Constellation Software Inc. Stock Report

Constellation Software Inc.

Revenue per share (the red line) has grown very rapidly and steadily although with a notable slow-down in 2015 partly caused by currency impacts. Adjusted earnings per share (pink line) have also grown very rapidly and steadily although slower in 2016 mostly due to currency impacts and with growth resuming (but not as high as in the past) in 2017. The GAAP earnings per share have been more volatile. The adjusted earnings are usually very substantially higher than the GAAP earnings mostly due to adding back amortization of intangible assets. The company adds that amortization back (net of an income tax effect) on the grounds that in reality those are not depreciating assets. We agree with this adjustment. However, some of their adjustments seem aggressive as discussed in our report. The green line is the book value per share. It flattened due to the introduction of a dividend in 2012 and due to comprehensive losses associated mostly with currency impacts. Growth resumed after 2014.

Constellation Software Inc. (CSU, Toronto)
Report Author(s): InvestorsFriend Inc. Analyst(s)
Author(s)’ disclosure of share ownership:  The Author(s) hold no shares
Based on financials from: Dec ’17 Y.E.
Last updated: 30-Mar-18
Share Price At Date of Last Update:  $                              677.73
Currency: $ U.S.
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): (lower) Sell rated at CAN $814, U.S. $678
SUMMARY AND RATING: The graph shows that adjusted earnings per share have grown at an extraordinarily strong and steady rate in recent  years (although slower in 2016 and 2027). The value ratios would suggest a Reduce or Hold rating unless it is assumed that adjusted earnings will continue to grow faster than 15% per year (which could be a reasonable assumption). The company does reasonably well on the Buffett tenets although its products are not that easy to understand. Management quality is truly excellent with a strong focus on shareholder returns. However, we have long thought that management is somewhat aggressive by fully adding back adjustments with no reduction for income tax. And, with this update we noticed that they do no give any recognition for the minority interest in their earnings.  This combined with the high valuation and somewhat slowing growth leads to a lower rating at this time. The company’s services are somewhat protected from competition due to the fact that its products become very much integrated into its customer’s operations and it would be difficult to switch to new software. The outlook appears to be positive.  The insider trading signal is moderately positive. There is no doubt that the growth has been tremendous. The question remains, how much future growth should we pay for in advance? Overall we rate this stock as a  (lower) Sell at this time.  Past experience suggests that those who own it should hold for the long term. Nevertheless, we would trim the position at this time.
DESCRIPTION OF BUSINESS: (updated August 2017 largely based on 2016 fiscal) A large  conglomerate of software companies. It operates in a decentralized fashion. There are about 12,124 employees with only a small head office staff. There are 200 offices world-wide. It lists 132 independent businesses (some of which operate several divisions) that are owned in six Operating Groups. Equity market value of August 2, 2017 was U.S. $11,855 million.  Assets were $2,103 million, and adjusted earnings were $449 million per year. It has made over 300 acquisitions since it was started in 1995 including 40 in 2016.  It buys (usually quite small) software companies that provide critical enterprise software to small and  medium size businesses in a variety of industries with a majority being in the government owned sector. (Examples include software for buses, amusement parks, utilities, golf courses, health clubs and many others).  Based on 2016 figures, Revenues are 7% from software licenses, 20% from professional services, 7% from hardware sales and 66% from recurring maintenance and other. Most of the revenues are of a recurring nature. In effect it appears to be selling mostly the time of its employees and also access to software that it has bought or created.  It is a Canadian company but does most of its business in the U.S. and reports in U.S. dollars. In 2016 revenues by geography were U.S. 53%, Canadian 12%, British pound and  Euro 30%, rest of world 5%. 2016 revenues were 67% government and 33% private sector. No single customer accounted for more than 1% of total revenues.
ECONOMICS OF THE BUSINESS: (Updated based on Q2 2017) The adjusted profit as a percentage of revenue is 20%. Adjusted profit is 21% of assets. This is then leveraged up to an astounding 87% return on (ending) equity because assets are 4.1 times larger than equity. (But the book equity has basically been artificially lowered by amortization of purchase premiums even though the acquired companies have not declined in value) Leverage is provided by debt and by a large amount of deferred revenue, by accounts payable and by deferred income tax. Most of the revenue is recurring and sticky as customers would find it difficult to switch to new software. Overall it appears to have extremely strong economics and this is reflected in its high returns on capital employed. It is not capital intensive as revenues are 108% of (ending) assets.
