In the below note, we’ll discuss the reasons why we view Constellation Software, Inc (‘CSI’), as an exceptional investment opportunity.
CSI was founded by Mark Leonard (President & CEO) in 1995. Since the IPO in 2006, the equity has delivered a compounded annual total return of +37%. It has achieved this at the same time as limiting the extent of any equity drawdown to 26% over the same period.
If volatility were deemed a proxy for risk, some textbooks will tell you it is (we are less convinced), then Constellation Software offers one of the best risk-adjusted return profiles that you can find.
Since CSI’s IPO in 2006, Microsoft, Amazon, Apple, & Nvidia have all delivered phenomenal returns. However, the returns have been accompanied by significant falls in the equity price (drawdowns).
However, in the case of CSI, patient shareholders have been rewarded with exceptional returns and lower than average volatility. The ride has been highly rewarding and relatively stress free.
A SERIAL ACQUIRER
A serial acquirer can broadly be described as a company that actively & repeatedly seeks to acquire other businesses as a key driver of long-term value.
Serial acquirers are not typically the companies that make the headlines with announcements of massive acquisitions. In fact, they often operate in the opposite manner.
Critical to the serial acquirer strategy is the reinvestment of capital at high rates of return. At the risk of oversimplifying a complex business model, the underlying growth of a serial acquirer can be boiled down to the following:
Return on Invested Capital x Re-investment Rate
Successful serial acquirers have a strong track record of market outperformance stemming from their ability to regularly re-invest capital at high rates of return, compounding earnings over the long-term.
A SERIAL ACQUIRER OF VMS BUSINESSES
CSI is a serial acquirer of vertical market software (‘VMS’) businesses. Vertical market software is developed for & customized to industry-specific needs. VMS businesses possess compelling attributes that make them ideal targets for serial acquirers:
– Resilient & recurring revenues provide for a steady stream of incoming cash whatever the weather.
– High switching costs limit the potential for competitive disruption. Products represent a low % of total operating cost and are mission critical.
– High margins given a low marginal cost of production. Software is easily replicated & distributed.
– An attractive cash return profile given low levels of capital intensity & negative working capital.
Unlike many PE or VC companies, CSI is not seeking to acquire the fastest growing companies with large addressable TAMs. These markets are highly competitive, and valuations are expensive. Instead, CSI favours high cash margins & durable growth. This model has allowed CSI to consistently acquire attractive, cash-generative businesses at a reasonable price over a long time-period.
CSI’s acquired businesses operate across a wide range of verticals and typically have market-leading positions in small, niche markets. These are small, durable, mid-growth annuity businesses.
From its first acquisition in 1995, CSI now has over 1,000 businesses within the Group. In 2023 alone, it acquired over 100 businesses.
“CSI’s strategy is to be a good owner of hundreds (and perhaps someday thousands) of growing autonomous small businesses that generate high returns on capital. Our strategy is unusual…We seek out vertical market software businesses where motivated small teams composed of good people, can produce superior results in tiny markets.” – 2016 President’s Letter
Constellation runs an internal database of potential acquisition targets. It maintains, supports and develops relationships with potential targets over long periods of time and often receives preferred buyer status given a strong reputation within the industry.
Counter to the traditional Private Equity model, CSI favours long-term ownership in the businesses it acquires.
“Founder businesses tend to be a very good cultural fit with Constellation, and most of the ones that we buy, operate as standalone business units managed by their existing managers under the Constellation umbrella. We track many thousands of these acquisition prospects and try to regularly let their owners know that we’d love the chance to become the permanent owners of their business when the time is right for them.” – 2012 President’s Letter
In 2006, Constellation stated that its internal database contained 1,200 businesses and in 2017 this number had reached 35,000.
It would not be unreasonable to assume that the addressable market and opportunity for Constellation has continued to expand. And given that the company acquired over 100 businesses in 2023, the indication is that there is still significant room for growth.
AUTONOMY, LONG-TERM VIEW, MERITOCRACY
Leonard actively voices his disdain for imposing a set culture on a business, for fear of damaging or destroying what is already a well-functioning business. This is an inherent risk within M&A.
Instead, there are three traits that are prioritised: Autonomy, Long-term thinking and Meritocratic governance.
Autonomy is reflected in the decentralised structure of the Group & the measured actions of Head Office which avoids imposing itself unnecessarily.
Long-termism is reflected in CSI’s assessment of the underlying acquisitions & their durability, and a focus on acquiring founder-led companies.
“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.” – 2012 President’s Letter
Durability and longevity are priorities. Leonard bemoans the fact that traditional governance states that you should rotate senior members of the board regularly. He prefers board members to be engaged over the long-term, aligned with the business.
