CSU - Constellation Software

[KCLarkin]

From the 2014 letter:

 

Our confidence is growing that we can compete effectively with Private Equity firms for larger vertical market

software company acquisitions. This feels like a much bigger opportunity for capital deployment than the

market in which we've historically played, and is not a market where we can finance the “equity” portion

of transactions from our revolver.

[Jurgis]

The concern might be that the bigger acquisitions would be less moaty, have more competition, and more problems in terms of management and culture.

 

The price is expensive. netnet says "I sure wish I had known about this 10 years ago". Even if you knew it 2 years ago, you would have paid 4x less than right now. That 4x runup is destroying the margin of safety whatever we think about business.

 

But, yeah, it could be another VRX and go to 80B... maybe...

[KCLarkin]

The concern might be that the bigger acquisitions would be less moaty, have more competition, and more problems in terms of management and culture.

 

The price is expensive. netnet says "I sure wish I had known about this 10 years ago". Even if you knew it 2 years ago, you would have paid 4x less than right now. That 4x runup is destroying the margin of safety whatever we think about business.

 

But, yeah, it could be another VRX and go to 80B... maybe...

 

Most of that 4x was justified. It is only the last 8 months where it went really parabolic.

 

Remember VRX has issued massive amounts of stock (and debt) to get to 80B. CSU can grow market cap at a much slower rate and still provide similar per share growth.

[Jurgis]

I am sorry, I should not have compared CSU to VRX probably. :)

[loganc]

The concern might be that the bigger acquisitions would be less moaty, have more competition, and more problems in terms of management and culture.

 

The price is expensive. netnet says "I sure wish I had known about this 10 years ago". Even if you knew it 2 years ago, you would have paid 4x less than right now. That 4x runup is destroying the margin of safety whatever we think about business.

 

But, yeah, it could be another VRX and go to 80B... maybe...

 

Most of that 4x was justified. It is only the last 8 months where it went really parabolic.

 

Remember VRX has issued massive amounts of stock (and debt) to get to 80B. CSU can grow market cap at a much slower rate and still provide similar per share growth.

 

VRX has issued "massive amounts of stock" ?  Are you serious? 

[gary17]

Relative to CSU  , VRX issued massive amount of shares...

 

CSU

Revenue went from $165M -> $1.65B  (10x)

while share count went from 20M to 21M

 

VRX

Revenue went from $936M -> 8.2B (8.7x)

160M shares -> 344M

[loganc]

Relative to CSU  , VRX issued massive amount of shares...

 

CSU

Revenue went from $165M -> $1.65B  (10x)

while share count went from 20M to 21M

 

VRX

Revenue went from $936M -> 8.2B (8.7x)

160M shares -> 344M

 

From what time period?  You have to recall that the statements you see prior to (roughly) late 2010 are Biovail.  The reality is that Pearson has been extremely judicious in using VRX stock to do deals.  Look at the largest deals that have been done - B&L and Salix.  Have these deals been largely facilitated by stock?  That is obviously not the case. 

[gary17]

http://financials.morningstar.com/ratios/r.html?t=VRX&region=USA&culture=en_US

 

They also continue to have a lot of debt.

CSU used no debt

[loganc]

http://financials.morningstar.com/ratios/r.html?t=VRX&region=USA&culture=en_US

 

They also continue to have a lot of debt.

CSU used no debt

 

Yes, Pearson has primarily used debt to fund the purchase of businesses for the benefit of equity holders.  That is my point.

 

Look, I am not trying to say VRX is better or worse than CSU.  I have stated previously that I think Leonard is amazing.  My point is that it really grates on me that people will make flippant claims that Pearson is flagrantly issuing a bunch of equity to do deals.  That is simply not true. 

 

[gary17]

Thanks.

 

Agreed.

 

I own 1 share of CSU because I am hesitant to pull the trigger.  Please some one tell me not buying now is like not buying BRK A at $500

[giofranchi]

Interesting article from last year.

 

Cheers,

 

Gio

Constellation_Softwares_elusive_CEO_-_The_Globe_and_Mail.pdf

[giofranchi]

I have two questions for people who are knowledgeable about CSU:

1) In Table 3 of the 2014 AL we can see a column “Cash Flow from Operating Activities per Share”. Last year number was $16.11, and it has grown at a CAGR of 39% during the last 10 years. Immediately below that table Leonard writes:

In assessing CSI’s value, it is tempting to look at cash flows after tax, interest and capex as the “real” return on shareholders’ capital.

So, here is my first question: is “Cash Flow from Operating Activities per Share” on Table 3 cash flow after tax, interest and capex, or before them? If before, does anyone know the number per share after tax, interest and capex?

2) My second question is relative to the size of CSU’s market: does anyone know the size of their market for new acquisitions?