RISKS: See its Annual Information Filing for a discussion of risks. Interestingly, the company indicated (though not quite so baldly) that the risks listed in the AIF were essentially useless boiler plate discussions but that they were required to list them. In our view the most important risks would be operational in terms of the ability to continue to manage its operations and provide good service. Also to continue to make acquisitions at good prices.
INSIDER TRADING / INSIDER HOLDING: The insider trading signal is of limited value (for buys) because insiders are required to buy shares. From September 1, 2017 to March 30, 2018: (We ignore purchases “under a plan” since those are usually done without regard to price).  The CFO sold 475 shares at $840 but retained 4,784. One Director bought 100 shares at about CAN $797 and then another 100 at about $841. Although we don’t put weight on it insiders are buying shares regularly under a plan.  Overall the signal from insider trading is moderately positive given the lack of selling. In terms of insider ownership there are roughly 20 insiders that own very significant amounts of shares including 10 or more owning in excess of $10 million worth. Over 100 employees have at least one million dollars worth of shares.
WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is  simple to understand (marginal pass given that it sells to businesses and it’s not easy to understand its software products and it has many subsidiaries), has favourable long-term economics due to cost advantages or superior brand power (pass given demonstrated returns on capital and the sticky nature of its customers), apparently able and trustworthy management (pass – management appears highly rational, competent and trustworthy given their performance and the candid reporting), a sensible price – below its intrinsic value (marginal pass at best – assuming robust growth continues), Other criteria that have been attributed to Buffett include: a low  debt ratio (pass), good recent profit history (pass) little chance of permanent loss of the investors capital (marginal pass) a low level of maintenance type capital spending required to maintain existing operations excluding growth (pass)
MOST RECENT EARNINGS AND SALES TREND: Revenue per share growth in the past four quarters starting with the most recent (Q4 2017) has been 22%, 17%,  13%, and 14%.  Adjusted earnings per share growth  in the past four quarters starting with the most recent has been 15%, minus 4%, 25%, and 51%. The full year 2017 adjusted earnings growth per share was 17%. The full year 2016 was 6%. The full year 2015 was 35%. The full year 2014 was 33%. Therefore the recent growth rate in earnings  is quite positive after a lower growth in 2016. Currency impacts affect earnings growth.
Earnings Growth Scenario and Justifiable P/E; It’s recent adjusted earnings P/E of 31 requires robust growth to justify the price. For example a 12% average growth per share sustained for 10 years could justify a P/E of 13 even if the P/E in ten years was projected to be 18. This assumes a required rate of return of 7%. This growth is lower than it has been achieving.
VALUE RATIOS: Analysed at a price of CAN $874. The price to book value ratio is ostensibly unattractive at 24 times, however this mathematically reflects the very (extraordinarily) high ROE. The book value has also been “artificially” lowered through the accounting requirement to amortise intangible assets, although in reality these intangibles (or at least much of them) are apparently not decreasing in value and in reality appear to have indefinite lives.  This increases the calculated ROE to the very impressive but perhaps somewhat meaningless level of 87%. The valuation here hinges on management’s figure for adjusted earnings. The key and very large adjustment is to add back amortization of intangible assets. We would agree with that if the intangibles are the value of purchased customer relationships (akin to goodwill). In this case we also agree with adding back amortisation of purchased software assets because replacement and sustainment of those assets are expensed and not capitalised.  The company is aggressive in not tax affecting the adjustments and in not recognising that some of its earnings belong to a minority interest. The free cash flow was similar to their adjusted earnings but this is because that is essentially how they define adjusted earnings.  The P/E ratio is ostensibly unattractive at 31 but may be justified by the high ROE and high growth. There is also a modest dividend with a 0.6% yield. The pay-out ratio is 18% of the adjusted earnings. Revenue per share growth in the past five years has been strong and averaged 23% per year. (But growth in revenue per share slowed considerably in 2015 and 2016 although that is partly due to currency impacts and it was 17% in 2017.) Adjusted earnings per share growth has also been strong and averaged 25% per year but was only 6% in 2016 and recovered to 17% in 2017. The company has demonstrated an ability to grow rapidly by acquisition. Assuming (slower) future growth of 10% to 15% and the P/E regressing back to 15 or 20,  we calculate, respectively, an intrinsic value per share of  CAN $514 to $840 assuming a required return rate of 7.0%. Overall the Value ratios would support  perhaps a Reduce or  Hold rating unless growth higher than 15% for five years is assumed or the higher growth lasts longer than five years. It is certainly  possible that growth well above 15% will continue to be achieved.