Counter to most PE/VC buyers, Constellation buys VMS businesses to hold, with no view on an exit. The company sources & builds relationships over years and this contributes to a healthy pipeline and a leading position versus the competition when it comes to bidding and executing on integration.
In terms of meritocracy, employees have a clear path for advancement based on success within the operating group structure. Successful employees, from acquired businesses or internal to CSI, can easily find themselves managing a number of different businesses at the Operating Group level.
Employees are further incentivised through a share scheme that aligns them directly with shareholders. Employees are required to invest a portion of their after-tax bonuses into common shares. This simplifies reporting through the P&L. It also limits any share dilution that might be expected from the more common-place stock-based compensation seen in the rest of the equity market.
“To date there are over 100 CSI employee/shareholder millionaires. Ten years from now, my hope is that there will be five times as many.” – 2016 President’s Letter
The result is an investor base of employees who are fully aligned with shareholders, and who also represent a more permanent and well-informed shareholder base.
FUNDAMENTALS
Over the past ten years, CSI has compounded sales & operating cash flow at 21% and 23% respectively. EBITA margins have averaged 26% over five years.
The company provides no forward looking guidance, and sell-side coverage remains surprisingly low for one of the best performing equities in recent decades.
The sell-side is reluctant to model M&A, and this, alongside a management which provides limited-to-no guidance, creates an environment whereby the market consistently underestimates the durability of the company’s growth.
RUNWAY RISK
The key risk for CSI lies in the sustainability of its acquisition growth strategy. The pivotal question is: How long can the company continue acquiring smaller businesses before it needs to make increasingly larger, potentially more expensive, acquisitions in order to reinvest its cash flow?
This also needs to be considered in the context of increasing complexity & market competition.
Greatness often spurs imitation, and you don’t have to look too far before you find a number of other players that are adopting the CSI model.
While imitation is the sincerest form of flattery it also increases the level of competition within the marketplace, and this will undoubtedly be something to monitor going forward.
“There’s competition everywhere, there’s these copycats or private equity firms in North America and Europe and the far East and Australia, it’s everywhere… But there are more and more companies that are formed on a regular basis. And so I think there’s going to be enough to go around. We’re continuing to hold our share in terms of acquisitions. It’s still a very competitive market.” – Bernard Anzarouth, CIO, 2024 AGM.
The extent to which this additional competition makes it harder for CSI to continue to execute on its gameplan remains uncertain.
That said, there is real comfort from knowing that none of this is new. The aforementioned risks have been discussed at length in shareholder letters and at AGMs for a number of years.
Disciplined strategic planning and strong managerial execution, facilitates the strategic adaptation necessary to optimize long-term enterprise value.
The final paragraph from the President’s Letter published in February 2021 makes clear what changes can be expected in the future:
“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.”
DISCPLINE IN THE PURSUIT OF PERFECTION
Durable growth over decades relies on consistent improvement, driven by a strong & proactive management. There is clear evidence of this at CSI:
– They learn from other successful conglomerates.
– They regularly review VC-backed VMS disruptors.
– They perform post-acquisition reviews.
– They review all successes & failures.
“An investment only becomes a lesson if we diligently track its post-acquisition performance and take the time to analyse the outcome while the investment is still fresh in everyone’s mind.”
– 2016 President’s Letter
Management is intellectually honest. They are transparent in their recognition of the major risks. And the business strategy is disciplined whilst also being dynamic & open to change. There is a recognition that a failure to adapt can be existential.
CONCLUSION
It would be naïve to assume that CSI can continue to compound at the same historical level into perpetuity. At some point growth will revert to the mean, management acknowledge this. That said, they are fully committed to delaying this inevitability for as long as possible.
“Our goal, however, is to have our return on Total Capital revert to the mean as slowly as possible, while still deploying most of the Free Cash Flow (“FCF”) that we generate…
Our plan is to maintain investment discipline, keep overheads low and hire and coach a new generation of ambitious, hard-working BU Managers who can be taught how to be competent long-term “owners”. Hopefully we’ll still be having this reversion debate ten years from now.” – 2016 President’s Letter
For anyone wishing to learn more about CSI, we would look no further than the President’s Letters written by Mark Leonard that can be found on the Constellation Software website. They cover the period from 2007 to 2021 and offer the reader extraordinary insight into an exceptional business.
If you would like to know more about our investment strategy and investee companies, please don’t hesitate to contact us.
Written by Archie Tulloch, Senior Investment Analyst, Middleton Enterprises
Archie@middletonenterprises.com
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