Chit Chat Stocks - Constellation Software (CSU.TO) | Not So Deep Dive

Episode Date: July 15, 2021

Constellation Software acquires and operates many differing software businesses. The company specializes in niche sectors of the software market. Listen in as Ian, Brett, and Ryan go through the history, financials, and future prospects of Constellation Software. Enjoy the show! Our Thursday Deep Dives are sponsored by Quartr, the new way of doing company research. Access conference calls, presentations, transcripts, and more for FREE on your mobile device. Download Quartr on the App Store here: https://apps.apple.com/us/app/quartr-investor-relations/id1552412128  Download Quartr on the Google Play Store here: https://play.google.com/store/apps/details?id=se.quartr.android  Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Interested in more of Ian’s work? Follow him on Twitter: https://twitter.com/IanGrayLive  Rather watch us on video? Subscribe to our YouTube channel: https://www.youtube.com/channel/UCG5Ni-SI-jyrEsoNUhqftNQ  Contact us: [e-mail]  Timestamps Company Background | (2:21) Industry | (7:50) Management & Ownership | (9:28) Valuation | (15:59) Earnings | (18:00) Balance Sheet | (20:22) Our Analysis | (25:20) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or recommendation. Now, please enjoy this episode. Okay, welcome in. This is the Thursday Deep Dive. We got Ian Gray joining us as always. We're doing this on a Saturday morning. We've got a back-to-back episode. So if you're watching us,

for the few people that watch these shows on YouTube, we will be wearing the same thing, but that is because we are recording it at the same time. I do not think that we just wear the same outfits every day. But Ian, how are you doing? Are you ready to talk Constellation Software? First of all, speak for yourself, man. I was going to switch shirts between shows, you know, got to change it up, keep it fresh. I'm doing well. Looking forward to talking Constellation Software today. All right. Ryan, you want to introduce our flagship sponsor for the Thursday show, Quarter. Yep. Quarter is basically an investor relations page in your phone all your investor relations pages built into one you can listen to conference calls look

at investor presentations transcripts earnings reports all straight from your pocket so it's super easy i believe it's now on android big announcement so brett our anti ios user can officially access it so next earnings season no need to hop on to that terrible screen on your computer and log in you can just do it right from your phone maybe plug it into some headphones It's real easy, but feel free to check it out. It's 100% free. Go download it. They're also, right now, they're in 12 markets, so they have companies from all over.

They plan to add more throughout the year. You can request companies. You can skip through the boring disclosures, go straight to the Q&A. It's really convenient. Check them out on Twitter at quarter underscore app, and the quarter is no E, so Q-U-A-R-T-R underscore app. go ahead check it out yeah all right ryan do you want to introduce constellation software this is probably one of the more unique companies we've looked at in a long time uh constellation software is essentially an amalgamation of hundreds of different bms providers which are vertical market

software providers so they're basically software companies that target a very specific niche and so it's not companies going after a massive cam it's like what they call mission critical companies so for example it's like a police force operational software or there's one here that says a land a global web to print estimation and production and pre-press automation workflow provider so it's like they target one really specific objective and then just basically control that whole market and generate a lot of cash doing it. And management uses that cash flow then and management is sort of well-renowned in the compounder bro universe or the value investing universe. And we'll get into why that is, but they use that cash flow from these

businesses to go out and acquire more. And so we don't know the details of every acquisition, but it's reported that Constellation is a pretty disciplined buyer and they sometimes get these companies for one to 1.5 times sales, which is very cheap comparing it to bigger software companies that are in the public market. And the incentive for the company to sell to Constellation is, for one, you get money up front. And so that's kind of probably the primary incentive. But then also, if you're within Constellation, they talked about this on a show, I think

it's called Creator Story or something like that. there is a lot more upward mobility so you can go if you're like a smaller engineer and a smaller uh one of these tinier uh software companies you can go and sort of work your way up within constellation you can kind of get to a higher position i guess in your career um so there's that kind of incentive and then also the businesses themselves once they and this is kind of a hunch but once they implement constellations best practices or so they're i guess i'm gonna i'm gonna push back on that a bit i think uh a lot of it's very decentralized they let them on they honestly sometimes let them compete with each other so i don't know i've heard

that but then i also heard that they offer their best their best practices yeah they do offer that kind of a like a standardized thing if someone's not doing it but they really let them do whatever they want okay if i could jump in here i think that's i think you're you're both right here i think there's they'll ultimately let them do what they want but i think they have what i think mark leonard referred to as kind of a collegial environment where they're trying to have a lot of expertise across their companies and so that people can learn things from each other and kind of naturally grow that take what's take what's good for their company and apply it and there's a lot of sharing of ideas and and as ryan was mentioning best practices that really kind of

help all the companies because it's like this huge built-in network and you're probably not getting that advice from the ones you're directly competing with but um there's this huge net built in network of hundreds of companies that um you can kind of learn some learn some new tips and tricks from yeah the reason or the resources are there if you want them yeah i think it's like 500 companies now 15 000 employees or something like that it really is similar to the berkshire ecosystem of kind of learning from one another uh i mean probably not exactly applied the same since all these are software and some pictures are more diversified. But I'll get into the history because it's pretty fascinating.

