May 8, 2020: Learnings from the 2019/2020 Constellation Software Annual Meeting. Acquisitions in vertical market software industry, use of leverage, public vs. private market opportunity set, spin-offs, organic growth vs. acquisition trade-off, culture and difference with Berkshire.

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Episode Notes:

Constellation Software Shareholder Meeting Notes:

"High curiosity and a willingness to learn is what makes a great professional."

On discounts on software: “Well $BAM is investing in retailers so that they can pay $BPY rent, but we're not going to do that at $CSU.TO."

"We're willing to do minority investments sight unseen. Yes, you won't get the same price as PE firm xYZ, but we will hold the stake forever, where the PE firm will flip it 3/4 years out, and that's the decision you have to make"

Due Diligence

• "Some great businesses don't need a ton of diligence, just a review of history and a view on the industry". Mark Leonard: I'm willing to do small amounts of diligence.

• "I can do reputational checks easily in an industry. I came fro m a minority investing background, I know how to make a portfolio of minority stakes. It's not wildly uncomfortable vs. majority investing"

Leverage

• Prefer RE and don’t want to rely on that

• Will have cash on hand to help operating companies… but overall not fan of using leverage unnecessarily 

• "at some point the debt market won't be so easy. THe idea is to have a very well financed core business and then perhaps some leveraged subsidiaries as opportunities pop up that we can basically be a backstop for"

Copycat PEs: Study them all the time

Geographical update

• EU

  • Building foothold. Each country is different

• South America

  • Inherited local talent from acquisitions

  • Large pool of untapped highly technical talent

• Japan

  • Significant culture difference and leads to slower going

• Globally

  • Local talent is key. Also have significant minority shareholders in places like Japan

Software PE prior to COVID

• “Never before have people paid so much for large vertical software companies… with ever more dry powder available to PE investors in this space” - Expecting pricing to improve… haven’t seen it yet… but hope 

Large deal pipeline - Brokers showing more deals

What underlying assumption will break down for VMS Software?

• Depends on what VC groups do.. depends on situations

• Pension funds will be transacting with VC groups… left holding the bag...

• A lot of what PE has done is selling them back and forth to eachother. We won't be competitive if the biz is leveraged to the gills and is overoptimized."

• "At some point it costs you to overoptimize. As things change hands 5/6/7 times, and at some point the pensions will buy them directly because someone has to be left holding the bag"

Hurdle rates - will you reduce given falling interest rates?

• “It’s hard to maintain discipline in hurdle rates.. and hard to make it a cultural norm… and every inch you give.. hard to get back….and I’d rather not drop the rates until I’m absolutely certain that we are not deploying capital.. our bias… is to keep them high as long as we can."

• “Can you imagine any government voted back in wanting interest rates to go back up?… I think we’re kinda stuck at low interest rates."

New markets

• “Go into new markets in VMS every year… outside VMS.. definitely.. but hard pressed to find better business than VMS.. has a big moat around it and not capital intensive… tends to attract a class of employees you want to surround yourself with…. Really hard to find anything comparable… obviously we are looking.” -> ML is on the prowl to evolve. 

• If we can’t redeploy the capital we will find places for it or return it to shareholders

Common stock investments?

• ‘Investing in public companies is hard if you can’t have influence."

• “Made good rates of return on some public company investments… rates of return were better than the permanent investments… but the tenure was low… was because those companies tend to get taken out… so then targeted underperforming companies that get cheap… with underlying hope of buying those companies… we bought one of them but it was a process that got hostile… the company was doing poorly and we wanted more influence so bid… but had hard time having management listen to their advice prior to. PE got vast majority of other public investments…. Big rates of return but poor use of energy and time.” 

• “So would we invest in a public investing poorly? no. we would invest in a public company that is doing well where we don’t need significant influence.” 

• Control seems key here. 

  1. "We would invest in a public company that was doing well where we had respect for management, we would not invest in a public company that was struggling unless we had control."

• “Don’t predict the future.. we can just react to it."

