Note: All currencies are denominated in USD unless otherwise stated.
For those readers who are not that familiar with Constellation Software (OTCPK:CNSWF, TSX:CSU:CA), which I will abbreviate as CSI, I’d suggest reviewing my previous article where I deeply covered the company’s background, its business model, expected growth, and management.
In this article, my focus will be on the third quarter’s results, the most recent acquisitions, and the issuance of debentures.
Investment Thesis In A Nutshell
CSI has been building a highly defensive and well-diversified business model for over 20 years in the vertical market software (VMS) industry by acquiring over 800 different business units.
The company is still led by its founder Mark Leonard along with an outstanding and well-experienced management team, which has set the right incentives for its employees and adopted best practices to pursue new acquisitions at the right hurdle rates.
One of the most common concerns investors face when analyzing CSI is the company struggling to deploy all of its free cash flow into new acquisitions as its size expands, but as I’ll show in this article, this is not something we should worry about yet, and I anticipate growth rates above 20% in the coming years.
Q3 Results Review
Last quarter’s results brought us an outstanding 8% revenue organic growth (6% currency adjusted), well above its historical average (1.4% since 2007), and one of the highest organic growth rates in recent years:
It is important to note that the abnormal organic growth in Q2 2021 (14%, 8% currency adjusted) was significantly impacted by the U.S. dollar appreciation against the other currencies in which the company operates.
Remarkably, the higher organic growth has been achieved without increasing the R&D expenses over the last quarters, which has stayed around 14%, in line with the historical average. One of the explanations for the higher organic growth could be the higher-than-average inflation rates we had during last year. Since many of CSI’s contracts incorporate clauses to adjust prices based on inflation, the company has been able to pass an increase in prices to its customers.
I believe this trend could persist during next quarters due to the mission-critical nature of CSI’s products, limited churn rates, and the strategic approach to increase prices gradually. Many of CSI’s relationships with its clients have been built over many years, decades in some cases, and it might be easier to increase prices by 4-5% during three years than translating a one-time 10% price increase.
Sometimes, you’ll have these very large customers that have contracts that limit the amount of increases. And also, it’s the managers. Sometimes the managers are on the customer side and they don’t want to give them an increase that equals or exceeds inflation, especially since we’ve gone through the last decade or more at kind of 2%, 2.5% inflation and to go and all of a sudden give your customer a 10% increase or 8% increase.
Source: Dexter Salna (Member of the Board of Directors at CSI and Perseus). Analyst Call May 2023.
On the acquisitions side of the business, which I’ll cover in detail in the next section, there are some important adjustments to be made.
The biggest acquisition realized during last quarter was the Optimal Blue business and the Empower loan origination system (LOS) from Black Knight, Inc. (BKI) for a total consideration of $742M.
Of the total consideration, $40M has been paid in cash for the Empower LOS, and $201M for the Optimal Blue business (plus a $1M cash holdback). The remaining $500M has been paid through a promissory note issued to Black Knight, which is not reflected in the cash flow statement as cash used in investing activities.
When looking at the amounts spent on acquisitions, we should include the $500M to get a better picture of the acquisition pace during the quarter.
When adding the note issued to Black Knight, this Q3 has been the second-biggest quarter in CSI’s history regarding capital deployed into acquisitions following Q2 2022 with the Allscripts acquisition. Combined, the revenue growth during the quarter was at 23%, reaching over $2.1B.
Regarding expenses, staff costs increased by 20%, slightly behind the revenue increase, resulting in an improvement in operating margins from 13.8% a year ago to the current 15.5%. Non-cash expenses such as the redeemable preferred securities of Lumine Group (LMN:CA) (OTCPK:LMGIF) and the Topicus (TOI:CA) (OTCPK:TOITF) liability continued increasing during the quarter, which is positive given CSI’s interests in both companies.
The $1M impairment is nothing to be concerned about since it is related to the Optimal Blue acquisitions, where CSI recorded an allowance for cash flows not expected to be collected.
