Constellation Software: The Anti-Conglomerate

Mark Leonard, founder of Constellation Software, is a modern day Outsider CEO. Leonard built Constellation following a similar corporate doctrine as Buffett did at Berkshire, though in an entirely different industry.

Leonard’s unique approach has worked out well for shareholders. Constellation went public in 2006 at ~$18/share and today trades at nearly $1,800/share for a cool 100x original investor’s money. How has Leonard built such an impressive record of value creation? Like others we’ve written about, it’s thanks to a combination of a good base business and an exceptional and non-traditional company ethos. We’ve used this graphic many times before, and there’s a good reason for it.

Source: EPC Website, adapted from Connor Leonard at IMC

While changes in investor sentiment and general economic cycles drive investment results over short time periods (less than five years), it is return on capital and culture that drive investment results over long time periods. What Mark Leonard has built at Constellation embodies the far right of the graphic as well as any company I’ve studied.

Overview

After working for a decade in Venture Capital, Leonard founded Constellation Software in the mid-90’s with no prior experience in running or acquiring software businesses. Constellation Software is a vertical software business conglomerate comprised of six operating segments and hundreds of individual businesses.

Vertical Market Software (VMS) businesses are software companies tailored for a specific industry. Black Knight is an example of a VMS company dedicated to the mortgage and real estate lending space. Constellation runs six operating groups. Each operating group consists of dozens of software businesses that service specific verticals like agri-business, education, healthcare, real estate, construction, hospitality, and more. Without going into detail on each segment or business, Constellation has focused on acquiring and managing industry-specific software businesses that provide mission-critical software to their respective industries.

Leonard elected to roll-up VMS businesses not because he was a skilled programmer or had prior experience in the field. Instead, he chose this model because VMS providers are great businesses.

Business Model

Vertical software providers enjoy excellent economics. Among many benefits, software businesses:

1) Enjoy sticky, recurring revenue streams by way of subscription and maintenance revenue. Subscriptions are usually paid up front for the year and often subject to annual price escalators.

2) Very little capital is required to maintain revenues as most of the value comes from engineers and computer code, making almost all growth extremely accretive. Software is highly scaleable allowing for large operating leverage/margin expansion.

3) Many software providers enjoy high switching costs as replacing IT systems is costly, time consuming, and often not worth the risk and hassle. This is particularly true in niche VMS areas where Constellation focuses.

4) Often have the ability to cross sell other software and analysis add-ons in addition to the base offering.

In addition, there is a huge and fragmented market of small VMS businesses in the country with a few million dollars of earnings making the space ripe for consolidation. Basically Leonard was interested in executing a roll-up strategy and decided to fish in a stocked pond of great businesses.

Because of the above characteristics, the best indicators of value creation for owners are return on invested capital (ROIC) and organic growth. Because additional capital is not required to grow, intrinsic value will increase roughly as a function of ROIC + organic revenue growth. As you can see, Constellation has been a machine. Below are the results from 2008 – 2017 as laid out in Leonard’s last lengthy shareholder letter (he used to write them every year).

One of my favorite parts about Constellation is how transparent Leonard is in his annual letters. He discloses key metrics that any owner should care about, and I’d regard his letters as must-reads for anyone interest in capital allocation. As an example, he breaks out growth in the table below in as detailed a fashion as I’ve seen, providing data around new customers, lost customers, and pricing power.

Intrinsic value has consistently increased 20-40% annually for a decade thanks to the high quality nature of VMS businesses and Leonard’s ability to consistently deploy capital in attractive acquisition targets.

Unique Corporate Structure

Like all of the other Outsider CEOs profiled in Thorndike’s book, Constellation Software is extremely decentralized.

The main benefits of decentralization are; decisions can be made at the most appropriate level of the organization allowing business units to operate with agility and in response to local markets and customers; corporate bloat and overhead creep are avoided at all cost; and, most importantly, empowered leaders at the business unit level foster a culture of ownership and entrepreneurialism. Leonard described how businesses fit within Constellation in the 2013 letter:

“Our favourite and most frequent acquisitions are the businesses that we buy from founders. When a founder invests the better part of a lifetime building a business, a long term orientation tends to permeate all aspects of the enterprise: employee selection and development, establishing and building symbiotic customer relationships, and evolving sophisticated product suites.”

Leonard provided more thoughts in 2015:

“Shareholders sometimes ask why we don’t pursue economies of scale by centralising functions such as Research & Development and Sales & Marketing. My personal preference is to instead focus on keeping our business units small, and the majority of the decision making down at the business unit level.”

A culture of ownership and autonomy amongst subsidiaries is tough to quantify but when done effectively I’d argue it’s nearly priceless – just ask HEICO, Berkshire, or Constellation Shareholders.