So Mark Leonard, who is apparently six foot five and more than 250 pounds, he played college sports and he has this massive Gandalf beard. So if you've seen pictures of him, which they're kind of rare because he doesn't go out into the public eye very much, you'll probably recognize him. And so he started the company in 1995. But he's a really, really private person. Apparently, he had some traumatic PR experience, essentially. And since then, he's just been staying out of the public eye as much as he possibly can. So it's hard to find any surefire facts about him. But apparently, he had a bunch of unique jobs prior to starting Constellation. One of those included being a gravedigger, but he eventually went back to business school at the University of West Ontario, got his MBA there, and then ended up getting his start in venture capital land where he worked for 11 years. And as the story goes, he kind of grew frustrated with it because he'd see VC firms pass up on a lot of these VMS or mission-critical software companies because they didn't have a big enough team or they didn't have, I guess, big enough hopes and goals.

And he's like, well, we can generate a lot of cash from these things. They can dominate their market. And so he ended up deciding to try to, he got investor money. I think it was $25 million Canadian and started to buy up these smaller ones. And since then, he's just built this massive umbrella of tiny VMS software providers. And they're kind of making a shift here, which Brett will talk about. Yeah, we'll talk about that probably on the second half. There was actually a recent letter in February 2021 talking about the new strategy shift going

forward. But from 1995 to today, they've employed a very similar strategy, just kept the snowball rolling and compounded the business and kept acquiring more businesses each year. All that industry and competition, pretty simple, vertical software market for SaaS. The only number I could get was for the SaaS when it's valued at over $100 billion globally, if you go from not just SaaS to maybe just licensing and other stuff like that, it's probably a lot bigger. So it's a huge market and it's growing quickly. We all know that the software market as a whole is growing really, really fast, right?

Yeah. And if you're wondering how many companies are out there, I've heard a figure that it's like north of five or six thousand. Yeah, I got a number here. Next point. In 2017, there was an estimated 100,000 software companies worldwide, and that has likely grown substantially. in that 10X over 10 years.

And people are projecting I'll hit a million sometime within the next decade or two. So tons and tons of opportunities to go after. Competitors, Vista Equity is another PE firm that's been huge in this.

Although that was the company that was in that tax trouble, but that might've been just the founder. They do a lot of similar stuff here. There's Roper, who is a public company. Tyler Technologies is another roll-up, I believe, for public software companies. And there are a few other roll-ups

that employ this strategy. I mean, the strategy worked really well so there's going to be copycats out there but within each business unit i can't go through all of them they really compete in a variety of markets they compete in almost every market at this point so there's not you know go on the website if you want to check it out but that's not that important for constellation as a whole and if you go to um i guess i have a link in the show notes it'll be on the website uh if you just go to constellationsoftware.com and go to their investor relations page you can check out all their companies and operating units and

they basically operate in every industry. All right. Ian, do you want to hit management and ownership? Yep. As we've talked about, Mark Leonard is the CEO and that's really where the story starts here. He's a big part of this company and he is the company in some ways, but he's also diversified the responsibility of the company so much between all these different business units. And as Brett was mentioning, just allowing a lot of these companies to make their own way and trying to empower leaders and growing a lot of leaders through his company. And then also, for a CEO that's as revered as Mark Leonard, not a whole lot of outward kind of appearances, as we've talked about, and used to write a letter that was very popular. It used to be each quarter, and then it became each year.

Ended up doing away with it because I think the board got on him saying, our competitors are just taking your letters and implementing that business strategy. So he hasn't been writing them. he's just writing them now when there's um something he feels like he needs to tell to shareholders but a pretty low profile for a ceo that's as revered as he is um one of the things there's like so many gold nuggets in his in his letters but just a couple of things to kind of get an idea of um the his mindset and a couple of things i think are worth sharing is one is he isn't a fan of mission or vision because he said it's been proven how bad humans are at projecting in the future. We're so bad at like having any sort of vision of the future. So he doesn't want

to have a vision, but he likes the idea of an objective. So he says the constellation software, he says, our objective is to be a great perpetual owner of VMS businesses, vertical market software. So they really are positioning themselves and it's from his, you know, I don't want to call it a vision, but his objective from the beginning has been to be a perpetual owner and not the traditional PE, um, model of taking a company like this, growing it for five to seven years and then flipping it at a higher multiple. Um, that that's not what he's doing. And I don't know if they've ever sold a company. Um, but they like to be perpetual owners of these VMS businesses. And then he's also said in these letters that he doesn't see an upper limit to

the number of businesses that they can have and that they can buy. And a lot of people start to think at a certain point, the more businesses you get, the less ability you will to, you'll have to manage them properly. He doesn't really worry about managing them properly, at least from what I can see. He's trying to build up leaders and grow them so that there's just constantly leaders who can manage the businesses and they don't need oversight from someone in the central office. That's a little different than what I'd call the Berkshire model. And it's similar in some ways, but it's a little bit different that they've focused on a little bit bigger acquisitions and having a little bit more oversight and probably a little more sharing of

best practices. And, and I would say in the Berkshire model, there's probably more of a, I would say that, and you guys may disagree with me that there's probably more of an upper limit on the number of businesses that Berkshire wants to own. They don't want to own 500 businesses. Buzza wants to know each one of them in and out. And Leonard doesn't, he honored, like he said, I think once they got over like 50 or a hundred, I forget what the threshold was. He said, all right, I got to change it up.

