Thesis

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 action for investors with long investment horizons. Management thinks in decades and should therefore we. Constellation is exploring new growth opportunities to support the scalability of its M&A model. Constellation Software has been one of the biggest gainers since its IPO in 2006, growing more than 11,000% in less than 20 years.

Throughout this article I will often refer to Constellation Software Inc as CSI.

Laser-Focus on Vertical Market Software Mergers and Acquisitions

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 only a few million dollars in some cases. Why are they content with these small markets? Why not try to seize the hundred billion dollar CRM opportunity? VMS companies have a few key advantages:

• Due to the small size of the market, there are often only a few players, leading to low churn rates.
• VMS is often very sticky as most CSI companies focus primarily on applications critical to the customer’s day-to-day operations.
• The software requires little reinvestment and produces high and predictable cash flows.
• Often founder-run businesses where the founder wants to cash in on his life’s work and know he’s in good hands. CSI has an immaculate reputation in space.

M&A strategy

The VMS market opportunity is huge with tens of thousands of small businesses all over the world. CSI has a database with thousands of potential targets. They are often in contact with acquisition targets for years before making an offer. Constellation wants the owner to know they are here to make an offer if they decide to retire. CSI is interested in owning businesses long-term, the company owns about 700 businesses and only sold one (CEO and Founder Mark Leonard still regrets that decision).

Constellation Software has a very decentralized structure with six operating groups with business units under them and all operating independently. Cash flows from all owned companies go back to the holding company and are then used by CSI’s army of managers who will allocate capital to acquisitions that match their high rates of return. CSI has been known to stick to these hurdle rates, sometimes overriding offers over a few thousand dollars. This discipline in capital allocation and the decentralized nature of their strategy has allowed them to scale M&A like no one else can.

To achieve its decentralized nature, CSI has six operating groups, each focused on different verticals and operating independently with numerous business units operating under each operating group.

New opportunities

The company presented some opportunities for future growth. Their goal is to invest all of their Free Cashflow and more if opportunities arise. One of CSI’s main concerns has been its ability to scale capital reinvestment. Part of the strategy is to religiously stick to set limit rates. This works well with small deals ($1-20 million), but gets more difficult with larger deals that typically have more attention on them. The VMS market remains a tremendous opportunity, but the company has also defined new opportunities for future growth.

Expansion into new vertical markets

Last quarter, CSI mentioned that it was considering expanding into new verticals outside of its VMS competency circle. CSI has a very broad understanding of many industries through its ownership of hundreds of niche businesses. Even though these new verticals probably won’t be VMS companies and maybe not even software companies, I still see a good possibility that highly skilled managers will be able to find good business and be good owners at long term of these companies. Of course, this comes with a higher execution risk.

At the recent AGM, Mark Leonard gave 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 that was struggling to get funding (at the time). Oil prices soared and the deal fell through. It shows that they are ready to take a big swing if a good opportunity presents itself.

Venture capital funds

In 2021 CSI announced a new venture capital fund. The $200 million fund aims to invest primarily in current employees of CSI-owned companies who seek more than just being an employee. Historically, CSI had employees who thought a little differently than the norm, these employees then quit their jobs and started a business themselves. CSI now wants to offer these employees seed capital and potentially even acquire them directly in the future. This venture capital fund will not produce results for many years, as always CSI is investing for the next 5 years.

Bigger offers

Even though CSI wants to stick to the strategy of buying small VMS companies that meet their hurdle rates, they are also considering doing larger deals. Recently, the company made by far the largest acquisition in its history in acquisition of assets of Allscripts Healthcare Solutions for $700 million. This chord differentiates itself from his normal chords and signals that we may see more big chords like this in the future. This will certainly help the business scale faster, but investors need to watch the returns on these investments. CSI’s return on capital naturally declines as scaling the business becomes increasingly difficult, but the amount of decline is expected to be gradual and ultimately remain at a higher level than the average company listed on the stock exchange.

Evaluation

To evaluate Constellation Software, I will take a look at forward earnings and FCF yield. Both are not historically cheap but average. What makes CSI so interesting is that it’s one of the most resilient stocks I’ve ever seen, since its IPO in 2007, the company never had a drawdown over 26%. This comes from a very loyal, long-term oriented shareholder base and their unique executive incentive structure. CSI does not distribute stock options, but requires managers to buy stocks on the open market as part of the bonus and hold them for a certain number of years. From experience, most CSI managers keep them much longer than they would have. The company is currently down 16% while the general market is already in bearish territory. I expect CSI to continue to be a safe haven for investors.

Conclusion and final remarks

For me, Constellation Software is one of those stocks that you buy and never sell. The company has an outstanding track record in capital allocation and a unique decentralized structure that allows it to scale M&A far further than any competitor. CSI is an excellent anchor stock for any portfolio given its stable and resilient nature. I hold a 10% position in CSI and will continue to buy shares in the future.