downside) to the thesis. Over the next few years

we estimate 2-3% organic growth (though with potential upside there as they lap headwinds), 50 bps/yr

of margin expansion, a 5% FCF yield redeployed at a 20% ROIC, and no multiple expansion/compression

(currently trades at ~30x, in line with its historical premium to the market) for a 23%/yr IRR.

Business Overview:

Constellation Software is a Vertical Market Software (VMS) provider that acquires mission critical, high

market share, high switching cost, high recurring maintenance fee software platforms across more than

50 verticals; typically focused on billing, administrative, and operational software. The key software

platforms they manage provide the software backbone for transportation systems, education, home

building, manufacturing, facilities maintenance, and healthcare systems. We believe these are

extremely niche software offerings that are too critical to rip out while operating in mature markets and

as a result are well insulated from competition. Our research has shown that Constellation’s software

offerings are typically a very small percent of the customers budget, but, critical to their operations,

which leads to high pricing power.

In our view CSU’s focus on acquiring businesses with growth potential, managing them well and then

building them, has allowed them to generate significant cash flows and revenue growth over the last

decade. Their revenues primarily consist of software license fees, maintenance and other recurring fees,

professional service fees and hardware sale.

• Software license revenue: Comprised of license fees charged for the use of software products

generally licensed under multiple-year or perpetual arrangements

• Maintenance and other recurring revenue: Primarily consists of fees charged for customer

support on software products post-delivery; maintenance and other recurring fee arrangements

generally include rights to certain product updates “when and if available”

• Professional service revenue: Consists of fees charged for implementation and integration

services, customized programming, product training and consulting

• Hardware sales: Includes the resale of third party hardware that forms part of their customer

solutions

CSU’s customers typically purchase a combination of software, maintenance, professional services and

hardware, although the type, mix and quantity of each vary by customer and by product. Expenses

consist primarily of staff costs, hardware costs, third party licenses, maintenance and professional

services to fulfill their customer arrangements, travel, and product development.

Compounding via M&A

CSU has historically acquired VMS businesses at 1x revenue, which at 30% post-synergy PF EBIT margins

implies a 4x PF NOPAT multiple, which has fueled 23% EPS growth from ’13-’20. CSU deploys a unique

decentralized approach where the majority of capital allocation decisions are made at the operating

group level by operating group heads and their managers. Given managers are compensated on how

much capital they allocate and at what returns, they are incentivized to constantly be on the lookout for

acquisition opportunities which enables CSU to add more companies to their funnel year after year.

Here is a list of CSU’s operating groups along with the verticals they are most focused on:

• Volaris: Bio Sciences, Agri-Food, Education, Transportation, Retail

• Harris: Utilities, Public Services, Education, Healthcare

• Jonas: Hospitality, Clubs & Resorts, Construction, Payments

• Vela Software: Mining, O&G, Manufacturing & Supply Chain, Public Housing, Financial Services

• Perseus Group: Homebuilders, Dealerships, Real Estate Brokers

• Topicus.com: Government, Real Estate, Healthcare

We closely follow 4 key metrics for CSU:

• Annualized M&A dollars deployed as % of revenue:

o Averaged 15% from ’12-’20 and 12% over the past 5 years

• Multiple of revenue paid for acquisitions

o Averaged 1x from ’12-’20 and 0.9x over the past 5 years

• Total and recurring organic growth rate

o Total organic growth averaged 1.8% from ’13-’20 and 0.8% over the past 5 years

o Recurring revenue organic growth averaged 4.8% from ’13-’20 and 3% over the past 5

years

• Adj. EBITA margin

o Averaged 24% from ’13-’20 and 25% over the past 5 years

Mark Leonard

Mark Leonard is the Chairman, President, & Founder of CSU. He is an impressive capital allocator and

runs the business in a conservative manner, historically, without much leverage. His philosophy is to

acquire businesses with the intention of holding them forever. Over the years, Leonard has passed on

his operational best practices and M&A playbook to his operating group leaders and senior managers, ensuring the compounding machine is in good hands for years to come. We also like the fact that the senior leaders in the company and management team all have a lot of skin in the game with their equity

ownership and bonuses going back into equity with a lock-up schedule that vests starting in year 3 and

ending in year 5. Many of the senior leaders have been with Constellation for > 15 years.

Mark Leonard tends to be somewhat elusive, but a great way to learn about him is through reading his

Annual Shareholder Letters and checking out a few interviews that can be found on YouTube (for

example here: https://www.youtube.com/watch?v=D8U4wsXE5MI&t=1s).

