• Brett Schafer

Deep Dive: Constellation Software

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Show Notes

(Ryan) What they do: Constellation Software is an amalgamation of hundreds of different VMS providers. They buy software companies that target very niche markets, so for example like a police force operational software or like “Aleyant: A global web to print estimation and production and prepress automation workflow provider.” Basically it’s software businesses with a smaller TAM but a market they can capture.

Management then uses the cash flow from these businesses to go out and acquire more. We don’t know the details of every acquisition, but it’s reported that Constellation is a pretty disciplined buyer and sometimes gets these companies for 1x-1.5x sales. The incentive often times for these portfolio companies to sell is 1. Money, but also apparently there’s a better chance for upward mobility within Constellation as well as the business itself can be enhanced if they implement Constellation’s best practices.

(Ryan) History: So Mark Leonard, who is apparently like 6’5” and 250 pounds, played college sports, and has a massive gandalf like beard started the company in 1995. He is an insanely private person, so it’s hard to find any surefire facts about him.

Leonard apparently had a bunch of unique jobs prior to starting constellation (grave digger), but he eventually went back to business school at the University of West Ontario and ended up getting his start in VC land and working there for 11 years.

As the story goes, he was seeing a bunch of VC firms pass up on the smaller software plays because they didn’t think it could be a homerun. There wasn’t a big enough TAM. But he liked the idea of a small software provider dominating a small market and started constellation to help bring them all under one umbrella.

(Brett) Industry/Landscape/Competition:

  1. Vertical software market for SaaS valued at over $100 billion globally, growing very quickly

  2. In 2017 there were an estimated 100k software companies worldwide, which has likely grown substantially

  3. Competitors: Vista Equity, Roper, Tyler Technologies. There are a few roll-ups, but within each business unit it competes in a variety of markets

  4. If you look at the https://www.csisoftware.com/our-companies they operate in every industry

(Ian) Management and Ownership:

  1. Mark Leonard is the CEO

  2. Great letters. Does not write them annually anymore because they began to see competitors using them to their advantage

  3. Isn’t a fan of mission or vision because it has been proven how bad humans are at projecting the future. Instead. He likes objective. “Our objective is to be a great perpetual owner of VMS businesses.”

  4. See no upper limit to the number of business units they can have

  5. Trying to create a collegial atmosphere

  6. $2.4B net worth

  7. Doesn’t take a salary,

  8. Owns about 2% of the company

(Brett) Valuation:

  1. Market cap of $32.7 billion, ticker CSU.TO and CNSWF in the U.S.

  2. EV of $33 billion

  3. EV/s of 7.87

  4. EV/FCF of 25 (according to Koyfin, they do some internal stuff)

  5. Dividend yield of 0.21%, share count has stayed very flat

  6. Fun fact: From 2008 – 2012, there was a 5 year period where you could buy shares at a 6%+ FCF yield

(Ryan) Earnings: Using the 2020 numbers. There really isn’t a lot to cover here, just FCF and revenue.

  1. $3.97B in revenue, up 14% YoY

  2. They break down their revenue into 4 parts. Licenses, professional services, hardware and other, and maintenance and other recurring revenue (this one makes up the majority).

  3. FCF of $989M, up 68% YoY

  4. So roughly 25% FCF margins last year

  5. Since they use their business cash flow to acquire, they run a pretty lean balance sheet.

  6. Looks like share count has stayed steady

  7. Organic revenue growth was actually negative during 2020. Not always normal, Covid threw a wrench in a lot of the portfolio companies’ sales practices.

