CA - Constellation Software's Record 2022 Earnings

2023-04-03 13:58:37 ET

Summary

• Constellation Software Inc. had another great year, aided by the acquisition of Altera.
• We explain why we don't think we should expect these growth rates going forward.
• Profitability surged thanks to a more normalized accounting period, but cash flows remained stagnant due to the impact of non-cash operating working capital.
• Capital deployment enjoyed another record year and the "M&A machine" is intact.

Introduction

Constellation Software Inc. (CNSWF) finally reported its delayed Q4 and FY 2022 results . Recall that a couple of weeks ago, the company announced it had postponed these due to some complexity surrounding the Altera acquisition.

Constellation’s results were excellent, but there’s still significant “noise” in the numbers we must work through. We hope this article helps you “weed out” this noise and understand why Constellation is doing great.

Without further ado, let’s dig directly into the numbers.

The numbers

To avoid falling for quarterly noise, we’ll zoom out and focus mainly on the yearly numbers. There’s also noise in these, but we’ll work through it. Let’s start with the headline numbers .

The headline numbers

In 2022, revenue grew 30% year-over-year to $6.6 billion, and net income increased a whopping 226% year-over-year to $551 million (consolidated). If we only consider net income attributable to Constellation’s shareholders, growth was more muted, but still an impressive 65% year-over-year:

Altera (the company’s largest acquisition to date) played an important role in this growth. Excluding its impact, revenue would’ve grown 19% year-over-year, still impressive but not 30%.

The yearly revenue trajectory is outstanding, and it’s great to see revenue accelerate slightly compared to 2021:

Of course, we don’t think we must assume that revenue will grow at a 30% clip forever. In fact, we just laid out what growth would’ve been without including Altera, and it’s significantly below this number. Don’t get us wrong, Altera should undoubtedly be counted, but we doubt such large acquisitions will be recurring, and we should be prepared to see more muted growth going forward.

Digging deeper into revenue

As most of you might already know, Constellation has two sources of revenue growth: acquisitions and organic growth . As has been the norm throughout the company’s history, acquisitions primarily drove revenue growth this year, but there were some green shoots in organic growth.

Organic growth for the quarter and the year was severely impacted by foreign exchange headwinds, so we’ll focus on FX-adjusted metrics. Organic growth accelerated in Q4 to 4%, from 2%:

The FX-adjusted organic growth for the full year showed a slight deceleration from 5% in 2021 to 3%. Note, though, that Constellation’s revenue had a foreign exchange tailwind in 2021, which turned out to be a headwind in 2022. It also enjoyed easier comps. If we look at the non-FX-adjusted metrics, the difference between both years was even wider:

The bright spot of organic growth was once again in management’s preferred revenue source: maintenance and recurring . For yet another quarter, this revenue source grew faster than overall organic growth:

It was the 7th consecutive quarter of above 5% growth and the 10th consecutive quarter of positive maintenance and recurring organic growth. This is pretty impressive, considering the macro concerns that everyone is facing, but there’s a reason why management prefers this revenue source, and that is its resiliency .

Both Topicus and Altera impacted organic growth. Of course, it was impacted by many more acquired companies, but these are the ones that management discloses separately. This individual disclosure makes sense considering that Topicus was spun out to help Constellation improve its organic growth (we are getting Topicus numbers either way) and Altera was the largest acquisition in the company’s history. Topicus didn't impact Constellation's organic growth numbers this quarter, but Altera did.

Altera showed good news, not for the company itself but for Constellation. Constellation’s organic growth would’ve been higher without the negative impact of this acquisition, demonstrating that organic initiatives might be playing out well:

All in all, Constellation’s top line growth was great. Altera played an important role in growth this year, but it would’ve been more than acceptable even if we exclude it. Constellation has grown at 30% rates for two consecutive years (2021 was 29%, but you get us), something that the company had not achieved since 2014:

What can we expect of Constellation’s growth going forward?

Constellation has enjoyed two strong growth years, but the growth sources varied a bit between both.