When Constellation acquires a business they largely allow the company to continue operating as if it had never been sold. The company will report up through one of the operating groups but business leaders are immune from headquarters-driven mandates and initiatives. What the small team at headquarters does provide is data, and lots of it. Leonard’s analyst team is constantly benchmarking and reviewing data provided by the dozens of subsidiaries. Their aim is to constantly evaluate different strategies that local leaders are employing and quickly prove or disprove if they could be cross-applied to other verticals. They also have reams of data on potential acquisitions targets which gets fed into their acquisition engine through subsidiaries - more on that below. While this is by necessity a centralized function, it’s purely for the benefit of portfolio companies. Insights may be shared with leaders in the organization but actions are not mandated by headquarters.

Constellation avoids centralization by not just buying smaller businesses but by keeping them small. Leonard believes so deeply in the company’s structure that he actually breaks up businesses if the teams get to large to maintain past performance. From the 2017 letter:

“No one wants to admit that they’ve hit their limit. Some BU Managers lack the humility, some lack the courage, and most lack the time for reflection, to notice that their task is getting too large, and the sacrifices are getting too great. This is the point at which our Operating Group Managers or Portfolio Managers can provide coaching. If a large BU is not generating the organic growth that we think it should, the BU manager needs to be asked why employees and customers wouldn't be better served by splitting the BU into smaller units. Our favourite outcome in this sort of situation is that the original BU Manager runs a large piece of the original BU and spins off a new BU run by one of his/her proteges.”

As of 2017, the vast majority of BU’s at Constellation were less than 100 people.

This approach is almost without precedence, except in once case – Illinois Tool Works. John Nichols used the same approach when building ITW through acquisition. From 1981 to 1995 Nichols acquired hundreds of companies growing the company from $300M to $4.2B in revenue. The result was superb as the business delivered tremendous value for shareholders throughout Nichols tenure, and Leonard largely copied his approach with similar success.

Constellation also employs a highly rational incentive system. The company incentivizes business unit (BU) leaders to maximize ROIC and organic revenue growth, as these are the direct drivers of intrinsic value growth.

“Our best BU managers have overseen double digit rates of growth for years via a combination of organic growth and acquisitions in their vertical and in adjacencies. That kind of low capital intensity compound growth creates powerful economics that generate remarkable incentive compensation. For BU managers that are new to the job and running a single BU, the compounding effect isn’t as obvious, so we’ve started to roll out an additional bonus program targeted at keeping this contingent around until their wealth building potential becomes apparent. To date there are over 100 CSI employee/shareholder millionaires. Ten years from now, my hope is that there will be five times as many.”

The most successful managers have funneled free cash flow generated by their businesses into acquisitions that have produced consistently high returns on capital, while maintaining solid organic growth rates at existing businesses. These managers have, rightfully so, become very rich while also making shareholders rich, achieving precisely what a shareholder-friendly incentive system should.

Though rare among today’s empire-seeking conglomerates, employing shareholder-aligned incentive systems and allowing acquired businesses to maintain the autonomy that made them great is not entirely unique by itself. What is different about Constellation is that they have even largely decentralized capital allocation.

Acquisition Engine

Mark Leonard and the small headquarters team are the foundation for capital allocation at Constellation, but most of the work is carried out in the subsidiaries. Leonard is clearly a very skilled capital allocator and investor. He thinks like Buffett and has a repeatable framework when thinking about acquisition candidates, purchase prices, risk, and forward rates of return.

Constellation’s stated goal is to be a “great perpetual owners of VMS businesses”. They look for what they deem both “exceptional” and “good” VMS businesses. Exceptional businesses feature an outstanding manager, consistent profitability, and above average growth. Leonard classifies good businesses as first or second-ranked players in their verticals that may still be working to establish a solid track record of growth and profitability. Constellation has carved out a sweet spot by acquiring lower organic growth (GDP-like growers) albeit very high-quality software companies. They’ve been able to maintain valuation discipline by staying away from high-growth software businesses where valuation multiples are far higher. Obviously, this approach has worked incredibly well with operating cash flow per share compounding at 28% since 2008.

However, instead of being the primary point of contact for new deals, Leonard has instead trained his Portfolio Managers, BU Managers, and Operating Group Managers (different layers of leadership at subsidiary levels) in capital allocation. Leonard sets expectations around hurdle rates, provides myriad of data on past acquisitions, and ensures that leaders are capable capital allocators before unleashing them to conduct their own roll-ups.

The extreme decentralized nature of the organization combined with the ownership mentality by all levels of leadership, with capital allocation being a key part, is the company’s real moat.

For years analysts have been wondering when Constellation’s model will mean revert because of size and the need to either do more or larger acquisitions to move the needle. Leonard thinks Constellation’s human-capital moat will remain intact:

“I don’t know if the analysts and journalists who predict reversion to average performance for CSI will be proved correct in the next few years. Our plan is to maintain investment discipline, keep overheads low and hire and coach a new generation of ambitious, hard-working BU Managers who can be taught how to be competent long-term “owners”. Hopefully we’ll still be having this reversion debate ten years from now. Some businesses get their unique advantage from government-granted monopolies, some from natural resources, some from large patent portfolios, and some from enormous fixed assets. CSI doesn’t have these advantages. Our employees, and the customer relationships that those employees have built and fostered over many years, provide our competitive advantage.”

