Published on March 16, 2023
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.Analyst 1: I look at the terminal value a few ways. You can look at it, taking away the M&A platforms, so you can probably take out some costs associated with the M&A team for bonuses. If you want to give some credit for a higher organic growth rate, because all the management time is focused on organic growth, as opposed to acquisitions, you might want to give a little bit there. That’s a real effect that Mark has commented on, historically. The other one is, they are probably very unlikely to go to zero acquisitions in a terminal year, so how do you think about what that, potentially, looks like? Those are the three different terminal values I would think about when looking at 2033.I think the organic growth rate is a harder one. One of the things that I’ve seen people say is they disregard everything but the maintenance revenue. But for the mature portfolio companies, some of that other revenue – be it on the hardware side or professional services side – comes with incremental margin. That stuff has not, typically, been run at zero. If that is declining, is there a little bit of a headwind there, so you need to get back to the organic revenue growth rate, as opposed to just the maintenance, which is the highest margin part. I think one of the hard parts, at the moment, is that they acquire a lot of businesses that have declining revenues, or have one with slow growth or they acquire ones that they deliberately cancel contracts on. It kind of obscures what is happening there, on a true three-year out basis.How much does organic growth matter, at this point, for Constellation?Analyst 1: I still think it’s pretty important. If this is a 2% organic growth business, how much value are you ascribing to the current perimeter platform? Then, how much do you need to believe, from the M&A side? The way I look at it is, what do I have to believe, from the M&A side, relative to what’s been priced in today. If that organic free cash flow growth is 2% or 4% or 6%, it changes, quite materially, what you need to believe, in terms of M&A.It’s also hard because the revenue growth might be slowing or declining but, actually, they do a bunch of improvements to these assets, that probably grow the free cash flow or the margin?Analyst 3: The margin, especially.Analyst 2: It’s a remarginer. The way I think about Constellation is that they are really, really good at remargining their businesses. There is a weird part, to me, about Constellation’s value. Constellation’s businesses trade, in private markets, at about four times free cash flow, yet the entity as a whole, I think the most conservative among us would probably put 15X on Constellation; maybe 10X to 15X, excluding M&A. What do we do about that? If you pile a bunch of crap together, does that make it a higher multiple pile?