As I’m currently raising my search fund, I think a lot about which businesses I like. For example, I know I like asset-light companies with recurring revenue and high margins. When I say this I often get two responses:
1.- They are impossible to find.
2.- They would never have a reasonable price.
Today I’m writing about a company whose model is to acquire and integrate businesses with these exact characteristics.
If I remember well, I came across Constellation Software Inc (CSI) in this video https://www.youtube.com/watch?v=D6h5bvxnBKk. Will Thorndike mentions the company as an example of a current “outsider CEO” similar to the likes of Henry Singleton, Warren Buffet or John Malone.
The CEO, Mark Leonard, started the company with just $25 million (note that this could have been a search fund acquisition) in 1995. Constellation’s market cap today is around $15 billion. Since the company went public it has returned more than 3,000 % over 10 years.
CSI is a software conglomerate that encompasses 125 different companies. It grows a lot, although mainly by acquisition as you can see in this table:
CSI products are Vertical Market Software (VMS). They cater to the needs of a specific industry and can’t be used in any other (unlike spreadsheets, for example).
Why is the VMS industry attractive?
B2B vertical market software has many characteristics that I like:
- Recurring revenue. Clients prepay monthly or annually, making it easy to predict cash-flow. The cash influx can be put to work in the same way that insurance company does with float. Constellation uses it to finance the acquisition of companies.
- High switching cost. if you have ever gone through a ERP/CRM provider switch you will probably know this. It is a pain in the neck. It takes time to do it and much of this time is total chaos: functionalities don’t work as expected, users take much longer to complete tasks as they are not used to it, technical issues… Not something you want to do often. This is the blessing and the curse of the industry. It is equally tough to lose clients as it is to gain them. As multiyear contracts are the norm, companies often sacrifice profits at the beginning to get new clients. In other words, the high customer lifetime value justifies a high customer acquisition cost.
- Asset light (resilience). As there are no major capital investments, companies have the capability to downsize in case business slows down. Also, clients can cut cost but they can’t work without software and switching to another provider is an avoidable investment.
- High margin. The variable cost is usually low and an increase in revenue usually means an instant increase in operating margin.
The enterprise software industry as a whole is growing at low single digits.
Wait. Do you really care about the last sentence?
I don’t. Sometimes big trends have no impact at all.
Let’s take a Spanish small-hotel management software as an example. I would be focusing on occupancy rates, small versus-large-hotel performance, etc. It is not impacted by a decline in the enterprise software industry that might be caused by a war between SAP and Oracle. The situation of a small-hotel management software in Spain doesn’t change with growth in enterprise software in Asia.
I’d argue that Constellation is a group of companies totally uncorrelated with the overall trend.
Inorganic growth, creating a High-Performance Conglomerate (HPC)
If you go to the website of any of the companies you’ll find the acquisition criteria. The ability to find and acquire these businesses efficiently is a core competence of CSI.
Constellation acquires and integrates businesses on a regular basis. The integration process often boosts efficiency just by implementing the same processes that CSI has been using in all their companies. One of the hallmarks is a disciplined approach to R&D and marketing that avoids spending without getting results.
As the group grows, they realize synergies and increase margins. However, the different Business Units and many of the businesses seem to operate autonomously.
In the shareholders’ letter of 2015, Mark Leonard writes
“I have been encouraging our Operating Groups to push down more of the acquisition activity to the Business Unit (“BU”) level, even if it means higher capital deployment costs. If we can train a couple of hundred BU managers to be competent part-time capital allocators and provide them with acquisition analysis and structuring support when they need it, then I can foresee the day when we are doing 100 acquisitions per annum, instead of 30”
This is the only way to keep up the pace of small-cap acquisitions. If they don’t manage to train the BU managers to execute this acquisitions, they would need to look for larger companies. Narrowing down the scope and potentially lowering their margins due to higher valuations.
Employees are required to buy shares of the company
In the 2013 President Letter, Mark Leonard writes:
“Our employee bonus plan requires that all employees who make more than a threshold level of compensation invest in CSI shares and hold those shares for an average of at least 4 years”
I’m not sure whether this policy is good or bad for CSI, but I tend to like it.
CSI is trying to control the quality of the investor base by avoiding overappreciation of the stock price. The rationale is that the there are many sophisticated value investors that would sell in case they consider the stock overpriced. Furthermore, the CEO is against share buybacks (considering them a type of insider trading) because they turn the shareholders in prey instead of partners.
Either way, it is reassuring to see that the CEO just wants the share price to be fair rather than “as high as possible” (as most CEO whose compensations is linked to it).