(Ian) Balance sheet and liquidity:

  1. Cash of 932 mm up from 364 a year ago

  2. Debt of around $400m

  3. Net cash position of $530mm

  4. Most of the debt is not current

  5. Interest rate is sort of high for debentures Inflation plus 6.5%

  6. Balance sheet includes an undrawn revolving loc

  7. Also some preferred stock however that pays a 5% dividend

  8. Related to the spin-out of Topicus, euro based business

  9. Kind of hard to judge given how vast the enterprise is, but generally looks healthy to me.

  10. Lot of cash to potentially go after some

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Anecdotal Evidence:

  1. (Ryan) Most of these are B2B VMS softwares, and I haven’t really worked in a lot of places so I don’t think I have much experience with any of their products. As for CSI, Mark Leonard doing very little media related stuff is something I usually admire as long as they are producing good financials.

  2. (Brett) This is probably the real 21st century Berkshire Hathaway

  3. (Ian) Similar to Mark Andreesen talking about Hewlett Packard on Invest Like the Best

Future growth opportunities:

  1. (Ryan) Cutting the dividend seems like a good decision. I know this is now in the past, but since Constellation is able to invest capital more effectively than shareholders thanks to the position they’re in, cutting the dividend should result in more cash flow to the shareholders over the long run. They talked about this on the very first page of Mark Leonard’s letter.

  2. (Brett) Moving outside of VMS. In the recent shareholder letter from Leonard this February (first one in a few years), he said “we are trying to establish a new circle of competence.” This is the first time in its history Constellation is doing this. It will be risky, but interesting to see what they come up with

  3. (Ian) Larger acquisitions and reinvesting more capital. The thing that concerns me about it though is the low-rate of organic growth

Highlights and lowlights:

  1. (Ryan) Highlights: Exceptional capital allocator at the helm. Not really any threat of competition from big tech, since the TAM isn’t large enough to where it makes sense for them to go after. Lowlights: Ya I don’t have any, but perhaps size becomes a factor and I’ll explain why in my bear case.

  2. (Brett) Highlights: The decentralized structure that Leonard and the team created that allowed them to scale sustainably was very impressive (OCF/s went from like $0.10 to $50 in 15 years), the industry they are in, strategy of not caring if something is “hypergrowth” or declining, just looking for good price. Lowlights: none.

  3. (Ian) Highlights: Genius strategy, proven track-record, likely many, many effective managers. High FCF per share growth, ROIC etc Lowlights: Bad organic growth, and beginning to grow out of its comfort level

Bull case:

  1. (Ryan) Thanks to modern software tools, building a niche software business becomes easier than ever. There’s a massive pile for CSI to pick from and they continue down this same path they’re already on.

  2. (Brett) For existing shareholders, you probably just want the team to keep doing what it has been doing and got them to become a 100 bagger. But if you are thinking of buying here at a somewhat elevated valuation I would be looking closely to what they are doing with these larger VMS purchases and the new “circle of competence.”

  3. (Ian) Pivot to larger acquisitions works. They are able to replicate the success they have had with seven-figure acquisitions and become great at nine figure acquisitions. Continue to compound capital at great rates, benefiting shareholders

Bear case:

  1. (Ryan) The one issue I keep thinking about and maybe its been addressed by management. The bigger they get, the less effect a single small acquisition has on the business, so they either have to acquire a lot more (which it seems like they are doing) or buy larger companies. Could they begin to runout of valuable additions to the portfolio? There’s fairly high MOS since these businesses are generating cash flow themselves.

  2. (Brett) Two come to mind that wouldn’t be detrimental but a headwind. Acquisition prices creep up as more PE demand hits the industry, which makes it tougher for CSI to find deals. New acquisition strategy doesn’t work out

  3. (Ian) These VMS (vertical market software) businesses are in industries that are dying out. More and more consolidation in the software industry to the big players and ERPs. Lowcode for other forms of VMS.

*Our Thursday Deep Dives are sponsored by Quartr. Quartr is democratizing investor relations by bridging the gap between companies and stakeholders. Download on the App Store or Google Play Store today.

Disclosure: The authors and podcast guests are not financial advisors. Brett Schafer and Ryan Henderson are portfolio managers at Arch Capital. Clients of Arch Capital may hold securities discussed on this podcast.

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