CSU - Constellation Software

[KCLarkin]

It's an effective strategy, not something I'd trumpet, but when you earn a salary and options based on your stock price it works....

 

Actually, this is an example of why CSU is unique. They don't give options or RSUs or any stock compensation. They give very large cash bonuses that are rationally tied back to your sphere of influence. Management is expected or encouraged to use the cash bonus to purchase stock on the open market. There is no incentive to artificially game the stock price. They have the most rational incentive system of any company I follow. The only others that come close are BRK and the 3G companies.

[Liberty]

It's an effective strategy, not something I'd trumpet, but when you earn a salary and options based on your stock price it works....

 

Actually, this is an example of why CSU is unique. They don't give options or RSUs or any stock compensation. They give very large cash bonuses that are rationally tied back to your sphere of influence. Management is expected or encouraged to use the cash bonus to purchase stock on the open market. There is no incentive to artificially game the stock price. They have the most rational incentive system of any company I follow. The only others that come close are BRK and the 3G companies.

 

Yeah, the incentives are tied to the ROIC/IRR and organic growth of the specific business unit where the people work, and there are zero options, it's all stock purchased in the open market.

 

They've also recently been rejigging incentives to better capture the long-term results of initiatives that might take long periods of R&D and investment before they bear fruit, to avoid de-incentivizing those because if you just invest less, you can have a seemingly higher ROIC but it reduces your long-term growth. They really have a long-term mindset.

 

Oh, and the CEO has cut his salary and bonuses to zero (salary since 2014, bonuses too since 2015), he's now only making money through being a shareholder. Before that he had a pretty small salary compared to others in similar businesses (his peak salary+bonus right before he cut it was around $2m). He never had any options either, afaik.

[no_free_lunch]

At a meta level I guess CSU is essentially arbitraging this.  They find small niche-y businesses that are private, buy them at a private multiple and by nature of now being public earn a public multiple on the money.

 

I have been thinking about this as well.  I don't think they have any real edge but what is it that has made their process successful and consistent?  I have owned the company in the past and

actually did go through quite a few transcripts and reports to try to understand the process.  I think it must come down to changes at the actual company.

 

I recall reading they have a team that goes to the acquired companies and tries to implement certain standards.  Beyond that, I'm speculating here, each of the acquired companies must have overhead admin staff (HR/payroll) that can be cut as they centralize those processes.  It wouldn't be a huge savings but it would drop right to the bottom line.  There might even be room to cut some developer positions if the customers are sticky but that could jeopardize the future.

 

As far as the arbirtrage theory, I don't think it holds up as they aren't selling shares to make acquisitions.  There is definitely a gap between their public valuation and the purchase price valuations but they don't take advantage of the gap.

 

The biggest risk to the whole thesis would seem to be cloud services.  I know it's a bit overused buzzword and I know it comes up at CSU conference calls where they say they're not too concerned.  However, I think it is where things are going long-term and it could start to eat away at some of their businesses.

[Liberty]

At a meta level I guess CSU is essentially arbitraging this.  They find small niche-y businesses that are private, buy them at a private multiple and by nature of now being public earn a public multiple on the money.

 

I have been thinking about this as well.  I don't think they have any real edge but what is it that has made their process successful and consistent?  I have owned the company in the past and

actually did go through quite a few transcripts and reports to try to understand the process.  I think it must come down to changes at the actual company.

 

I recall reading they have a team that goes to the acquired companies and tries to implement certain standards.  Beyond that, I'm speculating here, each of the acquired companies must have overhead admin staff (HR/payroll) that can be cut as they centralize those processes.  It wouldn't be a huge savings but it would drop right to the bottom line.  There might even be room to cut some developer positions if the customers are sticky but that could jeopardize the future.

 

As far as the arbirtrage theory, I don't think it holds up as they aren't selling shares to make acquisitions.  There is definitely a gap between their public valuation and the purchase price valuations but they don't take advantage of the gap.

 

As I've said above, the VMS businesses and CSU are different animals, which explains the different valuations. VMS businesses can't redeploy the vast majority of the cash they generate, so they are valued mostly as slow-growing cash cows. CSU can redeploy the majority of the cash it generates at high ROICs, so it is valued differently. VMS are also very vulnerable to disruption in a single industry. CSU is not only diversified across industries and geographically, but as a buyer of asset, it benefits when there is disruption that causes distress and lower valuations (in fact, in the past CSU has invested in publicly traded software companies opportunistically, another way to deploy capital).

