CA - Right Tail Capital - Constellation Software: Potential To Double In Share Price In The Next ~4 Years

Summary

• Constellation’s return on invested capital is exceptional.
• Negative working capital due to customers paying in advance is also a nice feature.
• If we are in a tougher economic environment, I expect the business to hold up well.

The following segment was excerpted from this fund letter .

Constellation Software ( OTCPK:CNSWF , CSU:CA )

Constellation Software buys and builds niche software businesses which provide mission-critical solutions. Current President Mark Leonard founded the company in 1995. He has produced a track record of incredible growth and returns on capital. Constellation is headquartered in Toronto and has an enterprise value of ~$34B.

Like the little things I do to become a better investor, Constellation does many little things well, which is a great source of competitive advantage. They buy and grow many “little” businesses. They remain fastidious on price, usually only relying on their own cash flow to buy businesses. They balance growth and profitability rather than solely focusing on growth at any cost like many companies over the past several years. As a result, Constellation’s return on invested capital is exceptional.

Often when I study businesses that consistently acquire, I must strip out intangible assets to calculate a return on capital that might be attractive. Then I ponder the intangible assets. “Are the intangibles worth more or less than what the company suggests?” This is not the case with Constellation. Returns jump off the page at 40% or higher even when including intangible assets. The company also keeps 95%+ of its customers each year. Perhaps Constellation can sell these customers an additional module in the future. Perhaps the intangible assets are worth even more than stated.

Additionally, Constellation has achieved these returns with negligible net debt. Buffett’s retained earnings test also confirms the stellar returns – market cap has grown by $33B since 2010 while retained earnings have only grown $1.2B. This indicates that Constellation has created tremendous value. Negative working capital due to customers paying in advance is also a nice feature.

Mark Leonard strikes me as a once-in-a-generation leader. Building a business from scratch to $34B over 27 years is an eye-popping result. It’s not like he did it by inventing one product that the world needed and was willing to pay for. Rather he has done it brick by brick with an incredibly disciplined approach to buying software businesses. While he is 65, I would not be surprised if he works for a long time and continues to figure out ways to evolve the business. He’s begun to do this by using modest amounts of non-recourse leverage and considering buying software businesses that are mission critical though more horizontal in nature.

Constellation’s share count has not grown at all since coming public. This dilution disdain is unheard of. (Usually, companies provide equity compensation to their employees that dilute shareholders by 1-2% per year. It’s also not uncommon to see companies use their equity to help pay for acquisitions.) The company also requires employees to use part of their bonus to buy the stock. This alignment is increasingly rare and reminds me of Warren Buffett’s approach to Berkshire. I would encourage you to read Mark Leonard’s letters. They are insightful, self-deprecating, and have taught me a lot about software and other great businesses.

Growing revenues at a 20% CAGR and free cash flow at a 25% CAGR over the past 10 years while maintaining a flat share count are exceptional results. As the business gets bigger, these growth rates will likely decelerate. However, at recent prices, I believe Constellation Software can generate a 15-25% IRR for several years (vs ~30% IRR over the past decade) even with a slower rate of growth. At a 20% IRR, Constellation Software has the potential to double in share price in the next ~4 years.

If we are in a tougher economic environment, I expect the business to hold up well. Constellation loses fewer than 5% of its customers each year and is diversified across many software businesses and industries that their businesses sell to. Constellation should also fare well in an inflationary environment due to limited capex and the ability to charge higher prices. Additionally, Constellation’s acquisition targets could become cheaper if capital becomes more expensive.

The risks here are organic growth declines, poor capital allocation, and a headline valuation (~4-5% earnings yield) that does not scream cheap. Organic growth declines in the more important maintenance and recurring items would be a red flag. This seems unlikely given the company’s long history of organic growth and focus on mission critical software.

Other risk mitigants include the company’s paranoid discipline regarding returns on incremental capital. In addition, the company primarily acquires smaller businesses, lessening the potential negative impact of one deal. Also, if valuations keep coming down or capital becomes scarcer, Constellation’s ability to do new deals may become easier. One other mitigant is that Mark Leonard could begin deploying capital outside of vertical market software at extremely attractive rates. Normally, I’d frown upon this possibility, but I am impressed by Leonard’s thoughtfulness and discipline.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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