Ich hatte eigentlich vor das ganze auf wikifolio, als ersten Kommentar zu meinem wikifolio https://www.wikifolio.com/de/de/w/wf000natxc
zu teilen, jedoch geht das warum auch immer nicht. Weil ich diese auf Englisch schreiben will, ist der geschriebene Beitrag auch auf Englisch. Ich hoffe er gefällt euch trotzdem.
Constellation Software $CSU (-1,8%) , a leading player in the vertical market software (VMS) and IT services space, has been a focal point for investors due to its impressive track record and evolving strategy. This post delves into the company’s recent performance, strategic shifts, valuation concerns, and the bear thesis surrounding its declining return on invested capital (ROIC).
Recent Quarterly Performance
In its latest quarter, Constellation Software delivered somewhat mixed results, with several key highlights:
- Revenue Growth: Total revenue grew by 13% year-over-year. However, organic growth was notably weak at just 0.3%, the lowest in recent memory. Excluding the contributions of Topicus and Lumine, core Constellation Software Inc. (CSI) growth was a more respectable 12%.
- Net Income: Increased by 10%, reflecting solid profitability despite the organic growth slowdown.
- Acquisitions: The company deployed $133 million across acquisitions, a relatively light figure for Constellation, with $39 million deferred. Management signaled a significant ramp-up in merger and acquisition (M&A) activity planned for Q2.
- Cash Flow Strength: Cash flow from operations (CFO) rose by 12%, and cash flow available to shareholders (FCFA2S) increased by 14% to $510 million, underscoring the company’s ability to generate substantial cash.
- Alterra Performance: The Alterra segment underperformed, with a 13% decline in growth and a 5% drop in 2024. Despite this, Alterra maintains a decent cash internal rate of return (IRR), having returned $266 million in free cash flow (FCF) on a $892 million investment.
The earnings call provided deeper insights, revealing management’s conservative approach to acquisitions and a focus on maintaining high hurdle rates for new investments. The light acquisition activity this quarter may reflect a deliberate pause, possibly due to valuation concerns or a strategic shift, which we’ll explore further.
Strategic Shifts and Style Drift
At the 2025 Annual General Meeting, management highlighted a gradual decline in the quality of net new additions over the past decade, evidenced by a slow but steady drop in ROIC. Historically, Constellation’s success was driven by acquiring VMS businesses in niche geographies, capitalizing on their pricing power, sticky customer bases, and high switching costs. However, the VMS niche appears to be nearing saturation, prompting a potential style drift in the company’s strategy.
Geographic and Sector Expansion
- Geographic Moves: While Constellation’s Topicus Software Solutions (TSS) continues to target Europe, recent Q3 and Q4 moves indicate an increasing focus on Asia, with further expansion likely.
- Sector Diversification: The company is exploring opportunities beyond traditional VMS, with IT services, payment processors, and horizontal market software (HMS) emerging as prime candidates. This shift aims to sustain growth as VMS opportunities dwindle, though these new segments may not replicate the same high-quality characteristics of VMS.
AI as an Opportunity, Not a Threat
Management addressed concerns about artificial intelligence (AI) disrupting their business model. Unlike small software-as-a-service (SaaS) vendors, which face existential threats from AI, Constellation’s hybrid IT service and software model positions it to leverage AI as a complementary tool. AI can reduce costs, enhance scalability, and enable the integration of additional verticals into existing solutions. However, Mark Leonard, Constellation’s president, noted that while several portfolio companies have made significant AI investments, these have yet to deliver substantial ROIC. This suggests a cautious but optimistic approach to AI adoption.
Stance on Buybacks
Constellation remains opposed to share buybacks at current valuations, signaling confidence in its ability to deploy capital into acquisitions with higher returns than repurchasing stock. This decision aligns with the company’s long-standing capital allocation discipline but may frustrate investors seeking immediate shareholder value creation.
Valuation and Key Concerns
Constellation Software, due to its outstanding historic performance trades at premium valuations, but as some investors fear a shortening of the runway questions about the sustainability arise:
- Valuation Metrics:
- EV/EBITDA: 30x
- EV/FCF: 34x
- EV/FCFA2S: 35x
- Organic Growth Slowdown: The 0.3% organic growth rate and expected slowdown in core segment performance over the next few quarters are notable red flags.
- ROIC Decline: The gradual decline in ROIC is a central concern, tied to both measurement issues and the company’s evolving acquisition strategy.
- VMS Saturation: The biggest challenge is replicating the unique characteristics of VMS—pricing power, sticky business models, and high switching costs—in new segments like IT or payments. If Constellation cannot find a comparable growth lever, its ability to sustain historical returns may be at risk.
The million-dollar question remains: Can Constellation replace its VMS-driven growth engine with equally high-quality opportunities? If such a lever exists, why hasn’t it been fully utilized yet?
