Constellation Software ($CSU.TO, $CNSWF).

Counting Stars

May 10

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Today I will be completing an in-depth analysis on Constellation Software. Within, I will spend time giving a brief overview of the functionality of Serial Acquirer businesses and attempt to quanitify what has made the CSI story so interesting thus far. In addition, I will get more company-specific, and delve into the general organizational structure of CSI, outline their acquisition strategy, and break down their financials over the course of the last decade and within their most recent reported quarter, Q1’22. As always, the format of this research piece can be seen outlined below, feel free to skip ahead to the sections that you feel will be most useful:

1.0 Sponsor

2.0 Introduction

3.0 Serial Acquirers

4.0 Operational Nuances of CSI

5.0 Financials

6.0 Q1’22 Takeaways

7.0 Discussion

8.0 Conclusion

Disclaimer: The information and research contained herein is all my own opinion and should not be used as a substitute for proper due diligence. Please consult your financial advisor and evaluate your financial circumstances before making any investment.

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1.0 Sponsor

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2.0 Introduction

Our species has an undoubtable connection to the world around us, a natural fascination that is ingrained within the very fabrics of our being. Tied to this inexplicable wonder are the lure of the stars, of which have manifested themselves deeply within human culture. Our ancestors used these celestial objects as tools for navigation, as foundations for mythology and lore, and as starting points for astronomical discoveries that would eventually lead to a heightened understanding of our place within the universe. Interconnected are constellations, i.e. a group of stars that form a recognizable pattern and are named after their or association with a mythological figure.

After completing a substantial amount of research on Constellation Software (CSI), I found this dictionary definition to be quite fitting. Despite not dealing with celestial objects, the company itself is a grouping of vertical market software companies, of which are obtained based upon a set of rigid principles and quantitative standards that I will touch upon in later sections of this report. In addition, I would argue that much like constellations (in the astronomical sense of the word) being associated with mythical figures, CSI is directly tied to one of the most elusive, mysterious and fascinating business personalities of our era, Mark Leonard, someone you can see if you look close enough in the night’s sky.

Out of all of the publicly traded companies I have written about thus far, CSI stands out amongst the pack. With more than a decade's worth of President’s letters offering insights arguably more useful than an MBA, financial performance that has demonstrated remarkable resilience, ingenuity and relentless execution, and a culture that displays unparalleled amounts of skin in the game, I can understand why so many have been drawn to this corporation.

With this brief introduction in mind, let’s start to build our foundation of Serial Acquirers before delving deeper into all things CSI.

3.0 Serial Acquirers

In February of this year I started to familiarize myself with the world of Serial Acquirers, a journey that was daunting at the time but has proved to be enormously rewarding. Two pieces were instrumental in my initial immersion process, the Serial Acquirers Primer Report by Scott Management LLC and the Studying Serial Acquirers Piece by Canuck Analysts at the Exploring Context Substack. I highly recommend you check both of these write-ups out.

Serial Acquirers, much like their name entails, are businesses that leverage a growth by acquisition strategy, deploying the majority or entirety of their free cash flow in the purchase of companies, that should result in, both theoretically and ideally, high rates of returns on invested capital. The Serial Acquirer firms themselves often have low single-digit organic growth rates and thus rely upon a continuous cycle of investment -> cash flow generation -> investment in order to keep scaling and creating value for shareholders. Serial Acquirers can be split into four main categories, of which can be seen detailed below:

Roll-Up Serial Acquirers are companies that often thrive within one specific vertical or industry, commonly buying up companies that operate within the same end-market and merging them together. The “Rolled-Up” entity should theoretically benefit from economies of scale, expert-level research and knowledge capabilities of a particular area, and the ability to enjoy a higher deal volume cadence than their counterparts. However, there are typically issues related to the law of diminishing returns within a TAM, as well as the risk that acquired companies may not synergize within a rolled-up unit as intended.