In 2021 the company had (without considering 2022) a record year in capital deployment but also saw a significant contribution from organic growth , aided partly by foreign currency tailwinds and easy comps. However, 2022 was different in that Constellation managed to grow 30% while organic growth was negative 1% (recall that the 30% is not currency adjusted). This 30% was, again, a result of record capital deployment. So, similar growth rates but pretty different organic and inorganic contributions.

So, what can we expect from growth going forward? We don’t think we have a magic ball to tell you what will happen, but we think it’s tough to assume that growth will stay at this level going forward . Despite Constellation trying to grow organically, most of its revenue growth still comes from acquisitions, and there’s only a point to which the company can scale. What’s the ceiling to scalability? We don’t know, but there’s always a ceiling.

Does this mean that the thesis is busted? Not for us. Constellation’s thesis relies on steady growth for many years, which doesn’t mean growth will be consistently in the 30%s. Of course, if the company achieves this, that would be great, but we will not anchor our expectations to this.

If organic initiatives prove successful, we should see a more balanced mix of organic and inorganic growth going forward, which should be great for margins.

Looking at the expense side - Plenty of noise

There was quite a bit of noise regarding yearly profitability, but we’ll try to guide you through it. What we can see right out the bat is that accounting profitability improved markedly compared to 2021:

If we look at the company’s income statement, we see several expense items that played an important role in the “surge” in profitability (highlighted below):

Let's discuss them briefly.

The company saw quite a substantial foreign exchange gain this year compared to last year, which added $57 million to EBT (Earnings Before Taxes). Foreign exchange rates should not impact the company’s profitability a lot because the company does a good job of matching expenses with revenue, but the match is not perfect:

Foreign exchange impacts top-line growth, but if one euro of revenue is worth less in dollar terms this year, so will a euro of expenses . Recall that most of the company’s expenses are incurred by the companies generating the revenue.

The next expense item that stands out is that of the redeemable preferred securities . As part of Topicus' complex spinoff, Constellation incurred an expense when preferred shares were converted. The company recorded this expense in 2021, which did not apply in 2022. That was a $295 million benefit to profits. The foreign exchange gain and the absence of the preferred securities expense (among others) “helped” the company increase its EBT by a whopping 94%.

If we go down a bit lower in the income statement, we see substantial movements in tax items . The tax expense increased for several reasons, the most important one being the change in the accounting of R&D expenses:

Effective for 2022, research and experimentation (R&E) expenditures are no longer allowed to be deducted as incurred for tax purposes by US entities. The Tax Cuts and Jobs Act ((TCJA)) mandates that, for tax years beginning after December 31, 2021, R&E expenditures be deferred and amortized.

Source: Constellation MD&A .

This change had a substantial impact on the income tax expense, but management was able to offset it with deferred income taxes (emphasis added):

The total impact to current income tax expense is $105 million for the 2022 fiscal year. Negative $12 million and positive $105 million was accrued and expensed in the three and twelve month periods ended December 31, 2022 respectively. An offsetting amount has been booked to deferred income tax expense so there is no impact on net tax expense or the effective tax rate.

Source: Constellation MD&A.

What’s interesting is that if we calculate the effective tax rate (Income Tax Expense / Earnings Before Taxes) of both years, we see that the effective tax rate was much lower (and probably a fairer representation of what it should be) this year:

The preferred securities expense caused this, as it was not deductible for tax purposes last year. This means the company did not pay taxes on $374 million in EBT but on $669 million ($374 + $295).

What all of the above created was an unsustainably low margin level in 2021, which was somewhat corrected this year.

If we drill down on expenses, we get to the following table:

As has been the case for the last couple of quarters, the two expenses that showed the fastest increase were travel and Other, net . Travel increased primarily due to acquisitions and a more normalized business travel environment . Many stopped traveling in 2021 due to COVID but are back on the move.

If we look at Other, net, we can see that contingent consideration accounted again for almost one-third of the increase in this expense:

Contingent consideration is a “good” expense. The bottom line is that it measures the payments the company has to make when acquisitions go better than expected, which is great, of course. It allows us to have at least an idea of how acquisitions (those with contingent considerations) are doing.

