A Study of Constellation Software
A Study of Constellation Software

A Study of Constellation Software

Roll Ups
Last updated
Sep 4, 2023 8:45 PM
TLDR: CSU’s core strategy is simple: acquire small established owner-operated VMS businesses with a dominant position in a vertical, provide them with the support and resources of the mothership, let them operate with autonomy, and #neversell

Constellation Software History

  • Constellation Software was started in 1995 - Took public in 2006
    • Raised $25MM from mostly pension funds and some VC money
  • Currently,
    • Have acquired over 600 companies
    • Has over 25,000 employees
    • Revenue of $5.1b USD
    • Net income of $300m USD
  • Now they are looking into large companies and gaining knowledge in other areas outside of VMS because they are so huge
Some charts

Constellation Software Strategy

  • Constellation invests in Vertical Market Software (VMS) companies
    • These are businesses that are designed for a very specific industry/problem and often have high growth, are asset-light, have recurring & sticky revenues, have strong pricing power, and high switching costs
    • Able to get a higher ROI on these smaller businesses compared to buying larger businesses
    • They would also share information between business units to increase efficiency
  • Constellation’s strategy is to buy VMS businesses, take their cash flow and use that to buy more VMS businesses
    • Once they acquire these businesses they take a very hands off approach
      • But they put incentives in place to incentivize managers to produce high returns on capital and strong, efficient growth of revenues and earnings
      • The cash flow of these businesses gets pushed back up to the capital allocators to go and buy more
      • Money isn’t really going to grow the companies as much as it is being used to fund more acquisitions
  • Post acquisition they:
    • Manage - AKA monitor performance and improve operations
    • Build - AKA instill organic growth initiatives and tuck-in acquisitions
  • They do not sell their businesses
    • Have only sold 1 of their >600+ businesses and Leonard regrets it
  • Use very little debt, but not completely against it

How they are organized

  • Functionally they are a holding company with one head office that oversees six Operating Groups (OGs)
    • The head office is responsible for capital allocation assistance and decisions, disseminating some best practices, a few clear rules, a bit of coaching, and coughs up the occasional partly trained employee for the Operating Groups. Compliance, investor relations, and handling the finance function round out the head office duties
  • Each of the Operating Groups goes out and acquires businesses - essentially what Constellation was when they first started
    • Operating Group Managers (OGMs) oversee M&A. Are typically specific to a certain vertical
  • Each Operating Group manages dozens or hundreds of Business Units (BUs) where a BU typically represents one VMS company
  • BUs are operated as an autonomous entity where the BU manager is free to make all the product and customer decisions as if they were running their own business.
    • The only difference between a BU and an independently owned VMS business is that they get the support of a $25bln company and they typically defer capital allocation to other people in the CSU organization
  • When our Business Unit manager sees that a company is getting too large and no longer is hitting their organic growth goals, they often split it into two groups run by a protege
    • “The larger a business gets, the more difficult it becomes to manage. The more procedures, systems, roles, and regulations are generated. Talented people get frustrated, innovation suffers, and the focus shifts from customers and markets to internal communication, cost control and rule enforcement.”
      • Complexity increases at a much higher rate than headcount in a large organization
  • On staying small:
    • “Something wonderful happens when you spin off a new business unit.” … “With a clean sheet of paper, the leader only takes those he needs. They set up in an open office with good communication and no overheads. They cover for each other. They leave all the bureaucracy and the crap behind”
    • "When you get big you lose entrepreneurship"

What they look for in companies

  • They look for mid to large size VMS companies
    • They also want consistent earnings and revenue growth of at least 20% per year and an experienced management team
    • They would often buy companies at 1x revenue or 4x net operating profit after tax
    • They keep hurdle rates very high - 20% IRR
  • Dominant player or market leader in small niche markets with a relatively small TAM
    • Upside to this is the competition is usually limited to other small developers - Amazon isn’t going to compete
    • First mover advantage (because in these markets churn is low, so once you get customers it’s easy to stay dominant)
  • Founder-run with motivated small teams, composed of good people
    • Management team can stay in place
  • Solving a mission critical/hair-on-fire problem
  • They love companies that sell to the public sector, governments, etc.
    • Roughly half of Constellation’s subscription revenue is from government agencies which makes their revenue even more sticky and less prone to disruption from competition because governments are not incentivized to innovate or try new things
  • Potential to grow through geographic expansion, product expansion, and or acquisition
  • Fragmented competition
  • Diversified customer base - hundreds or thousands of customers
  • Low customer attrition/churn

What they emphasize in their business (culture, values, etc.)

  • Leonard’s mentor was Steve Schotchmer - taught him about high quality businesses
    • Leonard wanted to play long term like Buffet, Munger, etc.
  • Rules are few, trust and communication are high and the focus tends to be on how to increase the size of the pie, not how it gets divided
    • Autonomy is key - he doesn’t tell people how to run their business
  • Motivation is to create a company where worthy people succeed - whether they’re hired or brought on via acquisition (although he prefers to hire from within)
  • He encourage employees who work hard, treat others well, continuously learn, and share best practices.
  • The company requires that all employees who reach a certain level of compensation invest a portion of that compensation into the company stock that vests over four years anywhere between 25-75% of their after-tax bonus must be invested in Constellation
    • Over 3000 employees are above the threshold
    • This makes for high levels of insider ownership
  • Compensation is tied to the business unit while wealth is tied to the success of the entire organization
  • They rely on data to make decisions. “You can’t manage what you don’t measure.”
    • They use their own data that they’ve collected over the years to conduct this research
  • Tons of learning resources
    • They have summits for employees
    • They conduct post-acquisition reviews on the first anniversary of every acquisition
  • They are able to acquire companies for less than other PE firms because they have a reputation for having a culture that fosters personal and professional growth, provides autonomy, embraces meritocracy, and pays for performance