All I'm going to do is worry about the acquisitions or the big ones and then training these people to do what I used to do, which is, you know, be in charge of 20 different units and then just keep spawning those over and over. It's kind of a, it's pretty ingenious. It's a really good strategy. Yeah. And they've had success with it, I think, in really training these leaders. And like you said, you know, they train these leaders to be the head of these business units or these former companies. And then slowly, then they, those companies are kind of the lead and saying, oh, we think buying this company would be great for the business. And then all of a sudden, that person who was just leading that one company starts leading, you know, looking over two, three, four, five, six, you know, 20 companies. So one other thing that I think makes the strategy work well is they've laid out very clearly their acquisition criteria. So they talk about what makes an exceptional business, and that's mid to large size vertical market software companies with a minimum of a million dollars in earnings and consistent earnings growth, experienced and committed management, and then also good businesses.

And they say there's not very many exceptional businesses, but they have exceptional businesses and good businesses with criteria laid out, which I think makes it easy for him to kind of set, this is the standard, this is what we want. they have um they talk about their hurdle rates all the time and once people are given the parameters and kind of the rules to play in um making these acquisitions and growing these businesses is something that becomes kind of on them but they have kind of the guidelines but then they can you know they can they can do it how they see fit basically so yeah what's interesting too is that the head office which is that is very similar to the berkshire model i think they have 15 or 20 people there. It's Leonard and the team up there, probably accounting, CFO, stuff like that. But they give capital allocation capabilities to the sub people, which are called, I believe,

the operating managers. I forget the exact term, but the people below them have the capital allocation capabilities. They've even pushed that down. So it's even more decentralized than Berkshire Hathaway, where I believe, and maybe Greg Gable is doing this at Berkshire Hathaway now too, where almost all the capital allocation is from one person. Leonard has really pushed that down and that takes a lot of trust and it's actually worked out beautifully. Right. It's amazing to see what's happened. So some final quick notes. He's got about a $2.4 billion net worth. So his constellation has been good to him. He doesn't take a salary anymore. And part of the reason he says for that is he doesn't want to feel the responsibility

of like working super long hours for the shareholders, basically. He's like, I just want to help where I can help and not feel some sort of burden about working a ton more hours because I take a salary. And then he currently, and this was data as of early 2020, owns about 2% of the company. We still haven't gotten the equivalent of a proxy in 2021 yet. So it's unclear how much he's bought or sold. At least I haven't. I didn't dig into a lot of research, but he owns about 2% of the company currently. Yeah. And ownership with this company is not something... If you read the letters, they've really set it up so they want the ideal shareholders. I don't think ownership is something to dig into too much here, but I'll move forward.

We'll hit valuation quick. Market cap as of recording is $32.7 billion. And these are all going to be in U.S. dollars. Make sure if you're looking at Koi Fin or whatever, you're going from whatever country you want because you can get tricked because the Canadian dollar has a similar sign. Ticker is CSU.TO for Canada. And then if you're in the U.S. and only have access to the U.S. markets, it's CNSWF for the U.S. Enterprise value is slightly higher than the market cap of $33 million. EV to sales trailing is 7.87. EV to free cash flow is 25. That is according to Coifin. They do some internal stuff that mixes. They do some non-gap adjustments. So take a look and pick and choose whatever one you want. In one of his letters, they have a slight

disagreement. Some people like net income within their company, but he says that he tracks free cash flow per share growth. So that's maybe the best way to look at it because that's what the management is going to try to do and maximize as well. Dividend yield is there. It's actually at about 0.21%. And then share count has stayed very flat. So the capital returns, they got the dividend there, but it's not really relevant right now. And then share count, you're not going to have to worry about that. They actually tried to keep it as flat as possible. They don't want to use share. Well, maybe they'll change that in the future, but they don't like buybacks because they don't want to get rid of their long-term shareholders. So they try to optimize keeping

that share count flat, at least they have in the past. And then fun fact, if you want to get angry at the opportunity that aroused and maybe do a little hindsight bias here, from 2008 to 2012, that was a five-year period where you could buy shares at a 6% free cash flow yield or higher during that time period so hindsight that was a pretty good deal um it was more of an unknown company then but kind of interesting that's why it's been such a good stock over the long term all right ryan you want to hit earnings yeah i will are you sure on that enterprise value number because i believe they have a net cash position uh that's i just used the coifin number um could be slightly off either way it's not a huge difference there but uh it

