Constellation Software’s model is still working, this investor says

Enterprise software and growth-by-acquisition story Constellation Software (Constellation Software Stock Quote, Chart, News TSX:CSU) has lost some ground over the past couple of weeks, potentially giving investors a great entry point, and despite worries that the stock has been flying too high over the past 12 months, Ryan Modesto of 5i Research says Constellation is built to last.

“Constellation Software is one of our favourite companies that we've been covering, pretty much since day one at 5I Research,” said Modesto, CEO at 5i, who spoke to BNN Bloomberg on Wednesday.

“It’s a higher valuation name so there’s volatility and from time to time they'll have five-per-cent swings, things like that so you really got to think in terms of years with a company like this.”

CSU has been a dream of a stock for a number of years now, returning 230 per cent over the past half-decade with a steady growth profile and relatively few hiccups along the way.

It looks like we’re in one right now, however, as a combination of a poor reception to its latest quarter and this week’s market tank have pulled down the stock almost nine per cent since a February 13 all-time high of C$1524.42.

On that date, Constellation released its fourth quarter 2019 financials, which featured revenue growth of 15 per cent year-over-year to $956 million for the Q4 and growth of 14 per cent for the year to $3.490
billion. (All figures in US dollars except where noted otherwise.)

At the same time, all of that top line growth came through acquisitions, as Constellation’s organic growth was shown to be negative three per cent for the quarter and negative one per cent for the year. As well, CSU showed a Q4 net income decrease of 49 per cent to $92 million or $4.34 per diluted share.

But Modesto said Constellation’s proven formula is showing little signs of wear and tear.

“They’re a vertical markets software (VMS) company and vertical market software is niche software for very specific purposes, specific clients, and that's kind of where their bread and butter is,” he said. “It’s hard to compete in this space because often they have deals with governments institutions, things like that, and that specific software piece, it’s hard to develop that software. If you're a larger company it's hard to muscle in and steal those contracts away. So the contracts are kind of sticky that they tend to be higher margin because of that specialization piece.”

“What Constellation Software does is they come in and buy these companies at attractive valuations, essentially harvest those cash flows and then redeploy them into other companies,” he added. “There are a lot of VMS companies out there and Constellation has had a lot of success doing it.”

Modesto pointed out that over the years, the concern arises that keeping up its growth rate should theoretically get tougher as the company expands. Yet Constellation has been able to make the right adjustments to its strategy along the way, he noted.

“They've sort of pushed down decision making responsibility in terms of acquisitions down to lower levels of management to help increase the pace of acquisitions. So far it seems like it's working and their pipeline of acquisitions has been improving,” Modesto said. “A solid company overall.”