 

And as you point out, since they don't issue equity to acquire companies, they're not vulnerable to the reflexivity that happens with companies that depend on a high valuation to keep M&A going, and that depend on M&A to keep valuation high...

 

But if CSU couldn't do anymore M&A starting tomorrow, some things would happen, but it wouldn't be a catastrophe, IMO.

 

The valuation would likely compress since their track record of creating value through M&A is strong, but it wouldn't go to the floor. It's still a very good business (high margins, capital-light, recurring revenues, low competition), better than the average SP500 company, I'd say, so probably not a below market multiple. They'd probably redirect more capital to internal growth initiatives, so over time organic growth should tick up (probably not getting as good ROICs there are with M&A, but still high), the margins would go up for a while, as they've explained the recently acquired businesses have overall lower margins but go up over time after they own them. Margins would also go up because all the costs for M&A would go away (they're low, but still non-zero). Then there'd be a series of special dividends to return the extra cash. So with the growing margins and higher organic growth, I think results would still be nice for the long-term despite a one-time valuation hit. If they wanted to do even better, they could leverage a bit to some solid investment grade level, maybe 2-3x EBITDA, and I wouldn't be surprised to see double digit per share growth in FCF with very low risk. Not a terrible scenario.

 

The biggest risk to the whole thesis would seem to be cloud services.  I know it's a bit overused buzzword and I know it comes up at CSU conference calls where they say they're not too concerned.  However, I think it is where things are going long-term and it could start to eat away at some of their businesses.

 

SaaS is just a delivery method. Many CSU businesses operate with the SaaS model already. Leonard seems to think that the economics of SaaS aren't quite as good, but that seems to be a question of degree, not of kind. Also consider that Leonard is always pretty conservative in his forecasts. He's been saying for 10 years that valuations are high, it's hard to buy things, things are not looking as good, etc, yet they've done pretty well (you can also find Buffett letters from the 80s that mention how their large capital base means it'll be hard to outperform going forward).

 

SaaS doesn't change the fact that small vertical niches will be served by specialist companies, and that the Microsofts and Oracles and SAPs of the world won't develop specialized software and do customer support for small markets with just a few millions in revenue per year.

[no_free_lunch]

Thanks for your thoughts Liberty.

 

I wasn't even attempting to comment on valuation in my last post.  Just trying to understand the internal mechanics of how their business works.  It is very impressive to have grown via acquisitions at their rate without issuing equity or debt.  I'm not aware of any other companies that have done this although I'm sure others exist.

[Liberty]

Thanks for your thoughts Liberty.

 

I wasn't even attempting to comment on valuation in my last post.  Just trying to understand the internal mechanics of how their business works.  It is very impressive to have grown via acquisitions at their rate without issuing equity or debt.  I'm not aware of any other companies that have done this although I'm sure others exist.

 

It's indeed rare. A business like Heico does something a bit similar, financing acquisitions mostly through FCF (a bit of debt), as does Roper or Jack Henry.

 

Sorry, I didn't mean to make it sound like you said this, I was just trying to differentiate CSU from the more common model of private/public arbitrage that goes "get a high valuation because you're growing quickly by buying companies with stock issued at a high valuation because you're growing quickly by buying companies with cheap equity...". Obviously that's a brittle model. I like that CSU is the inverse of that and benefits from shocks to its industries or even from generalized lower valuations.

[vinod1]

Over the last 5 years they made about $1.5 billion in acquisitions and non-organic revenues (estimated by removing the organic revenue growth from their total revenue growth) increased by roughly $1.5 billion as well. We need to look back over 10 years to get a more accurate picture to reduce the timing differences between acquisitions and revenue growth but 5 years would give you a reasonable first order approximation.

 

So they are able to buy companies at roughly 1x sales. Since they have been able to maintain net margins at about 20%, that means they are able to buy these companies for roughly 5x of eventual earnings under their umbrella.

 

So the secret sauce is either they are

 

a) Able to buy these very cheap - if you assume there are no big cost savings by coming under their umbrella

 

b) Able to dramatically improve the earnings at the company acquired.

 

Or some combination of both as others have observed.

 

Assume you have $5 of revenues and $1 of earnings last year. Add in organic growth of 5% to the previous year's revenues you increase revenues to $5.25 this year. Then you use that $1 of earnings to go buy a company for $1 to get $1 of revenue growth. Total revenue for this year is $6.25.

 

With a 20% margin, you increase earnings to $1.25. There you have 25% annual growth.

 

There are timing differences where you have assumed that acquisitions are made on Jan 1st of the year but this is how the company is working overall.

