Description

Lumine Group is the most recent spin-off from Constellation Software (CSU), following Topicus which was spun in 2021.  The Lumine spin-off was completed in February 2023 in conjunction with the acquisition of WideOrbit, and Lumine’s stock began trading in March 2023.

Preliminary note on currency:  Lumine reports in US dollars.  Its stock trades on the TSX Venture Exchange in Canada in Canadian dollars.  The stock also trades in the US over the counter in US dollars.  All figures in this writeup are in US dollars; the stock price and resulting market capitalization and enterprise value figures are based on the price quoted in the US OTC market.

Constellation Software.  To understand the investment case for Lumine, one must understand the investment case for CSU.  I suspect many on VIC are familiar with CSU; it has been written up four times since 2014 and CSU’s previous spin, Topicus, was written up in 2021.

CSU is a Canadian cult stock and I mean that in a good way.  I am a recent convert to the cult, so to those VIC readers familiar with the name I probably can add little of value.  To those readers unfamiliar with CSU, I provide a CliffsNotes summary below.  Apart from this, however, I would urge those unfamiliar with the name to become familiar.  The flippant reason for this – just look at the stock chart since its IPO in 2006.  The more substantive reason is that CSU’s free cash flow per share increased at a CAGR of nearly 23% from 2010 to 2022, and any company that can increase free cash flow per share at over 20% per annum for twelve years with little debt, no stock repurchases, annual dividends (including a large special dividend), and organic revenue growth of only 2% per year is worth studying.  Apart from that, Mark Leonard, CSU’s founder and chief executive, is himself worthy of study.

CSU acquires, manages, and builds vertical market software (“VMS”) businesses.  These businesses typically provide mission critical software solutions, often entail high switching costs, and are often a small portion of the customer’s expenses.  That combination yields pricing power, sticky customers, and low churn.

CSU has six operating groups encompassing numerous business units and hundreds of companies.  CSU’s management mantra is decentralization and autonomy.  Decisions are relentlessly pushed down to the operating group, business unit, and individual company level, both with respect to operations and, increasingly, M&A.

The key to CSU’s stellar returns is its M&A system.  While the VMS businesses owned and targeted by CSU are not necessarily great businesses, the VMS universe provides an excellent environment for a rational, disciplined, extremely well executed roll-up program.  I encourage readers to review Mark Leonard’s shareholder letters, where he describes the process extremely well. Some highlights:

Disciplined.  The process is disciplined, with strict return hurdles.  CSU will not stretch – targets must meet the investment hurdle rates.  CSU does not disclose its hurdle rates; however, most observers believe that for CSU’s bread and butter small VMS deals, the hurdle rate exceeds 20%.  CSU has recently publicly disclosed that it reduced the hurdle for larger acquisitions.  Management has not disclosed what the lower hurdle is but observers believe it is 15% at a minimum.

Data Driven Evaluation.  CSU has a comprehensive database of potential M&A targets.  It also has an internal proprietary database of its M&A history and its current operating companies with key operational and financial metrics – what worked, what didn’t work, and why.  Assumptions and projections for all prospective deals are benchmarked against the database as part of the approval process.  This same data driven evaluation applies post transaction. CSU conducts post-acquisition reviews on the first anniversary of every deal – each target’s post-acquisition performance is scrutinized and the investment outcome analyzed.

Incentives.  CSU’s employee bonus plan requires that employees who reach a threshold level of compensation invest a portion of their compensation in CSU stock (purchased in the open market) that vests over a period of years.  Operating group managers must invest 75% of their after-tax incentive compensation.

Learning.  Company and business unit managers are strongly encouraged to be learning machines, both regarding CSU best practices and external practices that can be used to improve CSU’s processes.  Sharing of best practices is encouraged throughout the company.

Decentralization.  Business units are responsible for and encouraged to engage in M&A.  CSU has recently initiated a “keep your capital” program.  Essentially, it works like this:  You guys are doing great, you’re generating a great return on your acquisitions, keep your cash and buy more.  If the unit doesn’t engage in M&A, then the unit’s ROIC declines because of the increased capital base (accumulated cash).  If the unit does engage in M&A but makes crappy deals, the unit’s ROIC goes down.  ROIC is an important metric for compensation, so the incentives are clear.

