Investor Dialogue: Constellation Software

Constellation Software

Why is this company interesting?

Constellation Software is a vertical market software (VMS) serial acquirer. Founded by Mark Leonard, the company has several notable attributes: its 21 million shares outstanding have not changed since inception. It has compounded free cash flow at a 29% clip since its IPO in 2006. It has no debt, high returns on capital and maintains a rational, return-based corporate culture.

Leonard and his team are widely regarded as among the best corporate capital allocators in the world. The business itself consists of hundreds of software companies, dominant in their niches with pricing power and sticky customers.

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Disclaimer: This interview is for informational purposes only and should not be relied upon as a basis for investment decisions. In Practise is an independent publisher and all opinions expressed by guests are solely their own opinions and do not reflect the opinion of In Practise.

I think the first place to start is the Allscripts acquisition which was interesting news. What were your first thoughts when you saw the news on the size of the asset, it being potentially new territory for Constellation?

Analyst 1: With Constellation, most of us are in it partly because they are a great capital allocator. At first glance, seeing that they had deployed that much capital, my reaction was very positive. Getting into the deal, I was a little surprised that this deal, besides being the largest one they’ve ever done, is not typical in other ways, as well. The gross margins of the Allscripts business are 30% versus the 60%, 65% of where they usually acquire things; EBITDA margins of 10%, 15% versus 25% to 30%. This business seems more labor-intensive. It was interesting to look at the Allscripts conference call and how they described it. They said it had shrunk for three years, this being the third year in a row and they think it will shrink as far as they can see. Of course, they are selling it and they have mismanaged it for a long time, so I would take what they say with a grain of salt. They also said it was working capital-intensive and something about cash flows being more delayed in that business.

This is what Constellation does. They haven’t done anything this big but I suspect what they will do is will be some combination of price increases, adding capabilities to software and pruning. My initial reaction is positive. As I get into it more, there are some more things to think about because it’s not so typical for them but I’m willing to give them the benefit of the doubt.

One thing that struck me on the call was, firstly, they are selling it, so they’re not going to be exactly bullish on the asset, but they specifically said that they expect EBITDA to decline this year, 10% to 15%. Broadly, in the last 12 months to Q4, it was 145 million EBITDA so that may decline that to 125 million this year. They also quoted the free cash flow for last year as 50 to 60 million so, again, roughly a 33% EBITDA to free cash flow conversion. As you said, the working capital eats up some of the EBITDA in this business. That means that this years’ free cash flow, as a standalone, without Constellation doing anything, is actually closer to 40 million, which is 15X forward free cash flow. 15X looks a bit different from 10X, on the face of it, when you first look at the asset. Obviously, they know what they’re doing, so they must feel as if they can, at least, increase the prices 5% to 10% or cut out some costs to maintain that multiple. They don’t usually acquire stuff that expensive, or that big.

Analyst 1: Everyone made a big deal about the multiple being 0.75 times sales, or something like that. But when you work through it a little bit, yes, the multiple on free cash, today, seems higher than what they had done. Maybe somebody else has some thoughts?

Did anyone else look at the recent deal?

Analyst 2: I think carve-outs are some of the most attractive places to be if you have a long-term home and you have a different cap structure to some of these larger entities. Effectively, the larger corporates are always a price taker in this scenario. Let’s call the EBITDA that was reported might be 120ish, clean, pre the working capital movement because I think that just washes through in a Constellation world. Effectively, there’s likely to be at least a 20% to 30% upside, in terms of that post-operating model structure.

For a deal like this, I suspect that a Constellation would never pay anything north of a 6X cash flow metric, just to be able to get back to their 15% long-term IRR. If you were to ask me, it’s more likely to be a 15% to 20% because the entity would have been price takers, so I suspect they would have taken a discount and this is just a bit of smoke and mirrors where, in press releases, you have to tie it back to a reported figure that is auditable. When it comes to the operating model, it’s a very different scenario, in terms of the actual M&A team.

You think they are either going to be growing EBITDA or free cash flow from here, in 2022, 2023?

Analyst 2: I don’t think I know enough information to tell whether it’s going to be the growth topline or bottom line. From my perspective, it’s more about what the rolled-up IRR is on the capital deployed. Even with a 3% net drop in revenue, if they were able to get 20% IRR, then I’m okay with the 2% to 4% net dropping off, long term.

It’s more that I took a little bit of solace that in a previous life, having prepared PR documents like this, that go out to the external world, they can be a very different number to what is actually in the model, in terms of IRR. There could honestly be a delta of 20% or 30% between the EBITDAs reported in both those documents because one is an internal working doc; I’m sure lots of people here know that that is very normal.

Does anyone else have a view on what Constellation could potentially do with the biggest acquisition they have ever made?

Analyst 4: I don’t have any view on the specifics of the deal, per se, but when I first saw it, I thought, the size of the capital deployment, just the reinvest rate, with this one acquisition, I don’t know if it is a change in their strategy to say they are going to be looking more for these types of deals or if it was just opportunistic? They did mention that they had been looking at Allscripts and talking to them for a period of time.

One of our concerns, in 2020, was can the redeployment continue, close to 100%? You saw that it had gone down to around 60% of owners’ earnings; how is that going to look, going forward? That was a big question mark. I would say that you trust Mark Leonard to be not paying more than 6X free cash flow. If you can deploy 700 million in one shot, that’s amazing. That was a gamechanger, in a sense, for at least the near term, which doesn’t really matter, but it shows that these guys blew what expectations I had in 2020 out of the water, in terms of redeployment.

Analyst 1: That’s a good question you raise. Is this Constellation 2.0 or is this just a one off? Maybe this is Constellation 2.0 where they do much bigger deals than they have in the past. I don’t have a strong opinion.

You saw them announce that acquisition and then, two days later, they announced one for five million. I don’t know any company in the world that does these acquisitions on such different ends of the scale.

Analyst 3: I think that, in itself, opens up a pretty interesting thought. All of a sudden you had this company, Constellation, that was really well versed at these small two to 12 million type deals. If suddenly, they can step in to the batter’s spot and really swing at these sized deals, across the spectrum, versus something like a Roper Technologies, that is way over here in size, it really opens up the playing field that much more, for Constellation.

Looking at this operationally, this is a completely different ballgame, when you buy an asset this big. Do you think Constellation is really structured to operationally improve and implement best practices, with such a large asset?

Analyst 1: Yes, I think it’s possible. I went through the 10-K of Allscripts, to see how they described the business and I had a couple of highlights. They described their clients as ‘some of the most prestigious medical groups and hospitals in the US and internationally’. Then they mentioned they had a number of very large practices, with over 100 physicians. That seems a promising group to keep. They said that the number of large practices that have not yet acquired this technology, EHR – electronic health records – was small, but the number that were replacing it was increasing. They seemed to imply that there are opportunities here.

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