This argument has merit, which I’ll discuss next, but Leonard likes Constellations chance.

Scale Challenges and Recent Evolution

Though Constellation’s approach of acquiring lower growth, smaller, high-quality businesses has worked wonders so far, it has its limitations. Because the typical business Constellation acquires is small, maintaining anything close to historical growth rates requires either a) acquiring more and more businesses each year or b) wading into larger acquisitions. The company has maintained a consistent pace of smaller acquisitions historically, but in recent years as cash flow has grown they’ve been unable to funnel 100% of free cash flow into acquisitions. I would only expect this problem to grow and the situation is somewhat reminiscent to Berkshire a few decades ago when they began having more trouble deploying all of the cash coming into headquarters into acquisitions that move the needle. On the larger deal side, Constellation has only bought 3 “large” VMS businesses since inception.

The primary challenge with doing larger deals has been increasing valuation pressure from large PE firms like Thomas Bravo and Vista Equity Partners. These technology-focused PE funds are willing to pay way higher prices than Leonard is comfortable with historically. Leonard has said that Constellation is almost always not even included in the process by investment banks when they take a larger VMS company to market under the assumption Leonard is unlikely to make a competitive offer.

Over the past few years, Leonard has elected to sit tight and stick with the historical strategy, even if it means letting cash pile up on the balance sheet. Interestingly, this year his tune changed. His letter this winter he wrote:

“One of our directors has been calling me irresponsible for years. His thesis goes like this: CSI can invest capital more effectively than the vast majority of CSI's shareholders, hence we should stop paying dividends and invest all of the cash that we produce, even if it means lowering our hurdle rates. I used to argue that we needed to maintain our hurdle rates because dropping them for a few marginal capital deployments would cause the returns on our entire portfolio to drop… I have stopped arguing. I have converted, and with the fervour of the newly converted, I am busy demonstrating my new-found faith… To that end, we are working on two initiatives: 1) increasing the number of very large VMS businesses (i.e., those requiring multi-hundred-million-dollar equity cheques) that we pursue, and 2) developing a circle of investing competence outside of the VMS sphere.”

This is quite interesting. Not only has Leonard come around to the fact that even if he lowers his hurdle rate to say, 15-20% instead of 20%+, a dollar retained by Constellation is far more likely to be worth more than a dollar distributed to shareholders. Leonard is showing the flexibility at age 65 to pivot not only the size of acquisitions he’s willing to consider but even the type of company he’ll invest in.

There are two ways this could go. Leonard could pivot from his circle of competence too far and too quickly and undertake value-destructive acquisitions in the years ahead. This could take the form of over-paying for larger companies, getting sub-standard results because the historical approach of keeping smaller high-performing teams together no longer works at large companies, or the team will stray too far from its VMS circle of competence. Any and all of these scenarios are plausible and could lead to considerably worse returns than over the past few decades.

Alternatively, Constellation could unleash its acquisition machine on a new landscape of targets. Capital allocation has been nothing short of exemplary so far, and I have little reason to doubt Leonard and team can successfully pivot into buying larger companies and/or businesses in different industries. Leonard understands what makes a good business – it’s why he started out buying VMS companies – but he isn’t inherently married to the industry. At heart Constellation is more of a capital allocation vehicle than a software conglomerate, and the investment discipline that has served them well is undoubtedly transferrable into other areas.

Time will tell, but today Constellation sits at an inflection point and I think it’ll be fascinating to watch unfold.

Valuation and Returns

As noted above, Constellation has compounded intrinsic value (whether you want to use ROIC + organic growth, OCF/share, FCF/share, or something else) in the range of 25-35% annually for several decades. I would not bank on this pace continuing, and neither would Leonard. I also wouldn’t count the team out to deliver above-average results for many years to come. A slightly worse result over the next 15 years compared to the last 15 years would be far from a tragedy.

The existing VMS businesses will continue to grow organically at a GDP-like pace of 3-5%, so the bulk of future returns continue to hinge on successful acquisition activity. If Constellation finds a way to deploy ~100% of free cash flow by buying as many small and mid-size VMS companies as possible at historical 20%+ rates of return, a few large VMS businesses at modestly lower returns, and perhaps foraging into entirely new verticals, the business will continue to do far better than average. I’d expect at least mid-teens returns under a scenario like this. At ~30x free cash flow shares don’t look overpriced in this situation.

Alternatively, if Constellation acquisition engine sputters and growth suddenly converges closer to organic growth rates, let’s say high single-digits, then a valuation de-rating may be in store. Lower growth in intrinsic value with valuation compression wouldn’t be a winning proposition for the stock.

Investing in Constellation Software while they’re at somewhat of a crossroads requires faith in the unique culture and structure that Leonard has instilled and a belief that their human-capital moat will persist as scale increasingly becomes a challenge to rates of return.

Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.

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