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Constellation Software (CSU) Stock | TSX: CSU.TO

The GOAT of Capital Allocation

Constellation Software is known as CSI, but has the ticker symbol CSU.

The term GOAT (greatest of all time) must not be used lightly.

Constellation Software, has quietly been stringing together a massive tech portfolio through acquisitions.

Numbers speak for themselves in any GOAT conversation and CSU has the return on invested capital (ROIC) metrics to back said claims.

Constellation Software is an international provider of market-leading software and services to a number of industries, both in the public and private sectors. Our mission is to acquire, manage and build market-leading software businesses that develop specialized, mission-critical software solutions to address the specific needs of our particular industries.

Growth

58

Valuation

81

Quality

85
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Where Are We Now

Updated on: 11/4/2021

Conviction Score

10

Constellation is a best-of-breed vertical market software (“VMS”) company acquirer in a world that has tens of thousands of such companies serving every industry imaginable. Constellation’s management team is talented and empowers business managers to think long-term and always create value for customers.

  • We believe Constellation can continue growing quickly through acquisitions. Constellation purchased over $1 billion of new businesses over the last twelve months, a record for the company.

  • Although Constellation is a VMS specialist, it is now expanding its horizons by learning about how to enter new industries and conduct bigger acquisitions through its proven acquisition strategy.

Investment Thesis

  1. Constellation Software, headed up by all-star capital allocator Mark Leonard, has built a decentralized machine that can efficiently deploy capital into small vertical market software (VMS) companies around the globe in an impressive quantity.

  2. CSU makes software acquisitions through their decentralized operating groups. Upon acquisition, Constellation can assist the business and provide strategic direction, but they do not wish to integrate them with other businesses or change the culture.

  3. Constellation’s ability to deploy capital at sustained high Return on Equity (ROE) and Return on Invested Capital (ROIC) figures has allowed the business to compound at such a high rate.

  4. The existing VMS businesses are mission critical niche software with predictable cash flows and low customer churn. They do however, provide very little if any organic growth over time. Cash flows are extracted to fuel more acquisitions.

  5. Moving forward, CSU is open to bigger acquisitions as it will be increasingly difficult to deploy all free cash flow on acquiring small VMS businesses.

The Basics

Constellation Software is a team of Canada’s top technology capital allocators.

Headed up by founder Mark Leonard, Constellation Software has consistently brought value to shareholders through a steady stream of technology acquisitions with specifically Vertical Market Software (VMS) businesses.

Delivering high returns on invested capital, CSU has been able to acquire software businesses and extract free cash flow. They then take proceeds and continue making more acquisitions. This creates a powerful snowball of compounding.

It is important to note that CSU drives financial results primarily from acquisitions. There is very little, if any, organic growth.

Mark Leonard: One of a Kind

Who He Is

In today's day and age, finding information about someone is rather easy. All it takes is a quick google search and you can look through social media, news outlets, and reports easily.

For a man like Mark Leonard, the CEO of Constellation Software, he has been able to keep a low profile and remain quite anonymous all these years. On Google, you can find three photos of him.

All we know about Mark Leonard is that he is apparently 6'5", has a beard like Gandalf, plays rugby, and writes a killer annual shareholders letter.

How CSU Came to Be

After finishing his MBA, Mark Leonard started working in Venture Capital (VC).

While working, he found it irritating that these VCs were focused only on large addressable markets and passed out on opportunities in other markets.

He saw great potential with software businesses in niche markets as they had high gross margins, were sticky, and businesses offered software that was vital for certain operations.

He raised money from OMERS (Ontario Municipal Employees Retirement System) and from his venture colleagues to a whooping $25 million. Mark Leonard had a goal to become the best Vertical Market Software (VMS) business acquirer in the world.

With this money, he created the now known Constellation Software.

Best in Class Capital Allocators

“Acquiring, Building & Managing Exceptional Companies”

Constellation Software has consistently delivered high returns on invested capital by acquiring software companies.

CSU claims to buy "Good" vertical software companies and sometimes stumbles upon an "Exceptional" Company.

CSU Acquisition Diagram

Of the 500+ companies that Constellation Software has acquired, Mark Leonard ensures CSU is a perpetual owner, meaning they do not sell any of their businesses.

To date, Constellation Software has sold only one business, only because an absurdly price tag was offered. With the deal done, Mark Leonard still regrets selling it to this day.

Exceptional Companies

Constellation Software defines an "Exceptional" company as one with outstanding management, profitability and above average growth.

CSU is great at working with founders and managers to acquire their business regardless of the reason for selling.

They recognize that the founders wish to let them continue operating with the culture in tact.

“CSU recognizes the value of these rare companies, and following an acquisition, we leave them to continue their Exceptional operations as they have in the past.”

