Constellation Software Inc.
Revenue per share (the red line) has grown rapidly. Adjusted earnings per share (pink line) have also grown very rapidly and steadily, the flatter recent trend is is partly due to an unusual large gain in Q1 2021. Also due to the fac that Constellation “spun-off” two companies. 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 and changes in the value of contingent final payments on acquisitions that go up as the earnings improve – which gets reported as a loss whereas in substance it is just a higher payment for an acquisition a capital item as opposed to an expense in substance. The company adds back amortization of intangibles on the grounds that in reality those are not depreciating assets. We agree with this adjustment although we think it should lowered by an income tax adjustment as discussed in our report. The green line is the book value per share.
In the period shown, revenue per share has grown by a compounded annual average of 22% and adjusted earnings per share by 20%. This is huge growth!
| Constellation Software Inc. (CSU, Toronto) | |
| RESEARCH SUMMARY | |
| Report Author(s): | InvestorsFriend Inc. Analyst(s) |
| Author(s)’ disclosure of share ownership: | The Author(s) hold no shares |
| Based on financials from: | Dec ’22 Y.E. + Q2 ’23 |
| Last updated: | October 13, 2023 |
| Share Price At Date of Last Update: | $ 2,070.78 |
| 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): | Weak Sell / Hold at CAN $2828 |
| Qualifies as a stock that could be bought with confidence to hold for 20 years? | Yes |
| Has Wonderful Economics? | Yes, definitely |
| Has Excellent and Trustworthy Management? | Yes, definitely |
| Likely to grow earnings per share at an attractive rate over the next decade? | Yes |
| Positive near-term earnings outlook? | Yes |
| Valuation? | Appears Expensive |
| SUMMARY AND RATING: The graph shows that adjusted earnings per share have grown at a very strong rate. It has also “spun-off” two companies in recent years and growth would have been higher if those companies had been retained. The value ratios would probably support only a Hold rating or even a Sell rating based on excellent economics but tempered by the high value in relation to earnings. 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. The company’s services are somewhat (perhaps very much) 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 economics of the business are extremely good. The long-term outlook appears to be positive. However, it appears that growth will slow compared to past levels. The insider trading signal is neutral. Overall we rate this stock as a Weak Sell / Hold due to the high valuation. | |
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| LONG TERM VALUE CREATION: Constellation Software has created enormous value for its share owners compounding wealth at a very high rate. Each $1.00 of invested equity capital has a book value of $15.44 (despite dividends paid out) and a market value of a remarkable $442. | |
| DESCRIPTION OF BUSINESS: (updated October 2023) A large conglomerate of software companies. It operates in a decentralized fashion. There are about 45,000 employees with only a small head office staff. There are over 200 offices world-wide. It has over 1000 independent businesses that are owned in six Operating Groups. Equity market value of October 13, 2023 was U.S. $44 billion dollars. Assets are $7.4 billion, and adjusted earnings are ruining at $1.0 billion per year. It has made over 500 acquisitions since it was started in 1995. 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 2022 figures, Revenues are 5% from software licenses, 21% from professional services,3.5% from hardware sales and 71% 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 2022 revenues by geography were U.S. 44%, Canadian 10%, Britain and Europe 33%, rest of world 13%. | |
| ECONOMICS OF THE BUSINESS: (Updated based on Q1 2019) The trailing adjusted profit as a percentage of revenue is 18%. Adjusted profit is 17.5% of assets. This is then leveraged up to an astounding 115% return on (ending) equity because assets are 6.6 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 95% 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: Based on October 1, 2022 to October 13, 2023. Two insiders sold shares and 1 bought while many were listed as buying “under a plan”. Overall the signal from insider trading is neutral. 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. | |
| 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 – requires continued fairly robust growth), 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 (Q2 2023) has been extremely strong at 26%, 34%, 34% and 33%. And this followed similar growth in the prior year. Adjusted earnings per share growth in the past four quarters starting with the most recent has been 4%, 5%, 17% and 19%. The fully year 2022 adjusted earnings per share gain was minus 7%. The full year 2021 adjusted earnings growth was 39% probably boosted by an unusual gain, The recent revenue gains have been very strong but the earnings per share growth has moderated although this could be just due to volatile items. Historic numbers: in 2020 the gain was 35%. The full year 2019 adjusted earnings per share increase was 1%. The full year 2018 adjusted earnings per share increase was 29%. The full year 2017 adjusted earnings growth per share was 17%. The full year 2016 was 6% (reduced by an FX loss). The full year 2015 was 35%. The full year 2014 was 33%. | |