Buy and Hold.  CSU is a buy-and-hold acquirer.  This makes it a potentially attractive home for niche VMS software businesses as compared to private equity buyers.  Relatedly, CSU does not depend on acquisition synergies or economies of scale to reach its hurdles.  Targets operate autonomously with existing management generally retained.

Cash Buyer.  CSU pays cash for its acquisitions; it does not issue stock.  The Lumine/WideOrbit transaction is an exception in that regard but, importantly, the stock portion of the WideOrbit  price was paid in Lumine stock, not CSU stock.

To learn more about CSU, Mark Leonard’s shareholder letters are the place to start (note, though, that he stopped writing annual letters in 2018).  The transcripts of CSU’s annual meetings are another good resource – the AGMs feature long Q&A sessions, and senior management and group leaders all participate.  From there, Substack is a good resource – members of the cult like to write about the company.

Lumine Group – Overview.  Lumine acquires, manages, and builds VMS businesses in the communications and media industry.  Lumine began life in 2014, when David Nyland (Lumine’s current CEO) joined CSU’s Volaris Operating Group to found and build a communications and media business.  Lumine has three operating groups, two primarily operating in the communications vertical (i.e., the legacy Lumine operating groups) and the other being the media operating group (i.e., WideOrbit).  The communications operating groups together include twenty-two 22 independently managed business units.

WideOrbit.  WideOrbit Inc. provides advertising management technology for cable networks, local television stations, and radio stations, including a full enterprise resource planning system to manage advertising sales and operations from air to invoice for any media type or sales channel.  Services include advertising sales and commercial operations, inventory management, order management, ad placement and optimization, business analytics, billing, and accounts receivable.  Eric Mathewson (the current WideOrbit CEO and a member of Lumine’s board) founded WideOrbit in 1999.

Spin-off and WideOrbit Acquisition.  CSU’s management’s stated reason for the Lumine spin-off is that Lumine will grow faster, and perform better, as an independent public company than it would within the CSU group of companies (management also stated that, although Lumine will operate on a standalone basis, it will continue to benefit from the application of CSU best practices).  This can be viewed as another manifestation of CSU’s decentralization and autonomy ethos.

However, another purpose of the spin was to enable the purchase of WideOrbit.  WideOrbit was a large acquisition for CSU.  Structuring the acquisition within the structure of the spin enabled CSU to issue stock (albeit Lumine stock, not CSU stock) as partial payment of the purchase price and also allowed the issuance of debt to pay a portion of the cash consideration.

The purchase price for WideOrbit was $490 million.  Based on 2022 numbers, the price represented multiples of 3x sales and 11x EBITDA, well in excess of the multiples typically paid by CSU.  I seriously doubt that CSU compromised its hurdle rate criteria to make the acquisition although, as a “large” acquisition, the hurdle may have been 15% instead of 20%+.  My supposition is that CSU’s metrics showed that a 15% IRR was achievable, whether through organic growth and/or margin expansion.

The mechanics of the spin were as follows:

- CSU received one super voting Lumine share.  The super voting share entitles CSU to 50.1% of the aggregate number of votes attached to all voting shares.

- CSU also received 63,582,712 Lumine preferred shares.  The preferred shares are convertible into Lumine subordinate voting shares at a rate of 2.43 subordinated voting shares for each preferred share.  The preferred shares are also entitled to a fixed annual cumulative dividend of 5% per annum based on $21.74 per preferred share.

- The WideOrbit sellers received 10,204,294 Lumine special shares.  The special shares are convertible into Lumine subordinate voting shares at a rate of 3.43 subordinated voting shares for each special share.  The special shares are also entitled to a fixed annual cumulative dividend of 5% per annum based on $21.74 per special share

- Finally, CSU distributed 63,582,706 Lumine subordinate voting shares to CSU’s common shareholders.

The preferred shares held by CSU and the special shares held by the WideOrbit sellers will likely be converted into subordinate voting shares in 2024.  In the meantime, Lumine will be obligated to pay dividends of approximately $80 million per year on account of these shares.

