Up front disclosure: I own Constellation Software and Topicus in my personal account. CSU is currently my largest holding.

There is no doubt that Constellation Software Inc. (CSU) has been a tremendous business. Of course, that alone does not necessarily make a great investment going forward. Constellation Software trades publicly on the Toronto exchange (TSX) and is currently around a 40 Billion C$ market cap and slightly higher enterprise value (very little net debt). They have been operating since 1995 and publicly traded since 2006. It remains under the leadership of its long time CEO and founder Mark Leonard. He is known for being an amazingly smart capital allocator and leader and also for his distaste for public appearances. His letters to shareholders are must reads for a view into his mind and how a great capital allocator can provide amazing returns over the long term.

What do they do?

CSU has been buying small vertically integrated market software companies since its existence. Vertically integrated market software businesses means that these businesses offer specific services to the end customers for a particular business need. An example might be a scheduling and reminder software feature for a dentist or doctor’s office. It is not horizontal market (classic example being Microsoft Excel) where the product is used by many people and organizations for many reasons.

The target acquisitions for CSU are relatively small (they claim they want at least 5 million in revenue) but usually mature market leaders in a particular niche market. Ideally, these products are “mission critical” but a small portion of the overall cost the end users cost. Because of this, these businesses dominate their niche market and enjoy repeat business and because they don’t tend to be “nice to have”, they enjoy a durable and long lasting customer base with little competition or changes in technology that might upheave the business. Margins in these businesses tend to be very good and the theme going forward will be to offer SaaS (software as a service) whenever possible to allow recurring revenues.

In a simplistic sense, the business is broken out into several operating groups that oversee the smaller business units (the actual software companies). The organization into small groups and not some large centralized entity from headquarters is done on purpose to ensure the operating decisions are made as close to the ground as possible. Only large capital allocation decisions are made at the top levels. Even acquisitions these days are made at the operating group level with exceptions for very large acquisitions which are something that will be relatively new as the business grows larger and larger.

Do they make money?

The individual software businesses make very good margins (some better than others). The business has always been profitable and now that the scale has grown significantly, the business is a very reliable generator of free cash flows. It has grown free cash flows and its margins significantly over the years. To give you an idea, the top line revenues have grown around 20% a year for the past decade while the free cash flows have grown between 20 and 30%.

The quality of software revenue is quite amazing, the gross margins for the corporate entity sits just under 90% currently and has been steadily above 85% for the past 10 years. The free cash flow margin has grown from 20 to 30% over the past few years.

Are there reinvestment opportunities?

The bear case for CSU over the past decade or so has always been that there will be a shorter runway for good acquisitions in order to maintain growth at high rates compared to when CSU was a small company. At first glance, it is fair to say that the shear size of the company will make it MORE challenging to continue the growth rates compared to its own past. That being said, this is not the worst problem a business could face.

According to CSU it has a database of around 40,000 VMS businesses that it is aware of for future potential acquisitions. It currently has bought and continues to own over 500. So even if it only ever acquires 10% of the total available businesses, it could stand to grow significantly larger over the next decade. It is also hard to imagine more VMS businesses not becoming available over the next 20 years as the world goes more and more digital in all of its business needs.

In recent shareholder letters, the company has acknowledged its size as potentially being a headwind and commented that it will be looking for larger acquisitions to offset this. While larger acquisitions tend to also be more expensive, the bottom line is that if these can still be a higher return compared to giving capital to shareholders, it is still creating value for shareholders.

Is there a risk of a blow up?

Financially speaking, the company does not have significant debt on its balance sheet. It has recurring revenue businesses that are not focused on any one industry or any one customer or any one geographic area. From this perspective, there is little risk of any significant permanent loss from the continued operation of the business. The majority of the end VMS businesses are mature and do tend to perform somewhat correlated with the broader economy but that being said, this is less so than most businesses and they require much less capital to maintain.

As the business ventures into larger acquisitions, this will be something to keep an eye on. I suspect the management team will apply the lessons learned from the hundreds of smaller acquisitions but that is to be determined.

Is management sketchy?

Other than the big long beard, no.

The management team operates in a decentralized fashion. This means that the business groups oversee their areas and make all decisions without any overarching committee from headquarters breathing down heir necks. They do not try to fundamentally change or integrate new businesses into the other owns. That being said, they have been open about sharing best practices and generally seeking assistance in areas where others succeed.

Historically, the board has given a regular dividend which they have increased periodically over the years and have also periodically provided special dividends when cash has built up with no special place to put it to work. While the regular dividend remains, more recently, special dividends have been cancelled. This was explained in a special letter to shareholders and went on to discuss better opportunities for reinvestment as the driver. This was a great example of the ability of the CEO, Leonard, to think strategically for the long term benefit of shareholders. He listened to a board member and was able to change his mind from his previous thoughts on dividends.

Does it have a moat?

Its moat is best characterized as its organizational structure and culture. It appears that it has successfully become a great place for small VMS to sell to in order to have a permanent home. CSU has basically never sold any of its businesses and does not try to tamper with the details of how to run them nor do they try to integrate them into some corporate version of what they “should” be. This combined with a culture of long term thinking and smart capital allocation, I believe is a moat that is not easily attacked or replicated. It can likely source better deals than most because of these traits.

I do believe that as the business continues to become larger and larger, this culture will be slightly more difficult to maintain. That being said, the decentralized structure means that it should be able to keep chugging along for a while. The truth is, it isn’t Leonard that is the brilliant deal maker in these hundreds of acquisitions. He has taught his managers how to do this. It is something that can be repeated over and over and it appears that they learn from mistakes…something that is beneficial when you do many small deals compared to a few massive ones.

Is it cheap?

On most traditional metrics, CSU does not appear like a steal of a deal. It never really has appeared on any “deep value” lists. Historically, the best time to get into owning CSU has been as soon as possible. That being said, given the size of the company and if you believe the bear cases regarding its ability to continue growth going forward, it does appear to be at best fairly valued and is perhaps overvalued to an extent where future returns will not meet the returns of the past.

The P/E is hovering at or near 10 year highs around 90 at the time of writing and the P/S is around 7.5. It will require continued growth at reasonable rates (15-20% a year) for many years for this high valuation risk to be mitigated. It is also always possible that the market’s willingness to value these businesses so high to erode the multiples even if the business fundamentals continue to hit their marks. This has happened to great companies in the relatively recent past (think Microsoft from 2001 to 2012 or so). This is likely the biggest risk the stock faces (mind you, this is not really a business risk but rather a market risk that could impact future returns for investors).

Final thoughts:

Constellation Software is no doubt a great business. It is not screaming cheap (but never has). The two things to watch for will be the ability to continue growth by acquisitions as the company becomes very large. The other will be the market sentiment and willingness to continue valuing the business at high valuations.

BUT WAIT THERE’S MORE:

On a related note, another interesting similar business to look at that is much smaller but could have similar traits is Topicus (TOI.V). Topicus does the same type of business focused in Europe and was recently spun out from CSU after CSU made the purchase in 2013. If you believe CSU is too big, Topicus might have a slight edge in that regard (and is also likely less well known).

What do you think? Let me know what you think and share/subscribe if you enjoyed. Follow me on twitter @MoS_Investing

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