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The rise of software (e.g. iOS) — as opposed to hardware (e.g. the iPhone) — can be both scary and exciting.

On the one hand, automation, AI and disruption have the power to displace workers, suppress the media and even harm those who go against the prevailing ideology. (although the cynic in me would say that’s been happening for centuries)

On the other hand, the optimist or enterprising investor in me would say that software enriches people’s lives by freeing up their time, and, for example, by solving complex problems in the health, transport and environmental sectors. Finally, let’s not forget about long-term investors who buy into software companies because they can be hugely profitable.

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A few months ago, I almost welcomed Canada’s Constellation Software (TSE: CSU) into the Rask Invest model portfolio. As a reminder, Rask Invest is our members-only service which includes access to my personal model investment portfolio. It costs just $365 per year to join!

For the record, Constellation Software is not an official investment idea of Rask Invest (yet). Nonetheless, I figure it might be worth sharing some of my days’ worth of research with Investor Club readers.

What does Constellation Software do?

Constellation Software buys and owns hundreds of small software companies. Not just any software. It buys companies that produce software in specific ‘verticals’ or industries. It calls these ‘Vertical Market Software’ or VMS for short.

It’s not the kind of happy, colourful and easy-to-use software you would get from Google (NASDAQ: GOOGL) or Apple (NASDAQ: AAPL). Oftentimes, this software is used by businesses to fulfill a very specific function.

For example, it might be software for scheduling tee-offs at a golf club, software used by bus companies to coordinate arrivals and departures, by the US government to track inmates’ journey through the prison system or software used by gyms to record memberships and facility usage.

I’ve experienced software like this at previous jobs. When I was a manager of an IGA we would use software to track inventory, automate orders, change prices and so forth. I hated it. The software was clunky, ugly and hard to use. But you know what?

We kept using it!

Why?

Because we had no choice. If the supermarket stopped using the software the shop would grind to a halt. More likely, we would be forced to shut down for a week while we transitioned to a new system.

Mission Critical Software Is All Around You

This type of solution is often called “mission critical” software. It is frequently made by small technology companies with experience in their customer’s business or industry (e.g. local supermarkets, transport, justice, construction, etc.).

Big software companies like AmazonMicrosoft, SAP (to a limited extent) and Google aren’t as dominant in this space because the software is often only useable in one market. For example, you couldn’t take the supermarket software I used as a teenager to a prison guard and say, “Here you go! Track that inventory!”

It just wouldn’t work. And for the Googles and Amazons of the world, it’s not worth their time to pursue a $10 million company to enter a small market.

Mr. Mysterious

The founder of Constellation is Mark Leonard. I *think* he is the guy on the right-hand side of this photo:

Source: Ivey Business School, Western University.

It’s the only verified photo of Leonard I could find. He has built a multibillion-dollar business and is worth millions. But Leonard’s public profile, aside from his annual letters to shareholders (which are Buffett-like and simply brilliant), is just about non-existent.

After 11 years in Venture Capital (VC), buying and selling small tech companies, Leonard founded Constellation Software with $25 million. Constellation Software is now worth more than $US16 billion. 

Since the 90’s Constellation has bought more than 300 small software companies which typically provide mission critical solutions to hundreds or even thousands of individual businesses. It has sold 1 company.

When Constellation is looking to buy these software companies it targets “exceptional businesses” which can be bought for between $1 million and $50 million. However, they are often at the smaller end of this range.

Constellation targets software companies that:

  • Are #1 or #2 in their market
  • Have profit over $1 million, and
  • Are run by experienced and committed managers

Constellation has a target of buying 100 companies each year.

Constellation’s newly purchased software companies often continue as they are under their new owner, which makes integrating many companies a little easier than it is for other acquirers. The company founders tend to stay on — but they pocket the cash Constellation pays them for their business. So they’re winners, too.

From the top-down, the company has 6 individual operating units across ‘private’ and ‘public’ customers.

In the past Leonard did all of the buying of the small software companies but because it has grown so quickly, the bosses of the six units are responsible for buying and selling companies under $5 million.