| INDUSTRY SPECIFIC STATISTICS: | |
| Earnings Growth Scenario and Justifiable P/E: It’s recent adjusted earnings P/E of 41 requires very robust growth to justify the price. The stock is probably pricing in growth in the high teens or higher. | |
| VALUE RATIOS: Analysed at a price of CAN $2727 and U.S. $2071. The price to book value ratio is ostensibly extremely unattractive at 291 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. Also delayed increases in purchase price of companies due to better earnings have been treated as an expense rather than an additional cost of the purchase. This increases the calculated adjusted earnings ROE to the very impressive but perhaps somewhat meaningless level of 74%. The valuation here hinges on the figure for adjusted earnings. The key and very large adjustment is to add back amortization of intangible assets since they are not likely decreasing in value. We also add back increases in contingent acquisition costs and a strange expense related to a spin-off divestment in 2021. It’s not clear if our adjusted earnings figure is a fair representation of earnings given the complexity if earnings here. The P/E ratio is ostensibly quite unattractive at 41 but may be justified by the high ROE and high growth. There is also a modest dividend with a 0.2% yield. The dividend pay-out ratio amounts to only 8% of the trailing adjusted earnings. Revenue per share growth in the past five calendar years has been very strong and averaged 22% per year. Adjusted earnings per share growth has also been very strong and averaged 17% per year despite the 2% decline in 2019. The company has demonstrated an ability to grow rapidly by acquisition. Assuming (slower) future growth of 10% to 15% and the P/E regressing significantly back to 17 or 25, we calculate, respectively, an intrinsic value per share of CAN $1363 to $2485 but this may be quite conservative and assuming a required return rate of just 7.0%. Overall the Value ratios indicate an extremely strong company but one which may possibly be at or above full value and therefore suggesting a rating of Hold or even Sell. | |
| TAXATION: Nothing unusual. With a tiny dividend this stock is bought for capital gains which are taxed at half the rate of employment income at least for now. | |
| SUPPORTING RESEARCH AND ANALYSIS | |
| Symbol and Exchange: | CSU, Toronto |
| Currency: | $ U.S. |
| Contact: | info@csisoftware.com |
| Web-site: | www.csisoftware.com |
| INCOME AND PRICE / EARNINGS RATIO ANALYSIS | |
| Latest four quarters annual sales $ millions: | $7,530.0 |
| Latest four quarters annual earnings $ millions: | $485.0 |
| P/E ratio based on latest four quarters earnings: | 90.5 |
| Latest four quarters annual earnings, adjusted, $ millions: | $1,061.0 |
| 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. 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 except the minority interest in it (again not tax-effected). This seems aggressive. In addition we are not clear why they adjust for volatile FX losses and gains for EBITDA but not for net income. In Q1 2018 a large finance liability was not adjusted for. Starting Q3 2019 management stopped providing adjusted net income and we calculated our own figure adding back amortisation of intangible and unusual and deducting the approximate minority net income in a subsidiary TSS. | |
| 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. | |
| P/E ratio based on latest four quarters earnings, adjusted | 41.4 |
| Latest fiscal year annual earnings: | $512.0 |
| P/E ratio based on latest fiscal year earnings: | 85.7 |
| Fiscal earnings adjusted: | $1,019.0 |
| P/E ratio for fiscal earnings adjusted: | 43.1 |
| Latest four quarters profit as percent of sales | 14.1% |
| Dividend Yield: | 0.2% |
| Price / Sales Ratio | 5.83 |
| BALANCE SHEET ITEMS | |
| Price to (diluted) book value ratio: | 28.63 |
| Balance Sheet: (last updated Q1, 2022) The Balance sheet is strong. Retained earnings are 14 times as large as the capital equity capital invested (despite several large special dividends) which indicates a very strong 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 June 14, 2020) at about 21 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%. The directors (and this excludes some executives) other than the CEO collectively own about 2.2% of the shares. We could not find updated figures but it has likely not changed much. | |
| Market Equity Capitalization (Value) $ millions: | $43,883.9 |
| Percentage of assets supported by common equity: (remainder is debt or other liabilities) | 16.7% |