Good Companies

The more abundantly found “Good” company still can drive value for Constellation Software.

Good companies are defined as first or second ranked in their respective verticals. They then wish to acquire the business and understand what is stopping them from becoming an exceptional company.

They work with the recently acquired management team and assist with resources to improve capital allocation, incentives and learn from the other businesses inside of the CSU ecosystem,

Once acquired, businesses can leverage the vast ecosystem of businesses that Constellation Software owns. Whether it be direct integrations or leveraging training and mentorship, these businesses are given sufficient resources to become Exceptional.

CSU does not take over daily operations. Rather, they assist with strategic direction, resources and capital allocation.

At the end of the day, Good companies can become Exceptional.

A Look at Operating Groups

Constellation Software acquires and builds businesses through the main operating groups:

  • Volaris

  • Harris

  • Jonas

  • Vela Software

  • Perseus Group

  • Total Specific Solutions

CSU Operating Groups Diagram

Each operating group caters to a specific list of vertical markets. Among each operating group sits hundreds of business units.

From public to private industries and financial services to utilities, CSU is able to cover many VMS (vertical market softwares) through this ecosystem they have created with their operating groups.

Constellation Software also has a 30.35% stake in Topicus.com (TOI.V), a spinoff company similar to CSU.

Topicus also acts as a decentralized operating group, deploying their own capital and managing acquisitions.

Read our report on Topicus: The New Kid on the Block.

CSU Operating Groups Flowchart

Compounding

  1. Acquire software businesses.

  2. Provide resources.

  3. Extract value and recurring cash flows.

  4. Repeat.

This is the formula for Constellation Software's success over the last few decades.

The business model allows for predictable growing cash flows that turns into a powerful compounding machine.

Constellation Software has maintained an average ROIC (return on invested capital) of a whopping ~40%.

Constellation Software EBITDA ($M) (Q3 2021)

Constellation Software Free Cash Flow ($M) (Q3 2021)

Constellation Software Revenue ($M) (Q3 2021)

CSU 2.0

Constellation Software has successfully been able to deploy capital and integrate companies into their ecosystem seamlessly. Prioritizing Vertical Market Software (VMS), specifically in niche markets, ensures growing free cash flow and consistent compounding.

CSU Capital Deployment on Acquisitions ($M) (Q3 2021)

Source: RBC Capital Markets CSU Q3 2021 M&A Tracker

These niche markets provide a massive growth runway for CSU as the opportunities for different businesses are still at large.

Now the question arises how long can this capital allocation last for? Constellation Software will not be able to maintain this massive growth in Free Cash Flow every year.

Mark Leonard has brought up this issue and has mentioned the idea of branching out of VMS into other markets to continue deploying capital. The CSU team plans on looking at sectors that are new and under-appreciated in order to reap the benefits of attractive returns and sustainable advantages.

Risks

Capital Deployment

It is no surprise Constellation Software has had explosive growth over the last decade. Their financial metrics continue to grow rapidly, which is a great thing for both the business and investors.

The issue arises with the kinds of acquisitions that CSU makes from this point onwards.

With a larger market cap, the business has to continue to make larger deals in order to move the needle and grow the company. Sticking to smaller companies may have short term incentives, but they will need to increase their volume of acquisitions if they want to continue their growth and please investors.

Mark Leonard and the team have addressed this issue and are already trying to resolve it.

Constellation Software has deployed more capital for acquisitions in the first half of 2021 than they ever have in any other 6 month period in the company's history.

Therefore, this risk is not currently concerning as the business continues to find ways to deploy a record amount of capital through its decentralized structure.

Increased Competition

Constellation Software's entire business model revolves around making acquisitions.

Since their IPO in 2007, the market has become more saturated with capital acquirers and growth by acquisition companies. This means more companies are interested in acquisitions, especially competition from private equity.

An increase in demand always translates into a price increase. This may prove troublesome for CSU as they may have to pay a higher price tag for some deals than anticipated.

Investors should keep an eye on Constellation Software's financial statements, specifically their cash reports related to acquisitions and investments.

Bottom Line

Investors can expect continued growth from Constellation Software for a long time to come.

There is a long runway for opportunities for CSU to acquire software businesses at high returns on capital. The profitable businesses they acquire can pump more free cash flow for further acquisitions.

This is their capital deployment flywheel. It really works.

Be aware that the business has inconsistently shown organic growth. This means without more acquisitions growth would be almost non-existent. Sometimes they even demonstrates negative organic growth every year from the businesses in their ecosystem.

If CSU can continue to execute on excellent acquisitions and effectively use their operating groups to deploy capital, the business will keep their title as the GOAT of Capital Allocation.

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