Holding Companies are Serial Acquirers that own a portfolio of unrelated companies, allowing these entities to control their own day-to-day operations, only exerting influence via some form of board representation or presence. These entities often offer cost-efficient exposure to a variety of businesses but fail from a lack of transparency between different parties such as shareholders, customers and managers.

Accumulators are Serial Acquirers that allocate capital within a series of different verticals, allowing the acquired businesses, platforms or roll-ups contained therein to exist independently, oftentimes not seeking to synergize or restrictively oversee/manage operations. These businesses benefit from a generalist approach to Serial Acqusitions, often unfettered from allocating capital to different TAMs, and are thus able to reinvest capital in the areas that may provide the best opportunities. This strength is also a downfall, as the accumulator often exposes themselves to the possibility that they don’t understand an acquisition or industry well-enough. In addition, these businesses face scaling issues as increasing cash flow burdens requires heightened M&A processes and bigger acquisitions, which often lead to diminishing acquisition cadence and returns on invested capital, respectively.

Platforms are Serial Acquirers that operate a handful of platform businesses, of which behave in a roll-up esque manner, expanding within a particular market or vertical through “bolt-on” acquisitions. These businesses present themselves as good opportunities if they are able to purchase additional platforms without hindrance and if they are able to pass bolt-on acquisition processes down the organizational hierarchy but may falter due to the large financial risk that is often associated with platform purchases or if knowledge transfer is not able to occur through an organization efficiently.

Getting more specific to the company of discussion today, CSI can be categorized as an Accumulator. As alluded to earlier, there are operational challenges with these types of serial acquirer businesses, particularly those with maintaining a high degree of growth, earnings and returns on invested capital, cash flow deployment, acquisition cadence and organizational wellbeing/responsibility delegation in unison with increased scale. As an example, surpassing a deal threshold of 10 deals or more is often required to continue to spur meaningful growth, however, this feat is often burdensome, and proves to be challenging for most firms to achieve sustainably. In addition, operating as a serial acquirer for an extended period of time almost never translates into the creation of shareholder value. A study performed by The Boston Consulting Group, illustrates the fact that only approximately ½ of Serial Acquirers create value in their deal flows, and often fall short to businesses that leverage acquisitions sparingly (single acquirers), with the top quartile of the former earning on average returns of 13.5% in comparison to the 4.8% of the latter. This is what makes CSI so special, the company has managed to excel from the pack in terms of deal cadence, maintain high rates of ROIC, ensure OCF, EBITDA and Revenue grow at impressive CAGRs and deliver phenomenal returns to shareholders in the process, phenomena that is not omnipresent amongst typical accumulators.

In order to quantify this praise, we can take a look at some of CSI’s key metrics relative to an extensive list of Serial Acquirers, of which I was able to create based on data provided by the Exploring Context piece and the Serial Acquirers Primer Book.

Looking at CSI amongst other successful SA peers, the company has had much higher 5yr and 10yr returns in comparison to the mean, is bolstering a NTM EV/EBITDA multiple that is on par with the mean depsite operational excellence, has a very low LTM Net Debt/EBITDA ratio (i.e. the amount of years it would take for a company to pay back net debt with LTM levels of EBITDA) all while managing to grow Revenue, EBITDA and OCF at commendable rates despite operating with nearly double the Enterprise Value. Although these metrics may appear superficial at the moment, they are quite remarkable given the law of diminishing returns that tends to kick in with respect to both time and scale. With all of these ramblings in mind, let’s start to get more specific with CSI and break the company down in a way that sheds some light on the foundations behind their success.