Symbol and Exchange: CSU, Toronto
Currency: $ U.S.
Latest four quarters annual sales $ millions: $2,479.5
Latest four quarters annual earnings $ millions: $222.0
P/E ratio based on latest four quarters earnings: 64.7
Latest four quarters annual earnings, adjusted, $ millions: $462.9
BASIS OR SOURCE OF ADJUSTED EARNINGS: We used management’s figures which add back amortization of intangibles and use the cash taxes and adjusts for certain other expenses. We agree with these adjustments, although we would normally reduce this by an income tax effect.  The company seems aggressive in adding back all deferred income tax as if it will never be paid. That may be effectively be true if the deferred income tax balance continuously increases. We would not normally add back amortization of software but in this case the company appears to expense software development and so we agree with this add back in this case. We also deducted a large gain on the sale of investments in 2012 that the company did not deduct. Strangely, due to a put option, a large minority interest in one of their major subsidiaries does not get recognised as a reduction in earnings available to common share holders. Instead, the minority share of interest is reflected in a growing liability which reduced net income. But the company adds back all of that liability increase (again not tax-effected). This seems highly aggressive.
Quality of Earnings Measurement and Persistence: Adjusted earnings appear to be of good quality as they are earned in cash and have been growing steadily historically. However, the company may be aggressive in not tax effecting the adjustments and in not recognising that some of the earnings in substance belong to minority owners.
P/E ratio based on latest four quarters earnings, adjusted 31.0
Latest fiscal year annual earnings: $222.0
P/E ratio based on latest fiscal year earnings: 64.7
Fiscal earnings adjusted: $462.9
P/E ratio for fiscal earnings adjusted: 31.0
Latest four quarters profit as percent of sales 18.7%
Dividend Yield: 0.6%
Price / Sales Ratio 5.79
Price to (diluted) book value ratio:                                     23.76
Balance Sheet: (last updated Q2, 2017) The Balance sheet is strong. Retained earnings are 347% as large as the capital equity invested which indicates a history of profit. There is a very large deferred revenue liability since they collect fees in advance of providing service in many cases. Most of the assets are intangible including purchased software, purchased goodwill and purchased customer relationships. This is not a company that is valued for its assets.
Quality of Net Assets (Book Equity Value) Measurement: The quality of the assets in terms of book value is of little relevance because the stock traded (as of April 1, 2018) at about 24 times book value. The assets are clearly worth far more than book value.
Number of Diluted common shares in millions:                                     21.2
Controlling Shareholder:  As of April 2017, the CEO founder (technically with his children) owns about 6.8%. Other directors and officers also own significant share although we did not see a total figure. He directors (and this excludes some executives) other than the CEO collectively own about 2.2% of the shares.
Market Equity Capitalization (Value) $ millions: $14,362.4
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 26.4%
Interest-bearing debt as a percentage of common equity 55%
Current assets / current liabilities: 0.9
Liquidity and capital structure: Good liquidity with reasonable debt and strong cash flow. The credit rating is good at BBB minus but we would have expected it to be higher.
Latest four quarters adjusted (if applicable) net income return on average equity: 87.2%
Latest fiscal year adjusted (if applicable) net income return on average equity: 87.2%
Adjusted (if applicable) latest four quarters return on market capitalization: 3.2%
5 years compounded growth in sales/share 22.7%
Volatility of sales growth per share:  Strong steady growth
5 Years compounded growth in earnings/share 19.1%
5 years compounded growth in adjusted earnings per share 25.2%
Volatility of earnings growth:  Strong steady growth
Projected current year earnings $millions: not available
Management projected price to earnings ratio: not available
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? Yes
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 71.2%
More conservative estimate of compounded growth in earnings per share over the forecast period: 10.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 15.0%
OUTLOOK FOR BUSINESS: It seems likely that the company can continue to grow in the future. It is difficult to say whether the growth can continue to be in the range of 15 or 20% or more. Clearly that cannot continue indefinitely.
LONG TERM PREDICTABILITY: Its earnings are reasonably predictable given that the majority of revenues are recurring. It requires a large number of small acquisitions in order to continue to grow revenues at its historical rate  but it appears to have the ability to continue to make those acquisitions.