 

I keep wondering though why these owners keep selling at such low prices? Maybe they need to cash out and there is really no big competition for these really small companies? Either way that contact list of 35,000 odd companies is a key competitive advantage.

 

Any thoughts?

 

Vinod

[gary17]

Over the last 5 years they made about $1.5 billion in acquisitions and non-organic revenues (estimated by removing the organic revenue growth from their total revenue growth) increased by roughly $1.5 billion as well. We need to look back over 10 years to get a more accurate picture to reduce the timing differences between acquisitions and revenue growth but 5 years would give you a reasonable first order approximation.

 

So they are able to buy companies at roughly 1x sales. Since they have been able to maintain net margins at about 20%, that means they are able to buy these companies for roughly 5x of eventual earnings under their umbrella.

 

So the secret sauce is either they are

 

a) Able to buy these very cheap - if you assume there are no big cost savings by coming under their umbrella

 

b) Able to dramatically improve the earnings at the company acquired.

 

Or some combination of both as others have observed.

 

Assume you have $5 of revenues and $1 of earnings last year. Add in organic growth of 5% to the previous year's revenues you increase revenues to $5.25 this year. Then you use that $1 of earnings to go buy a company for $1 to get $1 of revenue growth. Total revenue for this year is $6.25.

 

With a 20% margin, you increase earnings to $1.25. There you have 25% annual growth.

 

There are timing differences where you have assumed that acquisitions are made on Jan 1st of the year but this is how the company is working overall.

 

I keep wondering though why these owners keep selling at such low prices? Maybe they need to cash out and there is really no big competition for these really small companies? Either way that contact list of 35,000 odd companies is a key competitive advantage.

 

Any thoughts?

 

Vinod

 

I am part owner of a small business myself in a niche market, and one needs to keep in mind that for a specialty business it's often only valuable to strategic buyers who are in the industry or understand the business... So this is partly why the valuation is low.  For most private businesses, a number of valuation guys tell us it's usually 3x pre-tax earnings or sometimes just book value depending on the business.  Which is rougly 1x revenue  doesn't really answer your question but just trying to point out it's not because they want to sell so cheaply, but because often for a small business the reality is the market is small and when you had a decent career, you wanted to get bought out as part of retirement, 3x seems reasonable. 

[vinod1]

Over the last 5 years they made about $1.5 billion in acquisitions and non-organic revenues (estimated by removing the organic revenue growth from their total revenue growth) increased by roughly $1.5 billion as well. We need to look back over 10 years to get a more accurate picture to reduce the timing differences between acquisitions and revenue growth but 5 years would give you a reasonable first order approximation.

 

So they are able to buy companies at roughly 1x sales. Since they have been able to maintain net margins at about 20%, that means they are able to buy these companies for roughly 5x of eventual earnings under their umbrella.

 

So the secret sauce is either they are

 

a) Able to buy these very cheap - if you assume there are no big cost savings by coming under their umbrella

 

b) Able to dramatically improve the earnings at the company acquired.

 

Or some combination of both as others have observed.

 

Assume you have $5 of revenues and $1 of earnings last year. Add in organic growth of 5% to the previous year's revenues you increase revenues to $5.25 this year. Then you use that $1 of earnings to go buy a company for $1 to get $1 of revenue growth. Total revenue for this year is $6.25.

 

With a 20% margin, you increase earnings to $1.25. There you have 25% annual growth.

 

There are timing differences where you have assumed that acquisitions are made on Jan 1st of the year but this is how the company is working overall.

 

I keep wondering though why these owners keep selling at such low prices? Maybe they need to cash out and there is really no big competition for these really small companies? Either way that contact list of 35,000 odd companies is a key competitive advantage.

 

Any thoughts?

 

Vinod

 

I am part owner of a small business myself in a niche market, and one needs to keep in mind that for a specialty business it's often only valuable to strategic buyers who are in the industry or understand the business... So this is partly why the valuation is low.  For most private businesses, a number of valuation guys tell us it's usually 3x pre-tax earnings or sometimes just book value depending on the business.  Which is rougly 1x revenue  doesn't really answer your question but just trying to point out it's not because they want to sell so cheaply, but because often for a small business the reality is the market is small and when you had a decent career, you wanted to get bought out as part of retirement, 3x seems reasonable.

 

That makes sense. Good to know from the perspective of a small business owner.

 

Vinod

[sjh]

OpenText (OTEX) has a very similar business model, they acquire software companies with a large installed base, remove management, sales and admin positions. Also there are usually many synergies in research & development and professional services, which lead to a boost in margins very quickly.

