Chit Chat Stocks - Constellation Software (CSU.TO) with Leandro

Episode Date: March 31, 2022

Constellation Software acquires, builds, and manages software business in various locations. The company specifically works within vertical markets. This means the software companies provide very specific solutions for niche markets. Listen as Brett and Ryan ask Leandro questions about the company, its business model, and valuation. Enjoy the show! This episode is brought to you by Knack Bags. Use our link and enter promo code “KnackChat” to get a $15 TSA approved lock with your purchase of a bag: knack-bags.pxf.io/4eMgNZ Subscribe to 7investing with the code "CCM" and get $10 off: https://7investing.com/subscribe/aff/4/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Interested in more of Leandro's work? Follow him on Twitter here: https://twitter.com/Invesquotes?s=20&t=0NSDbs0svMweFlA1XoT0Yg Contact us: [e-mail]  Timestamps Constellation Software | (4:31) How Can They Grow? | (27:02) 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. This is our Thursday deep dive episode where we interview an analyst or an expert on a single stock. And today we talk with Leandro about Constellation Software, which is known, I guess, for being a high quality compounder, a serial acquirer of software businesses. He gets into all of that. But before we get there, any highlights from the episode for you, Brett? Yeah. So Leandro, this is his first time on the show and he works with Chris at potential multi-baggers. And we know that that's a very popular service for listeners of the show and for when he comes on. So it's very similar style of investing. And he runs something called Best Anchor Stocks. I think I should mention, we talk about that, that you can go check out.

It's in conjunction, I think, with potential multi-baggers a bit, but it's its own seeking alpha service. Besides that, it's Constellation Software. I think the highlights are, one, that it's a hundred bagger since his IBO in 2006 to, uh, the hat it's only had, I think a 30% drawdown. So low volatility, amazing returns, and kind of trying to identify what gave them the special sauce to add those phenomenal returns over the last 15 years is very interesting to talk about. And Leandro goes through all the details, you know, or acquisitions, organic growth, IRRs, everything. What am I missing? The management team, the decentralized structure. I loved all that stuff. Yeah, no, he covers it really well. I was actually surprised how thorough his analysis

was, especially for having, I guess, owned it for, and he talks about this only, I think, three or four months. But yeah, he really understood the business well. Before we get to the interview though, we've got a new sponsor alert. Sound the alarms. The new sponsor is Knack bags and they sent us a bag and i just i recently went to mexico so i used it and these things are it's versatile is the word i would use and i'm i'm i know they're our sponsor so i kind of got a puppet but the uh the bag is actually pretty sweet it it's uh i was able to throw like flip-flops plus computers in different pockets it you can basically add anything you want it's expandable too so it can kind of turn into almost a suitcase in a sense um but everything you need

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It's a great bag. I love it. If you actually want me to show you a picture, just shoot us an email. It's chitchatmoneypodcasts at gmail.com. It's a pretty sweet bag. And we've got an extra one for Brett here once he gets back to the offices. But yeah, go ahead and check them out. Without further ado, let's get to our interview. Welcome to Chitchat Money. On this show, hosts 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 guest is not formal advice or a recommendation. Now, please enjoy this episode. Welcome to Chit Chat Money. Today we are welcomed by Leandro. We met Leandro through Twitter, actually through our friend Chris from Potential Multibaggers. And he is the main contributor at Best Anchor Stocks. It's a service for Seeking Alpha. Feel free to look it up. We'll try to drop a link in the show notes

and connect it however we can. But Leandro, welcome to the show. We're talking Constellation software so how when was the first time you came across constellation well uh first of all thank you guys for for having me i normally listen to your podcast so it's it's an honor to be here um well i i first heard about constellation something like three months ago maybe four four or three months ago because uh i follow on twitter maybe you guys know him is cj opel that he is a canadian canadian investor and he talked regularly about about constellation and i and i read a thread where he described some of mark leonard's uh policies and the one that surprised me the most is that a software company had not issued a single share since IPO so that's