Other companies with similar management structures

W.L. Gore

  • Company behind the GORE-TEX material

Illinois Tool Works

  • This is the company that Leonard himself studied for many years

Further reading

The Best Capital Allocator You've Never Heard Of: Mark Leonard | Constellation Software (TIP531)

Clay does a deep dive into Constellation Software (Ticker: $CSU). Constellation Software is a Canadian holding company that has acquired over 600 vertical market software businesses. The company was founded by Mark Leonard, and has delivered exceptional returns to shareholders since their IPO in 2006. The stock has had an average annual return of over 34% from 2006 through the end of 2022. If you are like Clay and enjoy learning about high quality businesses, then you won’t want to miss this episode. IN THIS EPISODE, YOU’LL LEARN: 00:00:00 - Intro 00:01:52 - Mark Leonard 00:03:46 - VMS Businesses 00:05:56 - Constellation Software 00:09:42 - High Performance Conglomerates 00:10:15 - Organizational Structure 00:14:36 - Culture 00:18:22 - Illinois Tool Works 00:18:35 - Rewarding Managers 00:20:28 - Empowering Employees 00:27:04 - Share Dilution 00:31:44 - Return on Invested Capital 00:34:57 - Acquisition Strategy 00:37:09 - 2021 Letter 00:42:06 - Expanding Internationally 00:43:23 - Investing in Constellation? 00:45:06 - Valuation 00:48:03 - How to Buy Shares 00:48:36 - Q3 2022 Results 00:53:21 - Final Quote ✔️ Subscribe to the We Study Billionaires channel: https://www.youtube.com/c/WeStudyBillionaires 🎧 Listen to our episodes here: https://link.chtbl.com/WSB 🖊️ Access our free show notes and transcript here: https://www.theinvestorspodcast.com/episodes/mark-leonard-the-best-capital-allocator-youve-never-heard-of/ ▶️ RELATED EPISODES: - (TIP529) Joel Tillinghast & Uncovering the Art of Outperformance: https://link.chtbl.com/WSB529 - (TIP526) Quality Investing | Lessons from Terry Smith: https://link.chtbl.com/WSB526 💡 OTHER RESOURCES - Mark Leonard’s Letters: https://www.csisoftware.com/category/pres-letters - Chris Mayer’s blog post on Constellation Software: https://www.woodlockhousefamilycapital.com/post/100x-almost-there - The 10th Man Blog: https://www.the10thmanbb.com/ - Seeking Alpha is a crowd-sourced content service for financial markets. Take control of your financial future — Use our link here for a special $140 discount: https://bit.ly/3WG6WU3 ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ABOUT OUR SHOW 🎙  On We Study Billionaires, we interview and study famous financial billionaires including Warren Buffett, Bill Gates, and Ray Dalio. We teach you what we learn and how you can apply their investment strategies in the stock market. 🌍 Website: https://bit.ly/3TehwjE ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ LISTEN OR WATCH 🎧 OTHER SHOWS FROM OUR NETWORK: 🏆 Learn from high-profile guests on how to succeed in markets and life on Richer, Wiser, Happier: https://bit.ly/3p3pcHZ 💸 Get introduced to the world of investing and business on Millennial Investing: https://bit.ly/3QakOTf 🏘 Learn the ins and outs of real estate investing on Real Estate 101: https://bit.ly/3JDBXm1 ₿ Get updated on all things Bitcoin on Bitcoin Fundamentals: https://bit.ly/3JEE1di 💰 Learn everything you need to know about investing on The Investor’s Podcast Network: https://bit.ly/3D61QsZ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ OUR FREE INVESTING COURSES/RESOURCES: 📧 Stay up-to-date on financial markets and investing strategies with our daily newsletter, We Study Markets: https://bit.ly/3eC0n4a 📱Check out our hosts’ favorite apps and services for investing, personal finance, and education: https://bit.ly/3VCzIVo ✏️We Study Billionaires Starter Pack: https://bit.ly/3EMOwuT 🎬 Warren Buffet Investing Course: https://bit.ly/3gdxbAY 🗂 Asset Allocation Course: https://bit.ly/3TehLv4 📂 Intrinsic Value Index: https://bit.ly/3CImuxL 🔥 If that is not enough: https://bit.ly/3VyCsTP MY FAVORITE STOCK INVESTING TOOLS: 💲 (Paid) TIP Finance Tool: https://bit.ly/3s3tH6J 🎁 (Free) Fizviz: https://bit.ly/3smtkVf ☑️ Complete list of tools I find most valuable: https://bit.ly/3yJvt0H ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ WHO I AM: I’m Clay Finck, host of the 🎙We Study Billionaires Podcast. I’m passionate about learning top 💰investing and business insights and sharing them with others. ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ GET IN TOUCH WITH ME 💬: I’d love to hear from you! Send me a tweet 🐦 directly at https://twitter.com/clay_finck if you’d like to have a quick exchange of thoughts! ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ⏤ ❗ DISCLAIMER: This show is for entertainment purposes only. Before making any decisions consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.

The Best Capital Allocator You've Never Heard Of: Mark Leonard | Constellation Software (TIP531)