The Beautiful Thing About Constellation

You can look around the ASX and find many acquisitive growth companies, such as G8 Education Ltd (ASX: GEM), Greencross Ltd (ASX: GXL) or even Wesfarmers Ltd (ASX: WES).

However, buying businesses in childcare (G8) or retail (Greencross) tends to add very little value beyond what can be generated by buying any private company (for cheap) and making it part of the larger public business. Worse yet, many ‘roll ups’, as they’re known, issue shares or debt to buy smaller businesses.

Constellation doesn’t do either of those things. It has used debt in only one or two of its larger acquisitions — of the more than 300 it’s made since 1992. Constellation shares have outperformed Amazon since 2006.

The company funds its new investments using the free cash flow from the companies it has already purchased. For example, Constellation can use the revenue and cash flow from the last acquisition to fuel its next one.

Pleasingly, Constellation says it has a market of more than 35,000 potential takeover targets in the private software market. Of course, it has competitors like Roper IndustriesSage and Oracle as well as private equity funds. However, many of these companies simply don’t have the goodwill, balance sheet or management quality of Constellation — that’s been born out in the investment returns.

But Wait, There’s More

In case you’re still thinking, ‘who cares about some Canadian tech company’ consider this next chart:

Source: Constellation’s 2016 President’s Letter

The chart reveals some incredible economics.

First up, revenue growth from acquisitions has increased at double-digit rates for 10 years (in 2013 revenue from acquisitions rose 34%).

Under “Organic Sources” from the period around 2008/2009 we can see:

  • New maintenance revenue (e.g. from add-on features) pushed revenue 9% higher
  • The price for Constellation’s software was increased 9% in both 2007 and 2008 and rose 4% during 2009
  • Around 3% of software went out of date in 2008, and
  • 4% of customers left

What the table is saying is this: even though Constellation increased prices 9% during the GFC it lost just 4% of customers. Imagine if a supermarket increased prices 9% each year. It would lose many more than just 4% of customers!

And that, ladies and gentlemen, is the embedded power of mission-critical software providers like Constellation (and SAP). It’s something value investors won’t see on the balance sheet — and a feature that growth investors never fully appreciate.

So what’s wrong?

Two things are holding me back from making Constellation an official investment idea:

  1. Valuation. Going back to July (when I first released this update to Rask Invest members), Constellation’s 5-year average price-earnings ratio (P/E) and price to sales ratio (P/S) are 54x and 4.6x, respectively. That’s on the high side. In July, its shares traded at a premium valuation to even those lofty averages. And with a few headwinds, such as increasing valuations in the private market and execution risk on larger deals, Constellation has big shoes to fill.
  2. Liquidity. Constellation Software shares can be bought using the international stockbroking platform I suggest to Rask Invest members but they are extremely illiquid shares because they come via what’s called an Over The Counter (OTC) market. It’s called OTC Pink. As Investopedia describes: The OTC Pink, or Pink Sheets, is the lowest and most speculative tier of the three marketplaces for the trading of over-the-counter stocks… This marketplace offers to trade in a wide range of equities through any broker and includes companies in default or financial distress. Since it has no disclosure requirements, categorization of OTC Pink companies is from information provided by the company.”

With one too many minor red flags, including valuation, Constellation is unfortunately not a business that will be going into the Rask Invest model portfolio anytime soon.

Takeaway

I have invested many hours of research into Constellation, its management, financials and more. At the end of the day, however, I believe successful investors will make much more money sitting on their hands than they do by acting without conviction.

Indeed, there are many more high quality businesses like Constellation around the world, so I’ll keep digging.

Until then, if you have come across something interesting please let me know.

 

Owen Raszkiewicz
Lead Adviser, Rask Invest

 

This article contains general financial information only and should not be relied upon. This information does not take into consideration your needs, goals or objectives. Therefore, you should consult a licensed financial adviser before acting on any of the information presented here. Past performance is no guarantee of future returns. At the time of publishing this article, Owen Raszkiewicz owns shares of Apple Inc and Alphabet Inc. 

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