#plays **Constellation Software is the best serial acquirer in the world.** Since Mark Leonard IPO’ed CSU in 2006, **the company has bought over 500 companies and grown from 25 million CAD to 90 billion CAD.** Let’s dive into **one of the best-performing stocks over the past 30 years.** | | | | |---|---|---| ||[](https://substack.com/redirect/9d5173dd-8d66-4da3-898c-debb346ba8db?j=eyJ1IjoiMTM4bGEifQ.PZ-OR4qDrWvAlQRP7f0gstxNRmE7_mu_grHi7nSB068)|| # Constellation Software - General Information -  ** Company name**: Constellation Software -  ** ISIN**: CA21037X1006 -  ** Ticker**: CSU -  ** Type**: Owner-Operator Stock -  ** Stock Price**: 4,345 CAD -  **Market cap:** 92.1 billion CAD -  ** Average daily volume:** 111 million CAD # Onepager **Here’s a onepager with the essentials of Constellation Software:** (Click on the picture to expand) | | | | |---|---|---| ||[](https://substack.com/redirect/27d905ca-df28-4cf1-843a-d8bbcef2091c?j=eyJ1IjoiMTM4bGEifQ.PZ-OR4qDrWvAlQRP7f0gstxNRmE7_mu_grHi7nSB068)|| # 15-Step Approach ### 1. Do I understand the business model? Constellation Software is **the best serial acquirer in the world.** The company focuses on buying businesses with **high growth potential**. They use a **decentralized structure** and let the acquired companies run on their own. **The idea of Constellation Software is to buy niche software companies that have:** - A loyal customer base - Strong market position - Active in Vertical Market Software (VMS) But what is Vertical Market Software? **VMS is software developed for niche applications and/or specific clientele.** Consider a software system for an amusement park to show the waiting lines of different roller coasters or applications for certain medical requirements. VMS is important because **it’s tailored to specific needs**, making it essential for users. **This gives Constellation Software a lot of pricing power.** **The revenue split looks as follows:** - **Maintenance and other recurring revenue (72.4% of sales)**: charging customers for things like helping them with their software after they buy it, keeping it updated, and giving access to services over the internet (like apps or online tools) - **Professional service revenue (20.4% of sales)**: setting up the software, making custom changes, teaching people how to use it, and giving advice to help businesses use the software - **Software license revenue (4.2% of sales):** selling licenses to use their software, which could be for a few years or forever - **Hardware and other revenue (3.0% of sales)**: selling hardware (like computers or devices) that go with their software, or by selling things they build themselves **Customers of Constellation Software typically purchase a combination of software, maintenance, professional services, and hardware.** Here’s what Constellation’s revenue split looks like: | | | | |---|---|---| ||[](https://substack.com/redirect/abb207e1-2bc8-4e23-b640-73b2feb56ed5?j=eyJ1IjoiMTM4bGEifQ.PZ-OR4qDrWvAlQRP7f0gstxNRmE7_mu_grHi7nSB068)|| ### 2. Is management capable? **Mark Leonard founded CSU in 1995 and he’s still the CEO today.** He’s an excellent capital allocator who puts the creation of shareholder value first. **He once said the following about capital allocation:** “Over the long term, stock returns will be determined largely by which capital allocation decisions the CEO makes. Two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders.” - Mark Leonard **Today, [[Mark Leonard]] and his family still own 7% of the company.