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Constellation Software (CSU) Stock | TSX: CSU.TO

Covered by Stratosphere

The GOAT of Capital Allocation

Constellation Software is known as CSI, but has the ticker symbol CSU.

The term GOAT (greatest of all time) must not be used lightly.

Constellation Software, has quietly been stringing together a massive tech portfolio through acquisitions.

Numbers speak for themselves in any GOAT conversation and CSU has the return on invested capital (ROIC) metrics to back said claims.

Constellation Software is an international provider of market-leading software and services to a number of industries, both in the public and private sectors. Our mission is to acquire, manage and build market-leading software businesses that develop specialized, mission-critical software solutions to address the specific needs of our particular industries.

Stratosphere Score

10

Growth

8

Valuation

9

Quality

9

Margins

10

Dividend

1

Balance Sheet

6
Braden Dennis

Author

Braden Dennis

Founder

Investment Thesis

  1. Constellation Software, headed up by all-star capital allocator Mark Leonard, has built a decentralized machine that can efficiently deploy capital into small vertical market software (VMS) companies around the globe in an impressive quantity.

  2. CSU makes software acquisitions through their decentralized operating groups. Upon acquisition, Constellation can assist the business and provide strategic direction, but they do not wish to integrate them with other businesses or change the culture.

  3. Constellation's ability to deploy capital at sustained high returns is second to none.

  4. The existing VMS businesses are mission critical niche software with predictable cash flows and low customer churn.

  5. They do however, provide very little if any organic growth over time. Cash flows are extracted to fuel more acquisitions.

    Moving forward, CSU is open to bigger acquisitions as it will be increasingly difficult to deploy all free cash flow on acquiring small VMS businesses.

Key Company Metrics

A set of metrics we constantly keep updated to monitor the investment thesis.

Competitive Advantages

Best in Class Capital Allocators

In today's day and age, finding information about someone is rather easy. All it takes is a quick google search and you can look through social media, news outlets, and reports easily.

For a man like Mark Leonard, the Founder & CEO of Constellation Software, he has been able to keep a low profile and remain quite anonymous all these years. On Google, you can find all of three photos of him.

All we know about Mark Leonard is that he is apparently 6'5", has a beard like Gandalf, plays rugby, and writes a killer annual shareholders letter.

Constellation has built a highly decentralized vertical market software (VMS) acquisition machine. Their structure allows them to consistently eat up the VMS market at an incredible pace.

CSU Operating Groups Flowchart

Each operating group caters to a specific list of vertical markets. Among each operating group sits hundreds of business units.

From public to private industries and financial services to utilities, CSU is able to cover many VMS (vertical market softwares) through this ecosystem they have created with their operating groups.

Constellation Software also has a 30.35% stake in Topicus.com (TOI.V), a spinoff company similar to CSU.

Topicus also acts as a decentralized operating group, deploying their own capital and managing acquisitions.

Read our report on Topicus: The New Kid on the Block.

Sticky Software

Customers of Constellation's business units face high switching costs - they are contractually bound for years to these services and would waste lots of time and money by seeking other niche alternatives.

Even if there are alternatives available for a particular field, these vertical software products generally represent an insignificant portion of customers' expenses. All in all, customers face major disincentives to switch vertical software providers.


This also gives them the ability to consistently flex pricing power over time. Real pricing power in software does not negatively impact churn nor net new recurring revenue. This is one of the clear cut advantages of this business.

Opportunities Ahead

  • Scaling with larger acquisitions. CSU 2.0 is the next chapter for this wonderful company. Continuing their excellent acquisition strategy of small niche software businesses while bolting on new and much larger acquisitions.

  • Accelerating Organic Growth. CSU has been consistent in their messaging around organic growth efforts by leaning on operational expertise from their best performing operating groups when it comes to organic growth in VMS. They also launched a Venture Fund to explore large opportunities to refine and develop organic growth opportunities across the rest of the organization.

  • The vertical software market remains highly fragmented. With thousands of market players with valuations at sub-$20 million levels. The kicker here is that big tech is not really interested in scooping up these companies, either. Vertical software companies are too small, focused on a narrow set of customers, and would consume vast amounts of resources to scale to any meaningful level.

Risks

Capital Deployment

It is no surprise Constellation Software has had explosive growth over the last decade. Their financial metrics continue to grow rapidly, which is a great thing for both the business and investors.

The issue arises with the kinds of acquisitions that CSU makes from this point onwards.

With a larger market cap, the business has to continue to make larger deals in order to move the needle and grow the company. Sticking to smaller companies may have short term incentives, but they will need to increase their volume of acquisitions if they want to continue their growth and please investors.

Mark Leonard and the team have addressed this issue and are already trying to resolve it.

Constellation Software has deployed more capital for acquisitions in 2021 than it ever has in any other year in the company's history.

Therefore, this risk is not currently concerning as the business continues to find ways to deploy a record amount of capital through its decentralized structure.

Increased Competition for Deals

Constellation Software's entire business model revolves around making acquisitions.

Since their IPO in 2007, the market has become more saturated with capital acquirers and growth by acquisition companies. This means more companies are interested in acquisitions, especially competition from private equity.

An increase in demand always translates into a price increase. This may prove troublesome for CSU as they may have to pay a higher price tag for some deals than anticipated.

Investors should keep an eye on Constellation Software's financial statements, specifically their cash reports related to acquisitions and investments.

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