It looks like they, Ian, you'll get into it, but it looks like you don't have a cash position, right? All right. It's a little complicated, but I'll get into it. I'll talk about 2020 earnings. And so there really isn't a lot to cover here just because, I mean, the only numbers that seem to matter to them is revenue and free cashflow,

but I'll try to break it down a little bit more. So they had 3.97 billion in revenue last year, up 14% year over year, so roughly 4 billion. And they break down their revenue into four parts. So it's licenses, professional services, hardware, and other and then maintenance and other recurring revenue. The maintenance and other recurring revenue, I think makes up, I'm blanking on the percentage, but it makes up the majority of revenue by a lot. And then they have free cashflow of almost a billion dollars. That's up 68% year

over year. And so that's roughly 25% free cashflow margins in 2020. And since they use that business cashflow to acquire and get into this, they run a pretty lean balance sheet. And then as Brett mentioned, it looks like share count has stayed steady. So when you look at free cash flow, free cash flow per share growth is probably going to be exactly in line with free cash flow growth. And then organic revenue growth was actually negative during 2020. So keep in mind they have, it's not just like they acquire these businesses and they die. They are obviously hopefully growing in their own right. But their growth was negative during the year because COVID kind of threw a wrench in sales practices for a lot of their portfolio companies.

Usually, if I'm not mistaken, it's not negative growth. It's usually pretty low, but yeah, they say their goal is, in best case scenario, like mid-single digits, but they're not going to be upset if it's lower. It's really small. Most of the contribution to growth is from the acquisitions, and some of it is from that organic revenue growth. It's kind of like a mature retailer where you might get tiny or, you know, maybe a fast growing retailer where you might get tiny amounts of comp sales growth. But a lot of it is just expanding, acquiring new stores, if that's kind of a similar analogy for someone to use.

That makes sense. Ian, balance sheet? Yep. The balance sheet is, like you said, fairly light for the size of a business. They've got cash of $932 million, which is up from $364 million in the quarter a year ago. So they've really been growing their cash balance recently. And I think we're going to get into this later, but they might start using that cash a little more aggressively. They've got debt. And this is a number that you probably want to do a little bit more research on if you're going to buy this company. But I think the proper debt number is about $400 million. And I was using kind of management's discussion about this as well. um the debt on the balance sheet would say it's higher than that from what i can tell it looks like they're reporting um an undrawn line of credit on their balance sheet and so that makes it look like they have a net debt position um and that they've got more debt than they actually have drawn currently like i said you're going to want to do a little bit more research on that from

what i can tell though and what from management's discussion of it in the financials uh that seems to be what's going on. So what that means is, if that's correct, they've got a net cash position of about $533 million. The interest rate on the debt that is out there is a little bit high for some debentures they have. It's inflation plus 6.5%. So it's a little bit high, but the amount of debt relative to the market cap is very low. So it's not a huge concern. They've got plenty a cash flow. This is definitely not a business you're worried about going under having a credit problem. So one other thing I'll note is there's some preferred stock on the balance sheet that pays about a 5% dividend that accumulates. And then when the shares are converted, then it gets

paid out. It's related to the spinoff of an entity called Topicus, which is, it looks like that's They're Euro-based businesses, and presumably that was for – they just decided that that was a better structure. They still have ownership in those businesses from what I can tell. Yeah, I can kind of explain. I'll try to read up on the Topicus one. It was a big acquisition they did, and it is based in the Netherlands. And it was, I believe, in 2013 or 2014, one of the larger acquisitions they did, at least for the time period. But the management team there apparently wanted, they didn't want to get bogged down within the Constellation ownership anymore.

So they wanted to do their own thing. So now they're going to run something separately, but Constellation still is connected to them through an ownership. So that's why they decided to split off and spin out some shares for the existing shareholders. And it's kind of interesting. Maybe they'll start doing that more, kind of going for an IAC strategy. Yeah, that would be interesting. And one of the things also to note on some of the financials is now it's listed that they do have a non-controlling interest, which is something new this year based on this spin out. So the last thing I'll say is the balance sheet, it's hard to get super granular in this balance sheet and really try and pull out a lot of insights.

There's there's some work you can obviously do. But given how vast the enterprise is and how many different companies are actually within it, there's it's not just like a simple it's not just a simple like software company balance sheet in some ways because they also have this capital allocation strategy. So it's an interesting business. Balance sheet looks good, though. it's interesting that they don't they seem to be against taking out long-term bonds right because you would think they'd be able to get you know a 10-year bond in this interest rate environment you know at least three four percent i don't know a flat one because they're going to continue doing these acquisitions is that what do you mean like take out a you know i don't know like every other company in the u.s has been doing we're going to take out a 2032 note at 2.8 percent but they're taking this high interest rate debt they seem to have an aversion

to the bonds which seems interesting like i'd like to know why they've got it yeah i mean i think it's probably just that they have so much cash right now but if they have this other debt i don't know yeah those are so that other debt is and we'd have to dig deeper into it to see if they could retire it early um i suspect maybe they can't but that other debt was created in 2013 and 2014 i believe that there's part of it the debentures um and those have a are they're basically you know kind of long-term bonds in a sense so um those those expire in uh 2040 so okay so those are those are long-term but they might not be able to get they might not be able to refinance right that's the question is we'd have to dig a little deeper but um they may not

be able to refinance those yeah this seems like the exact kind of business they would get an extremely low rate i know and maybe they don't need it anymore like you were saying ryan but if they're gonna take out that that's the only question you can really lower your interest rate um here but who knows they seem to they seem to go about everything in a unique manner uh which we'll get to more in the second half of the show let's take the ad break and then we'll get back to it this episode is brought to you by kpmg as a business leader how can you innovate build trust, and move forward in a digital era. KPMG can help by bringing together the right talent and technologies, generating insights that spark opportunities. To explore