like I was kind of surprised and I started reading about the company and then I just like liked what I was seeing and was kind of surprised also that it wasn't well known considering the the high quality of the company and do you want to go through the I'm sure some of our listeners have heard of it, but for those who haven't, do you want to go through the basics of their business model and then maybe provide an example of some of the businesses that they own? Yeah, sure thing. Well, Constellation is a serial acquirer of vertical market software companies. Maybe many people are not familiar with what BMS companies are, but they're basically software companies that are tailored to one specific vertical like healthcare or maybe

fitness or whatever like the prison system and they satisfy critical needs for the customers there they're typically very specific needs and they differ from horizontal market software businesses in that they cannot be applied to other verticals okay so their time are constraints for example an example of a horizontal market business or software is microsoft office you can basically use that that software for an industry an example of vertical market software could be the reservation management software of a sports club. We can say for sure that that time

is not going to be in the billions because it's very specifically tailored to that vertical. So Constellation, what they do is they basically acquire a lot of these companies that are cash flow generative and then they get those cash flows and they reinvest them in more acquisition

and they sort of get a flywheel spinning to make like, it's like a kind of a snowball effect with acquisitions. And how many, I don't know if you have this number on the top of your head, but how many VMS providers

or software providers do they own? Is it in the thousands? Am I getting that right? No, it's close, but not yet in the thousands. It's around 700 to 800 BMS companies, but they are acquiring now at a rate of 100 per year. So in a couple of years, we should be in the thousands. Okay. And I think the big question people have when looking at something like this is, okay, how does a management team not lose all of the, you know, I mean, lose track of everything.

it seems very stressful or something like that where you would own all these companies and you had to keep track of them, you know, the CEO or something like that. But what they've done is set up a decentralized operating structure. Can you explain what that is and how do you, how that's helped them, you know, get to where they are today? Yeah. So the, if, if we go over the, the like the typical path for any serial acquirer is,

that they typically start with small acquisitions. And then as they grow, the small acquisitions don't move the needle anymore because if you're a 100 million company and you make a 1 million acquisition, well, that's not going to be very significant. So they try to do more acquisitions, but then they start to suffer bottlenecks because most of these acquisitions have to go through the CEO's desk and the CEO's time is limited. So they end up scaling up by making larger acquisitions

instead of increasing the number of acquisitions. Mark Leonard, who founded Constellation, knew that this was a problem and the only way to scale the number of acquisitions without having to do larger acquisitions was by setting up this decentralized operating structure where the companies that Constellation acquires are operating independently from Constellation. The only difference is that they are backed up by Constellation.

They have their know-how. And they also have a financial cushion because Constellation is going to be there for them in case they need it. but the parent company that can be as true as Constellation doesn't go into the operating matters of these companies in the majority of cases. Sometimes they do.

So if, for example, you acquire a company that has three business lines and one business line is losing money, sometimes they'll close that business line because they're interested in the cash flow and they don't want to have a business line that is burning cash. So for this goal, they basically broke the company into six operating groups that act like mini constellations, so to say.

So they are like a small constellation. And then these operating groups have expanded further into sub-operating groups and business units that can also make acquisitions. So what they have done is push the capital allocation decisions and the operating decisions down the operating structure to the company level. And when we say business unit, a business unit can be a company that has 10 employees and they are responsible for allocating capital to. OK, and the OK, one thing that people think about with them is software. They're like, all right, you're competing kind of with all these private equity funds. you're competing with all these VCs, but actually when you look at Constellation, they're competing in something that no one has really wanted to touch in the past.

And that is kind of those slower growth VMS companies. Can you explain that niche they've gone in and why they're able to acquire companies for two times sales, three times sales that may have these really, really high margins? Yeah. So Constellation just focuses on the internal rate of return and so price is the most important thing they go after when when they're acquiring a company uh of course well we can see the public markets differ from the private markets but you can see in public markets that buying a sas company with a large time and high growth is impossible to buy cheap because these things come really expensive So the only way to buy companies where the price makes sense is first going into small acquisitions because as private equity firms and venture capital firms get large, they don't target these companies anymore.

