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Constellation Case

September 23, 2017 10:37 AM

Introduction
• John Sikes is an equity analyst at LLY Capital - wants to invest in Constellation Software Inc.
(Canadian software maker) that is earning high returns on invested capital deployed
○ Rejected before, because it didn't meet the fund's investment criteria
▪ Low analyst coverage
▪ Small market capitalization
□ Either strong competitive advantage or
□ Low P/E ratio and low P/B ratio
• Stock price is now $74.75 a share, more than 2x what it was PY
○ Just need to make sure it passes both investment criteria
○ Also trade at a discount to its intrinsic value

Business Overview
• Global provider of enterprise software to 42 different vertical markets
○ Acquire, manage, and build vertical market software (VMS) businesses
○ Vertical market = market that supplies goods to a specific industry
• Company had 2 main segments
○ Public sector - software to serve government clients
○ Private sector - software to serve commercial customers

Enterprise Application Software Industry
• Moderate industry growth from 2009 - 2010
○ In Canada, revenues for software/computer service reached $43.8B in 2010 (2.9% CAGR
since 2005), and 11.5% net profit margin
○ In USA, revenues were $150.7B with 2.3% CAGR since 2005, and 20% net profit margin
○ Overall prediction is for next 5 years, software would grow annually at 2.9%
• During 2009, due to recession there was a 4.1% revenue decline (but 3.6% increase in Canada
due to stable performance)

Vertical Market Software
• VMS is subsection of applications software sector
○ Companies make software solutions that help businesses improve productivity, be cost-
effective, boost sales, and improve customer services/satisfaction
○ Each VMS sector had high market concentration and high switching costs = favorable
market structure to Constellation, who targets small/medium businesses in market
niches
• Large player, Oracle, dominates the horizontal applications market
○ Vertical markets are too small for them to enter
○ Existing vertical markets were quite saturated already (everyone had a provider)
○ Also, these are small markets so big players don't find incentive to go into it

Competitors
• Product features, availability of high-quality maintenance & support, knowledge of software
vendor's sales team, and price (4 major factors)
• Large companies do compete with CSU in select markets, but rarely offers industry-specific
solutions to meet exactly what each vertical market needs
• Few companies competed in major verticals that CSU operated in- but overall across 42
markets, they had a lot of competition

1. Tyler Technologies
• Based in Texas, focuses on education, government, legal, public safety, transportation (mostly
public sector)

AFM 479 Page 1

engineering. and paratransit operators) ○ 1995 to 2006. governments. HR.ROIC of 8% • Thinking of expanding via acquisitions in other vertical markets • Cash rich and low leverage. Birch Hill Equity Partners. it's not been great financially . service & supply chain management • They are the biggest competitor in application software • Asset base of US$28B . Debt to capital ratio = 10% (likely strategic acquisition for VMS companies) 3.2% ○ Birch Hill held 16. IT.directors. public sector) • Competes with CSU on acquisition candidates (they serial acquire as well) • High return on invested capital (ROIC) 16% in this sector • They haven't been getting much revenue growth.would invest in this segment first Company Background History • CSU founded by Mark Leonard (venture capitalist). Trimble Navigation Limited • Based in California.) and emphasized on maintaining revenues for the business (can give insight to whether long term intrinsic value is up or down) ○ He wants to increase shareholder value and intrinsic value Ownership and Management • High insider holdings . and other organizations • Largely horizontal in nature to focus on this segment • Unlikely to directly compete with many of CSU's vertical markets • ROIC has been increasing the last 5 years. with $25M investment from OMERS. 2 holds) • Many of CSU's shareholders are patient to hold it for long term investment. sales. they made 45 acquisitions in other vertical markets. execs.has huge financial ability to acquire VMS companies • But their priority is building/acquiring horizontal applications (ROIC of 15% and 21% operating margin) • Unlikely to be a direct competitor in VMS segments 4. marketing. SAP AG • On-premises and software-as-a-service solutions via cloud computing for various sectors ○ Asset management. and revenue grew 20% in 2010 (indicating their segment is still in a growth phase) .3% ○ OMERS held 34. Manhattan Associates. procurement. R&D. focuses on asset management and agricultural verticals ○ Optimize scheduling/routing of field service technicians • But due to saturation of its vertical. principal shareholders (OMERS. only 1/11 of the shares have changed hands in 2009 • Organizational structure was highly decentralized . and want to expand geographically via acquisitions in the public sector vertical 2. • Supply chain commerce software solutions for retailers. finance. Inc. corporate strategy & sustainability. went public in 2006 • Leonard's focus is to operate CSU as if it were private company (did annual letters.CSU only had 2 vertical markets (public transit. manufacturing. exec officers and directors held 16.because of so many acquisitions and diverse markets Senior executive positions were mainly filled from within the company AFM 479 Page 2 . and Ventures West Capital (Leonard's people) ○ Focus on great businesses too small to attract notice ○ Helping theses businesses grow/improve operations helps get greater ROIC than large scale acquisitions • 1995 .5% • 5 analysts had stock recommendations for CSU (3 buys. etc. manufacturers. wholesalers. Birch Hill) holding 67% of the 21.2M common shares ○ Of this.

