Constellation Software is undervalued right now, this investor says

Canadian tech stock Constellation Software (Constellation Software Stock Quote, Chart, News TSX:CSU) has done relatively well in 2020 but there should be more upside from here, says portfolio manager Jason Del Vicario, who thinks even with its gains over the last few months CSU is looking like a cheap pickup.

It’s been a mixed year for Canadian tech stocks so far, with some names doing very well in the COVID-19 pandemic environment —Shopify anyone?— while other well-known companies like Open Text and CGI Group
which one might expect to have prospered are not bringing in the big returns.

The work-from-home economy was said to be a tailwind for the technology sector as businesses across the board seek to boost their online performances and build up their networks and infrastructure. And while that may be the case, the market has paid attention to some areas like e-commerce, where SHOP is up a whopping 170 per cent for the year, while failing to reward others: OTEX is now down three per cent
year-to-date and CGI is down 17 per cent.

Put Constellation Software somewhere in between the two camps. CSU is currently up 20 per cent for the year, with much of those gains coming in the first half of the year. Over the past few months, the stock has been mostly trading sideways.

But the middle-of-the-road share price appreciation shouldn’t be a turnoff, said Del Vicario of HollisWealth, who spoke on BNN Bloomberg on Tuesday and argued that Constellation’s fundamentals should be looking attractive to investors right now.

“It’s not uncommon for me to be on here talking about Constellation Software,” said Del Vicario, “but what is uncommon is that I’m rarely able to recommend them as being reasonably valued, or I’ll even go out on a limb here and suggest that they are undervalued.”

“Their free cash flow yield is north of four per cent right now for a company that has been growing their free cash flow at 30 per cent a year for the last ten years. And even if that drops to 20 or 15 per cent, they are cheap,” he said. “A 4.25-per-cent free cash flow yield — that’s very compelling value.”

A serial acquirer in the tech space, Constellation makes its bread and butter buying up often smaller software companies that fill niche, vertical-specific markets and continually reinvesting earnings in new acquisitions. The practice has worked for CSU, which has seen its share price balloon from about the $50 mark ten years ago to now above $1,500 per share. Constellation seems to be faring well during the pandemic, too, posting revenue that was up nine per cent year-over-year for the second quarter 2020, with net income up 12 per cent.

“I won’t go on about how we absolutely love the management team and the way that this company is run because I’ve talked about that ad nauseum,” Del Vicario said, “but they are cheap at these levels.”

Part of CSU’s management savvy was recently on display when last month the company announced plans to spin out Netherlands-based vertical market software company Topicus, whose acquisition by CSU was first announced earlier this year, and list it on the TSX Venture Exchange. The new public company will have 4,250 employees, reported sales of €518-million last year and be will focus on M&A activity in Europe, while current CSU shareholders will receive 1.86 Topicus shares for each Constellation share.

“Under the proposed transaction structure, Constellation will remain a significant shareholder of Topicus.com and the current Constellation shareholders will be entitled to receive, pro rata and by way of a dividend-in-kind, subordinate voting shares in Topicus.com Inc,” said Constellation in a press release.

According to Scotia Capital analyst Paul Steep, the move is seen as part of CSU’s attempt to bolster its expansion efforts .

“Our take is that the Topicus acquisition demonstrates that Constellation can win against private equity competitors in situations where price isn’t the only consideration; Constellation is demonstrating its ability to use innovative and complex deal structuring to win over sellers,” Steep said, speaking to the Globe and Mail.

“[Constellation’s] ongoing merger and acquisition activity over the past 12 months validates the steps that Constellation took in modifying the organizational structure to support an increased acquisition pace, with the firm having delivered a material increase in both acquisitions and total capital deployed over the past several years,” Steep said.

Constellation announced the agreement to buy Topicus in May, saying it would combine the company with CSU’s own TSS operating group and subsidiary TPCS Holding B.V. to form the new company Topicus.com. Constellation president Mark Leonard said the move to create a new public entity was part of the discussion in acquiring Topicus.

“They didn’t want their legacy disappearing into the craw of an omnivorous conglomerate,” said Leonard in a press release. “While they knew that Topicus would have autonomy within Constellation, they also wanted identity. The public listing is expected to afford our Netherlands-based businesses a platform from which to celebrate their culture and achievements.”