and the other way is to go for companies that are in some sort of trouble and then trying to they don't even have to remodel this company so that they start growing because if you pay the a fair price it doesn't matter if it's if it's declining like the business is declining because you can make a fair return on the on the investment so the competition is mostly is mostly around price. And the good thing that Constellation has against its competitors that it's also, it's not a differentiating factor as price, but it's their reputation because a venture capital firm, well, first a venture capital will most likely have a portfolio of companies that are much riskier than a VMS company. And they'll be expecting some large

payoff on very few investments and then private equities what they do is they buy a company they change completely the company and then they sell it at a higher price constellation works differently because they buy a company and they expect it to hold it forever and they let the owner that was in the business run the business so so they have this sort of reputation behind it where some uh vms owners want to be acquired by it and so to say like some of them just don't think only about the price they also think about the conditions that they are going to have if they are owned by constellation and you you touched or you talked about it briefly um which is mark leonard so do you want to go into who he is and then why do you think he's been so successful

at Running Constellation and just kind of talk about how crucial he is to the company overall. So Mark Leonard started working as a venture capitalist. He worked there for 10 or 11 years, but then he realized that that wasn't really what he wanted to do because he didn't want to buy a company uh with the objective of selling it so he started to get the idea to to run a permanent investment vehicle and well he was looking at several industries and he found a vms industry which had everything that other industries like good industries had but lacked a growing TAM, a growing addressable market. So he basically saw an opportunity here

because there wasn't much competition. These were good businesses. And he would be able to own these businesses forever because they were resilient businesses. And that's sort of like, that's how he started Constellation. and then i i think he's been a core part well he is a core part of the thesis on constellation but i think he's less important now than what many people think i think he was really really important during the early stages of constellation especially because he looked for managers that

were excellent capital allocators like the average management tenure in constellation is around 20 years so they'll they have been a long time with him and he basically delegated from the very beginning the decisions to his operating group managers which is why i say that i don't think that he's so so critical for for the thesis now because if he were to leave the i remember reading in one of his president letters or i don't know if it was in the annual general meeting he said that almost all of the capital allocation decisions have been that had been delegated in the year 2005 so the his managers have been already 17 years allocating the capital of constellation and as you can see they've done quite well yeah and we we were kind

of talking about this before the show but he's not in the public eye and i'd be we got a lot of questions on twitter about his beard um but i'm not gonna i'm not gonna you can comment on that if you want but how do you think there's i guess do you want to talk maybe about the reasoning behind why he's so discreet and how does that play into how does that sort of low profile play into the compensation structure and maybe talk broadly about the compensation structure yeah so um mark leonard had a bad experience with the with the press when he was a venture capital so he decided like he they got some the media got some of his words out of context and he didn't like it uh i guess that's what the majority of the media does so i don't

know why he was surprised um so then he he decided to not be a public figure there i think there are like there's one picture on the internet or two pictures one of them is a screenshot of a youtube video that has been taken down like 10 times when people have tried to upload it and i think one of this this is the main reason why he is not a public figure but i think it also has to do with the fact that he wants to keep Constellation out of the spotlight because Constellation has a rather strange compensation plan if we compare it with the SaaS companies that we are used to. They have not issued one share since IPO,

but they obviously want their managers to be aligned with shareholders. so what so managers above a certain threshold of of pay are are forced so to say to invest their bonus in the company's stock and because they don't issue more shares they have to go to the open market to buy them so mark leonard is really interested in having a stock price that clearly tracks the fundamentals of the company. Because if the stock price goes too high, then managers are going to buy less shares with the same money. And they're not going to like it

because they will be obviously buying an overvalued stock. And if it goes too low, Mark Leonard argued, this was probably during the early days, if the stock price was too low, they were an acquisition target. And he didn't like that either. So he always made an effort to maintain a stable stock price. I think one of the ways he did it is by being out of the spotlight himself. The other way was by not being U.S. listed.

