ConstellationSoftware

LastyearIaskedmyfriendstosendmethenamesofthecompaniesrunbyableandhonest
managerslikeWarrenBuffett.WithouthesitatingbothofthemmentionedaboutMarkLeonard,
aterrificguywhorunsConstellationSoftware.Ipromptlyaddedittomyreadinglist.Inarecent
interview,ShaneParrishmentionedaboutMarkLeonard.

Berkshirehasanincrediblyuniquemodelofwritingtoshareholders,andfranklynooneelseis
asgood.Onethatsslightlyoffthebeatenpath,althoughitsbecomealotbetterknownover
thepastfewyears,isaCanadiancompanycalledConstellationSoftware(CSU).
TheCEOthere
istrulydoingGodsworkasfarashowhereportstoshareholders.Veryclearpresentation
ofthefinancialperformanceofthebusiness,andalucidandhonestdiscussionofwhats
goingon.
ShaneParrish

ShanetoldthatMarkisdoinggodsworkandhiscommentmademetoanalyzeandwriteabout
ConstellationSoftwareInc.(CSI).Takealookatthetableshownbelow.Thecompanywent
IPOin2006.Innineyears,Markcompoundedshareholderswealthby43percent.Definitely
MarkhasdonegodsworktotheshareholdersofCSI.

Business

CSIwasfoundedin1995anditsheadquarteredinToronto,Canada.Itisaninternational
providerofmarketleadingsoftwareandservicestoaselectnumberofindustries,bothinthe
publicandprivatesectors.Itacquires,manages,andbuildsverticalmarketsoftware
businesses.Whatdoesaverticalmarketsoftwaremean?

Softwareprogramslikewordprocessorsandspreadsheetprogramscanbeusedinwidearray
ofindustries.Theyarecalledashorizontalmarketsoftware.Ontheotherhand,verticalmarket
softwareisdevelopedforandcustomizedtoaindustryspecificneeds.Constellationhas
comprehensivesuiteofsoftwaretargeting
Homebuilders
isanexampleofverticalmarket
software.

Asof31Dec2015,CSIhad182businessunits(BU)servingmorethan75verticals,runby
158BUmanagersthatarerolledupintoCSIvia6operatinggroups.Exceptforsomecases,
eachBUisorganizedtoserveasinglevertical.BUmanagersareautonomous,compete
vigorouslywitheachother,andareheldaccountableonlyfortheirownresults.Mostofthe
operatingdecisionsaretakenattheBUlevel.CSIorganizationstructureappearsverysimilarto
BerkshireHathaway.

IfCSIdependedonlyonorganicgrowththenservingmultitudeofverticalmarketswouldnthave
beenpossible.Thecompanyisabletoservesomanyverticalmarketsasitacquiredhundreds
ofcompaniesduringthelastdecadebydeployingfarmorethan90percentofitsfreecashflow.
Exceptforsomecases,CSIacquisitionsaresmallinthe$2to$4millionrange.

In2015,CSIgenerated$1.84billioninrevenue.Around69percentofthisrevenuecamefrom
sellingproductsandservicestopublicsectorcomprisingofgovernmentandgovernmentrelated
customers.Theremaining31percentcamefromprivatesectorcomprisingofcommercial
customers.Around54percentofrevenuecomesfromUnitedStatesand12percentcomes
fromCanada.Nosinglecustomerrepresentsrevenueinexcessof5percent.

CSIrevenueconsistsprimarilyofsoftwarelicensefees,maintenanceandotherrecurringfees,
professionalservicefeesandhardwaresales.CustomerspaylicensefeesforusingCSI
softwareproducts.Around7percentofCSIrevenuecomesfromlicensefees.Maintenanceand
otherrecurringrevenueprimarilyconsistsoffeeschargedforongoingsupportofsoftware
productspostdelivery.Italsocontainsrecurringfeesderivedfromsoftwareasaservice,
subscriptions,andothertransactionrelatedrevenues.

Mostofthemaintenancerevenueisannuitybased.Thereareseveralbenefitstoanannuity
stream
(1)
Itprovidesasolidbaseofbusinessingoodandbadtimes
(2)
Itreflectsdeep
customerrelationships
(3)
AllowsCSItooperatewithnegativeworkingcapitalasaresultofthe
collectionofmaintenancepaymentsandotherrevenuesinadvanceoftheperformanceofthe
relatedservices[deferredrevenuesconstitutes26percentofsourceoffunds].Around64
percentofCSIrevenuecomesfrommaintenanceandotherrecurringfees.