 

I think they are not buying those companies for a cheap price per se, however they have an operating model which allows them to extract a lot of value.

 

Enterprise Software is a pretty sticky business with high switching costs for customers, so you can use a lot of leverage without too much risk. There is however some headwind coming from pure SaaS companies, who see much larger organic growth and will have a bigger market share in the future.

 

Although the existing business will probably suffer from those pure SaaS competitors I guess that  M&A companies like CSU and OTEX will also benefit from this trend as pure on-premise software  companies will be cheap aquisition targets with lots of value to extract for a smart acquirer.

 

[FiveSigma]

Constellation does not extract synergies or 'integrate' acquired businesses - they run them on a standalone basis (as a holdco) and have been clear about it many times.

 

You are forgetting that a business that provides mission-critical service/product, is dominant in its niche, and is a small expense for the customer likely has substantial untapped pricing power.

 

Specifically, CSU will acquire something at 1x sales and 10x earnings, increase maintenance by 13% just once, that 13%, 10% net of tax falls right to the bottom line bringing ROIC to 20%.

 

As a customer, are you going to say 'OK' or go ripping out the enterprise software package to switch to something else over a single price increase?

Labor costs would be orders of magnitude of the total maintenance, let alone any savings. Plus, by far not every IT department even has the talent

to pull off a migration like that even if they wanted.

 

That's why you see a lot of ancient sofware (written in the 80s/90s) still running all over the place.

 

One of the most significant moats of enterprise software is switching costs - non-tech people generally don't appreciate the full extent of it.

[vinod1]

1. I think they are not buying those companies for a cheap price per se, however they have an operating model which allows them to extract a lot of value.

 

2. You are forgetting that a business that provides mission-critical service/product, is dominant in its niche, and is a small expense for the customer likely has substantial untapped pricing power.

 

Specifically, CSU will acquire something at 1x sales and 10x earnings, increase maintenance by 13% just once, that 13%, 10% net of tax falls right to the bottom line bringing ROIC to 20%.

 

As a customer, are you going to say 'OK' or go ripping out the enterprise software package to switch to something else over a single price increase?

Labor costs would be orders of magnitude of the total maintenance, let alone any savings. Plus, by far not every IT department even has the talent

to pull off a migration like that even if they wanted.

 

Both these imply that the prior owners are underestimating the pricing power. It is a possibility. I am wondering why these owner operators who presumably know the business for a long time and are in a position to know the pricing power and stickiness of their software are not able to recognize that.

 

Why sell out on the cheap?

 

Vinod

[vinod1]

OpenText (OTEX) has a very similar business model, they acquire software companies with a large installed base, remove management, sales and admin positions. Also there are usually many synergies in research & development and professional services, which lead to a boost in margins very quickly.

 

I think they are not buying those companies for a cheap price per se, however they have an operating model which allows them to extract a lot of value.

 

Not sure if OpenText approach is relevant here since we are talking about companies with $1 to $2 million in sales. It is unlikely they have a lot of admin overhead.

 

Vinod

[FiveSigma]

Both these imply that the prior owners are underestimating the pricing power. It is a possibility. I am wondering why these owner operators who presumably know the business for a long time and are in a position to know the pricing power and stickiness of their software are not able to recognize that.

 

Why sell out on the cheap?

 

Vinod

 

As it was said before - the market for small VMS firms is quite illiquid. Private equity is only really present in much larger deals as they have too much capital to deploy and fairly quickly (assuming finite fund life).

 

As for why sell - just like in other industries, it may be succession issues - founder reaches retirement and kids don't want to run it (it's a complex business anyway) or there is more than one kid and it's easier to sell and divide the proceeds.

 

Some of these founders (per my past conversation with Steve Sadler, CEO of Enghouse) being 50+ have fought through major technological shifts and are just not sure if they have the energy/desire to fight through another shift if it comes, so they choose to sell.

 

[vinod1]

Both these imply that the prior owners are underestimating the pricing power. It is a possibility. I am wondering why these owner operators who presumably know the business for a long time and are in a position to know the pricing power and stickiness of their software are not able to recognize that.

 

Why sell out on the cheap?

 

Vinod

 

As it was said before - the market for small VMS firms is quite illiquid. Private equity is only really present in much larger deals as they have too much capital to deploy and fairly quickly (assuming finite fund life).

