Constellation Software’s adept acquisition approach has yielded substantial shareholder value over the past several decades. However, the company’s expanding revenue multiple and the diminishing quality of acquisition targets raise questions about the sustainability of strong returns in the future. When solid companies trade at multiples of 5-6 times revenue, it warrants concern. Nonetheless, the stock has the potential to continue performing well if Constellation Software can successfully expand its investment universe. Nevertheless, future returns are likely to resemble the broader market’s performance more closely.
Constellation Software’s business model revolves around acquiring software companies with particular attributes: mission-critical B2B applications, a focus on specific verticals, recurring revenue, minimal customer churn, and diversified customer bases. The company also considers acquiring shrinking businesses with promising ROI prospects. These targeted acquisitions generate a steady stream of free cash flow, fueling further acquisitions. Leading positions in mature verticals reduce the need for product development investments, fostering free cash flow generation. Low churn also minimizes sales and marketing expenses.
Constellation Software typically acquires companies with a buy-and-hold mindset, seeking to enhance their value through effective management and low overhead costs. Performance benchmarking and sharing of best practices aim to improve acquired companies’ performance. The company’s decentralized structure, with autonomy and control at the business level, allows for cost-efficient scaling.
Constellation Software has evolved its strategy to maximize value creation as its business has grown. This has involved expanding its acquisition universe to continue deploying its free cash flow. Consequently, the company is targeting less attractive segments and making acquisitions with lower ROIs. However, this should not be viewed negatively, as Constellation Software maintains its disciplined approach, acquiring only companies that meet its hurdles. It does, however, foreshadow the company’s future trajectory.
Software companies generally boast high ROICs, but that value is limited if profits cannot be reinvested in the business. By using profits to finance acquisitions, Constellation Software unlocks the true value of its portfolio companies’ ROIC. Targeting companies in saturated markets with limited volume growth aligns with this strategy. Additionally, Constellation Software often acquires relatively small, private companies, which may have limited liquidity for owners, resulting in depressed valuations. By building a portfolio of such companies, their valuations can increase significantly through the provision of liquidity. Offering shareholders diversification and professional management also contributes to higher earnings multiples for acquired companies.
Constellation Software’s decentralized structure has enabled it to continue driving attractive growth by effectively delegating decision-making. However, human capital becomes increasingly important in such a structure, potentially posing a bottleneck at some point. The limited pool of appealing target companies has also been a concern surrounding Constellation Software’s business.
In the past, Constellation Software has executed numerous smaller acquisitions. As the company scales, it has been forced to widen its investment universe to sustain growth. In recent years, Constellation Software has shown a willingness to pursue larger acquisitions, such as the 2022 purchase of Allscript’s Hospitals and Large Physician Practices business, now known as Altera. Altera is expected to generate approximately 10% of Constellation Software’s revenue in 2024, although it may slightly reduce profit margins.
Compared to companies like Roper Technologies, Constellation Software has ample room to pursue larger acquisitions and higher organic growth targets. While this will likely result in lower ROIC, it could still create attractive growth for shareholders if executed well. Knowledge sharing and implementing best practices are also potential value levers for Constellation Software, albeit to a lesser extent than companies like Danaher.
Constellation Software has also spun out some larger segments for unclear reasons. It could be addressing a perceived conglomerate discount by isolating segments. Following the acquisition of Topicus.com in early 2021, Constellation spun out TSS and Topicus into a separate public company. After spinning out Lumine Group, a subsidiary, with WideOrbit in December 2022, Lumine was spun out of Constellation Software in 2023.
Constellation Software has maintained a robust growth rate across multiple revenue magnitudes, a remarkable feat given its consistently high ROI. The company’s diversified revenue streams across customers and geographies contribute to its high quality. No single customer accounts for more than 5% of Constellation Software’s revenue, and about two-thirds originate from the public sector, providing downside protection during economic downturns.
Constellation Software’s margins are fairly modest and have not significantly improved in nearly two decades. The company’s cash flows are more robust, but excluding acquisitions and divestitures, they do not fully capture the essence of its business. As Constellation Software’s business matures, there may be opportunities for margin improvement. R&D expenses could be reduced if the company focuses solely on harvesting profits. Similarly, general and administrative expenses could be lowered, especially by reducing acquisitions.
Constellation Software’s asset turnover has declined significantly in recent years, primarily due to increased goodwill on the balance sheet. This likely indicates that recent acquisitions have been valued more fully and may reflect a shift towards acquiring companies with greater organic growth potential. Some variation throughout the business cycle is also natural, with higher valuations late in a bull market leading to lower ROIs.
It can be tempting to disregard this trend by analyzing cash flows and excluding intangible assets from the balance sheet when evaluating ROI. However, for Constellation Software, acquisitions are the primary investment form, necessitating a coherent recognition of these investments across income, cash flows, and the balance sheet. If Constellation Software continues to spend more to generate less growth, it will ultimately affect growth and the cash flows available for distribution to shareholders. Given the company’s culture, I anticipate that capital will be returned to shareholders via dividends or buybacks (depending on valuation) before this occurs.
Constellation Software’s valuation has steadily increased over the past 15 years as the market has recognized the strength of its business model. This is supported by the company’s high ROIC, robust growth, significant government and recurring revenue mix, and potential for margin expansion. While Constellation Software will likely remain an exceptional company, its current valuation makes its merits as an investment highly dependent on continued strong growth.
Constellation Software still has a substantial growth runway, but it appears to be approaching a point where more of its acquisitions will be marginal in nature. The company can continue to pursue small vertical software acquisitions, larger targets, and companies offering greater organic growth opportunities. Constellation Software also has the potential to expand beyond its core vertical software strategy. It is somewhat paradoxical that Constellation Software’s valuation has never been higher at a time when its future prospects have never been less promising. Valuation is a function of both growth and ROIC. While growth should remain reasonably strong, ROIC will continue to decline. Considering the company’s evolving revenue mix and its past ability to find attractive acquisitions, I believe the stock can continue to perform well, although future returns will likely be closer to the broader market’s performance (mid to low teens CAGR) than in the past.