Professionalservicerevenueconsistsoffeeschargedforimplementationandintegration
services,customizedprogramming,producttrainingandconsulting.Around21percentofCSI
revenuecomesfromprofessionalservices.Hardwaresalesincludetheresaleofthirdparty

hardwareandinsomecasescustomizedhardwareassembledinternallybyCSI.Hardware
segmenthashighgrossmarginsofaround40percent.And8percentofrevenuecomesfrom
hardwaresegment.

Acompanycanrecognizerevenuewhentheservicesorproductshavebeenprovidedor
deliveredirrespectiveofcashchanginghands.SomeofCSIsoftwareimplementationsand
customizationscantakefewyearstocomplete.HowdoesCSIrecognizerevenueinsuch
cases?Underthosecircumstances,CSIuses
percentageofcompletion
methodtorecognize
revenue.Tocomputethepercentagecompletediteitherusesdefinedmilestonesorlabour
hours.

Letslookatanexampletounderstandthepercentageofcompletionmethod.AssumethatCSI
signedupforaprojectthatisworth$300million.Itestimatesthatitwouldtake3yearsto
completetheproject.Itdefinedthreemajormilestoneseachtakinganyeartocomplete.Under
percentageofcompletionmethod,CSIwouldrecognizerevenueof$100millioneachyear.
EventhoughCSIbookedanaccountingprofitof$50millioneachyear,ithadacashoutflowof
$50millioneveryyear.Onlyattheendofthethirdyear,thesumofcashinflowsandoutflows
matchesthetotalaccountingprofitof$150million.

Therearetwokeytakeawaysfromtheabovetable.First,weshouldunderstandhowacompany
recognizesrevenue.Withoutityouwillbeaoneleggedmaninanasskickingcontest.Second,
togaugethequalityofaccountingprofitsweshouldcompareitwithoperatingcashflows.From

thetableshownbelow,wecanconcludethatCSIqualityofearningsisveryhigh.Acurious
readershouldaskwhyisthereabigdifferencebetweenoperatingcashflowsandnetincome?

Thereareacoupleofreasonsforthat.UnderIFRSaccounting,whichCSIfollows,interestpaid
ondebtisclassifiedunderfinancingactivities.Thisamountisverysmall,lessthan5percentin
CSIscase,anditgavealittleboosttoitsoperatingcashflows.Themajorreasonforsuchabig
deviationisduetotheamortizationofintangibleassets.Beforediggingintothedetails,letslook
atthecoststructureofCSI.ThetableshownbelowbreaksdownthecoststructureofCSI.

EverycompanydependsonthreekindsofcapitalHuman,Physical,andFinance.Incaseof
softwarecompanies,humancapitalismuchmoreimportantthantheothertwo.Thiscanbe
clearlyseeninCSIscaseasstaffexpensesonaveragecontributetoaround53percentof
revenues.Around30percentofstaffexpensesgoestowardresearchanddevelopment.CSI
doesntcapitalizeitsresearchanddevelopmentexpenses,whichistherightwaytohandleit.

Takealookatthecontentsinsidetherectangle.EBITAmarginisalmosttwotimesofEBIT
margin.EBITAmarginishigherasCSIisaddingbackamortizationofintangibleassets.CSI
managementfocusesonEBITAinsteadofEBITmargin.Isthiscorrect?Howshouldwethink
aboutamortizationofintangibleassets?AnytimeIamstuckwithanaccountingquestion,Igoto
Buffettslettertoshareholders.

Iwontexplainalloftheadjustmentssomearesmallandarcanebutseriousinvestors
shouldunderstandthedisparatenatureofintangibleassets:Sometrulydepleteovertime

whileothersneverlosevalue.Withsoftware,forexample,amortizationchargesareveryreal
expenses.Chargesagainstotherintangiblessuchastheamortizationofcustomer
relationships,however,arisethroughpurchaseaccountingrulesandareclearlynotreal
expenses.GAAPaccountingdrawsnodistinctionbetweenthetwotypesofcharges.Both,that
is,arerecordedasexpenseswhencalculatingearningseventhoughfromaninvestors
viewpointtheycouldnotbemoredifferent.

