#49 Valuation always matters
Navigating the stars of valuation: a journey through Constellation Software
In the art of investing, it's easy to get caught up in the excitement of finding a company that appears to have a solid business model and excellent management. However, one critical aspect that cannot be overlooked is the valuation.
In this post, as Constellation Software prepares to release its 2022 financial results, and following its recent spinoff of Lumine, we'll take a closer look at this iconic company that has long been admired for its shareholder-aligned management team and exceptional execution.
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Constellation Software has long been known for its exceptional alignment of interests between shareholders and the management team. It's a company that has consistently delivered outstanding results, prompting investors to consider increasing their positions. However, the question remains: can Constellation continue deploying its free cash flow at high returns as the company grows in size?
This conundrum is not new; similar concerns arose a few years back, but Constellation has proven its ability to execute remarkably well. Although the company's valuation may seem demanding, it has consistently outperformed expectations.
But the question remains current. Is Constellation overvalued? Many value investors are aware of the quality of the company. But those who give substantial weight in their decisions to valuation and margin of safety usually decide to pass.
Most people understand the margin of safety solely from a quantitative standpoint. As if a low enough price would protect you from a bad business, an indomitable cycle, or a terrible management team. But that's a topic for another day. Let us take a closer look at the valuation of Constellation Software, and determine whether it is currently overpriced or undervalued.
A glimpse into the past
Our analysis shall begin with a thorough examination of Constellation Software's growth and performance over the years. By tracking key metrics from 2003 to the present, we gain valuable insights into the company's development.
Some preliminary considerations:
The reinvestment rate is calculated as the amount of cash deployed in new acquisitions divided by the generated FCF.
To measure the return on incremental investments, the difference between the FCF of two consecutive years divided by the cash deployed has been calculated (reducing the FCF of the following year by 2% to account for the organic growth that Constellation has had over the years).
The data collected has been represented in various graphs, which highlight different metric trends we consider relevant and provide a clear picture of how Constellation Software has evolved and successfully navigated the business landscape.
FCF margin has grown consistently to the >20% range.
The company has managed to maintain a consistent return on new Investments well above 25% throughout this period.
the pace of reinvestment has been very fluctuating over the years, but it seems clear that after a peak of reinvestment, FCF growth subsequently follows.
Lastly, while the reinvestment rate had decreased between 2015-2020 to levels around the 50%, there is a significant uptick in the last two years, not yet reflected in FCF growth.
Key future value drivers
The market is rightly talking about the risks and challenges that Constellation is facing / will face in the future:
The larger the company becomes, the more difficult it is to allocate all the capital it generates.
To deploy more capital, they will have to acquire larger companies that will require paying higher multiples, which will impact returns on capital.
The tremendous success of Constellation has attracted competition from numerous copycats and private equity funds, which has increased competition and may make it difficult for Constellation to maintain its high hurdle rates, resulting in lower returns on investments.
This lower capacity for growth at lower returns could lead to a re-rate of the multiple, exposing investors to significant losses if they invest in Constellation.
And well, the trends seem to support these concerns...
But trends often deceive reality…
When we look at it in terms of a 5-year rolling average, we can see three things:
The return achieved on investments has remained constant above 30%.
As mentioned earlier, Constellation Software's Reinvestment Rate has seen an upswing in recent years. This suggests that the company has successfully “adjusted” (decentralized even more) its decision-making processes and found new ways to allocate capital efficiently. It's worth noting that this resurgence happened before the peak of the bubble and during a period of strong market activity. Additionally, in the LTM, the amount of FCF used in acquisitions has been close to 150%.
This recent spike in reinvestment has not yet been reflected in the FCF. In fact, LTM FCF has been lower than in 2021, but history teaches us that this level of reinvestment will eventually be reflected in the FCF.
As investors, monitoring these key parameters will help us gauge the sustainability of Constellation Software's growth and make informed decisions about the company's future.
Understanding the future and its implications on today’s price
Very well, it appears that Constellation Software's business model is still intact. However, this does not necessarily mean that we should invest in the company directly. In order to assess Constellation's investment potential, it is important to carefully consider what we are buying at current market prices.
To do this, we will explore several scenarios that could be more or less plausible, and conduct a very simple sensitivity analysis to evaluate what this means for the company's stock price. In the case of Constellation, this exercise is relatively straightforward. We will assume a 0% organic growth rate, and estimate the future value of the company based on its ability to reinvest x% of its FCF at a return rate of y%. This xy% will constitute the future growth of the company's FCF.
We will use a discount rate equal to our desired rate of return, as well as different valuation “exit multiples that could be reasonable given the performance we are assuming over the next five years. Currently, Constellation trades at approximately 30x LTM FCF, which equates to a 3% FCF yield, in an environment where the “risk free asset” gives a 5%. Surprising.
These scenarios don't account for any organic FCF growth but provide a range of possible outcomes that will help us understand the potential risks and rewards associated with investing in Constellation Software. By comparing the Enterprise Value (EV) derived from each scenario with the company's current EV, we can determine the margin of safety “MS”.
Now it's up to each individual to evaluate what is feasible and what makes sense to expect from this company in the coming years. Is it overvalued or not? Is there risk in executing a medium scenario? Will there be a de-rating? Will they have to lower their hurdle rates? Will they enter new industries for investment?
I would love to read your opinions.
Valuations are crucial, but they don't tell the entire story. When considering an investment in Constellation Software, it's essential to look beyond the numbers and embrace both the risks and opportunities the company offers.
The recent uptick in reinvestment rates over the last two years suggests that Constellation Software has found a way to decentralize decision-making and enter a new cycle of high reinvestment. This development is encouraging, as it demonstrates the company's ability to adapt and deploy capital effectively, even as it continues to grow.
Additionally, Constellation Software's management team has a proven track record of creating shareholder value. By investing in the company, you're putting your capital alongside experienced leaders who understand the intricacies of the business and know how to capitalize on opportunities in the market. Sidecar investing.
However, it's essential to remember that, despite the seemingly bright prospects, risks still exist. High valuations can limit the margin of safety, and changing industry dynamics may impact the company's future performance. As an investor, it's crucial to weigh these risks against the potential rewards and make informed decisions based on a comprehensive understanding of the company's financials, strategic positioning, and market dynamics.
Note: This is the result of a quick (but presentable) check I conducted on the train while returning from a skiing trip last Sunday, to revisit Constellation Software's current valuation. So make sure to conduct your own analysis as well ;)
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Excellent post, enjoyed reading.
great take, thank you!