This year I had the opportunity to present Constellation Software at the Intelligent Investor Conference (formerly ValueX Vail). It’s always a pleasure to ezchange ideas with other thoughtful investors. I always leave energized and with a list of ideas to resarch.
My slides and talking points are below.
Slide 1 — Title
Hi, my name is Matt Franz and today I’m going to discuss Constellation Software.
Slide 3 — Elevator Pitch
Constellation is a serial acquirer of VMS business. VMS stands for Vertical Market Software. I’ll explain what that means in a moment.
The stock has fallen 50% and now trades at 15 times free cash flow. This is a compelling valuation for a high quality business.
The stock fell over fears of AI disruption, the founder’s recent retirement, and concerns about the pace of capital deployment.
My view is that these are overblown and unlikely to impact the company meaningfully.
Slide 4 — What Is VMS?
VMS is hyper-specialized software for niche industries.
For example, Constellation owns businesses that
- run public transit for cities
- handle the billing for water utilities
- act as the operating system for country clubs, and
- manage operations at grain elevators.
They are not household names. They work behind the scenes and touch aspect of the global economy.
VMS are unusually good businesses. They are mission-critical, deeply embedded, have high switching costs, and low churn.
Customers cannot operate their business without Constellation’s software.
Despite this, Constellation prices for value. The average customer pays Constellation less than 1% of sales.
This is a strong value proposition and why Robert Smith called software “better than first-lien debt” back in 2018.
VMS produces predictable cash flow, driven by maintenance and SaaS fees, and benefit from fixed cost operating leverage as they grow.
These qualities make VMS good businesses. They also make VMS less vulnerable to AI disruption than your typical software business.
Slide 5 — Cumulative Acquisitions Graph
The problem with VMS is that they are small businesses with small addressable markets. Constellation typically buys them for a few million dollars, which is too small for private equity or venture capital.
Constellation was built to acquire lots of tiny VMS businesses, aggregate their cash flow, and use it to buy even more VMS businesses.
That’s exactly what they’ve done. They’ve made over 1,200 acquisitions since 1995, spread across 100 countries.
Slide 6 — Cloning High Performing Conglomerates
To make 1,200+ acquisitions over thirty years requires an unusual organization and culture.
When Mark Leonard founded Constellation, he studied conglomerates that performed well for several decades.
Two key insights came from this: the power of incentives and importance of decentralization.
Constellation pushes all business decisions to the lowest level, the business unit manager. Headquarter’s job is to distill beat practices and coach, not to manage.
Constellation even decentralized acquisitions. This is critical because it allows them to make hundred of acquisitions for just a few million dollar each every year. If M&A was centralized, like at Berkshire, Constellation would have to hunt for larger prey.
Even though there is extreme decentralization, there is a culture of high accountability.
Constellation rigorously measures its subsidiaries performance. Its favorite metric is the sum of ROIC plus Net Revenue Growth. That’s because improving one usually comes at the cost of the other.
At some Constellation events, managers have been required to post their numbers on their name tags.
Slide 7 — FCF & Stock Price
This has all worked out financially for them. Free cash flow has compounded at 26% since the company’s 2006 IPO. The stock has done even better, even in spite of its recent draw down.
Crucially, Constellation has not issued a single share since their IPO, which is highly unusual for software businesses. All of these economics have flowed to common shareholders.
Slide 8 — Source of Growth
Constellation’s growth has primarily come from acquisitions, not organic growth. M&A is the main driver of business results.
Organic growth has averaged just 1.5%, which is similar to the rate of inflation over this period. Being mission-critical, Constellation’s businesses has untapped pricing power. This is one of the most valuable qualities a business can have. If inflation were to run hotter, Constellation would likely be able to pass that through. This would materialize as higher organic growth.
Constellation intentionally does not push price in order to maintain a trusted relationship with its customers. It also does not want to create a pricing umbrella that invites competition.