| Interest-bearing debt as a percentage of common equity | 191% |
| Current assets / current liabilities: | 0.6 |
| Liquidity and capital structure: Good liquidity with reasonable debt and strong cash flow. | |
| RETURN ON EQUITY AND ON MARKET VALUE | |
| Latest four quarters adjusted (if applicable) net income return on average equity: | 70.8% |
| Latest fiscal year adjusted (if applicable) net income return on average equity: | 73.5% |
| Adjusted (if applicable) latest four quarters return on market capitalization: | 2.4% |
| GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE | |
| 5 years compounded growth in sales/share | 21.7% |
| Volatility of sales growth per share: | Strong steady growth |
| 5 Years compounded growth in earnings/share | 18.2% |
| 5 years compounded growth in adjusted earnings per share | 17.1% |
| 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 (adjusted) earnings per share? | Yes |
| Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: | 67.6% |
| 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 AND AMBITIONS FOR BUSINESS: It seems likely that the company can continue to grow in the future. The two most recent quarters showed lower growth but that may or may not be indicative of a change in the trend. | |
| LONG TERM PREDICTABILITY: Its earnings are reasonably predictable given that the majority of revenues are recurring. It requires a large number of small acquisitions (or one or more large ones) in order to continue to grow revenues at its historical rate but it appears to have the ability to continue to make those acquisitions. It is difficult to say whether the growth can continue to be in the range of 15% or more. Clearly that cannot continue indefinitely. The founder and CEO indicated in his Spring 2018 letter that he would have difficulty forecasting a long-term increase in intrinsic value per share that exceeds 12%. In May 2019 the company announced it would use a lower (but undisclosed) hurdle rate for large acquisitions. This suggests returns will be somewhat lower in future but also suggests it plans to make large acquisitions. This was basically repeated in the Spring 2022 letter. | |
| Estimated present value per share: We calculate CAN $1365 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 much (vastly) reduced P/E of 17 and CAN $2485 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 much reduced P/E of 25. Both scenarios may be too conservative especially the reduction in the P/E ratio assumed. Both estimates use a 7.0% required rate of return. If the P/E declines only to 25 or higher then the intrinsic value is higher than the current share price assuming 15% or more annual growth. | |
| ADDITIONAL COMMENTS | |
| 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 or very 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 “Spun-off” its Topicus division in 2020. That company now trades separately. But Constellation still owns about a third of the company and controls it with special voting rights. It still consolidates Topicus and therefore breaks out a minority interest in earnings. This has somewhat complicated the financials. Constellation continues to make significant acquisitions. A $700 million acquisition was announced in late July 2023 and subsequently close in September. In March 2023 announced an acquisition with no price given. Constellation spun out its Lume subsidiary in early 2023 and its Topicus subsidiary in early 2021. In March 2022 announced a $700 million acquisition. Apparently they make roughly 100 small acquisitions per year that are not specifically disclosed. | |
| ACCOUNTING AND DISCLOSURE ISSUES: The disclosure is good. In 2019 the company switched to a focus on free cash flow to shareholders. Their approach could be volatile as it includes cash from changes in non-cash working capital and it uses only cash taxes. The company previously 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. See comments under adjusted earnings where we do have some concerns. Their previous approach to adjusted earnings indicated there was a minority interest in subsidiary TSS, yet that was apparently not adjusted in net income or earnings per share. We found it necessary to make large adjustments to arrive at adjusted net income and that makes the figure less reliable. | |
| 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 (together with his adult children) 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 June 2022) Compensation is not at all excessive by today’s standards ranging from U.S. $1.1 to $2.4 million for the five top officers. Most of the compensation is in the form of bonuses. Some of the bonus has to be used to buy shares and there is really not that much left to pay in cash after taxes and share purchases. The CEO (remarkably) 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: Ten individuals. 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. A 2017 addition to the Board was 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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