4.0 Operational Nuances of CSI

In my mind, there are three fundamental facets of the intertwined system that is CSI: the company’s acquisition standards, their organizational hierarchy and their culture. Starting off with acquisition standards, CSI is primarily an accumulator of Vertical Market Software (VMS) businesses. This software primarily addresses the needs or requirements of individuals or businesses situated within a particular vertical, much like the name suggests. In essence, VMS has usefulness in the hands of a particular subset of individuals but little utility elsewhere. In contrast, Horizontal Market Software (HMS) exists as a polar opposite, providing functionality that generates value for many individuals, no matter the industry they operate in. As examples, commonly used dental software such as ABELDent would be a good example of VMS, i.e. serving the needs of dentists but largely useless in the hands of others. Alternatively, Adobe Acrobat PDF viewer is a great HMS example, seeing as it can be used by many, no matter their profession. To entities such as CSI, VMS businesses are enticing acquisition targets because they are abundant, with thousands of verticals existing worldwide, often benefit from recurring revenues at the hands of sticky product offerings, and have attractive unit economics, to name a few positives. As an example, at the end of 2021 there were over 20 vertical software businesses valued at unicorn levels, a phenomenon that should highlight the fact that there is substantial value up for grabs (despite all verticals not being built the same):

CSI applies a set of semi-rigid principles to the acquisition of vertical market software companies, outlining the criteria they leverage for classifying a business as either Exceptional or Good on their website. Exceptional businesses can be classified as those that operate in mid or large sized vertical markets, possessing a minimum of $1M in EBIT, demonstrating earnings (EBITDA) and top-line growth of approximately 20% or more per year, with a great management team. Good businesses on the other hand can be classified as those with strong competitive footing in a smaller vertical market, with a minimum of $5M in revenues, thousands of customers, and competitors that are not threatening. Delving deeper, outside of these surface-level business categorizations, what exactly makes a company a good acqusition that will deliver value for CSI’s shareholders? Within the 2015 President Letter, the company analyzed the IRR for all of the investments they’ve made and noticed two driving factors behind good IRR, particularly the revenue multiple that was paid at the time of acquisition (the lower the multiple the better) as well as the ability for the acquired company to grow their EBITA margins after acquisition. Looking at the company’s financial data, we can see they’ve maintained substantial control over top-line multiples paid for companies, as outlined below:

CSI also demonstrates quite impressive mental flexibility on their acquisitions. A positive IRR can be generated in situations where a business grows, as well as when it is in decline, therefore there is money to be made in both situations. This assertion is corroborated by Mark Leonard as follows:

“How about a thought experiment? Assume attractive return opportunities are scarce and that you are an excellent forecaster. For the same price you can purchase a high profit declining revenue business or a lower profit growing business, both of which you forecast to generate the same attractive after tax IRR. Which would you rather buy? It’s easy to go down the pro and con rabbit hole of the false dichotomy. The answer we’ve settled on (though the debate still rages), is that you make both kinds of investments. The scarcity of attractive return opportunities trumps all other criteria. We care about IRR, irrespective of whether it is associated with high or low organic growth.”

As mentioned earlier, one of the biggest challenges within the serial acquirer space is negating the law of diminishing returns while scaling. This gets into the second fundamental facet of CSI’s business, their organizational hierarchy. Said hierarchy has four major components, Operating Groups (OGs), Verticals, Business Units (BUs) and Businesses. In essence, an OG caters towards a specified subset of different verticals, each vertical will contain a BU and each BU will contain a series of businesses that operate within said vertical. The following schematic outlines the hierarchy in a rudimentary manner:

CSI has six different OGs contained under its metaphorical umbrella, Volaris, which caters towards verticals ranging from Agri-Food to Rental Management, Harris which caters towards verticals such as Utilities and Property Management, Jonas, which is geared at verticals ranging from Hospitality to Moving and Storage, Vela which is aimed at verticals ranging from O&G to Financial Services, Perseus Group which is geared at verticals such as Homebuilding and Real Estate, and Topicus, which is aimed at verticals such as Government and Legal. How these OGs function is the epitome of organizational decentralization, i.e. instead of having a reliance on upper-levels of the organization, acquisition standards, best practices and hurdle rates are passed down to the OGs, which in turn are passed down oftentimes to the BUs, which allows acquisition decisions to be made closer to the targets themselves and ensures bloating doesn’t occur as CSI itself continues to scale. As for the acquisitions themselves, once a business has been obtained by CSI, and exists under its associated OG and BU, there is a significant amount of autonomy that remains. In the 2013 President’s Letter, Leonard outlined the fact that CSI prefers acquisitions of founder-led businesses:

“Our favourite and most frequent acquisitions are the businesses that we buy from founders. When a founder invests the better part of a lifetime building a business, a long term orientation tends to permeate all aspects of the enterprise: employee selection and development, establishing and building symbiotic customer relationships, and evolving sophisticated product suites. Founder businesses tend to be a very good cultural fit with CSI, and most of the ones that we buy, operate as standalone business units managed by their existing managers under the CSI umbrella.”