** **Read more about Mark Leonard** via this [article](https://substack.com/redirect/1bc2ee4a-b475-4746-a163-4fdc7c09fce7?j=eyJ1IjoiMTM4bGEifQ.PZ-OR4qDrWvAlQRP7f0gstxNRmE7_mu_grHi7nSB068). You also read all shareholders of Mark Leonard [here](https://substack.com/redirect/89767a56-5c99-40e1-9adf-c23293eec022?j=eyJ1IjoiMTM4bGEifQ.PZ-OR4qDrWvAlQRP7f0gstxNRmE7_mu_grHi7nSB068). | | | | |---|---|---| ||[](https://substack.com/redirect/733b683f-075b-4444-90f8-9864d6bf7e1d?j=eyJ1IjoiMTM4bGEifQ.PZ-OR4qDrWvAlQRP7f0gstxNRmE7_mu_grHi7nSB068)|| ### 3. Does the company have a sustainable competitive advantage? Constellation Software is a **clear** **market leader in a niche.** Mark Leonard’s role can’t be underestimated in this. **The company’s moat is built on three main pillars:** - **A lot of pricing power:** CSU offers mission-critical solutions for their clients - **Economies of scale:** CSU acquires a lot of small businesses - **Decentralized approach:** acquired companies run on their own When Constellation acquires a company, they do not seek to take over day-to-day operations. **It’s very similar to the business model of Berkshire Hathaway.** “The key is always to hire the right people first, train them well, push decisions down the organization, and then resist the temptation to be involved with details. Putting this trust and power in the hands of workers is critical to success.” - Warren Buffett **This decentralized approach allows acquired companies to keep their independence, identity, and culture.** Constellation provides them with all the resources while the acquired company keeps running on its own. **Companies with a sustainable competitive advantage are often characterized by the following:** - **Gross Margin:** 88.7% (Gross Margin > 40%? ) - **Return On Invested Capital (ROIC)** 7.8% (ROIC > 15%? ) | | | | |---|---|---| ||[](https://substack.com/redirect/474cb1a4-1bf3-44b0-a4bb-bfe9e7577058?j=eyJ1IjoiMTM4bGEifQ.PZ-OR4qDrWvAlQRP7f0gstxNRmE7_mu_grHi7nSB068)|| ### 4. Is the company active in an attractive end market? **Constellation Software doesn’t have (a lot of) direct competitors.** The company focuses on acquiring VMS Software companies dominating their niche. However, **Constellation competes with others to buy VMS companies.** Sometimes, competitors accept lower returns to win deals. The good news? **Constellation has an excellent reputation and plenty of capital.** Like Berkshire Hathaway, they may not offer the highest price, but you know that your business will get into good hands. **As you can see here, the VMS market is expected to grow at attractive rates:** | | | | |---|---|---| ||[](https://substack.com/redirect/d7874f7d-3490-411c-8297-6427e96996e9?j=eyJ1IjoiMTM4bGEifQ.PZ-OR4qDrWvAlQRP7f0gstxNRmE7_mu_grHi7nSB068)|| ### 5. What are the main risks for the company? **Here are the main risks for Constellation Software:** - The quality of software businesses they buy has declined over the past few years according to insiders - Regulatory risks - Technological disruption for the VMS companies they own - Size hurts your performance (law of large numbers) - Dependence on Mark Leonard - Lack of great reinvestment opportunities - Rich valuation levels (see later) ### 6. Does the company have a healthy balance sheet? **I look at 3 ratios to determine the healthiness of Constellation Software’s balance sheet:** - **Interest Coverage:** 6.1x (Interest Coverage > 15x? ) - **Net Debt/FCF:** 1.6x (Net Debt/FCF < 4x? ) - **Goodwill/Assets:** 11.0% (Goodwill/assets not too large? < 20% ) The interest coverage has declined over the past few years. **I don’t worry about this as Constellation has very predictable revenue streams.