their thinking, visit reed.kpmg.us slash opportunities. This episode is brought to you by La Quinta by Wyndham. Here you are miles from home and ready to start your vacation. Good thing you're staying at La Quinta by Wyndham. They have free high-speed Wi-Fi to stream all your favorite movies. And in the morning, get fresh waffles with their free Bright Side breakfast, or squeeze in a workout at their fitness center. Either way, you're ready to conquer the day. Tonight, La Quinta. Tomorrow, you triumph. Book your stay at LQ.com. Okay, welcome back. Next up, we have anecdotal evidence. Ian, we'll kick things off with you. I'm going to start with a podcast episode I actually listened to just a couple nights ago.

So Mark Andreessen was on Invest Like the Best and was talking about venture capital and some of the strategies and how Silicon Valley really got started. And one of the things he was talking about was Hewlett Packard and how Hewlett Packard started developing all these different business units and had this environment that, in a lot of ways, as I was reading through the Constellation shareholder letters, it seemed like a very similar type model. I think what Constellation Software has been able to do, though, is decentralize it even more than Hewlett-Packard did and give people more ownership over their own units. Because what he really spoke about is that VC got going because they had all these people working at Hewlett-Packard who'd been just getting money from Hewlett-Packard and running their business unit. But then VC came in and said, hey, what if we just gave you a bunch of money and you did it on your own? And in some ways, I think that's what Constellation Software has gone even further that model, but still trying to provide that kind of collegial environment to share a lot of information, to share ideas, to have some of those benefits of a large organization within these small

vertical market software. So anyways, if you're interested in this business, I think that episode, like I said, it was a recent episode on Invest Like the Best with Mark Andreessen, definitely worth a listen. yeah the keeping the people around and not getting these groups to want to spin off because i bet there's other people like topicus uh that want to have their own ownership and people there's probably pe firms that pitch them hey let's spin you off you can do your own thing but the way they've set it up is giving people full autonomy and i believe they say they've created you know over a thousand millionaires within constellation software so they try to keep these people around

by paying them extremely well. They give them ownership of Constellation software through some of these deals. I don't know. It seems like, yeah, it's a smart strategy to try to keep them away from VC. All right, Ryan, what are your thoughts? Well, we typically for this segment

do product experience slash anecdotal evidence. And seeing as these are mostly business-to-business mission-critical softwares, I have no experience with any of the products. But as far as kind of just anecdotal evidence with CSI or Constellation Software at large. I tend to like when CEOs are reserved and stay out of the media.

And Mark Leonard really, really does that. But I guess that's only if the financials kind of follow up. Like if you're doing this and if you're not in the media and you have a terrible business, then it's probably more of a red flag. Yeah.

I mean, he's just so, like Ian said, he's so well-revered. But I really, the corporate structure here, I could not find a flaw. Oh, yeah. I mean, I got no low lights on this company. I mean, Angle, for me, I'd probably say, I mean, this is the 21st century, you know, Berkshire Hathaway. It's, yeah, they could probably, I don't know, who knows what's going to happen at the end. But it's on a track that it could have better returns.

I think they're at a 28% CAGR. But as they scale, that might slow down. All right. future growth opportunities, Ian, kick things off. This is something they talked about in a recent letter, but they're talking about trying to get into more larger acquisitions. And they haven't done a whole lot of large acquisitions in their past. Most of them have been, you know, three, five, eight, $10 million acquisitions. But Mark Leonard has identified that there are some opportunities for more of that $200, $300 million acquisitions, that there's a lot of those out in

the market. And then as they've gotten larger and have the cash and also need to continue to generate returns for people, that those larger acquisitions can become a possibility for growth for them. Now, one thing that concerns me about this is that they have not had, at least in the last couple of years, a very, and even historically, they have not had very good organic growth. And so as they bring in these larger acquisitions, I worry about the operational effectiveness of some of them and whether these larger acquisitions are really going to be incorporated well or if they're just going to kind of be more of a drag on the company. But that is something they seem to be getting into and something that I would be excited about as a shareholder for them to get more into larger acquisitions. Yeah, it adds, it's interesting, but it does add new variables, a little more uncertainty. Ryan, what's your future growth opportunity?

So I guess there isn't a whole lot you can say for this that's like revolutionary for the business because it's a pretty simple strategy. But this is something they talked about in their most recent shareholder letter, which was cutting the dividend. um and he like this was the very first paragraph that he talked about this and he's finally kind of caving in on it which was uh constellation is able to invest the capital more effectively than the shareholders because of the position they're in uh and so bore the one of the board members like we shouldn't be giving the dividend if we can effectively invest that capital better and he finally caved, I guess. So they are apparently cutting the dividend.