In essence, this allows businesses operate unabated, or in other words, as if they had never been acquired at all, only being required to send data upwards in the organizational hierarchy. By not centralizing operations, growing pains and synergistic problems are avoided, while also allowing CSI to stay nimble from both an overhead and general functionality standpoint. The aforementioned pass-down efforts of responsibilities from the top all the way down to BUs is also done with a consistent focus on remaining “small”. BUs are routinely split up once they reach a certain size in order to ensure that responsibilities do not become burdensome in relation to headcount. In short, the organizational hierarchy of CSI abides by a set of simple heuristics: operate in a decentralized manner and distribute responsibilities accordingly, don’t fix what ain’t broke, or in other words, leave founder-lead acquired business to operate as usual, and focus on simplicity, i.e. avoid overhead creep and growing pains wherever necessary.

Lastly, CSI’s culture is an evident driving factor behind the company’s success. We’ve all heard the success stories of founder-led companies excelling in comparison to the benchmark, and this tale is no different, with Mark Leonard still playing a significant role in the story after more than two decades at the helm of the fast-growing Serial Acquirer. Being that as it may, there is more to the tale, particularly when one starts to delve deeper into the tales of employee enrichment, and the high levels of skin in the game that members of CSI are encouraged to bolster. In the 2015 President’s Letter, Leonard outlined the fact that there are over 100 employees that are millionaires at the company, a figure that has no doubt been aided and abetted by the lack of gravity felt by the price of shares in the company, but one nonetheless that Leonard stated he hoped to grow by a factor of 5X by 2026. These values are aided by the low turnover rate of employees and their tendency to rise up the ranks, as well the employee bonus program requirement that requires ones to buy and hold shares for a period of four years once they exceed a certain threshold income. Something that stuck with me during my research was a note Leonard made in his 2017 President’s Letter, one that outlines what a career path would look like for an ambitious employee joining CSI:

“Immerse yourself in learning about the peculiarities of VMS economics. At some point, transition from analyst or knowledge worker into a leader of people. I find there is no magic to managing and leading. If you are smart, work harder than everyone else around you, treat people fairly, do not ask them to do anything you would not or have not done, share the credit, keep learning and keep teaching, then pretty soon you have followers. If you make sure that the team members are intelligent, energetic, and ethical people with whom you would want to work for the rest of your career, it won’t be long until you are running one of our BU’s.”

Judging by the amount of millionaires under CSI’s umbrellas, as well as the anecdotes that most analysts have come across, I have no doubt that this path has been followed by many an employee despite only being put down on paper recently. CSI’s reputation speaks for itself, and has blossomed into not only an organic recruiting tool, but a proposition to companies that may eventually be required by CSI, a phenomenon that may set the entity apart from other bidders. With that in mind, I will leave you with a snippet from the same 2017 letter that I feel sums up Leonard’s phenomenal attitude:

“You may have noticed that I deferred the “why are we doing this?” question. The answer to that is personal to each of us who are involved in Constellation. My motivation is to help create a company where worthy people succeed. Whether they join us with an acquisition or are hired from the outside, I want to support and encourage employees who work hard, treat others well, continuously learn, and share best practices. I try to make sure that sycophants, spin-doctors, and mercenaries don’t survive in Constellation’s senior ranks. Harder, but not impossible, is helping identify and remove hidebound managers who rely upon habit and folklore to run their businesses rather than rational enquiry and experimentation. Constellation is as close to a meritocracy as I have experienced. I hope it will continue to provide an environment where entrepreneurs and corporate refugees can invest their lives and their capital and thrive.”