** | | | | |---|---|---| ||[](https://substack.com/redirect/1df9c81d-660b-44de-ad10-1f7afc713b22?j=eyJ1IjoiMTM4bGEifQ.PZ-OR4qDrWvAlQRP7f0gstxNRmE7_mu_grHi7nSB068)|| ### 7. Does the company need a lot of capital to operate? **I prefer to invest in companies with a CAPEX/Sales lower than 5% and CAPEX/Operating Cash Flow lower than 25%.** **Constellation Software:** - **CAPEX/Sales:** 0.5% (CAPEX/Sales < 5%? ) - **CAPEX/Operating Cash Flow:** 2.3% (CAPEX/Operating CF? < 25% ) Talking about a business with a low capital intensity! ### 8. Is the company a great capital allocator? **Capital allocation is the most important task of management.** And you know what? **Mark Leonard is one of the best capital allocators I know.** **Constellation Software:** - **Return On Equity (ROE):** 27.2% (ROE > 20%? ) - **Return On Invested Capital (ROIC):** 7.8% (ROIC > 15%? ) But Pieter… you just said that Mark Leonard is one of the best capital allocators you know… Constellation Software’s ROIC is lower than 15%?! **Half of Constellation Software’s assets are intangibles (46.7%).** It’s a combination of mainly Technology Assets and Customer Assets. For Constellation Software, **it’s better to look at the Return On Capital Employed (ROCE)**. This metric only takes into account the active capital in circulation. **Constellation ROCE is equal to 22.4%.** That’s an attractive number. | | | | |---|---|---| ||[](https://substack.com/redirect/72df9de2-85b2-4557-8089-9ce4c78d0150?j=eyJ1IjoiMTM4bGEifQ.PZ-OR4qDrWvAlQRP7f0gstxNRmE7_mu_grHi7nSB068)|| ### 9. How profitable is the company? The higher the profitability of the company, the better. **Here’s what things look like for Constellation Software:** - **Gross Margin:** 88.7% (Gross Margin > 40%? ) - **Net Profit Margin:** 7.0% (Net Profit Margin > 10%? ) - **FCF/Net Income:** 305.1% (FCF/Net Income > 80%? ) Over the past 5 years, CSU’s Gross Margin and FCF Margin have averaged 88.8% and 22.9%. **These figures are amazing.** | | | | |---|---|---| ||[](https://substack.com/redirect/e7551214-9913-4a78-b2a9-6460f8226cb4?j=eyJ1IjoiMTM4bGEifQ.PZ-OR4qDrWvAlQRP7f0gstxNRmE7_mu_grHi7nSB068)|| ### 10. Does the company use a lot of Stock-Based Compensation? Stock-based compensation is a cost for shareholders and should be treated accordingly. **Preferably I want SBCs as a % of Net Income to be lower than 4%.** SBCs as a % of Net Income higher than 10% are seen as a bad thing. - **SBCs as a % of Net Income:** 0.0% (SBCs/Net Income < 10%? ) - **Avg. SBC as a % of Net Income past 5 years:** 0.0% (SBCs/Net Income < 10%? ) **Constellation Software doesn’t pay any stock-based compensation.** That’s exactly how I like it! ### 11. Did the company grow at attractive rates in the past? I look for companies that grew their revenue and FCF by at least 5% and 7% per year in the past. **Constellation Software:** - **Revenue Growth past 5 years (CAGR):** 23.3% (Revenue growth > 5%? ) - **Revenue Growth past 10 years (CAGR):** 20.3% (Revenue growth > 5%? ) - **EPS Growth past 5 years (CAGR):** 9.9% (EPS growth > 7%? ) - **EPS Growth past 10 years (CAGR):** 21.0% (EPS growth > 7%? ) | | | | |---|---|---| ||[](https://substack.com/redirect/4a96b763-2dbe-4e21-9a78-c92d4d2cb56a?j=eyJ1IjoiMTM4bGEifQ.PZ-OR4qDrWvAlQRP7f0gstxNRmE7_mu_grHi7nSB068)|| ### 12. Does the future look bright? You want to invest in companies that manage to grow at attractive rates as stock prices tend to follow EPS growth over time. **Constellation Software:** - **Exp. Revenue Growth next 2 years (CAGR):** 20.5% (Revenue growth > 5%? ) - **Exp. EBITDA Growth next 2 years (CAGR):** 21.7% (EPS growth > 7%? ) - **Long-Term Growth Estimate EPS (CAGR):** 25.6% (EPS growth > 7%? ) **This outlook looks very attractive.