 

Thank you very much! :)

 

Gio

 

[giofranchi]

CSU is in my “sweet spot” today:

1) Leonard is not yet 60;

2) He has a proven and amazing track record;

3) Though not sure yet, I guess an $11 billion market cap is still very small if compared to its market;

4) Software is an industry that will keep growing for a long time;

5) Valuation:

 

“Cash Flow from Operating Activities” in 2014 has been $16.11 and has grown at a CAGR of 39% for the last 10 years. Now, that number simply is Net cash flows from operating activities divided by the number of shares outstanding. And it includes Income taxes paid, but excludes Interest paid and Property and equipment purchased. Which together have been 7.8% (8%) of Net cash flows from operating activities. This leads me to believe that what Leonard calls cash flow after tax, interest, and capex should have been $16.11 x 0.92 = $14.82 in 2014.

Now, let’s suppose it grows 30% this year, and the 2015 number gets to be: $14.82 x 1.3 = $19.27.

It means CSU is selling for a multiple of $531 / $19.27 = 27.6 x FCF.

Let’s also suppose FCF grows at a CAGR of 20% for the next 10 years: 10 years from now it will be $119.32 per share.

And let’s suppose 10 years from now CSU’s multiple has contracted from 27.6x to 20x: its share price will be $119.32 x 20 = $2,386.4.

If it actually goes from $531 today to $2,386.4 ten years from now, a CAGR of 16.2% will be achieved.

 

This valuation assumes an annual growth in FCF per share which is 50% what it has been on average during the last 10 years, and a 27.5% contraction in the multiple CSU is selling for today.

 

Therefore, imo the only question that remains is the following: is CSU’s market for new acquisitions large enough to make FCF per share grow at a CAGR of 20% for the next 10 years?

 

Cheers,

 

Gio

 

[abyli]

Gio:

 

Your calculation is wrong. CSU reports in US $, stock trading in Canada $, that is a difference of 24%.

 

Bing

[giofranchi]

Gio:

 

Your calculation is wrong. CSU reports in US $, stock trading in Canada $, that is a difference of 24%.

 

Bing

 

Ok... Thank you! :-[

 

Even better, don't you think? Is it therefore trading at a FCF multiple of 27.6 x (1 - 0.24) = 21?!... Am I right now?... Why do people say it is so much expensive then? ???

 

Gio

[gary17]

Would be good if people with skills can do a DCF analysis to estimate the intrinsic valuation !

[giofranchi]

From the 2014 letter:

 

Our confidence is growing that we can compete effectively with Private Equity firms for larger vertical market

software company acquisitions. This feels like a much bigger opportunity for capital deployment than the

market in which we've historically played, and is not a market where we can finance the “equity” portion

of transactions from our revolver.

 

Ok... I guess this answers my question, doesn't it? ;)

 

Cheers,

 

Gio

[giofranchi]

Would be good if people with skills can do a DCF analysis to estimate the intrinsic valuation !

 

Well, it all depends on the future CAGR of FCF, doesn’t it? That’s what I have tried to do… though, of course, I am not knowledgeable about CSU yet! ;)

 

Cheers,

 

Gio

 

[ap1234]

Gio,

 

I’ve been a shareholder for a while. It is a wonderful business. Mark Leonard is a very saavy capital allocator and he has a talented team of (relatively young) managers who run the different divisions. The decentralized business model and incentive structure are brilliant.

 

If you’re going to try and value the business, a good starting point is looking at adjusted net income (GAAP reported earnings are skewed by the non-cash amortization charges). You can look at the company’s historical record in their President’s Letters.

 

To value the business, I don’t think it’s as simple as saying that adjusted EPS grew at 40%/year so just slash it in half and grow it by 20%/year for the next decade. That is no easy feat! If you’re going to grow FCF/share at 20%/year, you should probably work backwards to see what is being implied in those growth rates.

 

For example, let’s assume that CSU has organic growth of 5%/annum over the next decade (this is not a simple task). That still leaves 15%/year of acquisition growth (assuming no margin expansion). Clearly, as you scale up the top line, you need to do significantly more deals (or fewer VERY large deals) to maintain the same growth rate.

 

You will need to make reasonable assumptions about the average deal size, # of deals, acquisition multiples, how much debt will be employed, terminal operating margin, etc.

 

Go out to Year 10 and look at the revenues in your model and ask yourself how many deals were implied to get there and whether that was a reasonable run rate. As you start walking through this exercise, I suspect you will find that 20%/share CAGR for the next decade (while very possible) is certainly not an easy task.

 

I think it's also a worthwhile reading the President's Letter in 2013. On pg. 4-5 of the letter, Mark discusses some of the different drivers of CSU's intrinsic value and provides some sensitivity analysis. 