On the less positive side, finance costs increased during the quarter, from $29M the same period last year to the current $50M. The increase is related to a higher amount of debt under its credit facility and higher interest rates during the period. Given its debentures are linked to inflation, the company is paying higher than ever interests, which will reduce next year as inflation decreases.
On the bottom line of last quarter’s financials, cash from operations and free cash flow available to shareholders increased by 60% to $513M and $367, respectively.
Issuance of Debentures
In October, CSI issued an additional tranche of its unsecured subordinated floating rate debentures Series 1 maturing in 2040, a product the company has used in the past.
The proceeds were allocated to pay down indebtedness under its existing credit facility, which totaled $686M at the end of the quarter, nearing the $840M limit.
Before explaining the characteristics of the product, I’d like to provide a bit of background. The initial issuance of the debentures was in 2014 at a price of C$95 per C$100, providing investors with a 5% discount to face value and receiving total proceeds of $81.2M, which were used to pay down debt related to the TSS acquisition.
In 2015, CSI issued another tranche, this time with a premium at C$115.00 per C$100 principal, collecting $159.7M. The principal amount outstanding under the unsecured subordinated Series 1 stood at $208M before the latest issuance.
With the latest tranche, CSI collected $209M issuing at C$133.00 per C$100.00 principal amount, increasing significantly the premium paid at subscription.
Terms and Interests
CSI issued one subscription right per share, entitling to a subscription of C$100 principal amount for every 3.03 rights. To make it simple, shareholders were entitled to subscribe C$100 for every three shares owned.
Since the debentures are redeemable at the option of CSI, the company distributed to its shareholders a warrant that neutralizes the redemption rights, which was necessary to guarantee that some debt was subscribed. Otherwise, it would be risky for an investor to subscribe debt at a 33% premium to par value, knowing it might not have time to receive enough interest to cover the premium.
The debt carries a variable interest rate calculated as a fixed 6.5% interest plus the annual average percentage change in the CPI Index. From issuance to March 2024 it carries a 13.3% interest rate, and then it is reset every March until maturity in 2040.
Although it could look like an abnormally high interest rate, there are a few points to take into account. The first is the high premium to par value, and the second, is the nature of the debt, which is unsecured, meaning that if the company was going bankrupt, it would come after the Credit Facility.
The debt is trading in the TSX under the symbol CSU.DB, and as shown in the chart below, it has been trading above par since the first issuance.
Interests are payable quarterly and if the change in CPI is negative, it will be deducted from the fixed 6.5%, but the interest rate applicable will never be less than 0%.
During 2023, until November, the average change in CPI has been at 3.9%, so for the next year I expect the interest rate to be reset to 10.4%. The expected return is presented in the table below, although it is assuming the subscription during the offering, and it would be higher if the debentures are bought now in the market due to the current price of C$129.
Due to the high premium to par value, the yearly average rate of return assuming a 2% inflation (consistent with the average since 1998), would be 7.12%.
Fitch has assigned a BBB rating to the debt, the 4th highest of Fitch’s 11 rating categories, which I find quite conservative taking into account CSI’s defensive business model, recurring revenues, and financial ratios.
Acquiring At A Good Pace
During the last quarter, CSI was able to deploy a significant amount of capital thanks to the opportunistic acquisitions from Black Knight, but if we exclude this large acquisition the number of smaller companies acquired has slightly decreased compared to the first half of the year or 2022.
Based on the press releases and news published by CSI’s operating groups, I estimate the total amount of acquisitions has been around 25 during Q3. When excluding the largest acquisitions, CSI has deployed $164M into the acquisition of smaller software companies with an average price of ~$8M, being Harris and Jonas the most active operating groups with 7 and 6 acquisitions announced during the quarter respectively.
Although the number of smaller companies acquired has slightly decreased compared to the first half, CSI’s third quarters have on average the lowest spending on acquisitions. During the last 5 years, the third quarter spending on acquisitions is on average 35% lower compared to the second quarter, which tends to be the most active.