Addressing the Bear Thesis
The bear case for Constellation centers on three main arguments: a potential “runway” exhaustion for VMS acquisitions, the difficulty of finding high-quality replacements, and the
declining ROIC. Let’s unpack these concerns and provide counterpoints.
ROIC and ROIIC Analysis
The decline in ROIC has been a focal point for critics, with some pointing to historical estimates (e.g., 42% ROIC) as evidence of diminishing returns. However, these figures are misleading due to measurement issues, such as excluding accumulated amortization of intangibles, which inflates ROIC. A more accurate historical ROIC is closer to 29%.
More importantly, return on incremental invested capital (ROIIC) is a superior metric for evaluating Constellation’s performance, as it isolates the returns generated from new investments. ROIIC is calculated by dividing the change in net operating profit after tax (NOPAT) by the additional capital deployed. Based on NOPAT and acquired enterprise value, Constellation’s ROIIC is estimated at 16.5–17%, an impressive figure that confirms new investments are meeting or exceeding hurdle rates.
The ROIC decline is driven by two factors:
Measurement Issues: The invested capital base has grown faster than NOPAT due to frequent small bolt-on acquisitions, causing rolling ROIC to drift lower even as hurdle rates are met.
Acquisition Drift: Since 2021, Constellation has shifted toward larger deals, which face higher competition and fees but offer strategic benefits like larger moats, network effects, and global exposure. This shift has coincided with a 230%+ stock price increase, reflecting market confidence in the strategy.
Acquisition Strategy: SMID vs. Large Deals
Constellation’s pivot to larger acquisitions has sparked debate, as smaller deals (SMIDs, under $5 million) historically delivered higher ROIC. However, the total cost of sourcing, building relationships, and retaining SMIDs outweighs their returns compared to larger deals. Larger acquisitions, while more competitive, improve broker relationships, reduce operational and administrative costs, and provide strategic advantages. For example, management cited the Asseco deal, noting that the relationship came with significant upfront costs but long-term benefits.
Despite the focus on larger targets, Constellation continues to pursue SMIDs opportunistically, maintaining a balanced approach. Management’s goal remains to acquire businesses growing at 10% and accelerate their growth to 15%, a core moat that aligns closely with the calculated ROIIC.
Cash Flow and Capital Deployment
Cash flow available to shareholders (FCFA2S) is the ultimate metric for tracking Constellation’s capital allocation. This quarter, FCFA2S was $67 million (excluding Topicus), with an expected surge to over $427 million in the next quarter. Constellation remains committed to deploying 100% of its FCF into acquisitions, dispelling concerns about a lack of opportunities. Management’s conservative approach, led by Mark Leonard, ensures that hurdle rates are prioritized, even if it means lighter quarters like the current one.
Alterra Context
The underperformance of Alterra has raised eyebrows, but management emphasized that the growth decline was anticipated and factored into their investment thesis. Alterra’s $266 million FCF return on a $892 million investment demonstrates its resilience, reinforcing Constellation’s ability to generate value even in challenging segments.
Growth Outlook and Future Levers
While the VMS niche may not be fully replaceable, Constellation has multiple growth levers to sustain its trajectory:
Spinoffs: Portfolio companies like Topicus provide opportunities for value creation through independent growth and capital allocation.
Horizontal Market Software: Moving beyond niche VMS into broader software markets offers scale and diversification.
Payments and IT Services: These sectors align with Constellation’s IT provider model and offer stable cash flows, though they may lack VMS’s pricing power.
Geographic Expansion: Continued focus on Europe (via TSS) and increasing presence in Asia provide new markets for acquisitions.
The ROIIC trend remains a critical indicator, and its current strength (16.5–17%) suggests that Constellation’s newer investments are performing well. While a VMS-equivalent growth engine may be elusive, the company’s disciplined approach to capital deployment and ability to enhance acquired businesses’ growth rates position it for continued success.
Conclusion
Constellation Software faces legitimate challenges, including a slowdown in organic growth, a declining ROIC, and the difficulty of replicating VMS’s high-quality characteristics in new segments. However, these concerns are mitigated by the company’s robust cash flow generation, disciplined acquisition strategy, and strong ROIIC of 16.5–17%. The shift toward larger deals and new markets like Asia, IT services, and payments reflects a pragmatic response to VMS saturation, while maintaining hurdle rates ensures capital is deployed effectively.
Investors should focus on FCFA2S and ROIIC as key metrics to monitor Constellation’s performance. While the stock’s premium valuation (EV/EBITDA 30x, EV/FCF 34x) demands scrutiny, the company’s ability to generate consistent returns and navigate style drift supports a cautiously optimistic outlook. The fuss around Constellation is warranted, but the bear thesis overlooks the company’s adaptability and capital allocation prowess. As long as hurdle rates are met and ROIIC trends remain strong, Constellation Software remains a compelling long-term investment. Through it all Mark Leonard and the Constellation team remain on of the greatest capital allocator ever.