Nonrealamortizationexpensealsoloomslargeatsomeofourmajorinvestees.IBMhas
mademanysmallacquisitionsinrecentyearsandnowregularlyreportsadjustedoperating
earnings,anonGAAPfigurethatexcludescertainpurchaseaccountingadjustments.
Analystsfocusonthisnumber,astheyshould.AnonrealamortizationchargeatWells
Fargo,however,isnothighlightedbythecompanyandnever,tomyknowledge,hasbeen
notedinanalystreports.TheearningsthatWellsFargoreportsareheavilyburdenedbyan
amortizationofcoredepositscharge,theimplicationbeingthatthesedepositsare
disappearingatafairlyrapidclip.Yetcoredepositsregularlyincrease.Thechargelastyear
wasabout$1.5billion.Innosense,exceptGAAPaccounting,isthiswhoppingchargean
expense.
WarrenBuffett

FromwhatBuffettwrote,wecanseethatcertainamortizationcharges,likeamortizationof
customerrelationshipsorcoredepositsinWellsFargo,arenotrealchargesandtheyshouldbe
addedback.ButBuffettalsowrotethatincaseofsoftwarecompanies,amortizationchargesare
realexpenses.HowmuchofCSIsamortizationshouldweaddback?

Inordertoanswerthisquestion,Iconstructedasimpletableshownabove.Imaginethatwe
acquiredcompaniesAandBbypaying$100each.LetsassumethatAandBhadidentifiable
assetsworth$50each.Thismeansthattheremaining$50shouldbeaccountedforasgoodwill.
LetsassumethatwhileacquiringAandBweexpectedanIRRof15percent.

ClearlytheacquisitionofAworkedoutverywell.Whyisthat?TheIRRofAis30percentwhich
ismuchhigherthanourexpectationof15percent.Notonlythat,Awasabletogrowsitscash
flowsatadecentratewithoutanyadditionalcapitalexpenditure.TheeconomicgoodwillofAis
muchhigherthanthatoftheaccountinggoodwillof$50.HadAamortizeditsgoodwillthenit
shouldbeaddedback.

TheacquisitionofBdidntworkoutverywell.Whyisthat?TheIRRofBis9percentwhichis
muchlesserthanourexpectationof15percent.Notonlythat,thecashflowsofBisshrinking,
likeameltingicecube,overtheyears.TheeconomicgoodwillofBismuchlesserthanthatof
theaccountinggoodwillof$50.HadBamortizeditsgoodwillthenitshouldbeleftasitis.

Thekeyideathatwecaninferfromthisexampleisthatamortizationofintangiblesisnotareal
expenseifthefollowingcriteriasaremet
(1)
IRRfromacquisitionsisaboveyourhurdlerate
(2)
Iftheacquiredbusinessescangrowitsrevenueandprofitswithoutanymajorreinvestment.
MarkLeonardspentalotoftimeexplaininghisshareholdersonwhyheisfocusingonEBITA
andEBIT.Read,reread,andreflectonwhathewrotebymappingitbacktocompaniesAand
B.

Thetoolthatweusedtoidentifytheseimpairedassetswastheinternalrateofreturn(IRR)
thatweareforecasting/experiencingfortheseacquisitions.Anothertoolforidentifying
impairmentisOrganicmaintenancerevenuecontraction.Whenmaintenancerevenue
contractionhasoccurred,thentherehasalmostcertainlybeenimpairmentintheunderlying
intangibleasset.NeitheracceptableforecastIRRsnorOrganicmaintenancerevenuegrowth
aloneareproofofunimpairedintangibleassets:
Abusinessmusthavebothanacceptable
forecastIRRandOrganicmaintenancerevenuegrowthtoclearlyhaveunimpaired
intangibleassets.
Itisworthwadingthroughacoupleofexamplesandhowtheywouldeach
measureeconomicearnings.

IRRcanbehighwhilemaintenancecontractionisalsohighifabusinesswithapoorstrategic
positionand/oradeterioratingmarketisbeingmilkedout(i.e.runtogenerateveryrapid
paybackoftheoriginalinvestment).Thiswouldlikelybetherightstrategytopursuewithsuch
anasset.However,therighteconomicaccountingtopursue,wouldbetoamortisethe
goodwillagainsttheincomeofthebusinessovertherelativelyshorteconomiclifeofthat
asset.YoushouldnotuseAdjustedNetIncome(i.e.NetIncomeplusAmortisation)when
judgingtheeconomicearningsofabusinesssuchasthis.

Similarly,IRRcanbelowwhileOrganicmaintenanceisgrowingrapidlyifacompanyiseither
investingirrationallyinorganicgrowth,orpayingtoomuchforacquisitionswithhighorganic

growth.Atthemargin,wewouldarguethatthemajorityofmultiproductsoftware
businessesoverinvestintheirOrganicgrowthinitiatives.Thisdoesntgiverisetomisleading
NetIncomefiguresunlessthecompaniesarealsocapitalisingR&Dwhichwedonotdo.If
toohighapriceispaidforagrowingacquisition,thenthereisgoingtobeintangibleasset
impairment.GAAPoftenallowsthisimpairmenttobeaveragedoutagainstabroader
intangiblespool,orquicklyamortisedbeforetheimpairmentisapparent(atwhichpoint
GAAPceasestocare,sinceithasalreadybeenwrittenoff).