 

As for why sell - just like in other industries, it may be succession issues - founder reaches retirement and kids don't want to run it (it's a complex business anyway) or there is more than one kid and it's easier to sell and divide the proceeds.

 

Some of these founders (per my past conversation with Steve Sadler, CEO of Enghouse) being 50+ have fought through major technological shifts and are just not sure if they have the energy/desire to fight through another shift if it comes, so they choose to sell.

 

Thanks! Makes sense.

[Liberty]

A lot of the small VMS businesses are lifestyle businesses run by technical founders who have started them decades ago, have known the employees for a long time, etc. The considerations and skills are different than for much bigger businesses, publicly traded, run by a bunch of MBA non-founders, etc.

 

OpenText is pretty different in model from CSU, in my opinion. Even Enghouse, which is run by someone who knows Mark Leonard, tends to integrate the businesses more and stick to fewer verticals.

[FiveSigma]

Sadler doesn't just know Leonard, he was his mentor back in the day.

[Liberty]

"Constellation Software Announces Appointment of Robin van Poelje to its Board of Directors" (TSS founder)

 

https://globenewswire.com/news-release/2018/02/19/1361477/0/en/Constellation-Software-Announces-Appointment-of-Robin-van-Poelje-to-its-Board-of-Directors.html

[Liberty]

Volaris co launches new unit for the cruise industry (organic growth initiative)

 

http://www.seatrade-cruise.com/news/news-headlines/spectec-launches-cruise-unit.html

[Liberty]

They stopped the calls, but at least they created an interesting alternative...

 

https://globenewswire.com/news-release/2018/02/23/1386886/0/en/Constellation-Software-Inc-Announces-Cessation-of-Quarterly-Results-Conference-Calls.html

[villainx]

What symbol do folks buy under?  I’m US based schwab.

[Shooter MacGavin]

Its either cnswf , which is the us ADR or CSU.to

[villainx]

I plan to attend the CSU AGM again this year and will be flying in on 25 April from Boston where I am attending the Tyler Technologies annual conference. Would be good to see you all again.

 

Any extra commentary on Tyler Tech? 

 

Sorry for the detour, but first time I came across this name, and going through the Constellation thread, and trying to get a little deeper into software, hoping to learn more.

 

Any podcast fans? http://investorfieldguide.com/savneet/  Invest With the Best latest with Savneet Singh - with some discussion on Constellation. 

[Liberty]

https://globenewswire.com/news-release/2018/03/13/1421219/0/en/Constellation-Software-Announces-Resignation-of-Ian-McKinnon-and-Appointment-of-Lori-O-Neill-to-its-Board-of-Directors.html

[rukawa]

I think most companies are unique.  Not genius model, but for example, the companies CSU is buying all fit this.  They fill some certain need very well.  It's a novel and unique need, and the users are clearly happy.

 

At a meta level I guess CSU is essentially arbitraging this.  They find small niche-y businesses that are private, buy them at a private multiple and by nature of now being public earn a public multiple on the money.

 

The concept is a unique value proposition.  If you own a business in a sales call a prospect says "why should we buy with you?" and you have to explain why you're unique.  But CSU isn't unique, the companies they own have this, but they themselves are just doing this private-public arbitrage.

 

I don't mean to belittle it or anything.  I have owned companies like this in the past, it's a valid thing.

 

The glassdoor reviews are sort of sad.  Not bad, just sad. Mostly because this is a company buying these little companies, squeezing them, or letting them run on auto-pilot and redirecting cash.

 

I get that as investors this is magical.  Maybe I have too much of a human element to me, but I've experienced being at these little companies, and I've worked for a CSU type company, and it's a shame.  There are so many clients that need solutions that just aren't getting served well, or served as well as they could.  I guess that's always the opportunity for a competitor.  I guess better worded, it's sad that they're buying all of this potential, and instead of re-investing to make it better they're just milking it.

 

So is the investment thesis basically that investors expect this to continue for a while?  The past has been good, and the future will be similar?  Is there key man risk here?

 

Glassdoor is interesting as an investment tool. Berkshire has horrendous reviews. Geico isn't much better. Telsa is worse than constellation. Its quite possible that you can treat your employees like shit for extended periods of time and still have excellent investment performance. I guess it all depends on how difficult it is to find replacements.

 

Fairfax is good. Google, Facebook have excellent reviews. Amazon is not great. Bloomberg isn't great either and I'm pretty sure they are making money hand over fist.

 

Its hard for me to say what Glassdoor indicates but I'm guessing it has low correlation to investment performance. This is one of those things that seems like is should matter but doesn't.