resolves their issues on a timely basis. they need to increase market share by acquiring competing players in that vertical □ Dominate.they'd seek acquisition candidates to get high ROIC ▪ Managers of these companies are usually kept by CSU to leverage their knowledge AFM 479 Page 3 . and is at a fair price (usually 1% of revenue annual cost) • In 2010. CSU takes their suggestions/feedback into new versions of mission critical software.5% of sales • CSU also provides mission-critical software solutions to customers (depend on CSU) ○ Customers aren't likely to cut on CSU contract even in economic downturns ○ Maintenance revenues are stable even during recession • 3 main sources of revenue: ○ Licenses (new software bookings. usually one-time purchases . CSU made 21 acquisitions for initial cash $91M and $6M in holdbacks ○ Helped enter new markets like health clubs.because they don't depend on just one industry group boom and bust cycles ○ Public is less volatile than private (government IT spending was less sensitive to economic cycles) • Broad customer base of 10. legal) • They set only certain benchmarks and best practices. held 3-5 years in escrow before they can be sold Business • 6 operating groups (3 in public sector.000 customers. ○ Senior executive positions were mainly filled from within the company • CSU HQ had less than 15 employees (finance.usually 20% of the license cost annually) ○ Professional services (consulting/implementing the software for the customer) • They want to retain customers.work was delegated mainly down to its 6 operating groups. tax. local governments ○ More tight credit environment made competition less from other private equity buyers Strategy • 2-fold strategy: ○ Build existing VMS businesses via tuck-in acquisitions (acquiring company merges the acquired company into an existing division) and organic growth initiatives ▪ In existing verticals. 3 in private) • Revenues are not very cyclical. each of which had the 5 functions above ○ Each operating group is supposed to seek out acquisitions and integrate them to meet performance targets • Bonus plan focuses on ROIC: ○ Profitability ▪ ROIC generated . because maintenance was a big part of CSU revenues and is usually stable. acquisitions.Risk free rate ○ Growth ▪ Year over year increase in net revenues for the particular VMS business • If the ROIC < Risk free rate. accounting. and build new VMS businesses through platform acquisitions ▪ Verticals they didn't operate in. increase pricing power ▪ They also expand geographically in that vertical (acquire overseas) ○ Acquire. and no single buyer is more than 1. leisure centres. then managers simply don't get their bonus for that year • Managers also are encouraged to invest 75% of their after-tax bonus into CSU's common shares by buying through open market.they've been good at retaining customers (4% in 2009) ○ Part of this is because customers have a high switching cost in vertical markets (entire company depends on this software) ○ Most of CSU's software is implemented enterprise-wide and is mission-critical (customers need this software to even run day to day operations) • Leonard says that average customer would stay with CSU for 26 years. but also recurring revenue ○ Low and stable attrition rate of 5% .just for right to use software) ○ Maintenance (continuous support and upgrades for the license -. manage.

acquisitions by whichever gave the highest IRR and jumps over hurdle rate ○ Historically.3% 2009 ○ Due to acquisition of Public Transit Solutions in 2009 ○ But the margins aren't volatile because not cyclical. but at risk of decline due to customer dissatisfaction from higher maintenance costs ○ Professional services expected to decline. Oracle. weak job growth. but didn't go to debt financing ○ Used cash flow from operations to finance this . ▪ Managers of these companies are usually kept by CSU to leverage their knowledge • VMS businesses that were acquired usually had favorable industry dynamics ○ i. SAP continue to grow via acquisitions (taking over smaller vertical players in particular) • Overall ERP market is supposed to grow 5. limited access to capital ○ Buying the dominant player allows CSU competitive advantage and tuck-in acquisition changes in future ○ It was important for CSU to be integral to customer's business "sticky" . 7% . One dominant player in market. or enter new markets • They decide between organic vs. IRR from organic has been a lot lower than IRR from acquisitions • They have lots of potential acquisition candidates lined up for the future Financial Position • Sales increase of 44% from 2009 -2010 (large # of acquisitions in 2010) ○ Maintenance revenue growth = more long term metric to analyze a software company's performance • 2010: company had maintenance revenue growth of 35% (28% .acquisitions. most vendors are not putting money here in favor of higher margin software revenue The Decision AFM 479 Page 4 . compared with 19.8% from 2010 to 2011 • Revenues: ○ Licence growth is to flat line and decline past 2014 (more businesses switch to subscription-based model) ▪ Subscriptions to grow at CAGR of 21% annually through 2015 ○ Maintenance is still a large component. and new acquisitions are adjusted to benchmark asap • They had $91M acquisitions in 2010.e.which means high switching costs for the customer • Once the business is acquired.15 per share in 2006 to $2 per share in 2010 Economic Outlook • Negative economic outlook: ○ Deteriorating household confidence.5%. persistent economic slack ○ Equity market volatility increased because of higher uncertainty for downgrade on US sovereign credit rating and increasing tensions in the eurozone • US and Canada both kept their rates low to stimulate economic growth Industry Outlook • Large players like Infor Global Solutions. adjustments to cost structure /headcount reduction) ○ They monitor these regularly so capital can be put on the ones with highest ROIC potential • Organic initiatives: invest in internal research and development for new software solutions. ROIC of 34% (higher range) • Dividends grew from $0.organic) ○ Most of organic was due to new maintenance contracts and price increases (strong pricing power) • 2010: operating margins declined to 17.believed additional debt would be financially inflexible ○ 2010 Debt to capital = 24%. CSU has benchmarks and performance measures to assess it ○ Improvement on revenue optimization (price increase. competed with smaller private vendors.

earnings power value. now may be the right time for LLY Capital to buy shares • Leonard says that CSU's board thinks that its stock price doesn't reflect the company's performance and ability to retain capital at high returns ○ Complexity of the business creates a discount because only enterprising investors are willing to do the work to understand the business • He also said there may be a potential slowdown in acquisitions.4 • Birch Hill wants to sell some of its holdings.The Decision • CSU share price increased nearly 2x to over $50/share since IPO ○ High P/E ratio of 25. by estimating net asset value. and if relevant growth value ○ Need to also discuss any potential catalysts or franchises and their associated probabilities AFM 479 Page 5 . which affects CSU's strategy • Need to base valuation on the value-investing method.