This was in the 2021 update, right? Yeah. And it starts with like, we're cutting the special dividend because they used to do these infrequent special dividends. And so I guess just keeping that cashflow to themselves, reinvesting at higher rates of return,

that's probably better for shareholders in the long run. Yeah, yeah, for sure. And I'll hit mine. They talk about this in the 2021 letter as well. if they didn't have that 2021 update we would have nothing to talk about here so good that they did that uh but it was the other big thing they talked about in that letter and it's moving outside of bms which again is vertical market software um they were thinking about if you're still confused on what vertical market software is or is it market yeah okay yeah it's market horizontal

software the epitome of that is excel which is for everyone vertical is for specific niches And then in the recent letter, they said that they're actually going to try to establish a new circle of confidence. So this is the first time in its history Constellation is going to be moving outside of EMS. It will definitely be risky, but interesting to see what they come up with. Who knows? It could be anything. I hope it's not meme stocks or anything like that. Or crypto, maybe that might turn some shareholders. I have a feeling it won't be. Yeah, but I don't know. I have no guesses of what it will be since they're such a closed book.

but watch them just go Berkshire public equities. Public equity. Yeah. They did do some public equities in the early two thousands. I think, I think I'm not, I'm not entirely sure on that. It might just be bigger software companies. Well, no, this is a different part of it. Like, like it's outside. Right. Cause we, we read that update, right. They talked about they're going into large VMS more like they're going to do

more of the topic is outside of this was outside of this. They said we're trying to establish a new circle of competence outside of VMS. So who knows what that is, but I feel like the shareholders were like, whoa, this is too much for this two page letter. This is the first thing we see in four years and you're, you're throwing all this stuff. And it doesn't help that it's cloaked in secrecy because now we're not, we might not know what that new circle of competence is for four years.

Yeah. But they do have annual general meetings. I don't know if they're recorded. They could talk about that stuff there. i might watch the recent one um maybe see what they say phones policy there yeah i don't know it's kind of a canadian virtue they keep the house secret i might want to go to one of these meetings sometimes but uh let's move on don't want to go too long here highlights and low lights and what do you like and dislike about this business so the highlights for me and we've touched on this but it's a genius strategy they've got a proven track record um and and likely just you know tens if not hundreds of of good managers and capital allocators right

they just they've really done a good job of building building out this network of business units the other thing is just the high free cash flow per share growth returns on invested capital all those numbers that you love to see they've just been compounding for years and years and years um a couple of low lights for me actually is just especially in recent years but even going back they've never they've traditionally not had very good organic growth with these acquisitions that hasn't seemed to hurt the stock or their returns. They've been able to generate cash flow, but the revenue growth has not been there,

which says to me they've really focused on operational efficiency and have not been good at growing these companies at massive clips. I wonder if that's something inherent in some of these vertical software businesses that you kind of hit your niche and then kind of stall out a little bit,

for lack of a better word. You kind of get a base of companies, an install base, And then slowly, you know, those companies go out of business and they kind of decline a little bit in their in their revenue or there's just not new opportunities to sell to new companies or there's other software that comes along and starts, you know, picking up the new clients. So I assume that there's some level of that that's inherent in vertical market software, and especially the size of the companies they're growing or they're buying. If they were to start acquiring more larger brands, I would definitely want to see the organic growth higher because they can make it work when it's these smaller brands, I think. But if they started making bigger acquisitions and the organic growth wasn't there, that'd be a little bit concerning to me. And then this is just a question for me as they start to move towards these larger acquisitions potentially, is are they beginning to grow out of their comfort level? And how does that affect the business going forward? that it seems like going forward, whether it's through new lines, new circles of competence, or just to larger acquisitions.

I wonder a little bit about, is this business going to still be able to kind of keep the same structure, the same units, and really generate the same success that it has in the past? Because it's reached a level of scale now that's changing what they can do. yeah yeah that's because their old model some of the one of the reasons why they were so successful is because they went after things that most vcs or i guess all vcs wouldn't touch which is stuff that may have declining revenue growth or just total stalled out revenue growth and stuff that was tiny and there was no one else fishing in that pond now they might be going to areas where

there's a ton of demand. Right. There's more demand. And then the other thing I'd say is each of those acquisitions, they've said that they don't think there's an upper limit on the number of acquisitions they can make. And I agree with that. I think they could continue to grow out these small businesses and just keep going out. But the reality is that each of those acquisitions becomes less and less impactful as the organization gets bigger and bigger. And so there's not an upper limit in terms of how many they can manage, I think, but they're starting to become an upper limit on how many if they can actually acquire these businesses fast enough to generate meaningful returns for investors if organic growth is going to be flat um so that's that's that's my low light

my concern yeah they are good right that's my low light as well because there aren't a lot of low lights with the actual business itself but just what does what does size end up doing to the business in the long run i think they were talking about this in 2013 so we may be laughing at themselves in 2030 with this one but i mean it will i'm always thinking about it too highlights for me uh obviously mark leonard's an exceptional capital allocator uh and there's not really any threat from the competition of like big tech whereas a lot of these other software bigger software companies with huge tans or whatever they tend to get that competition from microsoft stuff like that i mean think about the company that comes to mind is like slack uh with the

the competitor teams you know so like there's just not that much interest from big tech to go after these tiny verticals um so i think it's a bit of an advantage for them i mean there's highlights across the board the corporate structure is perfect yeah and i'd say maybe the way they're going to counter the bureaucracy and the size is just by spinning off stuff and making like i i know topicus will probably still have connections to constellation software and constellation shareholders still own it i don't know the exact structure but you just package package package the companies and ship them right just yeah like maybe that's the way they're going to do it is spin out stuff like topic or maybe they won't but like if topic is is its own thing

they go about you know leonard has and i bet the managers there were good beforehand but leonard and the people at constellation software have trained these people to become really good at what Constellation does. Now they can go repeat it in their own way. It could be in another way just as this kind of spawning type deal.

