CONSTELLATION SOFTWARE INC (CSU.) CSU CN
November 07, 2014 - 2:34pm EST by
ima
2014 2015
Price: 312.00 EPS 14.50 17.10
Shares Out. (in M): 21 P/E 0 0
Market Cap (in M): 6,600 P/FCF 0 0
Net Debt (in M): 120 EBIT 0 0
TEV: 6,720 TEV/EBIT 0 0

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  • Software
  • Rollup
  • Outsider-type CEO
  • Capital Allocation
 

Description

Summary – Constellation offers mission critical software to very niche verticals. The CEO is the Warren Buffett of software, having acquired 200 small software companies and generating high 20s IRR on deals. The business should grow revenues MSD organically, and if the company deploys all its FCF to acquisitions they will generate another 20% or more in growth. Management is also willing to do large deals funded with debt which raise growth to a 30% CAGR.

Best in class management – 1) amazing capital allocator. IRR approaches 30%. 2) Amazing operator. He has setup a simple process for identifying, evaluating and integrating acquisitions. Every employee is molded after him and properly incented. The company is setup so that it can scale into another 2-3 business units and do more deals going forward. 3) He is completely transparent. His shareholder letters read like Buffett’s letters; His focus is to maximize long term shareholder value without sacrificing the sustainability of his business. 4) He owns $500M of stock and has never sold.

Acquisitions are extremely accretive– Their internal hurdle rate is > 20%, possibly 25%. Between 2009 and 2013, I estimate that they paid 0.7x sales and generated a 29% IRR on their investment. They paid 0.73x sales in 2013 and 0.55x in 2012/2011. They buy at 4-5x EBITA. The high IRR is available for structural reasons: 1) the software industry tends to focus on growth whereas Constellation focuses on FCF and pricing power. 2) the typical acquired company is poorly run and often loses money. The average deal is $7M with sales < $10M. The businesses are run by mom and pops that do not take advantage of their pricing power and often spend too much to grow the business. In the typical scenario, constellation raises prices 20% and cuts significant opex. 3) There is minimal competition on their deals; < 20% of the time.

We are at an inflection point as the Company will look to do large acquisition like the recent TSS acquisition. Since 2004, they have spent 127% of FCF on acquisitions. It was 85% through 2012 but they recently did a large acquisition funded with debt. I expect them to cut the dividend; they are clearly signaling this and this action will allow them to spend 100% of FCF on acquisitions. They will spend more than that by using debt. They are ready to grow aggressively in Europe which will help them find attractive targets. This is a new area of growth for them. They have a pipeline of 17k companies and employees are assigned to each company and mandated to ask them every 6 months if they are ready to sell. The pipeline was 11k 12 months ago and is now 17k as they expand in Europe. there are other signals they are looking to make acquisitions: 1) issued unsecured subordinated debt with a 20 year life. 2) added the former CFO of open text to the board. he was responsible for open text's successful acquisitions. 3) hinted at their desire to cut the dividend. 4) they are executing faster than expecting on raising margins at TSS which gives them confidence they can repeat this process on future deals.

Valuation – LSD organic growth peers trade in line with constellation on FWD EPS and FCF despite Constellation compounding at a 35% historical CAGR due to acquisitions. Constellation deserves a premium for demonstrating a record of deploying all FCF towards acquisitions and achieving extremely high IRRs and because they have a more sustainable franchise (mission critical, niche verticals).

Forecasts vs Consensus – Consensus models the base business correctly. they are a little low on margins. consensus assumes half of FCF gets deployed at approximately 20% IRR. right now the company is deploying about 50% of FCF. the key differentiating view is that i believe the company will step up their acquisition pace and deploy over 100% of FCF. a large deal would offer a 20% IRR and smaller deals will be 30% in my view. that gets me to $19.50 EPS in 2016 ($19.50 USD, $22.25 CAD) and $26.00 in 2017 ($29.50 CAD).

Risks

  • They do not spend as much as I expect on acquisitions.
    • They used to spend < $100M a year on acquisitions, or < 20 acquisitions at $5M each.
    • Going forward they will have to spend ~$200M on tuck-in acquisitions. Average deal size is approaching $7M which means they need to do 30 deals. Their expansion into Europe will allow them to do 1/3 more deals.
    • They have a pipeline of 17k companies, up from 10k 6 months ago as they expand into Europe. At $5M per company that is $85B in TAM. At $7M that is $120B. VAR indicates they will not be short on deals and recent history shows that deal economics haven’t changed.
    • the risk is that in a web 2.0 environment, targets demand higher multiples. Constellation will not budge on its hurdle rate. they prefer to hold on to cash and buy up companies in a downturn if necessary.
  • Organic growth slows
    • They grow organically MSD and it is intentional that they don’t grow faster. The CEO invests just enough to maintain market share and ensure the franchise is sustainable. He prefers acquisitions to spending on opex and driving HSD organic growth because of the higher IRR that acquisitions offer.
    • I believe that only 20% to 25% of revenue is meaningfully at risk of SaaS competition. The rest of revenues are in small mature verticals with high barriers to entry. churn is LSD and entirely due to bankruptcies and mergers, not switching to the competition. Of the 20% to 25% of revenue that I believe is at risk, I see no near term threats but the potential is always there. The most likely threat is that a big player acquires a niche competitor and expands their product offering.