Company culture

• 11K employees. Their sense of identity with me is low but their sense of individual identity with operating company is high.. and the focus is pushing the autonomy down. 

• We pay out cash bonuses and require employees buy shares of the business. 

• Spin outs is a healthy idea and don’t know if serial spin outs is a successful model but are willing to try a few. 

• Don’t see any discount reflected in our stock so that wouldn’t influence me (on spinning out operating unit). 

• New operating unit would mean mark would have to work harder and have more people reporting to him and he doesn’t want that lol… don’t want it to happen easily. 

• Japan currently is an experiment they are running and mark is personally very involved… but it may one day be an operating group.. 

Churn

• Was historically 4-5% but not published..

• Stopped publishing because it didn’t accurately reflect what was happening… 

• March was not hard hit by COVID.. nearly all industry sectors were decimated in April… so suspect terrible results in Q2 for S&P

Protecting software assets

• If competitors ignore ROIC.. you will concede market share… then you focus on your internal operation and creating your own subsegment… short term irrational you can tough it out… for long term irrationals… good luck. 

• Do R&D to keep customers for the long haul… some shrinkages are customers going from one platform to another within CSU. Still pour in whole lot into product lines. 

• They breakout headcount by function and R&D is largest. 

Product development/SaaS

• #1 way for rewrites is IRR for several years.. 

• Protecting customer base with new rewrites because it provides another option for them. 

• Clients don’t adopt new platform as quickly as you’d hope. There are data conversion and retraining costs… and all the bumps on the road. The switching costs are high. They don’t naturally want to join a new product even when they trust you. 

• We lose shares not because of technical debt… it’s because we take our customers for granted from being in the industry for 10+ years. We need to study the customers needs and adapt for that

• High probability + significant use of cash + high return => criteria for things in pipeline for rewrites of softwrae

Competitors

• ML is shocked at how much money the VC backed software companies are spending their money. They blow cash in the name of “large TAM” but ML doesn’t believe that TAM isn’t accurate. 

• The usually attack a value chain and try to bundle more to have a sufficiently bigger TAM… which gets more VC funds… it got the game going for a long long time… eventually the public markets won’t support that at 10x sales and no profits and the game will end. 

Organic growth of Revenue

• We are driven by IRR

• If you get greedy on organic growth.. you will overpay on acquisitions and have poor incremental ROIC.. and vice versa

• Would happily buy a low organic growth company with a wide moat. 

• We favour growth in recurring revenue over other revenue streams

• Many businesses we are a small part of the customers operating costs and there are opportunities to expand the services

• Also have to realize that customers in VMS groups are consolidating and that may limit organic growth in future.

• New product development = Most challenging. Wired to look at new products with the discipline of generating profits… not the ‘make and they will come’ approach

Why no ANI in key metric?

• Trouble with adding back D&A

Learning from high performing conglomerates

• Smaller acquisitions, down in branches, debt used sparingly, disciplined hurdle rates

• Many in the study had highly levered, lowering hurdle rates, acquisitions made at head office. 

Acquisitions

• More acquisitions => decrease growth 

• Distractions go up too because the best and brightest aren’t focused on the existing products

• Seeing gov’t capital substituting market capital but will see opportunity to buy bigger companies at reasonable prices if economy stumbles out… through corporate carveouts. 

• There is a scenario where they will do an acquisition with stocks. ML has been luring the board down that path. 

Employee churn

• Jonas: Highest churn cohort = 0-1yr cohort; 2-5, then 5-10, 10+ are the cohorts; very low churn as it gets higher up

• Employees get to buy shares that are locked up and are tax beneficial from that

Best practices

• Not disclosing best practices

• Showing managers how some ways destroy value like showing them ROIC results of actions etc… 

Difference with BRK

• More collegial… a group of colleagues here than it being a holding company like BRK. Sharing best practices..

• Not 2 master capital allocators like BRk… 

• Homogenous to VMS

• Focus on culture + ROIC