Constellation Software (OTCPK:CNSWF) has done the impossible and found a way to effectively scale an M&A strategy. This is a buy-and-hold stock for investors with long investment horizons. Management thinks in decades and so should we. Constellation is exploring new growth opportunities to sustain the scalability of its M&A model. Constellation Software has been one of the biggest winners since its IPO in 2006 going up over 11000% in under 20 years.
Throughout this article, I will often refer to Constellation Software Inc as CSI.
Laser-Focus on vertical market software M&A
CSI focuses exclusively on Vertical market software, which represents niche software applications for small markets. Most of CSI’s acquisitions are in niches with a TAM of just a few million dollars in some cases. Why do they just go for these small markets? Why not try to catch the hundred billion dollar CRM opportunity? VMS companies have a few key advantages:
- Due to the small market, there are often just a few players, which leads to low churn rates.
- VMS is often very sticky because most of CSIs companies primarily focus on applications critical for the day-to-day operations of the customer.
- The software requires little reinvestment and produces high and predictable cashflows.
- Often founder-led companies where the founder wants to cash out his life’s work and know it is in good hands. CSI has a pristine reputation in the space.
The VMS market opportunity is very large with tens of thousands of small companies all over the globe. CSI has a database with thousands of potential targets. They often are in contact with acquisition targets for years before making an offer. Constellation wants the owner to know that they are here to make an offer if they decide to retire. CSI is interested in owning businesses for the long term, the company owns around 700 companies and only ever sold one of them again (CEO and Founder Mark Leonard still regrets this decision).
Constellation Software has a very decentralized structure with six operating groups with business units under them and all operating independently. The cash flow from all the owned companies flows back to the holding and is then used by CSI’s army of managers that will allocate the capital into acquisitions meeting their high hurdle rates. CSI is known for sticking to these hurdle rates, sometimes calling deals off over a few thousand dollars. This discipline in capital allocation and the decentralized nature of their strategy enabled them to scale M&A as nobody else can manage.
To achieve its decentralized nature, CSI has six operating groups, each focused on different verticals and operating independently with lots of business units operating under each operating group.
The company outlined a few opportunities for future growth. Their goal is to invest their entire Free Cashflow and more if opportunities arise. One of the main concerns for CSI has been its ability to scale capital reinvestment with scale. Part of the strategy is to religiously stick to the set hurdle rates. This works well with small deals ($1-20 million) but gets harder with bigger deals that generally have more eyes on them. The VMS market remains a tremendous opportunity, but the company also laid out new future growth opportunities.
Expansion into new verticals
In the last quarter, CSI mentioned that they are considering expanding into new verticals outside of their circle of competence in VMS. CSI has a very broad understanding of many industries through its ownership of hundreds of niche companies. Even though these new verticals probably won’t be VMS businesses and maybe not even software businesses, I still see a good possibility that the highly skilled managers will be able to find good deals and be good long-term owners of those companies. This of course does come with a higher risk of execution.
In the recent AGM, Mark Leonard made a very interesting comment regarding an oil investment they looked into, a $1 billion investment that would have been their largest ever. He described it as an attempt to buy a tax-advantaged asset in an industry with hard times to get financing (at the time). Oil prices ran away though and the deal didn’t go through. It shows that they are ready to take a large swing given a good opportunity.
Venture capital fund
In 2021 CSI announced a new Venture Capital fund. The $200 million fund aims to invest primarily in current employees of CSI-owned companies that seek more than being an employee. Historically CSI had some employees that thought a little different than the norm, these employees then left their job and started a company themselves. CSI now wants to offer these employees seed capital and potentially even acquire them outright in the future. This venture fund won’t produce results for many years to come like always CSI invests for the next 5 years.
Even though CSI wants to stick to the strategy of buying small VMS companies meeting their hurdle rates, they also are considering doing bigger deals. Recently the company did by far the largest acquisition in the company’s history by acquiring assets from Allscripts Healthcare Solutions for $700 million. This deal differentiates itself from its normal deals and signals that we could see more big deals like this one in the future. This will definitely help the company scale faster, but investors need to watch the returns on these investments. CSI’s return on capital naturally is declining as scaling the business becomes harder and harder, but the amount of decline should be gradual and eventually stay at a higher level than the average publicly listed company.
To value Constellation Software I’ll have a look at the forward earnings and the FCF yield. Both aren’t historically cheap but are coming back to the mean. What makes CSI so interesting is that they are one of the most resilient stocks I’ve ever seen, since coming public in 2007 the company never had a drawdown exceeding 26%. This comes from a very loyal and long-term oriented shareholder base and their unique incentive structure for execs. CSI doesn’t give out stock options, but they require managers to purchase shares on the open market as part of the bonus and hold them for a certain amount of years. From experience, most of CSIs managers hold them much longer than they would have too though. The company is currently in a 16% drawdown while the general market is already in bear market territory. I expect that CSI will continue to be a safe haven for investors.
Conclusion and final remarks
For me, Constellation Software is one of those stocks you buy and never sell. The company has a remarkable track record of great capital allocation and a unique decentralized structure that enables them to scale M&A much further than any competitor could. CSI is a great anchor stock for any portfolio given its stable and resilient nature. I hold a 10% position in CSI and will continue to buy shares going forward.