 

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

Catalysts – 1) dividend cut. 2) Acquisitions. Especially in Europe, or a large deal next year. 3) Earnings.

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    Description

    Summary – Constellation offers mission critical software to very niche verticals. The CEO is the Warren Buffett of software, having acquired 200 small software companies and generating high 20s IRR on deals. The business should grow revenues MSD organically, and if the company deploys all its FCF to acquisitions they will generate another 20% or more in growth. Management is also willing to do large deals funded with debt which raise growth to a 30% CAGR.

    Best in class management – 1) amazing capital allocator. IRR approaches 30%. 2) Amazing operator. He has setup a simple process for identifying, evaluating and integrating acquisitions. Every employee is molded after him and properly incented. The company is setup so that it can scale into another 2-3 business units and do more deals going forward. 3) He is completely transparent. His shareholder letters read like Buffett’s letters; His focus is to maximize long term shareholder value without sacrificing the sustainability of his business. 4) He owns $500M of stock and has never sold.

    Acquisitions are extremely accretive– Their internal hurdle rate is > 20%, possibly 25%. Between 2009 and 2013, I estimate that they paid 0.7x sales and generated a 29% IRR on their investment. They paid 0.73x sales in 2013 and 0.55x in 2012/2011. They buy at 4-5x EBITA. The high IRR is available for structural reasons: 1) the software industry tends to focus on growth whereas Constellation focuses on FCF and pricing power. 2) the typical acquired company is poorly run and often loses money. The average deal is $7M with sales < $10M. The businesses are run by mom and pops that do not take advantage of their pricing power and often spend too much to grow the business. In the typical scenario, constellation raises prices 20% and cuts significant opex. 3) There is minimal competition on their deals; < 20% of the time.

    We are at an inflection point as the Company will look to do large acquisition like the recent TSS acquisition. Since 2004, they have spent 127% of FCF on acquisitions. It was 85% through 2012 but they recently did a large acquisition funded with debt. I expect them to cut the dividend; they are clearly signaling this and this action will allow them to spend 100% of FCF on acquisitions. They will spend more than that by using debt. They are ready to grow aggressively in Europe which will help them find attractive targets. This is a new area of growth for them. They have a pipeline of 17k companies and employees are assigned to each company and mandated to ask them every 6 months if they are ready to sell. The pipeline was 11k 12 months ago and is now 17k as they expand in Europe. there are other signals they are looking to make acquisitions: 1) issued unsecured subordinated debt with a 20 year life. 2) added the former CFO of open text to the board. he was responsible for open text's successful acquisitions. 3) hinted at their desire to cut the dividend. 4) they are executing faster than expecting on raising margins at TSS which gives them confidence they can repeat this process on future deals.

    Valuation – LSD organic growth peers trade in line with constellation on FWD EPS and FCF despite Constellation compounding at a 35% historical CAGR due to acquisitions. Constellation deserves a premium for demonstrating a record of deploying all FCF towards acquisitions and achieving extremely high IRRs and because they have a more sustainable franchise (mission critical, niche verticals).

    Forecasts vs Consensus – Consensus models the base business correctly. they are a little low on margins. consensus assumes half of FCF gets deployed at approximately 20% IRR. right now the company is deploying about 50% of FCF. the key differentiating view is that i believe the company will step up their acquisition pace and deploy over 100% of FCF. a large deal would offer a 20% IRR and smaller deals will be 30% in my view. that gets me to $19.50 EPS in 2016 ($19.50 USD, $22.25 CAD) and $26.00 in 2017 ($29.50 CAD).

    Risks

     

    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

    Catalysts – 1) dividend cut. 2) Acquisitions. Especially in Europe, or a large deal next year. 3) Earnings.

    Messages


    SubjectBasic questions
    Entry11/08/2014 11:22 AM
    Membernathanj

    What does the company's software actually do and who do they compete against?  Or is this a thesis where it doesn't really matter what they do because the CEO is the Warren Buffett of software?


