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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

Manhattan Associates. Birch Hill) holding 67% of the 21. Inc.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. Trimble Navigation Limited • Based in California. only 1/11 of the shares have changed hands in 2009 • Organizational structure was highly decentralized . manufacturers. IT.ROIC of 8% • Thinking of expanding via acquisitions in other vertical markets • Cash rich and low leverage. and revenue grew 20% in 2010 (indicating their segment is still in a growth phase) . execs.2M common shares ○ Of this. • Supply chain commerce software solutions for retailers. and want to expand geographically via acquisitions in the public sector vertical 2. principal shareholders (OMERS. with $25M investment from OMERS. corporate strategy & sustainability. 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 . they made 45 acquisitions in other vertical markets. etc. procurement. focuses on asset management and agricultural verticals ○ Optimize scheduling/routing of field service technicians • But due to saturation of its vertical. marketing.directors. HR.3% ○ OMERS held 34.) 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 .2% ○ Birch Hill held 16. 2 holds) • Many of CSU's shareholders are patient to hold it for long term investment.5% • 5 analysts had stock recommendations for CSU (3 buys. it's not been great financially . went public in 2006 • Leonard's focus is to operate CSU as if it were private company (did annual letters. service & supply chain management • They are the biggest competitor in application software • Asset base of US$28B . governments. R&D. SAP AG • On-premises and software-as-a-service solutions via cloud computing for various sectors ○ Asset management. manufacturing. wholesalers. exec officers and directors held 16. and paratransit operators) ○ 1995 to 2006. engineering.because of so many acquisitions and diverse markets Senior executive positions were mainly filled from within the company AFM 479 Page 2 . Birch Hill Equity Partners.CSU only had 2 vertical markets (public transit. 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. sales. Debt to capital ratio = 10% (likely strategic acquisition for VMS companies) 3. finance.would invest in this segment first Company Background History • CSU founded by Mark Leonard (venture capitalist). 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.

just for right to use software) ○ Maintenance (continuous support and upgrades for the license -. tax.work was delegated mainly down to its 6 operating groups. and build new VMS businesses through platform acquisitions ▪ Verticals they didn't operate in.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. and no single buyer is more than 1. and is at a fair price (usually 1% of revenue annual cost) • In 2010. accounting.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. 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. acquisitions.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 .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. leisure centres. increase pricing power ▪ They also expand geographically in that vertical (acquire overseas) ○ Acquire. manage.000 customers. CSU made 21 acquisitions for initial cash $91M and $6M in holdbacks ○ Helped enter new markets like health clubs. resolves their issues on a timely basis. held 3-5 years in escrow before they can be sold Business • 6 operating groups (3 in public sector. 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.usually 20% of the license cost annually) ○ Professional services (consulting/implementing the software for the customer) • They want to retain customers.Risk free rate ○ Growth ▪ Year over year increase in net revenues for the particular VMS business • If the ROIC < Risk free rate. they need to increase market share by acquiring competing players in that vertical □ Dominate. ○ Senior executive positions were mainly filled from within the company • CSU HQ had less than 15 employees (finance. because maintenance was a big part of CSU revenues and is usually stable. CSU takes their suggestions/feedback into new versions of mission critical software. 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 . usually one-time purchases . legal) • They set only certain benchmarks and best practices. but also recurring revenue ○ Low and stable attrition rate of 5% . 3 in private) • Revenues are not very cyclical.

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" .15 per share in 2006 to $2 per share in 2010 Economic Outlook • Negative economic outlook: ○ Deteriorating household confidence.acquisitions. 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.3% 2009 ○ Due to acquisition of Public Transit Solutions in 2009 ○ But the margins aren't volatile because not cyclical. 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% .believed additional debt would be financially inflexible ○ 2010 Debt to capital = 24%. acquisitions by whichever gave the highest IRR and jumps over hurdle rate ○ Historically. 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.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.which means high switching costs for the customer • Once the business is acquired. ROIC of 34% (higher range) • Dividends grew from $0.5%. SAP continue to grow via acquisitions (taking over smaller vertical players in particular) • Overall ERP market is supposed to grow 5. compared with 19. most vendors are not putting money here in favor of higher margin software revenue The Decision AFM 479 Page 4 . One dominant player in market. weak job growth.organic) ○ Most of organic was due to new maintenance contracts and price increases (strong pricing power) • 2010: operating margins declined to 17. 7% . ▪ Managers of these companies are usually kept by CSU to leverage their knowledge • VMS businesses that were acquired usually had favorable industry dynamics ○ i. competed with smaller private vendors. CSU has benchmarks and performance measures to assess it ○ Improvement on revenue optimization (price increase. and new acquisitions are adjusted to benchmark asap • They had $91M acquisitions in 2010. but didn't go to debt financing ○ Used cash flow from operations to finance this .e. but at risk of decline due to customer dissatisfaction from higher maintenance costs ○ Professional services expected to decline. Oracle. or enter new markets • They decide between organic vs.

4 • Birch Hill wants to sell some of its holdings. and if relevant growth value ○ Need to also discuss any potential catalysts or franchises and their associated probabilities AFM 479 Page 5 . earnings power value. by estimating net asset value. which affects CSU's strategy • Need to base valuation on the value-investing method. 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.The Decision • CSU share price increased nearly 2x to over $50/share since IPO ○ High P/E ratio of 25.