Slide 9 — FCF Graph
Constellation used to trade for an extraordinarily high multiple, but recently its valuation has come crashing down to Earth, just like most software stocks.
Slide 10 —- Risk 1: AI
Now that we’ve talked about the good, lets talk about the bad.
Slide 11 — The Code Is Not The Moat
AI has reduced the cost to produce code, no question. But writing code is just one piece of a software company’s value, and it’s not Constellation’s moat.
Constellation’s moat comes from its close customer relationships. Its had customers for decades, who trust the operations of their business, and their livelihoods, to Constellation.
Constellation has spent those decades learning about their customer’s businesses and their workflows.
Constellation’s prices are already low relative to the value it provides, so there’s no room to undercut it. And Constellation’s software is mission-critical and deeply embedded, making the cost of switching high.
There are banks, even large money-center banks, which still run operations on mainframes running Cobol. Cobol hasn’t been high tech since the 1970s. That ought to tell you something about how switching costs and delay change, even in the face of technologic superiority.
Slide 12 — 1,500 Watertight Compartments
Constellation’s decentralized structure give an advantage when navigating change. Each business unit is left to respond in its own way. Headquarters looks at what’s working, distills best practices, and distributes them.
Constellation never has to make a top down, bet the company judgement call. The right answer arises organically.
Slide 13 — AI As A Tailwind
AI may even be beneficial to Constellation in a few ways.
First, it can roll out new products and features faster. As an incumbent, Constellation knows what its customers need and can bring those features to market fast.
VMS may embed AI models and act as the distribution and routing layer for them, which might be a pricing opportunity.
And a shift towards outcome based pricing could be disruptive, but also more lucrative, just as incentive fees tend to be larger than management fees, just less predictable.
Slide 14 — Risk 2: Capital Deployment
Slide 15 — M&A Is Systematic
Constellation does not wait around for the phone to ring. It treats M&A like a repeatable, data-driven industrial process.
They’ve built 40,000 relationships with VMS founders. These are not names purchased from a broker’s database. They are personal relationships. Constellation checks in with each one 3-4 times per year.
This helps Constellation learn about this business and build trust with the founder. It also keeps Constellation top of mind so that they are the first phone call wen the founder wants to sell.
Slide 16 — Lower Software Valuations Are A Tailwind
As Buffett says, if you are going to each cheeseburgers your whole life, you should root for the price of cheeseburgers to go down.
The price of VMS businesses have begin to decline, which benefits acquirers like Constellation.
They’ve ramped up capital deployment to the fastest in two years.
If AI leads to more software, there will be an ever-expanding pipeline of M&A targets.
Slide 17 — Beyond Niche VMS M&A
Beyond its core M&A, Constellation has begun investing in public equities as a minority, engaged, and permanent shareholder. Public valuations have declined faster than private valuations, and they’re leaning in. They’ve also done special dividends and spinoffs in the past. And they are studying other industries they could invest in.
Constellation’s management is thoughtful and aligned.
Slide 18 — Risk 3: Leadship Change
Slide 19 — Risk 3: Mark Leonard Steps down
Founder Mark Leonard recently announced that he was stepping down for heath reasons. I’m not worried because cultures tend to be sticky, for better or worse.
Mark Miller is taking over. He founded Constellation’s first acquisition, Trapeze Group, and joined Constellation in 1995, so he’s literally been there since day 1.
Slide 20 — Forward Returns
Here’s how I think about the stock’s forward returns. Constellation is dependent on its M&A engine to continue firing and for the inherent advantages of VMS to protect it from AI.
If it does I think shareholder do very well from here.
Slide 21 — Questions
EPC offers separately managed accounts, low minimums, and accepts most account types (including IRAs and 401k rollovers). Qualified Clients can elect a zero management fee structure inspired by the Buffett Partnership. EPC’s clients get complementary access to our premium Substack. To learn more please email info@eaglepointcap.com.
As a CSU summer intern, happy to see you on board the train man!!
Nice bro! Just followed 🔥