I underestimated Constellation Software, this investor says

Shane Obata has no problem admitting when he missed the boat on a trade, in this case with Canadian tech company Constellation Software (Constellation Software Stock Quote, Chart, News, Analysts, Financials TSX:CSU).

“I’ve made two mistakes with Constellation,” said Obata, portfolio manager at Middlefield Capital, who spoke on BNN Bloomberg on Wednesday. “The first one was not owning it early enough and the second one was selling it too early.”

Obata is surely not alone in underestimating Constellation Software. The company with a knack for acquiring niche software businesses and funnelling their cash flows into further acquisitions has had its strategy scrutinized by all-comers over the year, and while it invariably comes out on top, the question remains: how long can CSU keep it up?

Constellation’s playbook involves vertical market software (VMS) companies, those whose products are aimed at a narrow range of applications but whose value for those special niche markets is proven. CSU buys literally dozens of such businesses on a yearly basis, looking to gain a high return on invested capital so that the acquired companies, typically given a lot of autonomy under Constellation, can then bring in cash to fuel more M&A.

Habitually taciturn when it comes to speaking on the company’s past, present or future outlook, Constellation’s chairman and founder Marc Leonard made waves earlier this year by putting out a letter to shareholders, a relative rarity for him.

Constellation announced it would be maintaining its hurdle rate — the minimum rate of return expected from an investment — on future small and medium-sized VMS acquisitions but would lower it for less frequent but large VMS acquisitions, a move that Leonard said would allow CSU to make use of its stockpile of cash in ways other than payouts to shareholders.

The result will be no more special dividends and, potentially, a loss of the company’s quarterly dividend, as well.

“The obvious first step is to stop special dividends in all but the most compelling circumstances,” Leonard wrote. “That decision was made by our directors at the [February 12, 2021] CSI board meeting. We have maintained the quarterly dividend for now, but if we are successful in finding better uses for our FCFA2S, the quarterly dividend will also be sacrificed.”

Along with making use of extra cash, part of the reason for the change in plans, according to Leonard, is to put Constellation in the running for a number of the large VMS businesses sold every year through M&A brokers and banks (Leonard put their numbers at between 40 and 70 per year). Constellation’s typically high hurdle rate, Leonard said, was preventing that access, and thus, the lowered rate Leonard sees as the ticket to those larger buys.

“Over the last five years, we were aware of about 80 per cent of the large VMS businesses that were sold, but their brokers only invited us to participate in 16 per cent of the sales processes,” Leonard said.

“We are building a small, dedicated team at head office to pursue large VMS acquisitions and to work with M&A brokers. If we drop our hurdle rates for these acquisitions, I believe that competent and diligent M&A brokers will include us in more auctions,” he wrote.

The market seemed to approve the move, having lifted the stock in recent months to a respectable five per cent return year-to-date —not bad in the context of a poor first half of 2021 for tech in general. Constellation Software finished 2020 up 31 per cent, while for the past decade, the stock has returned about 2,300 per cent.

Obata says Leonard’s competence at the helm is above reproach, which should make investors feel at ease with investing in the company.

“I think the Constellation business model is great, and Mark Leonard is pretty much a legend already,” Leonard said. “Their model is repeatable, it’s scalable and it comes down to a very disciplined process for capital investment and what they look for in their companies. So, I think it’s a great name.”

“I got a little bit scared of the exposure, but this was unjustified. When tech valuations were really skyrocketing earlier this year that made me think that perhaps this wasn’t the best environment for a growth-by-acquisition model. And then, obviously, subsequent to that we saw a severe re-rating in a lot of higher growth areas but that’s perhaps not the best way to think about it,” he said.

“I think Constellation is a good long term hold, definitely,” Obata said.

Constellation reported its first quarter 2021 financials in May, showing revenue up 23 per cent year-over-year to $1.176 billion and a net loss of $175 million compared to net income of $83 million a year earlier. The company completed acquisitions for total consideration of $448 million over the quarter.