Estimated present value per share: We calculate   U.S. $398 or CAN $514  if adjusted earnings per share grow for 5 years at the more conservative rate of 10% and the shares can then be sold at a (very conservative) P/E of 15 and U.S. $651 or CAN $840 if adjusted earnings per share grow at the more optimistic rate of 15% for 5 years and the shares can then be sold at a (perhaps conservative) P/E of 20. Both estimates use a 7.0% required rate of return. The past growth rate has actually been far higher than 15%, so this may be quite conservative.
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry and the company’s particular incumbent position within that industry segment.) Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition based on the following four tests. barriers to entry (Pass, it is somewhat difficult for new competitors to convince a client to switch software). No issues with powerful suppliers (pass). No issues with dependence on powerful customers (pass), No potential for substitute products (pass – software is essential).  No tendency to compete ruinously on price (pass). Overall this industry appears to be attractive for incumbents.
COMPETITIVE ADVANTAGE: In the business of acquiring small software companies it has the advantage of sufficient capital and of deep experience. It keeps tabs on thousands of potential acquisition targets and this information would be a competitive advantage in making acquisitions.
COMPETITIVE POSITION: The company serves a large number of very specific business and government segments, targeting small to medium size businesses as well as mostly smaller government needs. We have no data on their market share.
RECENT EVENTS: The company has continued to make acquisitions . There were numerous mostly small acquisitions in 2017 totalling $$329 million which added 17% to the total amount of assets but only 2% of the value of the company. In 2016 there were 40 acquisitions with a total price of $211 million for an average of $5.3 million. Given that there are likely some larger acquisitions some must be quite small in the $1 to $2 million range. There were 31 acquisitions in 2015.
ACCOUNTING AND DISCLOSURE ISSUES: The disclosure is good. The company focuses on adjusted earnings by adding back amortization of intangibles. We agree with that approach. This is because these intangibles are (in most cases at least) not wearing out or decreasing in value or are offset by R&D which is expensed. There was some use of confusing terminology such as “customer assets” and “technology assets” which are not defined. The company also uses the word “vertical” to refer to specific industry or customer segments. We found the Management Discussion and Analysis of revenues and expenses to be fairly useless as reasons for changes were not provided and a presentation of expenses as a percent of revenue would have been more clear. There was an exceptionally clear description of the company’s growth by acquisition strategies and methods in the annual information filing. The CEO’s annual letter is also extraordinarily candid and informative. See comments under adjusted earnings where we do have some concerns.
COMMON SHARE STRUCTURE USED: The shares that trade are voting shares. There also exist non-voting shares which appear to have been issued to certain larger holders.
MANAGEMENT QUALITY: The CEO founded the company in 1995 and most of the executives are long-service. The description of the strategy in the Annual Information Form was very detailed and inspires confidence. Overall management appears to be both of high quality and of high trustworthiness. The CEO owns about 7% of the shares. The CEO is no longer taking ANY compensation and is now even paying his own travel expenses. Essentially no stock options exist, which we consider to be a positive indicator of management quality. But they do buy shares for employees as part of compensation. The fact that the company has made numerous acquisitions without adding to the share count is a very positive indicator. Management’s focus on percentage return on equity is a very positive indicator. This is an exceptionally well managed company.
Capital Allocation Skills: As a growth-by-acquisition company, the ability to spend capital wisely is absolutely essential. This company has shown extraordinary skill in that regard.
EXECUTIVE COMPENSATION: (Updated Spring 2017) Compensation is generous but not obscene by today’s standards ranging from $0.7 to $1.9 million for the five top officers. The compensation decreased in 2014 due to lower bonus payments.  Most of the compensation is in the form of bonuses. Some of the bonus typically has to be used to buy shares. The compensation is not excessive. The CEO no longer takes any compensation which is indicative of his approach of making returns as an owner as opposed to making money from employment.
BOARD OF DIRECTORS: Eight individuals with very strong representation from institutional investors. Most Board members own or represent significant share holdings.  There are three company executives on the board which makes  it less independent. Strong software and financial backgrounds. Overall it is probably a good Board but would be dominated by the founder and CEO who is chairman. The latest addition to the Board is Lawrence Cunningham who is best know for his books about Warren Buffett.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, achieved earnings per share growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
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