It's very interesting, but they've been able to evade any bureaucracy and we'll see if they can do it because it's going to keep being a headwind for them. Let's see, highlights for me. Yeah, I mean,

the decentralized structure stuff I like and just the ability that they've compounded cash flow per share. They give out operating taxable per share, which is very similar for a company like this because minimal capex and a lot of these things. So in around a 15 year time period, operating taxable per share went from around 10 cents to like $50 a share in 15 years. It's just really strong. That's a crazy number.

The only thing I can think of is like, you know, John Rotonti of The Fool always when you see a number like that, he goes, fools, that is compounding. You know, that is that is that is crazy right there. right 10 cents to 50 and 15 years you talk about a compounder yeah hundred bagger isn't it uh it is a hundred bagger um if i was if coifin is not lying to me as it may have lied on the debt so we'll see i think i think it's a hundred bagger if not it's close and it will be soon um all right let's move into bull case this one will be a little maybe boring as well but you know keep yourself with you what are your thoughts yep i'd say for the bull case the way i see it going is they pivot to larger acquisitions. It works. They are able to continue compounding capital

as they have been with those smaller acquisitions. And it just starts at a larger scale and it kicks off a whole new cycle for Constellation Software. Instead of these seven-figure acquisitions, they're making great nine-figure acquisitions and really incorporating them well, continuing to maintain that structure, and just continuing to compound capital at great rates, benefiting shareholders for years to come yeah right yeah it's uh something that i heard recently i think it was on a podcast covering constellation was new development tools have made creating these niche software solutions a lot easier and so it's kind of what is that like the no code twilio types like twilio and stuff like that yeah i think or maybe not maybe the process of the engineering

process i think it's just gotten more democratized it might be something else yeah it's probably over my head to be honest but uh if it's easier now i could see how that creates a bigger pile for constellation to choose from um and so if the pile is bigger than i think then they can continue the exact same track they've been uh doing here for the last what is it 15 20 years though yeah 25 1995 they're older than all of us so they've been commenting since we've been in the womb uh so for existing shareholders for my bull case i mean if you're an existing shareholder you've been around you know 10 bag or 50 bag or 40 or something i mean you probably just want them to keep doing what they're doing like you're not gonna i mean if you're already at that

point you're not going to complain if they only compound at you know age of 10 if it just drops a lot like they might with the while they scale up here but if if you're thinking of buying here you know at a higher valuation than it historically has been um i would look closer at the vms purchases or sorry the larger ones that they're going to get into and then this new circle of competence whatever that ends up being that's going to be a big driver if you're looking for outsized returns from the stock going forward so yeah just looking at that right bear case i know we've been you know very bullish as uh like on the business itself but what could go wrong for the company going forward, are you thinking? So I'm thinking for the bear case that

I just wonder about these vertical, and I touched on this earlier, but whether these vertical market software companies and these niches that they're attacking, whether those businesses are just declining in general across the board, are some of those software solutions dying out because of one, more consolidation in the industry. You're getting these massive ERP players, whether it's like Workday, SAP, NetSuite, Oracle, all these players that are just continuing to add more and more capabilities to their software, which I have to imagine starts impacting even some of these vertical niches because they just are adding more and more products to their general suite. And so that someone can just buy one software that covers

everything they need to do. The other thing I start to worry about, and I think the other solution to some of these and could create a little bit of a bear case here is low code. And Ryan mentioned this a little bit, but if there's truly companies, and like one company that does this is Appian, but if there's truly companies that can go in and help you build your own solution for whatever problem you're having that's customized to what you need within a month or two, and you can just buy your own solution that works exactly for your business, some of these niche vertical market software companies, I think start to be less attractive because you can just get your own solution fairly quickly up and running. That's customized, not just for your

niche, but actually for your company. So between those two things, I think that there is a bear case here that the vertical market software is just a little bit of a, that it's not going to grow at the same rates that it has historically. And that there's going to be some other options here instead of some of these small software companies yeah it's interesting the low-code stuff hadn't thought of that um ryan what's your what's your bear case well it's the one we talked about which is how does size play a role for them obviously they can keep doing what they're doing but then they have to increase the volume of their transactions so probably start to have to buy north of 100 companies a year um that probably presents maybe a few issues but then or they have

to expand i guess into that new circle of confidence which presents i guess some uncertainties i just think the old playbook will eventually no longer be as valuable uh they're gonna have to change uh if if anyone if i were betting on whether or not mark leonard could change i would say he probably can um yeah and what's interesting is that this was probably the bear case in 2013 2019 or whatever in the season that is a random time where you know the old strategy it's been going for 10 years it might not work in the future and that's why there was that opportunity it's strange i don't know if it's true eventually it might you know eventually it's got to be true on a long enough time horizon but yeah i mean the margin of safety is pretty high here like

there's a high floor given that they generate so much cash from their existing businesses yeah and they've said that they're going if they can't find any opportunities they're going to just return the cash to shareholders. So, I mean, if anything, you're going to just get special dividends. Plus the other thing I'd add is like with the, like the small verticals or like the sort of niche verticals, you have customers who just don't want to switch. Like it's just such a hassle for them to switch. So I guess the example that I heard earlier is like you have like a bowling alley operating system. Let's say that's like the software, like you're bowling Yeah, it's too costly for them to switch.