The counterparty to contingent considerations is impairments . These decreased in 2022:

A good deal of impairment charges was caused by a 2004 acquisition for which the customers were “transferred” to another company in the same vertical (emphasis added):

The expense for the three months ended December 31, 2022 primarily relates to the write down of goodwill associated with a business acquired in 2004. The majority of the customers from the business have been transitioned to another business owned by the Company that operates in the same vertical.

Source: Constellation MD&A.

If we plot both indicators together, we can see that Constellation is still doing great on the acquisition front. Of course, take this with a grain of salt because these indicators have their limitations:

Looking at cash flows - non-cash operating working capital weighing into the results

Profitability increased considerably, but cash flows remained flat in 2022:

So, how did margins expand significantly, but cash flows didn’t? The answer lies in cash conversion . In Q2, Constellation suffered a steep drop in cash flows due to changes in non-operating working capital. This impact also weighed on the yearly results:

Constellation Software’s non-cash operating working capital went from a $45 million benefit in 2021 to a $60 million headwind in 2022, adding up to a $105 million differential. If this differential had not existed, we would be talking about around an 8% growth in operating cash flow. There’s no doubt that cash flows have remained stagnant for some years now, but we honestly think the landscape should normalize in the coming years.

In fact, if we look at the quarterly results, we can see things already normalizing: operating cash flow was up 17% year over year in Q4 . Free cash flow suffered the same headwinds as OCF, with the added headwind of higher interest payments.

Acquisitions - The M&A machine remains intact

Constellation’s earnings confirmed what we already knew: it was another record year in capital deployment.

Of course, Altera, the largest acquisition in the company’s history, pulled capital deployment numbers up this year. However, even if we ignore it, we can see that capital deployment was great:

There’s evidently a ceiling regarding decentralization to boost capital deployment, but management seems laser-focused on deferring it.

Management will undoubtedly resort to larger acquisitions to deploy an increasing capital base, but judging by the performance of Altera, we don’t think there’s much to worry about.

Altera posted $96 million in operating cash flow in 8 months (the period when Constellation owned it). If we annualize this number, we get to around $144 million in operating cash flow in 2022. Constellation paid $700 million (including $30 million in contingent consideration) for this asset, implying Constellation acquired Altera for 6x operating cash flow multiple:

Altera is undoubtedly shrinking (or else it’s impossible to buy an asset at that valuation), but if Constellation manages to reduce the pace of bleeding and continues to streamline the company, we think this will be a great investment.

The financial position has improved slightly, and Constellation has plenty of dry powder

This year Constellation has levered (at least a bit more than it historically used to) the balance sheet a bit. As of the end of Q3, the company had the following financial position (emphasis added):

The company ended the quarter with a net debt position of $561 million , comprised of $665 million in cash and $1.2 billion in debt. From this amount of debt, $939 million is held by subsidiaries and is not guaranteed by Constellation.

Thanks to the company’s strong cash generation this quarter, it slightly improved its financial position. Constellation ended with net debt of $502 million , with $811 million in cash and debt of $1.3 billion. For Constellation’s standards, $1.3 billion is quite a bit, but the company is not overleveraged by any means. Constellation generated almost the same amount in operating cash flow this year as it carries in debt.

The company also has plenty of dry powder to make 2023 another strong year in capital deployment. If we add up cash, the undrawn portion of the company’s credit facility, and an expected $900 million of FCF generated next year (probably conservative), we get to dry powder of $2.2 billion . 2023’s capital deployment will rely on the opportunities available, but should they be there, Constellation has the dry powder to capitalize on them.

Conclusion

Constellation Software Inc. reported an excellent quarter again. Growth was very strong, aided by Altera and suffering headwinds from foreign currency. Organic growth in constant currency was a highlight yet again, and profitability returned to a more normal pattern.

The company excelled again in capital deployment, and 2023 should also be a strong year should opportunities be available to deploy capital.

In the meantime, keep growing!

For further details see:

Constellation Software's Record 2022 Earnings