Fulcrum Issues:

TAM of VMS businesses available for sale at 1x revenues

The main controversy around CSU remains whether they are able to continue to find businesses to

acquire for 1x revenues (or something close to that level), generating attractive IRRs on capital

deployed. While management has stopped disclosing the number of companies in the funnel, the last

reported number was > 30k and our research suggests the funnel has grown over time and likely

contains closer to ~50-60k businesses at this time. We believe Constellation will have to pay higher

multiples over time due to increased competition from PE firms, family offices, and strategic buyers, but

our research suggests that at least for the next few years, CSU’s funnel remains robust and they should

be able to continue to acquire VMS businesses at 1-2x revenue. Note that multiple inflation has not yet

shown up in the numbers, and Constellation has consistently paid less than we were modeling.

One thing Constellation can do to offset rising multiples paid is to deploy a greater percentage of FCF on

M&A. Mark Leonard’s latest shareholders letter (https://www.csisoftware.com/category/pres-

letters/2021/02/15/constellation-software-inc.-2021-president's-letter) outlines CSU’s new value

maximizing approach going forward (deploying all FCF at the highest possible ROIC, as long as ROIC is

well above cost of capital) rather than a ROIC maximizing approach (return any FCF that does not exceed

20-25% ROIC). We believe the power of deploying 100% of available FCF even at ROICs lower than their

historical hurdle rate can result in an acceleration of EPS growth. The new and old model can be broken

down as follows:

• Old CSU: deploy 50% of FCF at 25% ROIC = 23% EPS growth (inclusive of reinvested dividends)

• New CSU: old CSU, but deploying 100% of FCF at 17% ROIC = 26% EPS growth (inclusive of

reinvested dividends)

ROIC attainable beyond VMS

In his most recent shareholders letter, along with outlining the new approach to FCF deployment, Mark

Leonard also discussed an openness to acquiring companies outside of the core VMS businesses they

have historically acquired. Through our conversation with industry experts and former managers, we

were able to piece together a number of options CSU could pursue going forward, including:

• Entering new geographies. Constellation struggled to make the model work in Japan but had

success in Europe. SEA and Latam could be a bigger focus moving forward.

• Entering new verticals. Adjacent verticals to VMS, for example payments, where they have a

presence today but not in a focused and deliberate way.

• Going horizontal. CSU could apply operational best-practices to select horizontal businesses.

Beyond expanding outside of VMS, we think CSU has few additional options to keep driving growth,

including using leverage, something they have historically been hesitant to use, which would enable

them to potentially allocate >100% of FCF to M&A.

Slowdown in organic revenue growth

In 2020, organic revenue growth fell to -3% from 1% in 2019. This slowdown can be attributed to drag

from several verticals they are exposed to that were hard-hit during the pandemic, including travel,

hospitality, and fitness. This most likely resulted in a disrupted sales cycle with fewer implementations

and delayed purchase decisions. Maintenance organic growth on the other hand has stayed positive

suggesting customer churn is under control despite the pandemic. While organic revenue growth was -

7% and -3% in 2Q20 and 3Q20, respectively, it came in at -1% in 4Q20 suggesting some of the pandemic

induced headwinds might be easing. Despite the slowdown in organic revenue growth, EBITA margins

expanded 422 bps in 2020 to 28.4%.

Valuation:

CSU CN currently trades at ~31x consensus earnings, or a ~35% premium to the normalized market

multiple, which is in line with the trailing 5 year average premium. At 22% EPS growth over the next few

years, excess returns will offset premium paid in 35% / (22% - 9%) = 3 years. More immediately, over

the next few years we estimate: 2-3% organic growth, 50 bps/yr of margin expansion, a 5% FCF yield

redeployed at a 20% ROIC, and no multiple expansion/compression for a 23%/yr IRR.

Catalysts:

• Reacceleration of organic growth as cloud conversions continue and they lap covid

• Management embraces modest leverage

• Investors see the EPS accretion from deploying 100% of FCF into M&A

Risks:

• Bidding process for VMS businesses finally drives up purchases multiples faster than we model

• Or related to that, an inability to deploy > 50% of FCF on M&A at attractive IRRs

• R&D and S&M expenses might increase going forward if organic revenue growth remains

stagnant

• Mark Leonard has been the driving force behind the company…if he decides to quite a transition

would come with risks, both positive and negative

Disclosure:

We and our affiliates are long Constellation Software (CSU CN) and may buy additional shares or sell

some or all of our securities, at any time. We have no obligation to inform anybody of any changes in

our views of CSU. This is not a recommendation to buy or sell securities. Our research should not be

taken for certainty. Please conduct your own research and reach your own conclusion.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

• Reacceleration of organic growth as cloud conversions continue and they lap covid

• Management embraces modest leverage

• Investors see the EPS accretion from deploying 100% of FCF into M&A

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			2021	2022
Price:	1,706.94	EPS	0	0
Shares Out. (in M):	21	P/E	0	0
Market Cap (in $M):	36,090	P/FCF	0	0
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	36,090	TEV/EBIT	0	0