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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)

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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, and want to expand geographically via
acquisitions in the public sector vertical

2. Trimble Navigation Limited


Based in California, focuses on asset management and agricultural verticals
Optimize scheduling/routing of field service technicians
But due to saturation of its vertical, it's not been great financially - ROIC of 8%
Thinking of expanding via acquisitions in other vertical markets
Cash rich and low leverage, Debt to capital ratio = 10% (likely strategic acquisition for VMS
companies)

3. SAP AG
On-premises and software-as-a-service solutions via cloud computing for various sectors
Asset management, corporate strategy & sustainability, finance, HR, IT, manufacturing,
marketing, procurement, R&D, engineering, sales, service & supply chain management
They are the biggest competitor in application software
Asset base of US$28B - 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. Manhattan Associates, Inc.


Supply chain commerce software solutions for retailers, wholesalers, manufacturers,
governments, 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, and revenue grew 20% in 2010 (indicating their
segment is still in a growth phase) - would invest in this segment first

Company Background
History
CSU founded by Mark Leonard (venture capitalist), with $25M investment from OMERS, Birch
Hill Equity Partners, 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 - CSU only had 2 vertical markets (public transit, and paratransit operators)
1995 to 2006, they made 45 acquisitions in other vertical markets; went public in 2006
Leonard's focus is to operate CSU as if it were private company (did annual letters, etc.) 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 - directors, execs, principal shareholders (OMERS, Birch Hill) holding 67%
of the 21.2M common shares
Of this, exec officers and directors held 16.2%
Birch Hill held 16.3%
OMERS held 34.5%
5 analysts had stock recommendations for CSU (3 buys, 2 holds)
Many of CSU's shareholders are patient to hold it for long term investment, only 1/11 of the
shares have changed hands in 2009
Organizational structure was highly decentralized - because of so many acquisitions and
diverse markets
Senior executive positions were mainly filled from within the company

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Senior executive positions were mainly filled from within the company
CSU HQ had less than 15 employees (finance, accounting, acquisitions, tax, legal)
They set only certain benchmarks and best practices- work was delegated mainly down to its 6
operating groups, 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 - Risk free rate
Growth
Year over year increase in net revenues for the particular VMS business
If the ROIC < Risk free rate, 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, held 3-5 years in escrow before they can be sold

Business
6 operating groups (3 in public sector, 3 in private)
Revenues are not very cyclical- 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 10,000 customers, and no single buyer is more than 1.5% 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 - just for right to use
software)
Maintenance (continuous support and upgrades for the license -- usually 20% of the
license cost annually)
Professional services (consulting/implementing the software for the customer)
They want to retain customers, because maintenance was a big part of CSU revenues and is
usually stable, but also recurring revenue
Low and stable attrition rate of 5% - 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, CSU takes their
suggestions/feedback into new versions of mission critical software, resolves their issues on a
timely basis, and is at a fair price (usually 1% of revenue annual cost)
In 2010, CSU made 21 acquisitions for initial cash $91M and $6M in holdbacks
Helped enter new markets like health clubs, leisure centres, 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, they need to increase market share by acquiring competing
players in that vertical
Dominate, increase pricing power
They also expand geographically in that vertical (acquire overseas)
Acquire, manage, and build new VMS businesses through platform acquisitions
Verticals they didn't operate in- they'd seek acquisition candidates to get high
ROIC
Managers of these companies are usually kept by CSU to leverage their knowledge

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Managers of these companies are usually kept by CSU to leverage their knowledge
VMS businesses that were acquired usually had favorable industry dynamics
i.e. One dominant player in market, competed with smaller private vendors, 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" - which means
high switching costs for the customer
Once the business is acquired, CSU has benchmarks and performance measures to assess it
Improvement on revenue optimization (price increase, 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, or
enter new markets
They decide between organic vs. acquisitions by whichever gave the highest IRR and jumps
over hurdle rate
Historically, 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, 7% - organic)
Most of organic was due to new maintenance contracts and price increases (strong
pricing power)
2010: operating margins declined to 17.5%, compared with 19.3% 2009
Due to acquisition of Public Transit Solutions in 2009
But the margins aren't volatile because not cyclical, 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 - believed additional debt would be
financially inflexible
2010 Debt to capital = 24%, ROIC of 34% (higher range)
Dividends grew from $0.15 per share in 2006 to $2 per share in 2010

Economic Outlook
Negative economic outlook:
Deteriorating household confidence, weak job growth, 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, Oracle, SAP continue to grow via acquisitions (taking
over smaller vertical players in particular)
Overall ERP market is supposed to grow 5.8% 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, but at risk of decline due to customer
dissatisfaction from higher maintenance costs
Professional services expected to decline; most vendors are not putting money here in
favor of higher margin software revenue

The Decision

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The Decision
CSU share price increased nearly 2x to over $50/share since IPO
High P/E ratio of 25.4
Birch Hill wants to sell some of its holdings; 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, which affects CSU's strategy
Need to base valuation on the value-investing method, by estimating net asset value,
earnings power value, and if relevant growth value
Need to also discuss any potential catalysts or franchises and their associated
probabilities

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