With acquisition standards that are passed down the ranks and trusted to those close to the ground, an organizational hierarchy that almost negates the potential for the problems-with-scale phenomena commonly experienced by Serial Acquirers, as well as a culture that encourages excellence and allows the most-talented to rise to the top and be compensated handsomely for it, there is no wonder Constellation has been so successful since inception.

With that in mind, let’s take a look in the rear view mirror and quantify the company’s aforementioned success alongside some key financial metrics and values.

5.0 Financials

I will be delving into the company’s financials on an annual basis, from 2010 to 2021 within this section. In addition, I will provide a brief overview on some key talking points and happenings from the company’s most recent earnings. Please note that all dollar values displayed within graphics are in millions of USD.

Income Statement

Revenue

Starting off with the company’s top-line, this metric came in at approximately $5.1B for 2021, growing at a CAGR of approximately 21% from 2010 to 2021 and representing a YoY change of 29%, as outlined below:

Revenue can be split into four main components, License, Professional Services, Hardware & Other, and Maintenance & Other Recurring. Generally speaking, Licensing revenue consists of non-recurring revenue charged for the use of software, professional services revenue consist of fees generated by implementation services, custom programming etc., hardware & other revenue consists of the resale of third party or internally assembled hardware and travel reimbursements, and maintenance & other revenue consists of revenue that is largely recurring in nature, i.e. customer support, software contracts, managed services etc. The breakdown of Total Revenue to each of these constituents can be seen outlined below:

As the above figure clearly conveys, Constellation’s Revenue is being increasingly driven by the contributions of Maintenance & Other Recurring Revenue, coming in at approximately 71% of Revenue. Professional Services Revenue has remained relatively consistent, coming in at approximately 20% of Revenue in comparison to 27% in 2010, with Licensing displaying a similar phenomenon, coming in at 6% in 2021 in comparison to 8% in 2010. Lastly, Hardware and Other has almost become negligible, coming in at 3% of Revenue in comparison to 12% in 2010. Speaking conservatively here, I believe it is reasonable to assume that we continue to see sustained growth in the Maintenance & Other Recurring Revenue segments. The rise over the last decade has been driven largely in part by the overall dynamics of software as a whole, particularly the move in the direction of SaaS businesses overall, which function off of recurring revenues. With the higher margin nature of this business segment, this is a net-positive happening for Constellation’s business overall.

Next, it is worth breaking down the company’s Top-Line growth itself. As I alluded to earlier with Serial Acquirers in general, these businesses rely upon the deployment of capital to sustain both returns and growth overall, as such, it should come as no surprise that the majority of CSI’s top-line growth has come by way of acquisitions. From 2010 to 2021, the average Organic Growth Rate, i.e. the growth in the top-line of existing businesses under the CSI umbrella, was approximately 1%, with yearly behavior of this metric outlined below

From 2016 CSI also started to disclose the distribution of the Organic Growth rate attributable to each of the four Revenue segments, data that can be seen outlined below:

The biggest takeaway from this data, in my eyes, is the Organic Growth we’ve seen in Maintenance & Other Recurring Revenue. If this metric continues to be a driver in overall Top-Line growth, aided and abetted by the transformation of the software industry as a whole, coupled with sustained mid single digit organic growth rate (on average), CSI is likely to benefit substantially from these happenings.

