Investor Dialogue: Valuing Constellation Software & Lumine Spin

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.

Just to start, one thing I’ve always been curious about, especially in the last few years, is just how to value these businesses. Obviously, very few of them are cheap, at least on any normalized or free cash flow metric. Who wants to kick off and share any key drivers or what they look at when they are valuing, either when they are modelling something out or, even conceptually, how they look at valuing something like Constellation, today?

There are a couple of ways that I look at it. Free cash flow yield and the growth of free cash flow, which is organic growth and a bit of operating leverage, that gets you to some kind of standstill return. Then obviously, the net leverage and share dilution, you can take into consideration, in terms of pure value added, per year.

Then you get stuck at M&A, which is obviously the hard part. How much does it add value, beyond the cost of capital and M&A, per year? Really, the two things I look at are, how much capital to deploy and what is the return on that?

Analyst 3: That’s the bottom line, for me. Conceptually, I would say, it comes down to making an assumption about what kind of return on capital they are going to earn and how much can they reinvest? Those are the two things; that is what it comes down to. I know we’ve talked, in the past, about terminal value for Constellation. Earlier on, I had more concerns about that too but, now, I’m at a place where I don’t really worry about that. I don’t think you have any more terminal value risk with Constellation than you do with any other business, at this point.

For me, conceptually, it’s all about making some assumption about return on capital; making some assumption about how much they can reinvest, cast that out over a decade and put a multiple on it.

I don’t know why I compare these two businesses, but I do, in my head; TransDigm versus Constellation. Let’s say TransDigm don’t make another acquisition and nor do Constellation. For me, the terminal multiple on TransDigm would be higher than Constellation because, effectively, they are true, regulated monopolies. I agree, the terminal multiple question for me – depending on the price that you pay – is less of a real worry. There is a quote where Mark, around 2014, 2015, in one of the AGMs, he said, 50% of Constellation’s value is from M&A. If they can’t reallocate capital or, even let’s say you can’t allocate it at 25% and it’s at 15%, you can’t pay 30 times.

Analyst 3: There are two different things there. One would be the reinvestment rate and the other is the terminal value of what they have. The question is, how much cash can they get out and reallocate. I’m at the point where I don’t think there is any bigger risk than for any other business because they are not sitting still with it. They update the software; they try to keep it going. But at some point, possibly, they get pulled out for something better but I think that’s a risk that almost any software company has.

That’s the way I would think about it but the reinvestment risk, for me, is the big one. I don’t know what the bottom-line number is. If you get to 25% return on capital and they reinvest 60%, over a decade, that’s 15% compounding, roughly. If they wind up reinvesting 30% or 40% of what they generate, over the next decade, then you’ve got a problem, I think. Somehow, with Mark and his team, I suspect they are going to find good things to do.