IfitbecomesevidentthatanyofourOperatingGroupsaremilkingoutabusiness,orhave
overpaidforacquisitions,wewillprovideConstellationsshareholderswiththehistoricalcost
oftheintangiblesthatwepurchasedwiththatbusiness,andwewillreducetheAverage
InvestedCapitalthatwereport.Forcompetitivereasons,wewillnotadvertisethenamesof
thebusinesseswhereimpairmenthasoccurred.
MarkLeonard

Takealookatthetablegivenbelow.Since2004,CSIaverageROICis28percent.Andithas
beensteadilygoingupfrom15to38percent.Also,itsorganicgrowthispositiveanditaverages
around4percent.CSIhasbeenabletoachievethisorganicgrowthwithoutanymajorcapital
expenditures.Theorganicgrowthin2015isnegativeduetostrengtheningofUS$which
draggeddowntheorganicgrowthby600basispoints.FromallthiswecanconcludethatCSI
addingbackamortizationchargesistherightthingtodo.

IsthereamoatinwhatCSIisdoing?SomeofthebusinessunitsofCSIhaveterrificmoats.It
developssoftwareforseveralverticalsincludingparatransit,midtierutilities,equipmentrental
software,homebuildingsoftware,agriculturalsoftware,andpublichousingsoftware.By
narrowlyspecializing,CSIgotterriblygoodatoccupyingalotoflittleniches.

Softwarebusinessingeneralisverystickyandifsomethingisworkingverywellthencustomers
dontswitch[
statusquo
].Thismakeslifemuchharderforsmallcompetitorstotakeawaymarket
sharefromCSI.Biggercompaniesdontbothertoenterasthemarketsizeistoosmallforthem.
ThebestwaytoprovethestickinessofCSIsoftwareistolookat
(1)
organicgrowthofits
maintenancerevenue
(2)
churnofitscustomers.Takealookatthetablegivenbelow.Whatdo
yousee?

Withoutthecurrencyeffects,theaverageorganicgrowthcomesto9percent.Thecustomer
churnaverages4percent,suggestingthatonaveragecustomersstaywithCSIfor25years.
YoudontneedanyotherdatatoprovethattheswitchingcostsforCSIcustomersareveryhigh.

Management

EventhoughthereareterrificmoatsaroundsomeoftheindividualbusinessunitsofCSI,the
barriertoentryofstartingaverticalsoftwaremarketconglomerateisprettymuchacheckbook
andatelephone.ButitsdamnhardtoreplicateandmaintainthesuccessofCSI.Thisis
becauseofthestrongculturecreatedbyMarkLeonard.

InordertounderstandtheculturesetupbyMark,Ihaveextractedsomekeypointsfromhis
lettersandorganizedunderdifferentthemes.Thismethodofhangingexcerptsonthemesis
calledas
commonplacing
.Thisisapowerfulwaytounderstandandlearnthingsdeeply.

Howhetreatsminorityshareholders

IrecentlyflewtotheUKforbusinessusinganeconomyticket.Forthoseofyouwhohaveseenme
(Im65,andtipthenonmetricscaleat280lbs.)youknowthatthisisabitofahardship.Ican
personallyaffordtoflybusinessclass,andIcouldprobablyjustifyhavingConstellationbuymea
businessclassticket,butInearlyalwaysflyeconomy.Idothisbecausethereareseveralhundred
Constellationemployeesflyingeveryweek,andweexpectthemtoflyeconomywhentheyare
spendingConstellationsmoney.TheimplicationthatIhopeyouaredrawing,isthatthestandardwe
usewhenwespendourshareholdersmoneyisevenmorestringentthanthatwhichweusewhenwe
arespendingourown.

LastyearIaskedtheboardtoreducemysalarytozeroandtolowermybonusfactor.CSIhadagreat
year,sodespitethosemodifications,mytotalcompensationactuallyincreased.ThisyearI'lltakeno
salary,noincentivecompensation,andIamnolongercharginganyexpensestothecompany.I've
beenthePresidentofCSIforitsfirst20years.IhavewaivedallcompensationbecauseIdon'twantto
workashardinthefutureasIdidduringthelast20years.Cuttingmycompensationwillallowmeto
leadamorebalancedlife,withalessoppressivesenseofpersonalobligation.I'mpayingmyown
expensesforadifferentreason.I'vetraditionallytravelledoneconomyticketsandstayedatmodest
hotelsbecauseIwasn'thappyfreeloadingontheCSIshareholdersandIwantedtosetagood
exampleforthethousandsofCSIemployeeswhotraveleverymonth.I'mgettingolderandwealthier
andfindthatI'mwillingtotrademoreofmyowncashforcomfort,convenience,andspeed...soIm
afraidyoullmostlyseemeinthefrontoftheplanefromhereonout.