Black Knight’s divestitures
CSI was able to pursue an opportunistic acquisition during the last quarter, which I believe is the result of many years of building strong business relationships and becoming a trusted company in the industry.
Following the announcement of the acquisition of Black Knight by Intercontinental Exchange (ICE), the Federal Trade Commission (FTC) sued to block the transaction claiming it would give ICE a significant position in the market for loan origination software.
To move forward with the acquisition, the FCT and Black Knight agreed to divest some of its assets, which led to CSI acquiring a high-quality business at a great price.
Optimal Blue’s software allows market participants to price, lock, hedge, and trade mortgages, and is the industry leader used by thousands of originators to lock roughly 40% of mortgages in the U.S. The business was originally acquired by Black Knight for almost $3B (60% in 2020, and the remaining 40% in 2022).
Empower is a cloud-based loan origination system that automates repetitive processing tasks based on the lender’s configurations, monitors for any data changes during the loan process and triggers a separate work item when an exception occurs, which alerts the user that additional reviews are needed.
CSI has been able to acquire both companies for just $742M, paying 2x 2023 sales and less than 6x EBITDA. The market was valuing the two companies at $3.3B as part of Black Knight, and the divestiture reduced the price paid by ICE by $1.4B.
I expect these acquisitions to generate revenues of $370M during the next year and operating cash flows of ~$125M with significantly higher margins than the average CSI business.
While Q3 has been relatively quiet regarding smaller acquisitions, so far the company has been able to deploy almost $1.8B in acquisitions with one quarter remaining, where I expect another $340M to be spent in acquisitions, reaching $2.14B for the full year (compared to $1.6B in 2022).
In Q4, there has been a similar amount of smaller acquisitions alongside the medium-sized acquisition of Medhost, Inc. by the Harris operating group. Though the price paid has not been disclosed, based on revenues I expect the total cost to be around $180M.
Topicus accelerated its acquisition pace in Europe during Q4 compared to last quarter, since there have been already six acquisitions announced in verticals such as the electronic component distribution market, debt recovery, parking management solutions, healthcare, local government, and security.
For the second half of the year, I felt short in my previous article, where I expected total revenues for the year of $8.1B, while they will probably be above $8.3B.
Looking ahead to 2024, I foresee a substantial increase during Q1 with the acquisitions of the Curbside Management and Public Safety Businesses for ~$260M (8x TTM EBITDA) from Conduent Inc. (CNDT), and Nokia’s Device and Service Management Platform for €185M (plus a contingent consideration of up to €35M).
As for now, there have already been announcements for $464M deployed into acquisitions during Q1, leading me to anticipate an acquisition spending above $2B for the full year. This projection comprises a 20% acquired growth plus a 3% organic growth, above historical average rates based on the current momentum.
Throughout the recent quarter, CSI has been able to sustain a great pace acquiring VMS companies at a good price. Although the second half of the year tends to be less active regarding acquisitions, the company deployed a good amount of its operating cash flows (without lowering its hurdle rate) thanks to the opportunistic acquisitions of Optimal Blue and Empower, capitalizing on the FTC’s intervention in the ICE/Black Knight transaction.
While finance costs have seen an increase, a decline in interest rates and inflation might ease the interest payments for the next quarters. As long as CSI continues to find great businesses with a dominant position in their particular niche at a reasonable valuation, this approach remains the most optimal capital allocation.
CSI has recently announced the retirement of Dexter Salna, who has been with the company since 1995 and was a key contributor to the development of the Perseus operating group. He will remain on the board of directors and since the business culture is well spread across the organization, I am sure the right person will be found to continue leading CSI’s outstanding growth.
Finally, on the organic revenue side of the business, CSI is also growing well above its historical average, and I expect this trend to continue for some quarters ahead. Given the recent developments and opportunistic acquisitions, I expect the company to continue growing its revenues above 20% during the next two years and deliver average returns of ~16% CAGR over the next five years.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.