He remained in the Toronto Stock Exchange. There is a ticker in the U.S., but it's an unsponsored ADR. So Constellation has basically nothing to do with that ticker. And he also has done a great job in educating his shareholder base. If you read some of the transcripts of the annual general meetings, he is very focused on long-term investors. And he actually hates when there are traders around his stock. If you see the trading volume of Constellation, it's very, very low. uh he also had uh well this is like an anecdote but he also hates um index funds because they

he says that those when they go to the annual general meeting he always says like well these guys are here but we even count them as shareholders to be honest and he's if i'm not mistaken he's like he's sort of anti-share repurchases as well isn't he yeah um he doesn't he doesn't like well while i was researching the company one of like part of my thesis was well if constellation owns 700 cash generating businesses so if the thesis or the m&a strategy stop scaling uh there's some optionality in all this cash that the company generates to give out dividends or repurchase stock uh because the cash are the cash flows are not going to go away so it was like kind of a protection but then i read in one of his president letters that

uh he hates stock repurchases or buybacks because he thinks that if you a company starts doing buybacks they are doing so with insider information so to say and they are and the shareholders stop being shareholders and they become prey because you are going you're trying to cannibalize them so that's why he he hates repurchases and he hasn't done one single buyback since ipo like the shares the shares outstanding are basically the same but he has given out dividends he gave a special dividend not long ago but when he saw that when they turned to large acquisitions then he he cut this dividend and went back to the usual dividend don't you wish you could just hit skip on the worst parts of your life you know the same way

you can skip an ad i get it i'm siaya and i live in ice cove i've made some questionable decisions that didn't end up the way I planned. And today, I'm still figuring it out. Somehow, things usually get worse before they get better. Apparently, that's how I roll. So bundle up and come along for the bumpy ride. Stream a new episode of North of North Tuesdays on CBC Gem. Yeah, it seems very Buffett-esque of him that,

well, I mean, Berkshire's buying back stock now, but it's kind of similar, you know. I guess they're even more strict than Berkshire Hathaway. But that leads into the next question. You mentioned getting beyond these small vertical market software businesses. And a year ago, there was a great letter. It was kind of a big surprise, I think, for Constellation and specifically Leonard outlined two ways to continue growing at size. First one was moving to large VMS businesses. And then the second one was developing a new circle of competence. I think first question on that, what progress has been made on that front? okay so in in large bms they are already like the company is already doing these acquisitions uh constellation is very strict when it comes to capital allocation so they have set hurdle rates for acquisitions below 100 million and acquisitions above 100 million and if anything above 100 million is considered actually uh quite large so um they they always comply with

these hurdle rates regardless of the size of the company but of course uh they know that in large acquisitions they have to have a somewhat reduced hurdle rate because the competition is much more intense and they are more established companies in which the risk is also smaller so they typically were on a higher price they recently did the did the largest acquisition in the company's history which was 700 million and just to give a bit of context about this this size this is almost 50 percent of what the company deployed in in 2021 just in one acquisition so it's it was pretty large i i assume that they are going to keep doing more large bms acquisitions because it's impossible to have such a high capital base such a large capital base to deploy and deploy it all

in 3 million acquisitions, like acquisitions that are worth 3 million, 5 million, 10 million. It's just impossible, even if you are decentralized as they are, because there's a limit to decentralization. And on the other growth venture that you mentioned, that is moving to a new circle of competence,

I actually think Mark Leonard knows that this is really, really difficult. He actually says in the president letter and also in the annual general meeting, he gets asked about this and he says that the possibilities to find such an industry are very, very small. But I think it's positive for shareholders that management is thinking about diversifying away from VMS because we actually don't know. We know that the pool of VMS companies is really large. It's around 40,000 companies that can be potential targets for Constellation. But we don't know how the competition is going to evolve. maybe some companies emerge that are successful in copying constellations model and then prices

go up and that pool just so that constellation sees how that pool is reduced so if they want to find something that it's an alternative they have to start early which is which i think is what they are doing. But I honestly, as a shareholder, don't put much of my faith into finding another industry that has the same advantages. I do think that if this industry exists, then it's Mark Leonard and his team who are going to find it. But I actually can't come up with such an industry And I'm not putting my money on that venture being successful, to be honest. Yeah, I have a bunch of more questions, actually. But before we get to those, we're going to take a quick break.