    SubjectRe: Bigger Deals
    Entry11/17/2014 03:20 PM
    Memberima

    a certain amount will be comprised of small deals averaging $5-10M each. 30% IRR. the market opportunity is almost double what is used to be now that they have a toehold in europe through their TSS acquisition.

    they will do more acquisitions at the bottom of a cycle than near the top. rather than lower the hurdle rate they will delay acquisitions. at the bottom of a cycle it is much easier to get very high IRRs.

     

    I model < 20% IRR on big deals. TSS will come in > 20%.

     

    i think you have a margin of safety. consensus: MSD to HSD organic FCF growth, 50% of FCF goes to acquisitions at a 20% IRR.

    my view: HSD organic FCF growth, > 100% of FCF goes to acquisitions at a low 20% IRR (mix of 30% iRR small deals and < 20% IRR big deals). i think it could take time to deploy all the capital.

     


    SubjectRe: Basic questions
    Entry11/17/2014 03:22 PM
    Memberima

    the product matters. mission critical niche software. e.g. ERP system for municipal transit systems. ERP system for electric utilities. you can't rip this stuff out.

    e.g. software for electric utilities. exceptionally high switching costs. they would acquire a company and raise price 50% in year 1. zero churn. most acquisitions - raise price 20% immediately and see 5% churn.

    they raise price 6% a year. that is very good. they can do this because on average they have > 50% share in a vertical, the competition is a mom and pop, there are very high switching costs and the market is too small for a big software company to go after. and it is very hard to find customers. fragmented and small.


    SubjectRe: Re: Basic questions
    Entry11/17/2014 03:27 PM
    Memberima

    have you spoken with the CEO directly?

    - Yes. he's great

    1. how big is their M&A team? How are these guys incented?

    - 50 people + 14 at HQ.

    - heavily incented in stock. they want to do big deals.

    2. is the vast majority of the "organic growth" they report simply from price increases? Or do they actually grow the client base too?

    - yes. they target stable volume market share. these markets are mature and grow 1% a year. they see 2% churn, but get back 2% by adding new modules to a product and charging for them. then raise price 6% = 6% organic growth

    - CEO will not compromise on market share. it is not worth investing to win share, better to use the FCF and make acquisitions. but he cares a lot about sustainability and that means consistent market share

    3. what do you know about organic growth for older acquisitions? Do they just milk these with no R&D and high fee increases, and put them into perpetual decline (and therefore require more deals just to grow nominally?)

    - old acquisitions are growing inline with organic growth.

    - i spoke with former board members and PE funds that owned this for over 15 years. as well as competitors and customers. reported organic growth is very reliable.


    SubjectRe: Re: Re: Re: Basic questions
    Entry11/25/2014 04:35 PM
    Memberima

    limited cross selling, they get rid of management.

    the following is an illustration for the mom and pop acquisitions. for a very large acquisition like TSS, the synergies will be lower bc large companies aren't mismanged as badly as small ones

    on revenues

    - they raise price 20%. 5% of customers churn off. 15% revenue increase, all goes to the bottom line

    - organic growth is stable. but the mix changes. they move more toward price increases, figure > 5% annually, and reduce spending on R&D. they stop trying to add modules and features that customers don't value a lot.

    - the key is to buy mission critical software companies. otherwise, investing less in R&D is not a sustainable strategy

     

    on costs

    - most software companies are run to generate max topline growth. but spending on sales and on R&D. at mom and pops, it can often be taken to the point that a very good software business generates little to no FCF.

    - they cut R&D, they cut sales force. very aggressively.

    - they have a framework about how to think about which software modules add value and which don't. they don't cut to the bone and are mindful not to lose volume share, otherwise the business model is not sustainable

     

     


    SubjectRe: Valuation
    Entry11/30/2015 01:41 PM
    Memberima

    i missed this message. stock is trading about the same price as of early aug 2015. i am not sure where you get the 30x 2016 PE from. i think you are using USD EPS and a CAD share price. consensus of $20 USD in 2016 is $26.50 in CAD. stock is trading at 22x that.

    it comes down to the size of deals they can do and the IRR on those deals. i think you can confirm that past deals achieved a consistent 30% IRR. the large TSS deal is different and is on track to to hit 22-25% IRR.

    i think it is fair to assume a 25% to 30% IRR on small deals and 20% on large deals. plug that in and see what you get on a DCF. but i do not have a hard time getting to well over $30 USD in EPS and that is over $40 CAD. very easily and fairly quickly in my opinion. i think it is quite conceivable you get to $40 USD...

    i just updated my research on the SaaS risk. it is minimal. fair value of the underlying biz is > 17x. so not paying a ton for the NPV on deals given the extremely high IRR on deals.

     

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