** ### 13. Does the company trade at a fair valuation level? I always use 3 methods to look at the valuation of a company: - A comparison of the forward PE multiple with its historical average - Earnings Growth Model - Reverse Discounted-Cash Flow ### A comparison of the multiple with the historical average The first thing I do is compare the current forward PE with its historical average over the past 5 and 10 years. **Today, Constellation trades at a forward PE of 37.0x versus a historical average of 31.1x over the past 5 years.** This indicates the company trades at **rich valuation levels.** | | | | |---|---|---| ||[](https://substack.com/redirect/9a7839b1-e42a-4ffc-a806-2d84c06e90b8?j=eyJ1IjoiMTM4bGEifQ.PZ-OR4qDrWvAlQRP7f0gstxNRmE7_mu_grHi7nSB068)|| ### Earnings Growth Model This model shows you the yearly return you can expect as an investor. In theory, it’s easy to calculate your expected return: _**Expected return** = EPS growth + Dividend Yield +/- Multiple Expansion (Contraction)_ **Here are the assumptions I use:** - **EPS Growth** = 14% per year over the next 10 years - **Dividend Yield** = 0.1% - **Forward PE** to decline from 37.0x to 25.0x over the next 10 years _**Expected yearly return** = 14.0% + 0.1% - 0.1* ((25.0-37.0)/37.0))= 10.9%_ I would be happy with a return of 10.9% per year. ### Reverse DCF Charlie Munger once said that if you want to find the solution to a complex problem, you should revert. Always revert. **Turn the problem upside down.** A reverse DCF shows you the expectations that are implied in the current stock price. You try to determine for yourself whether these expectations are realistic or not. You can learn more about a reverse DCF here: [Reverse DCF 101](https://substack.com/redirect/ccea8dfc-3660-4bdf-acb6-733bc77a7bda?j=eyJ1IjoiMTM4bGEifQ.PZ-OR4qDrWvAlQRP7f0gstxNRmE7_mu_grHi7nSB068). The consensus states that Constellation’s Free Cash Flow over the next 12 months will be equal to CAD 2,922.3 million. Under these assumptions, our Reverse DCF indicates CSU should grow its Free Cash Flow by 14.8% per year to return 10% per year to shareholders. | | | | |---|---|---| ||[](https://substack.com/redirect/49f6e339-5590-4ad8-8611-4d5d7a724ddd?j=eyJ1IjoiMTM4bGEifQ.PZ-OR4qDrWvAlQRP7f0gstxNRmE7_mu_grHi7nSB068)|| **Constellation Software:** - **Forward PE:** 37.0x (lower than its 5-year average? < 31.1x? ) - **Earnings Growth Model:** 10.9% (Yearly return > 10%? ) - **FCF-Growth Reverse DCF:** 14.8% (Realistic growth expectations?) ### 14. How did the Owner’s Earnings of the company evolve in the past? **Over time, stock prices tend to follow the Owner’s Earnings of a company (EPS Growth + Dividend Yield).** That’s why I want to invest in companies that have grown their Owner’s Earnings at attractive rates in the past. **This is the case for Constellation Software.** **Constellation Software:** - **CAGR Owner’s Earnings (5 years)**: 10.0% (CAGR Owner’s Earnings > 12%? ) - **CAGR Owner’s Earnings (10 years):** 21.1% (CAGR Owner’s Earnings > 12%? ) ### 15. Did the company create a lot of shareholder value in the past? I want to invest in companies that can compound at attractive rates in the past. Ideally, the company returned **more than 12% per year** to shareholders since its IPO. **Here’s what the performance of Constellation Software looks like**: - **YTD:** +33.6% - **5-year CAGR:** +30.1% - **CAGR since IPO 2006:** +36.6% (CAGR since IPO > 12%? )