#12 Topicus: a Dutch serial compounder?
Topicus is the first spin-off of Constellation Software and hence, it has a demanding heritage to live up to. Will it repite its outstanding performance?
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Since the spin-off from Constellation Software 1.5 years ago, Topicus has more than doubled its price in the first 9 months, to drop later back to its starting point. Does it make sense? Is it currently undervalued? And above all, does Topicus have the necessary requirements to repeat the success of Constellation?
This post is not intended to be a Topicus or Constellation Software investment thesis. There are very detailed and relatively unbiased (it is difficult to be unbiased with Constellation) theses in the community. I will leave them as references below.
The objective here is to give a few brushstrokes of the advantages and differences that Topicus could find when replicating the Constellation model in Europe. As a European and since I speak daily with CEOs who could be targeted for acquisition by Topicus, I come across some cultural differences that could make the path sketchier. Lastly, I think it's wise to take a look at the current valuation and see what levels of growth the market is pricing in.
A warm welcome to non-believers
If you have never heard of Constellation Software, the moment you read these lines may be a turning point in your life as an investor. I recommend, actually, I urge you to immerse yourself deeply in the discovery of this amazing company. I have never seen a business with such an extraordinary alignment of incentives between any manager and the shareholders (below you will find a bunch of resources to dive deeper into Constellation and Topicus).
As a quick summary for all these non-yet-believers, Constellation uses almost all the FCF generated by its constellation of small businesses to acquire other businesses and boost inorganic growth at high ROICs.
The legs on which the business of Constellation, and now also Topicus, stand are:
Niche market with high switching costs: customised mission-critical VMS (vertical market software) products in a variety of markets: healthcare, education, finance, government, and a long etc. These specific, niche and many times unsexy software products lead to low customer churn and pricing power.
Decentralized operating structure and M&A: Constellation and Topicus (one of the previous operating groups) acquire businesses, but most of the time let the previous management team keep operating the business with autonomy. As small acquisitions are done normally at low multiples, the ROI is extraordinary.
Culture and management: the ultimate competitive advantage. I can not stress enough the enlightenment it is to read Mark Leonard’s president letters. The incentives set up in this company are just out of this galaxy. The remuneration schemes are based on unit’s return on invested capital, the bonus of the management has to be reinvested in shares of the company bought in the open market (no shares dilution in the last decade), and a long etcetera just make this company really unique.
All these levers have led Constellation Software to multiply its value by 80x in the last 15 years.
Will Topicus perform similarly?
Can Topicus really become a sequel and emulate the execution of Constellation Software? I hope I could give a clear answer, but the best one I can give is “it depends”.
Nevertheless, I consider there are 3 relevant points that will determine the future success of Topicus:
Scale: it has always been said that one of the difficulties for Constellation Software to continue with its growth and profitability was the scale that it was beginning to get. To achieve an efficient capital deployment becomes more difficult the bigger you are, being necessary to make a higher number of acquisitions (at some point you run out of opportunities) or make much larger acquisitions (normally at higher multiples and with lower profitability).
Well, Topicus has almost reset the game. They have a “greenfield” in Europe and start over with a relatively small size, which should allow it to allocate most of its capital efficiently and with good returns.
In both graphs it can be seen how the transactions carried out by Topicus have a much smaller unit value.
European market and culture: The North American and European market and culture are more different than it might seem at first glance.
Let's start with the market: the European market is way, way more fragmented than the American one for many reasons: different languages every 500km, infinite government bodies at national, regional and local levels. All this, which could seem interesting and give Topicus additional opportunities, comes along with suffocating bureaucracy, taxes and barriers to businesses. It has always been said that Constellation has no problem spending years waiting for an owner to decide to take the decision to join the group, establishing long-lasting relationships, etc. In Europe, this could require much more specialised and local teams, potentially increasing infrastructure and personal costs.
The culture: Europe is a region with a large percentage of SMBs that has hindered productivity in recent decades. European entrepreneurs who own companies with revenues between €500k - €10m (the interesting and attractive range for Topicus) are not used to selling their businesses and using that money for other projects. It is a much less dynamic market than in North-America. Here in Europe, there is a higher degree of sentimental attachment to the companies. It is the work of a lifetime and therefore, people use to believe that the company is worth much more than it actually is. And I say this knowingly and with some personal experience. This week I have spoken with several CEOs of companies that are on Topicus's radar (confirmed) and one of them even told me that he had received offers greater than 10x profits (not from Topicus). However, it seems it was not enough for him. We are talking about 2x or 3x revenue, far from the “typical” 0.8x revenue that Constellation used to have as “hurdle rate”.
Management, governance and the dilemma of organic/inorganic growth: Constellation’s culture has been one of the most important drivers for its result over the years. Therefore it is not a surprise we would like to see a replication of these incentives alignment and practises in Topicus. Constellation has the control of Topicus board, being Mark Leonard even one of its board members. I have to say that provides quite some confidence. However, Topicus executive management team has not yet (it is fair to say it is still early) most of their net worth within the business. It is true that most of their bonuses have to be invested in Topicus shares, bought in the open market. That is already better than 99,9% of other companies, but still a point to bear in mind for the future. Furthermore, Topicus invest “heavily” to grow organically, more than Constellation has ever done, which is a great future lever to be pushed if that organic growth comes with a higher ROIC. After all, I trust Constellation oversight and culture is already embedded in Topicus.
To sum up, Topicus has all the background, bases and the incredible know-how from Constellation to do it again. It is just a matter of time to see how this management team delivers.
Valuation
In the DCF model below, I simply wanted to do the exercise of seeing what the current share price is discounting, to understand which FCF growth rate Topicus has to achieve to justify the current price. As you can see, I have projected an annualized FCF growth of 25% and granted an EV/FCF multiple of 35 in 5 years to get more or less the current share price. Worth mentioning that I am applying a 15% discount rate as my personal opportunity cost.
What happened then during this last year when Topicus was valued at 140? Sincerely, no idea. Let’s say the market was playing one of its playful games.
Having said that, current prices are still demanding an extraordinary performance from Topicus. However, it should be noted that Constellation has always had a demanding price if it was to be valued under normal frameworks. And yet, the returns obtained, no matter your buy day, have always been remarkable.
Disclosure: I have a considerable part of my portfolio in Constellation Software. I also have a small position in Topicus. Everything expressed here is only my opinion. Always do your own research.
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References
Mark Leonard letters: https://www.csisoftware.com/category/pres-letters
Constellation Software: https://www.the10thmanbb.com/investment-ideas/csutsx
Topicus: https://www.the10thmanbb.com/investment-ideas/toitsxv
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#12 Topicus: a Dutch serial compounder?
I am curious to better understand the cultural difference that makes it more difficult for founders to sell. What is driving that? One could argue that may be an advantage for TOI, since they may be viewed as good stewards of the business when compared to the PE buyers. There examples of successful serial acquirers in Europe.