 

I hope this helps as a starting point in your valuation exercise.

 

[giofranchi]

Go out to Year 10 and look at the revenues in your model and ask yourself how many deals were implied to get there and whether that was a reasonable run rate. As you start walking through this exercise, I suspect you will find that 20%/share CAGR for the next decade (while very possible) is certainly not an easy task.

 

It is no easy task to build a CAD11 billion market cap company either, is it? ;)

 

Those kinds of hypothesis are imo too difficult and I suspect that even for knowledgeable people in the software industry are nothing more that educated guesses… But of course I am reading all Leonard’s letters! And I hope to gain some useful hindsight! ;)

 

By the way, are you planning to hold your investment in CSU, increase it, or sell it?

 

In other words, at a multiple of 21x FCF do you think CSU is fairly valued, undervalued, or overvalued?

 

Cheers,

 

Gio

 

[giofranchi]

What I mean is that usually when I find a great entrepreneur, in a good business, at a fair price, I am satisfied and I invest my firm’s free cash. Then I concentrate on generating more free cash to buy more of the same!

 

Therefore:

 

Is Leonard a great entrepreneur? I think the answer is yes. And he is still young enough.

 

Is he in a good business? I think software is an industry that will grow for many years to come and in the article I have posted Leonard says at CSU they have a list of 10,000 possible acquisition candidates! It is hard to believe they might run out of options soon… Therefore, I think the answer is once again yes.

 

Is CSU stock price fair? If I am correct it is selling for 21x FCF, I don’t even see a meaningful multiple contraction from the current level… And it all depends on how CSU will perform in the future: a 5% organic growth + a 10% growth from acquisitions and CSU might turn out to be a very satisfying investment 10 years from now. Those imo are not easy goals, bet certainly not impossible either.

 

I think I am reading all Leonard’s letter, and then I am pulling the trigger… And go back to my businesses to generate more free cash! ;)

 

Cheers,

 

Gio

 

[KCLarkin]

Why do people say it is so much expensive then? ???

 

Oops, I accidentally used CAD not USD stock price in my model for 2015. I need to re-run my numbers. The multiple is still high relative to the historical multiple but not as bad as I thought.

[netnet]

I think it's also a worthwhile reading the President's Letter in 2013. On pg. 4-5 of the letter, Mark discusses some of the different drivers of CSU's intrinsic value and provides some sensitivity analysis.

Thanks for the heads up.  I missed the implication of this when I read it the first time.  Basically, Leonard found that a year ago the company was trading at a fair price with little margin of safety!  So, given the growth, say 30% then a fair price would be on the order of 320-350 as an entry.

 

“Cash Flow from Operating Activities” in 2014 has been $16.11 and has grown at a CAGR of 39% for the last 10 years. Now, that number simply is Net cash flows from operating activities divided by the number of shares outstanding. And it includes Income taxes paid, but excludes Interest paid and Property and equipment purchased. Which together have been 7.8% (8%) of Net cash flows from operating activities. This leads me to believe that what Leonard calls cash flow after tax, interest, and capex should have been $16.11 x 0.92 = $14.82 in 2014.

Now, let’s suppose it grows 30% this year, and the 2015 number gets to be: $14.82 x 1.3 = $19.27.

It means CSU is selling for a multiple of $531 / $19.27 = 27.6 x FCF.

Let’s also suppose FCF grows at a CAGR of 20% for the next 10 years: 10 years from now it will be $119.32 per share.

And let’s suppose 10 years from now CSU’s multiple has contracted from 27.6x to 20x: its share price will be $119.32 x 20 = $2,386.4.

If it actually goes from $531 today to $2,386.4 ten years from now, a CAGR of 16.2% will be achieved.

 

This valuation assumes an annual growth in FCF per share which is 50% what it has been on average during the last 10 years, and a 27.5% contraction in the multiple CSU is selling for today.

 

Therefore, imo the only question that remains is the following: is CSU’s market for new acquisitions large enough to make FCF per share grow at a CAGR of 20% for the next 10 years?

 

Gio,  I used a similar model as yours, but I assumed a 50% multiple contraction, which makes the return below my hurdle.  (Ironically, I also was reading a study on the poor performance of glamor stocks versus cheap value stocks.  We know the ending--a basket of cheap value beats glamor, but you always hope to find the younger Buffett with a sustainable business model.)

[Liberty]

Thanks for the heads up.  I missed the implication of this when I read it the first time.  Basically, Leonard found that a year ago the company was trading at a fair price with little margin of safety!  So, given the growth, say 30% then a fair price would be on the order of 320-350 as an entry.

 

Don't forget FX.

[Jurgis]

Assuming US$16-19 FCF, discount rate of 15%, you need about 20% growth for 10 years to justify current price US$ price. FWIW.