Governance.  Lumine’s board consists of seven directors, consisting of (1) four directors nominated by CSU (CSU has the right to nominate six but delivered an undertaking to the TSX Venture exchange that two of the six would be “independent’ directors), (2) Eric Mathewson, the founder and CEO of WideOrbit (as a representative of the legacy WideOrbit shareholders), and (3) two independent directors.

The CSU board nominees include:  Mark Miller, CSU’s chief operating officer and also the chief executive officer of CSU’s Volaris Operating Group; Brian Beattie, the CFO of CSU’s Volaris Operating Group; David Nyland, Lumine Group’s chief executive officer; and Robin van Poelje, the chairman and chief executive officer of Topicus.

A majority of Lumine’s board of directors must approve acquisitions of $20 million or more, and CSU’s board of directors must approve all acquisitions that exceed $100 million.

Lumine’s officers are as follows:  Mark Miller (CSU’s COO) is the chairman of the board of directors; David Nyland is the chief executive officer; and Brian Beattie (the CFO of CSU’s Volaris Operating Group) is the chief financial officer.  In addition, Eric Mathewson serves as the chief executive officer of the WideOrbit operating group.

Bottom line – CSU controls the board and, through the super voting share and (after conversion of its preferred shares) ownership of a majority of the subordinated voting shares, controls the shareholder vote as well.  I consider this a good thing.

Enterprise Value.  Lumine’s current enterprise value (i.e., prior to conversion of CSU’s preferred shares and the WideOrbit special shares) is as follows:

As the preferred and special shares should be converted to subordinated voting shares in 2024, it is useful to also look at market capitalization and enterprise value on an as-converted basis.

Valuation.  The success or failure of an investment in Lumine shares rests on the success that Lumine management has in executing the CSU M&A system at the Lumine level.

At CSU’s annual general meeting in May, management made it clear that CSU’s spin-offs will operate by the same M&A guidelines that CSU does, both with respect to targeting acquisitions and using hurdle rates and modeling.  CSU’s governance controls and board and management representatives should ensure that.  Furthermore, the employee bonus system (i.e., the requirement to apply incentive compensation to open market stock purchases) is the same.

Apart from the ability to execute, a threshold issue is the size of the target pool for Lumine’s M&A strategy.  Management has expressed confidence that the pool is large and deep.  In that regard, I believe it is important to note that CSU’s management is not promotional.  Management, especially Mark Leonard, often goes out of its way to temper investor expectations.  However, while management has been forthright regarding certain M&A challenges (e.g., private equity and copycat competition, expanding market multiples, etc.), I have not heard CSU management temper expectations as to the size and depth of the VMS target pool.  To the contrary, management consistently expresses confidence that the pool is large and growing, and Lumine’s management echoes that with respect to Lumine specifically.

The preferred and special shares should convert to subordinate voting shares in 2024, which will eliminate the dividend burden and leave all free cash flow available for M&A.  I am estimating $100 million in free cash flow in 2024.  My very rough valuation range estimates are as follows:

- Assuming 75% of FCF is used annually for M&A, that M&A results in an IRR of 15%, zero organic revenue growth, and zero margin expansion, a terminal FCF multiple of 15x yields a stock price in 2033 of $19.  I expect that CSU management would deem those financial results a failure.

- Assuming 90% of FCF is used annually for M&A, that M&A results in an IRR of 20%, 2% zero organic revenue growth (CSU’s average), and zero margin expansion, a terminal FCF multiple of 15x yields a stock price in 2033 of $37.

- Finally, assuming 100% of FCF is used annually for M&A, that M&A results in an IRR of 25% (CSU’s historic average), 4% organic revenue growth (Lumine’s current blended organic growth rate), and zero margin expansion, a terminal FCF multiple of 15x yields a stock price in 2033 of $73.

Bottom line – if Lumine can maintain its current organic growth rate and duplicate CSU’s historic M&A results, Lumine’s stock will provide excellent returns.

Risks:

Unable to utilize all cash flow for M&A.

M&A results do not meet hurdle rates.

Business results deteriorate – lower organic revenue growth, declining EBITDA margins.

Catalyst

Time