Expenses

CSI’s Total Expenses (i.e. the combination of Staff, Hardware, Third Party License, Maintenance and Professional Services, Occupancy, Travel, Telecommunications, Supplies, Software and Equipment, Professional Fees, Other, Depreciation and Amortization) came in at approximately $4.2B for the quarter, representing a 30% increase YoY, in-line with the growth in top-line, and a 19% CAGR from 2010. Expenses have remained relatively consistent over the course of the last decade, a phenomena that points to the strict acquisition standards CSI maintains as well as the operational excellence acquired businesses continue to abide by once under the company’s umbrella, of which can be seen corroborated with the data below:

Profitability

Constellation Software is a profitable company, an assertion that is corroborated when we take a look at its EBIT, EBITDA and Net Income. EBIT came in at approximately $873M, representing a 21% YoY change and 35% CAGR since 2010. EBITDA came in $1.512B, a 23% change YoY and representing a 27% CAGR from 2010. Net Income was $169M, decreasing 61% YoY and representing an approximate 17% CAGR from 2010. The change in these values can be seen outlined below:

Associated margin profiles can also be analyzed. EBIT margins have been creeping up to the high teens over the last few years, with EBITDA displaying similar behavior in the high 20 - low 30s. Net Income Margins took a dive YoY as a result of some complexities associated with the company’s controlling interest in Toipicus and the conversions they made from preferred shares into associated units, lowering a value that has been in the low 10s over the last few years to a measly 3%, as outlined below:

The accounting nuances attributable to the $(142)M Non-Controlling Interest adjustment made to Net Income, i.e. the driving factor behind the dip YoY, can be seen outlined below:

Noncontrolling Interest Adjustment Information

Balance Sheet, Cash Flow Statement and M&A Activity

The change in CSI’s balance sheet over the course of the last eleven years can be seen outlined below:

Delving deeper into the position the company was in at the end of 2021, the structure of both assets and liabilities can be seen outlined below:

The change in the company’s Cash from Operations, Investing and Financing on the other hand for a similar time frame can be seen outlined below:

Lastly, we can gauge the company’s M&A activity by looking at the three metrics contained within the following figure:

When these three talking points are viewed in conjunction with one another, we can start to take away some key dynamics of how CSI is functioning. First off, CSI utilizes very little leverage within their operations. Within the earlier sections of the report we saw the company’s LTM Net Debt/EBITDA ratio, a value that was approximately 0.5 (per Koyfin estimates) in comparison to the mean of the serial acquirer group of 2.9. With the company’s increasing scale I find it likely that the company slightly ups this value in order to account for the fact that they will need to acquire companies that are larger in order to offset the increasing demands of heightened cash flows. Staying on the topic of increasing cash flows, the company’s OCF is evidently scaling, a proposition that may prove to be troublesome if CSU continues to maintain their high hurdle rates, a discussion that anyone with a remote familiarity with the company has heard a multitude of times. Cash Deployed in Acquisitions has rarely been the entirety FCF (relatively speaking), which has resulted in the Cash and Cash Equivalents component of the company’s balance sheet continue to increase in size. Despite the Cash Position remaining stagnant from 2020 to 2021, as a result of CSI deploying nearly $1.22B in capital to acquisitions, a figure that was 96% of FY’21 FCF on a relative basis, I find it likely that Cash continues to build up, unless the company is able to lower hurdle rates or decides to return cash in the form of dividends to shareholders if no attractive opportunities present themselves.

A dichotomy also exists with the connection between the size of the capital base Constellation aims to deploy and ROIC. Simply, as the amount of cash builds, the company either needs to substantially increase the number of small acquisitions they complete with their standard hurdle rate, or, as an alternative, complete larger acquisitions that, usually, by definition, have higher hurdle rates, and are thus likely to bring down ROIC in the process. ROIC and ROIC + Organic Growth have historically been quite phenomenal, however, it is very likely as CSI continues to grow these metrics (particularly ROIC) will feel downwards pressure and likely settle in the low-mid 20% range in the latter end of the next decade

Change in ROIC and ROIC + Organic Growth (%)

With that in mind, and before mulling over a few key points I’m thinking about with respect to CSI’s future positioning, let’s delve into some high level takeaways from the company’s Q1’22 earnings release.

6.0 Q1’22 Takeaways

Starting off with the company’s Top-Line, we saw a 22% increase in Top-Line overall, with Maintenance & Other Recurring Revenue showing the most rapid YoY growth, increasing to 73% of Total Revenue. Organic Growth rate was approximately 1%, driven by a 4% Organic Increase in Maintenance & Other Revenue, offset by Organic declines in all other segments across the board.