Inadditiontoourlongtermsophisticatedinvestors,wealsohaveasecondconstituencyofless
financiallyorientedlongterminvestors,includingsomeofouremployeeshareholders.Ouremployee
bonusplanrequiresthatallemployeeswhomakemorethanathresholdlevelofcompensationinvest
inCSIsharesandholdthosesharesforanaverageofatleast4years.Inpractice,theiraveragehold
periodhasbeenmuchlonger.

Onleverageandavoidsassetliabilitymismatchrisk

Iamnotcomfortableusingshorttermdebtorlongtermdebtwithhighlyrestrictivecovenantsto
financetheparentcompany.Personally,I'dusesignificantamountsofdebttofinanceourgrowthifit
werelongterm,noncallableandtheinterestpaymentscouldbedeferredforshortperiods.Wehave
demonstratedtheabilitytogenerategoodreturnsonincrementalcapitaloverthelonghaul,as
demonstratedbythetrackrecord.Unfortunately,investmentbankerstellmethatthissortofdebt
doesn'texist.

Decentralizedmanagementandseamlesswebofdeservedtrust

OnlyoneotherHPChasfollowedastrategyofbuyinghundredsofsmallbusinessesandmanaging
themautonomously.Theyeventuallycavedintoincreasedcentralisation.Myhunchisthatittakesan
unusuallytrustingcultureandalonginvestmenthorizontosupportamultitudeofsmallbusinesses

andtheirentrepreneurialleaders.IftrustfalterstheBUscanbechokedbybureaucracy.Ifshortterm
resultsareparamount,thesirensongofconsolidationsynergiesispowerful.Wecontinuetobelieve
thatautonomyandresponsibilityattractandmotivatethebestmanagersandemployees.

FromalloftheabovewecanconcludethatMarkLeonardisaowneroperatorwhoisgenuinely
passionateaboutthebusiness.Andheisrunningitforthebenefitsofallthekeystakeholders.

Valuation

BenjaminGrahamisthefatherofvalueinvesting.IlovehisquoteaboutthestockmarketIn
theshortterm,thestockmarketisavotingmachineinthelongterm,itsaweighingmachine.
Fromhisquoteonecanconcludethatoverthelongtermthestockmarketisrightincomingup
withafairmultipleforCSIshares.Thetablegivenbelowcontainsthejudgementofthestock
market.Whatdoyousee?

Basedonthecurrentstockprice,revenueandcashflowmultiplesarewayabovethelongterm
averages.Butifwecomparethecurrentmultipleswiththelastfouryearaverage[pricetosales
of4.5andpricetocashflowof41],thenthecurrentstockpriceappearsreasonablyvalued.
Whydidtheaveragepricemultiplejumpedtohigherbandsinthelastfouryears?

Thishappenedbecause
(1)
marketdiscoveredthatMarkLeonardisdoinggodswork
(2)
atone
pointMarktriedtosellhiscompany.SothemarketstartedpayingupforCSIsstock.Letslook
atthevaluationfromthevantagepointof
zenofcorporatefinance
.

TheassumptionsthatIusedintheabovetableare
(1)
Adjustednetincomecompoundat20
percentforthenext5years
(2)
CSIreinvests100percentofnetincomeintothebusiness.Mark
hintedthatifthereareattractiveacquisitions,thenhewouldconsidernotpayinganydividends
(3)
CSIwillgrowat5percentafter2020withoutfurtherreinvestment
(4)
Hurdlerateof10
percentgivestheexitmultipleof20[1/(0.10.05)].

WiththeseassumptionsthefairvalueofCSIcomesto$541pershare.Withthecurrentshare
priceat$506,thesharesofCSIisfairlyvalued.

References

1. Shareholdersletters
ofConstellationSoftware.
2. Annualreports
ofConstellationSoftware.
3. Article
onConstellationSoftware'selusiveCEO.

Disclaimer:Asofthiswriting,IdonotownsharesofConstellationSoftware.Thisisnota
recommendationtobuy,sell,orhold.Iamnotaregisteredanalyst.Iwrotethisdocument
toorganizemythoughtsandtodeepenmyunderstandingaboutthecompany.Iam
sharingitsothatyoucanlearnsomethingfromthis.

Authors:JanaVembunarayanan
Website:
https://janav.wordpress.com
Twitter:
@jvembuna