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Jun 8, 2017

This overlooked TSX tech stock has gone up 3,000% in last decade

Constellation Software 10-year chart: June 7, 2017

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The top tech stock on the TSX is up nearly 3,000 per cent over the course of the last decade, but most Canadians would likely struggle to name a single one of its products.

Toronto-based Constellation Software’s (CSU.TO) meteoric rise has been driven by an aggressive roll-up strategy, snapping up more than 250 niche software businesses since President Mark Leonard started the company in 1995 with $25 million in funding from OMERS and Ventures West Capital, eventually building it into a $15 billion behemoth.

Constellation operates by purchasing small vertical market software (VMS) providers, serving a far-ranging slate of industries, including golf course operators and municipal waste managers. These are companies with niches too small to attract wholesale software development competition from the Oracles and SAPs of the world.

The strategy isn’t without its detractors. Some investors worry Constellation’s aggressive M&A strategy is unsustainable and a shortage of solid acquisition targets would inevitably hurt future growth. But the company says it has amassed a database of some 35,000 potential targets and has beefed up its merger and acquisitions division with additional staff in a bid to increase its deal volume to 100 per year.

While Leonard admitted in his annual letter to shareholders that the M&A environment had grown more difficult over the years, Constellation’s pace of acquisition has actually picked up so far this year, with RBC estimating the company has deployed $123 million so far this year, easily outpacing the $76 million it spent in the same period of 2016.

Of further concern is the bevy of private equity capital jostling with Constellation for potential takeout targets, including stiff competition from cash-rich Vista Equity Partners and Thoma Bravo. Leonard warned in his April 25 letter to shareholders that the crowding of Constellation’s traditional stomping ground will not only drive up the prices demanded by takeout targets, but also heighten competition for skilled workers.

“A number of these new competitors are trolling our employee base for talent,” he wrote. “This much capital targeting the VMS sector has driven and will continue to drive up purchase price multiples.”

In spite of the higher multiples, HollisWealth portfolio manager Jason Del Vicario, whose Hillside Moderate Growth model portfolio counts both Constellation stock and debentures as among their largest holdings, thinks Constellation’s integration strategy will continue to allow it to make attractive acquisitions. In a phone interview, Del Vicario said the company’s tendency to integrate and retain existing management presents an attractive alternative compared to other potential suitors.

“If there’s a competitive bidding process, they’re not going to be the top bidder,” Del Vicario said. “But if you’re looking for a dance partner, [Constellation] will say ‘we’re going to take over your company and we’re going to let you run the business as you see fit’: that’s an appetizing proposition for a lot of potential sellers.”

Constellation has a track record of walking away if it thinks bidding is getting too rich. In December 2016, it struck a deal for a US$80 million investment in telecom software provider Redknee solutions, only to walk away when ESW Capital topped its offer by a mere US$3.2 million. In Leonard’s letter, which serves as one of the only missives from the publicity-adverse executive, he emphasized the need for every investment to meet the firm’s hurdle rate.

Del Vicario, who has held Constellation since 2014, also thinks Leonard’s extensive track record, built over Constellation’s 22 year run and his prior run as a venture capitalist, affords him some benefit of the doubt if shareholders grow concerned about the pace, or rationale, of Constellation’s acquisitions.

“It’s undisputed that Leonard is the rock star, the number one capital allocator in Canada,” Del Vicario said. “Constellation Software is a bit of a black box – we know what they do, how they do it and we know they have very strict measures for what they will and won’t pay for a company – we just don’t know what they’re going to buy quarter to quarter.”

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