Expense profiles remained largely the same, as outlined below, with Total Expenses increasing 27% YoY, a slightly faster rate than Top-Line overall.

Moving over to profitability, both EBIT and EBITDA were relatively stagnant YoY, with the former decreasing approximately 3% and the latter increasing 7% in comparison to Q1’21. Net Income on the other hand increased to $111M in Q1’22 in comparison to $(175)M in Q1’21, an improvement occurring as a result of redeemable preferred securities expense seen last year. Overall, margins are still healthy and one should not pay attention too much to QoQ variability (within reason), a phenomenon that occurs as acquisitions are digested, so to speak, into the CSI ecosystem.

The company’s balance sheet showed normal behavior, with asset positioning increasing 26% YoY, inline with top-line and liabilities increasing approximately 13% YoY, a phenomenon that should not come at a surprise given Leonard’s disposition towards leverage in most cases.

From the Cash Flow Statement, CFO remained stagnant YoY, CAPEX increased slightly and FCF came in with a 34% margin for the quarter, as outlined below.

Getting more specific to deal flow, the decision to finance the huge Allscripts deal is a smart one. Considering the fact that the team avoids debt unless the terms are favorable, as well as the fact that we are heading into a time of macroeconomic uncertainty, it makes sense to continue to treasure the substantial cash position on the balance sheet and continue to use it strategically over the course of the next few years. Similarly to the annual analysis that was performed earlier, on a quarterly basis the company’s M&A activity gauge is behaving similarly, with cash building up despite lots of acquisitions going through the metaphorical pipelines.

When one breaks down the estimated capital allocated towards acquisitions this quarter, despite CSI being very active in smaller business segments, we can clearly see deal flow heavily skews towards the large business cohort as a result of the majority of said capital being directed at Allscripts. I would not be surprised if we see 1-2 of these sized acquisitions now per year in order to combat the increasing CF burden, as outlined by the awesome figures C.J. Oppel shared on Twitter recently:

Deal Flow in Comparison to Previous Years - Q1’22

In short, it is encouraging to see the amount of acquisition activity we’ve seen CSI output, a phenomenon that should negate many an analyst’s worries about being unable to deploy increasing amounts of capital with scale. With these ramblings in mind, I would like to impart on you my final thoughts, in conjunction with everything discussed within the report thus far, on Constellation as a whole.

7.0 Discussion

The first point that is worth giving a gander is the company’s valuation. As of the sell-off yesterday, the company’s main forward and LTM valuation multiples can be seen outlined below:

In comparison to the early parts of the last decade, these valuations are elevated, a phenomenon I don’t believe is going to change in the near future due to a twofold thought process. Firstly, Constellation Software has nearly two decades (while publicly traded) of phenomenal performance under their belt, performance that displays their aptitude towards capital allocation and equally impressive stock-price appreciation. Secondly, the company is remarkably resilient, with its max drawdown from peak being only 26% despite existing through catastrophic market corrections in both 2008 and amidst the pandemic:

I keep coming back to the age-old euphemism that quality is expensive. No doubt the valuation on CSI is slightly rich, however, the company has evidently earned shareholder’s trust through years of proving itself, and, amidst uncertain times, flights to “safety” in equity markets may see CSI benefit. In addition, from a business fundamentals perspective, I believe CSI is in a great spot to perform well over the 5+ years. Over the last few years, we’ve seen a noticeable shift towards recurring revenue sources as a result of SaaS tailwinds, phenomenon that will benefit CSI immensely given the high EBIT margin nature of these businesses in general. As the company continues to create more and more FCF, as well as business dynamics shifting in the direction of heightened profitability generation, CSI is likely to be in a good position to generate a reasonable IRR for shareholders going forwards.