It's too much of a pain in the ass for them to retrain employees on a different software. So they just keep these old VMS providers, I guess. Yeah, that's interesting. All right, two things that come to mind for me. I mean, none of these things that we're talking about, I don't think are going to be detrimental, but I think can be a headwind. So acquisition prices creep up. as they've said before, that their hurdle rate, it's been harder and harder for them to hit their hurdle rate on acquisitions. And as more of the private equity industry comes into this,

as they have in the past, if that continues to grow, that'll be a headwind. And then the new acquisition strategy just doesn't work out as well. I mean, they're taking a risk here. It's something that they probably are forced to take because they've been so successful, but it just adds a slight amount of risk going forward you know they're not guaranteed to execute on that so it's not like this is a no stock is a sure thing and constellation might seem like the closest thing to it but it's not a guarantee um all right and you have something i just i just wanted to make a comment real quick so many of our listeners i'm sure probably will know what a hurdle rate is but we've mentioned it a few times so i just want to be clear and

they talk about it a lot so a hurdle rate for them is they say what is the rate of return that we project forward from making this acquisition? And is that higher or lower than the return we demand? So when we make an acquisition, for instance, they might say, we want it to return 20% each year. If an acquisition, if they model it out and say this acquisition is only going to return us 12%, then they won't do the acquisition. So, and those are just made up numbers, but that's kind of the idea. And that's what, when they talk about a hurdle rate, and when we talk about a hurdle rate, that's what we're talking about. So that they're, they're having a harder time seeing really high sustained returns that they that they demand um in many of these acquisitions

that they're making which is a result of price oftentimes yeah and their strategy they've it's and why we don't have any uh real numbers on that is because they don't give it out it's part of the secret sauce that they try to keep in-house it's like the coca-cola secret secret formula in that regard all right let's wrap things up more or less interested in this one's actually a little bit tough for me. So I'll say I'm a little bit more interested, but it's more because of the story of this company and like what has happened historically. It's just been so impressive. And they've compounded capital. Like it's hard to, it's hard not to be more interested in this company just in the way that they've done it. And Mark Leonard's run a success here.

My concerns though, about the vertical market software industry, kind of that's, that's what brings down my interest a little bit is I'm just not convinced that that's an industry um that i want to be in going forward uh so durability concerns durability concerns yeah that's a good way to put it okay uh ryan sorry more interested it seems like the kind of company like we're going through all these sort of bull case bear case scenario planning right now where if you just held it and looked away for the next 10 years like i think you generate a decent return um yeah and i guess it's hard not to be more interested just given how much about the business i actually like the price isn't terrible um yeah it's you know

it's not i said the valuation has crept up it's not as high as it has been in the past that could be some timing issues with 2020 there could be some cash things that smooth themselves out stocks close to all-time high but the free cash flow yield is not it's still a lot lower than it has been and i don't think expecting another hundred bag would be i don't know that that seems audacious the company is very large and but you don't need a hundred beggar to make a good return i mean this thing i don't know 10 12 a year i mean that's fantastic feels a bit like i don't know berkshire and like 97 if it could be yeah that was something or 98 where i mean 98 is when it kind of got that overvalued and i can't remember that same time period right where

the success has been so strong. People may have crowded into the stock. They do some interesting deals. And that's when they did that kind of surprising deal with Genry. I guess we don't need to go into all that whole deal, but I'm more interested. I think you have to put this on your watch list. I don't know. If you read about the company, it's kind of one you want to keep in your back pocket it's one that if there's a huge market downturn feels like something like sure bet feels like yeah feels like that you got to be worried i don't i get worried when i ever think about wow there's just nothing wrong with this company because things can always go wrong but definitely more interested um stock for next week which we're going to be recording right after

this but ryan it's it's robin hood our favorite broker uh we're going to go through the s1 i know how much a lot of people hate it it's actually you know what there's well some people like it some yeah some people like it i would almost call it uh one of those what's it called stocks battleground stocks surprisingly i thought i thought it was consensus that we didn't like it i thought yeah i thought it was consensus at least in like the investment fund community and like the financial advisor community i guess those are the people we follow on twitter a lot some people actually i'm in my own bubble silicon valley loves them yeah yeah well they have a lot of MAUs. All right. Sorry. All right. Sign us out. Yeah. All right. That's going to do it

for this episode. Thank you all for listening. Make sure to, excuse me, remember we are not financial advisors. Anything we say on the show is not formal advice or recommendation. Ryan and I are general partners at Arch Capital. Arch Capital clients may hold securities discussed in this podcast. Thank you all for listening. We'll see you next week. Thank you.