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. Welcome back in. So I guess one question that was kind of coming to the top of my mind is that it feels like a lot of this, it feels like it's kind of in a transitional period for

Constellation where, and we already just talked about this, where they are having to find new ways to grow and so how much of the and i know we already touched on this but how much of that new strategy come as a shareholder comes down to just trusting mark leonard and trusting the team that they're able to do that well i think if you invest in uh in any serial acquirer the trust on management is the number one thesis because you are you're not investing in a product or in a service like it's not as if uh i don't know if you're investing in apple you know that their technology is quite good well quite good not it's excellent their hardware is one of the the best hardware there is so if management gets replaced you more or less can say okay so

they can work with what they have but in when it comes to serial acquirers um it's you're investing in management's ability to allocate capital i think trust is the the number one characteristic that you have to look for in in acquirers i think mark leonard and his team has may have made an awesome job at building trust among shareholders i have been here like i have been a shareholder for a couple of months now and i have read the president letters since the year 2007 and just by reading the letters i think you can get to trust uh mark leonard because you you can see that what he said in 2010 it's becoming a reality in 2018 like everything he says he's actually uh he actually goes for it and in most occasions

achieves it so there have been it's not it's not a conventional company if you if you look at what management has done in some occasions that could be red flags for any other company for example they stopped um reporting return on invested capital because they thought that that metric was not relevant anymore maybe for another company that would be a massive red flag but But for Constellation, people trusted Mark Leonard. So they said, okay, I believe that this is not the relevant metric. Let's look at another metric. So I think all the shareholders have to trust what they have done because there is no reason not to trust them.

Maybe they screw it up, but I highly doubt it, to be honest. Yeah. And let's talk about valuation. uh i believe we were kind of talking about this before we uh hit record but the uh i think it trades at around 40 times it's trailing free cash flow how do you go about valuing constellation and then what do you think needs to happen for them to generate acceptable returns from here okay so when it trades like 40 times cash flow is their their free cash flow available to to shareholders metric uh this metric is a bit special because they for example this year like

in q4 the the metric decreased uh so that was if you don't have context you look at that metric and say, whoa, free cash flow is decreasing, that's not good. But it's because they included a non-cash expense in free cash flow. They didn't adjust for a non-cash expense, which was kind of weird, but it was a revaluation of a liability. But I guess that if they do it that way, it's because they think that it's quite probable that they'll have to pay it out. so they are not taking it to account like shareholders own it if you do it with the

traditional free cash flow way which is operating cash flow minus capex then the company is trading at around 30 times uh free cash flow which is not cheap obviously but it's more more in line which with the company's valuation over the last years. I think there's been quite significant multiple expansion because people have come to realize that the M&A strategy can scale a lot more than they thought it would. So if Constellation was valued at, say, 10 times free cash flow or 15 times, I think that reflects that people thought that it could not scale more, but now it just posted a record year in acquisitions.

For example, they made 95 acquisitions, which is a record. And they have deployed in the last three years like 50% of the capital that the company has deployed in its history. So I think people have come to realize that. And also, it's a bit tricky because if you see a high multiple, you also have to take into account that with all the cash that they are allocating now, the multiple is going to contract a lot faster. Because when all of the new acquisitions start to play a role in the free cash flow, like in the denominator, then the multiple will contract probably next year will be much lower if the company doesn't move from here, which I don't think it will happen. but i i think that valuation in in the case of a serial acquirer is so complicated because um it is not depending on on sales it's dependent on what acquisitions they do when they do them like you have to go into management heads to do that like imagine if you valued constellation

one month ago, and you projected that this year they would deploy, I don't know, $1 billion in acquisitions, and then they come out with a $700 million acquisition in one day. It completely changes the landscape. Right. How big is the world of the small software providers? Is there still a ton of room for them to acquire companies that way obviously it won't move the needle as much but is like do you know sort of the i guess the the potential acquisition target site like how many are there yeah according to to management there are around 40 000 um vms companies that could be acquired by constellation And considering that they have acquired 700, I think the penetration is quite low yet.

However, the difficult thing about constellations like M&A is that it's not like if you go out and say, okay, I want to buy this company, I do it in one week. I like what they do. The process takes years. so they contact they have i recall reading that they have a like a list of of potential acquisitions and they get in touch with with these founders two or three times a year just to maintain contact and so that if this if the founder wants to sell the first place where he goes is Constellation. So they're basically like building this acquisition base. And then

they're like working very hard to, so that they are loyal to them in case they want to sell. And this is really what's complicated because, and it's also part of their moat because it takes a lot of years to start building this model. So if now a new competitor comes in and wants to copy constellations model well to do his first acquisition maybe he has to be in contact with uh with an acquire like a potential acquirer for two or three years so how are you going to do that are you going to be without a single acquisition and then in two years you're going to announce your first acquisition i think that's part of the remote to be honest can you explain the topic is spin i don't know if i'm saying that name right

But that is a little confusing maybe for a first-time shareholder. Yep. So Constellation acquired two companies that were called Total Specific Solutions and Topicus. And then management decided to spin them off. So they merged them and spin them off as a standalone company that now is called Topicus.com. That is actually one of the six operating groups. The Constellation owns around 30% of Topicus.com, but has a super voting share that gives them like 50% of the voting rights.

The rationale behind the spin-off, well, we have not said this, but there's another source of growth for Constellation besides acquisitions, which is organic growth. So they have 700 companies, and if the 700 companies in the portfolio grow organically, then Constellation also grows, obviously. This has been typically low, and it's just a consequence of the industry because times are capped and well a company cannot grow further than than its market so topicus was a was a company that was really good at it's another serial acquirer that was really good at growing businesses organically so now the the objective is more or less to

after the spin-off is to share the lessons that they get from topicus from topicus organic growth and try to apply them to the rest of the operating groups to see if they can pick up organic growth too the the the spin-off is really messy like with the preferred shares and everything and all the parties involved so there's a lot of noise in this year's uh financial statements both for constellation for Topicus because when the shares converted, that created a non-cash expense. The companies appear to be less profitable than what they really are. It has created a bit of delusion in the case of Topicus. The rationale behind it is trying to pick up organic growth. you you talked about how constellation is being a serial acquirer it's it's like hard to value

are there any like individual metrics that you're watching to see how shareholder value is growing yeah i would i would look at a free cash flow available to shareholders uh well you should look at that metric per share but here it's not really relevant because the shares outstanding are always the same because that's basically the money that belongs to you as a as a shareholder that has been compounding nicely over the the last uh two decades well no yeah two decades less than two decades 15 years i think a constellation has been publicly traded and i also would focus on return on invested capital although i think that return on invested capital is a more difficult metric to to track because if constellation now um starts to deploy a lot of capital

its return on invested capital is going to go down because you are increasing a lot the denominator which is the average invested capital but the the net income is not increasing automatically so then you're going to see like a drop in return on invested capital that is not you shouldn't really trust because the results of the investments are going to are on a longer time frame and well mark leonard also always says that they are going to return to the mean when it comes to return on invested capital but the truth is that they are returning much much slower than than most of the companies so they do seem to have a very strong competitive advantage and those two metrics i think are the the most important when tracking constellation i would

say that also the number of acquisitions is important because you get a feel of of how the M&A strategy is scaling. So for example, if I were to see that next year the Constellation just does, I don't know, 20 acquisitions, then I would get a bit worried because it would mean that most of these acquisitions would have been large and they are not doing smaller acquisitions, which they also can do

at lower levels, like at the business unit level. And another metric to track, everything is about acquisitions. I would also look at organic growth, especially after the two ventures that if we want, we can talk about them now. The two ventures that the company has in place to try to increase organic growth. I will also look at what percentage of operating cash flow the company is being able to deploy in acquisitions. because a number close to 100 would mean that the company has plenty of opportunities to deploy the capital.

But a number close, for example, to 20% would mean that 80% of the capital was not deployed probably because none of the acquisitions in the market met the company's hurdle rate. And that would be worrying because that would mean that the market is getting very competitive. And then probably Constellation

would have to lower hurdle rates if they want to keep deploying that capital-based. Is there a ceiling to how much they can invest? Well, there surely is a ceiling. I don't know where it is. But the thing is that if you take what they have done with small and medium-sized BMS companies, they have been able to go from 10 yearly acquisitions

to 100. And now that they are turning to large acquisitions, well, the ceiling is difficult to draw a ceiling because maybe they do in the future 20 or 30 large acquisitions per year. And that's a lot of capital deployed. So I think it's probably very difficult that the company does 100 large VMS acquisitions because the large acquisitions are not delegated to the business unit level. So they are mostly done at the operating group level, joined with the headquarters where Mark Leonard is. There

surely is a ceiling, but I don't think it's close, to be honest. I think that the company has demonstrated that it can scale, and I don't see why they will not be able to apply that scaling to larger acquisitions uh you had a i think we i may have missed it but you want you wanted to follow up on the organic growth thing uh the two things they're doing there do you want to hit that before we have the last question here yep so the company has basically like we said before that organic growth has historically been pretty low um the company is trying to pick that pick up that growth because they know that it's also important for the basically because higher organic growth also increases your capital base so you

have more money to deploy um and they have done one to like two ventures to to try to to pick this up one is we already talked about it is the topic spin-off and then sharing the the best practices are across the other operating groups and the other one is the company open recently open um a vc fund a venture capital fund where they will be investing in around 20 to 40 companies in the next uh three to five years um and they are going to invest basically in high-growth VMS businesses. They know that they are probably going to pay more. Obviously, its venture capital is going to be riskier.

But they are interested in the best practices that they can learn from these companies to later apply to the whole portfolio. I like how Mark Leonard frames it because he says that they're investing into this VC fund, $200 million. And he basically says, like well uh if it goes well then organic growth is going to be much better because we're going to

be able to to pick that up and if it doesn't go well uh it's like 200 million and we're making more than 1 billion in free cash flow in a year so it's not like we are like betting the farm on this venture so it's basically uh they see it as a win-win i do too because i think organic growth has much more potential than it's showing and those are like the two ventures that the company has set up to pick up organic growth which i think is also an underappreciated growth lever for the company many people are focused are really really focused on the acquisitions and i understand because it's the majority of the growth for the last decade has come from acquisitions and not organic growth. But the impact of increasing organic growth two or three percentage points

per year are going to be huge over a long timeframe. Do you think the reputational advantage that Constellation has developed in the VMS space translates to venture capital, or is it kind of just a different, I guess, ballgame? Do you think they can take that like long-term owner principles to the vc world well i don't think i don't think that would be a a problem in the for the vc fund because constellation is trying to incentivize internal employees to be the ones who are starting the the new the newly created bms companies so um of course they will also look at projects that are outside of of the constellation universe but they would prefer if it would come from the inside because they know

that they are talking with someone that knows how constellation operates uh so i don't think that reputation is going to play a really important role there but if it's for a third party i do think that a vms owner that starts a new business would like to be under constellations umbrella because it's the largest owner of vms the vms companies worldwide all right last question here what could go wrong with an investment in constellation software okay so for me the the The biggest risk is that the company increasingly goes to larger acquisitions. Well, this is going to happen. The company is going to increasingly make more large acquisitions.

But if competition gets intense there in the large acquisitions and they start to run out of ideas, then two things can happen. One is that management will return this capital to shareholders, maybe mostly through dividends. Maybe even Mark Leonard changes his mind and does some buybacks. But the worst thing would be that Constellation is forced to decrease its hurdle rates to be able to compete in the large VMS industry. uh i don't think this will happen over the short term to be honest because if they're they are able

to find uh opportunities in such a hot market like we have now in in software businesses i don't see why uh this will not be the case going forward especially as things cool down a it, which they probably will. And also, I think they are protected against this risk because they are so focused on the internal rate of return, and they are going for companies that other acquirers don't even dare to look at. For example, buying a company that is expected to decrease revenue 10% next year. That's not a business that many people want to own. So I think that's Constellation's advantage. But a lowering of the hurdle rates, I think, would hurt a lot the current thesis.

Okay, I think that's all the questions we have. Brett, do you have any more? Leandro, did we miss anything that's important to Constellation? No, I think we touched mostly everything. Okay. Where can listeners find you? uh on twitter it's at invest quotes or seeking alpha at best anchor stocks okay perfect uh without further ado we want to remind our listeners that brett and i are not financial

advisors anything we say or discuss here on chit chat money is not formal advice or recommendation we are however general partners at arch capital so clients may have positions and securities discussed in this podcast thank you all for listening we'll see you next time We'll see you next time.