Next, it is worth discussing what many believe is looming around the corner and its connection to CSI, i.e. a recession. Reading through Leonard’s letters gives a glimpse into how CSI would perform in this situation. In the Q2’08 letter, CSI’s president addressed shareholders in the middle of one of the biggest financial crises the world had ever seen. Despite that fact, the company reported record Adjusted EBITDA, Net Income and Organic Revenue Growth at the time. In addition, Leonard also pondered the use of additional leverage in order to take advantage of price-tags on companies that were quite attractive, as outlined below:

“Until recently, we had avoided using significant amounts of debt. Circumstances, however, may dictate a change in our capital structure. The economy is slow, credit and equity markets are in rough shape, and buyers for vertical market software businesses are increasingly scarce. Concurrently, and for some of the same reasons, quite a number of vertical market software businesses are for sale at attractive prices. We may not be the successful bidders for these assets, but if we are, we will almost certainly be increasing Constellation’s financial leverage.”

Leonard went on to say:

“Rapid acquired growth is not an imperative, it is a choice. For most of the last decade we struggled to find enough attractive acquisitions to consume our operating cash flows. We believe that the situation has now reversed, and we are sorely tempted to buy as many attractive vertical market software businesses as and while we can.”

With the company’s LTM Net Debt/EBITDA indicating that the company is very underleveraged in comparison to its Serial Acquirer peers, as well as the fact that we may be entering into an environment where there are many tech companies in distressed states, it is an exciting time to be a CSI shareholder.

Lastly, it is worth pondering two additional happenings that may have long-term implications on CSI as a whole. The first is the VMS fund, an initiative that was launched announced in November of 2021. In essence, VMS is a $250M fund that will focus on financing rapidly growing VMS businesses that have the potential to become standalone BUs within CSI and will aim to deploy the entirety of their capital base in a 3-5 year period. Although this fund will likely not add anything meaningful to CSI’s organic growth rate, in my eyes this shows a willingness to experiment. Playing with power-law-driven business ventures is an important step, especially seeing as CSI has an ever-expanding cash flow arsenal that will need to be deployed each year. A management team that is willing to experiment that tail-driven strategies in order to continue to generate meaningful returns for shareholders is one that I’ll always have place for within my portfolio. Second, although Leonard’s mental flexibility has been on full display within his letters over the years, an Annual Meeting happening took a lot of shareholders by surprise. Sleepwell outlined it as follows:

Leonard corroborated looking outside areas of competency in the 2021 President’s letter as well as follows:

“In parallel with our established and growing small and mid-sized VMS practise and our nascent large VMS practise, we are trying to develop a new circle of competence. We are seeking attractive returns, a sustainable advantage, and the ability to deploy large amounts of capital outside of VMS. That will require highly contrarian thinking and is likely to be uncomfortable in the early going. Hopefully, we have built enough credibility to warrant your patience as we explore new and under-appreciated sectors.”

Regardless of how you may feel about O&G allocation being performed by CSI, I believe this again highlights the company’s willingness to consider a multitude of different scenarios to generate returns, actions that will likely stop both gravity and the law of diminishing returns from having any substantial effect on the best serial acquirer in the world, CSI.

The company is not without its risks however. The most obvious and quite clearly the one with the largest potential impact is the inability for CSI to live up to the performance of the past. If the company is unable to continue to deploy capital in a manner that spurs continous growth, reasonable levels of ROIC etc., there is likely an associated scenario where the company’s reasonably rich multiples compress as a result of faltering execution. Although this is unlikely, companies often take the stairs up and the elevator down, metaphorically speaking, and CSI will need to continue to perform to avoid being a fallen angel story we read about in business case studies years from now.

8.0 Conclusion

In short, I believe studying CSI was the most useful of my deep-dives thus far. I learned a ton about the quality of fundamental business execution that I will be aiming to translate into my future work going forwards. This business will be one that I will continue to track in the coming quarters and years and I will likely allocate some capital towards an investment in CSI in the coming weeks. With all of that in mind, thank you for reading my research.

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Lastly, a list of all the research pertaining to CSI that I found helpful over the last few weeks can be seen outlined below: