Constellation Software knows how to allocate capital

By Seleho Tsatsi

The Canadian holding company of Volaris, which made a takeover pay for SA’s Adapt IT this year, has strong financial fundamentals worth a look.

Adapt IT is currently the subject of a bidding war between JSE-listed Huge Group and Volaris, the subsidiary of a Canadian company called Constellation Software. We own Constellation Software in our funds on behalf of clients and we believe that the share is worthy of consideration for those investors looking to allocate capital to offshore equity portfolios.

Constellation Software focuses on acquiring what it terms “vertical market software businesses”. These software businesses are in a variety of “vertical markets”, from marine asset management to catering and parking.

Constellation has a fantastic long-term track record. The share listed in 2006 and has compounded at a rate of more than 40% per year between 2010 and 2020. This was driven by good operating performances. Earnings per share (EPS) grew at a compound annual rate of 31% between 2010 and 2020. Understandably, growth has slowed down as the business has scaled up. Nevertheless, its operational performance remains impressive even when assessed over a shorter time frame – EPS grew by 20% per year from 2015 to 2020.

We believe that Constellation’s moat is its attractive offering to potential acquirees that rival bidders may not always be able to match. Constellation offers potential acquirees three important things – autonomy, a permanent home, and access to hundreds of peer companies. Sometimes a founder is looking to sell their business but wants to continue to be in charge going forward. Whilst Constellation does offer advice to its subsidiary teams, it does not look to install new management teams in the way that a private equity firm might do. Another important distinction between Constellation and the average private equity firm is that Constellation can offer acquirees a permanent home. Private equity companies generally acquire businesses with the intention of exiting a few years later, ideally at a handsome profit. Constellation has an “acquire-for-keeps” mentality that may be more attractive to a prospective seller who does not want to be up for sale again in a few years. Finally, as the owner of a significant number of software companies, Constellation can give acquirees access to hundreds of peer companies’ insights and networks.

Highly acquisitive companies can be a cause of concern for investors and rightfully so. “Roll-ups” can show sparkling share price performance for years before unravelling quickly. However, we believe that there are important differences to keep in mind when thinking about investing in Constellation. First, Constellation does not take on debt to make acquisitions. The company has been in a net cash position for the last few years. Second, Constellation does not issue shares to acquire companies. In fact, Constellation’s share count has remained static at 21.192m shares over the past decade. The company can do this because it invests in businesses that are very cash-generative. Finally, returns on capital have remained high over time, suggesting that Constellation is not acquiring increasingly less profitable businesses over time to keep absolute growth rates looking good (see graph).

The quality of management is particularly vital for highly acquisitive businesses. Such businesses need management that is honest, able, and aligned with shareholders. We believe Constellation’s management has all of these attributes. The CEO is Mark Leonard, who founded the business in 1995. Leonard’s letters to shareholders are praised in financial circles for both their insight into the business and their frankness with shareholders. The company’s ability to allocate capital has been demonstrated over a long period of time, both by the share’s total return and the growth in its earnings and free cash flows. Finally, Leonard is also the biggest individual shareholder of Constellation, owning around 2%.

In our view, Constellation still has a good runway for growth. We don’t expect the business to compound earnings at its historic 30%-plus rates since it’s only natural that increased size makes prospective growth harder. However, we do believe it can grow at a mid-teens rate over the next few years. The vertical market software sector is very fragmented and this is conducive to opportunity for Constellation. Future opportunities will also be a function of valuations in equity markets. Naturally, we would expect the company to be less active as valuations for software companies and the broader equity market become less attractive.

Constellation Software has many of the attributes we look for when considering businesses in which to invest. It is capital light, earns high returns on capital, and management has a good track record of allocating capital as well as a meaningful stake in the business. Finally, there is still a runway for growth and the valuation is attractive. Given this outlook, we believe Constellation is an attractive investment opportunity now. ■ editorial@finweek.co.za

Seleho Tsatsi is the co-manager of the Anchor BCI Global Technology Fund.