It seems a bit extreme to say the Canadian markets have been “rocked” by news coming from Constellation Software. However, considering how much of a cornerstone this company has been for the index over the last 20+ years, I’d say it is a fair statement.
Constellation has been a highlighted company at Stocktrades.ca for many years, first in 2019 when it was just $1200 a share.
For the next 5+ years, the company seemed unstoppable. However, the company now faces headwinds from multiple areas that have impacted the stock.
Initially, I had planned to dedicate an entire newsletter to Constellation’s AI-related conference call. However, I decided there wasn’t enough information to warrant an entirely dedicated piece. However, further news surfaced last week that the company’s CEO, Mark Leonard, was stepping down due to health reasons. So, this gives me plenty to talk about this week.
First and foremost, I wish Mark Leonard all the best. We are talking about arguably one of the greatest investors of all time, and that is not an exaggeration. Since the company’s IPO 20~ years ago, Constellation has returned over 27,000% to investors.
But sometimes there are more important things in life than business.
I know there are many Constellation Software holders among Premium members
As mentioned, the company has been highlighted at Stocktrades Premium practically since we started the platform.
So, I’m going to dedicate this week’s newsletter to analyzing what is going on and whether I believe there is an opportunity here.
Spoiler alert: I did add to my Constellation Software position after the drop. It is important to note that although I am still fairly confident in the company’s success, there is a higher degree (albeit still small) of speculation in my most recent purchase, as there is no doubt additional risks that were not present even a week ago.
Let’s dig into it.
Leonard stepping down is a blow, but an understanding of the business makes it easier to swallow
Mark Leonard stepping down as President marks the first real test of succession at Constellation Software. Considering the company was founded in 1995, he has been with Constellation through thick and thin.
He seemed like the type of guy who would have stuck this out until the end of his days. Yes, there were continual talks of succession and planned successions, but I never really got the vibe that he was leaving anytime soon. Ultimately, his health is what drove him to make the choice to step down, which is a sad situation.
The market’s reaction was brutal. And before you say, “An 8% drop in share price is not brutal!,” it certainly is for a company like Constellation. In fact, this company is currently going through one of its largest drawdowns since its IPO. The fact it’s only around 25%~ highlights to you how resilient it’s been.
This company has had a cult-like following and shareholder base for many, many years. For shares to be flowing out at an 8% pace during a relatively bullish market overall, it was definitely one of the wilder days the company has had in years.
There are two reasons why Leonard’s resignation is not as bad as some are portraying it to be. Don’t get me wrong, it isn’t good, but it’s not thesis-altering.
First, the leadership handoff isn’t coming out of nowhere. Mark Miller will take over as President.
Miller has been with the company for over 2 decades, and he was instrumental in designing the company’s acquisition-based strategies and models.
When we think of continuity among leadership, it is arguably more important with a company like Constellation, as management is the biggest driver of this company’s returns.
I’m not saying management doesn’t matter for other companies. However, when your sole avenue of growth is through an acquisition-based strategy you have fine-tuned and perfected for the better part of 30 years, fresh management could be a disaster. The good news is that this is not the case with Constellation.
Where the departure of Leonard will ultimately hurt
Constellation’s decentralized model spreads decision-making across hundreds of managers, so Leonard’s impact on the business won’t be felt all that much on the operational side of things.
What I mean by “decentralized” is that when Constellation acquires a company, that company operates independently. The management team remains in place, their operating systems stay intact, and the brand lives on.
However, where Leonard’s absence will no doubt hurt is in losing a brilliant mind who is arguably one of the best on the planet when it comes to identifying strong companies to acquire.
As you can tell by the chart below, Constellation has little organic growth. Once it acquires companies, it will typically only generate anywhere from 4-5% annual growth organically. The thesis around Constellation lies deep within the company’s ability to acquire businesses. When you consider the fact the company has grown free cash flow per share by 20%~ annually, nearly 75% of that growth is coming from new busineses.
Whether they can do that without Leonard will be the true test. Now, with all that said, Leonard will remain on the board and will still be influential to the company. But, if his health condition deteriorates further, we will be left wondering when he will fully exit the business.
We have witnessed a similar case with Berkshire Hathaway. There is little doubt that significant influence in terms of decision-making comes from the people who work alongside Leonard and Buffett. Still, the resignations raise questions about whether Greg Abel (in the case of Berkshire) and Mark Miller (in the case of Constellation) will be able to take the helm and drive the same strong returns.
Where I am at with this
Ultimately, I view the resignation as the lesser of the two issues Constellation is faced with today. There is too much emphasis being put on a single executive’s shoulders when we’re speaking on companies worth hundreds of billions of dollars. The reality is that there are many people at the helm.
As long as Leonard remains on the board, I expect little change in terms of execution and decision-making.
The real issues lie in AI-related headwinds. But these are manageable
Constellation has structured its business around developing and maintaining complex coding for decades. The vertical market software companies it acquires have fine-tuned programs that provide mission-critical software for niche businesses.
In this regard, AI raises a massive question for the future of Constellation. Does the company’s buy‑and‑hold model of VMS software still work when tools like GPT, Codex, or Anthropic’s Claude can generate large-scale amounts of code in minutes?
The real risk here is the idea that many of these businesses that utilize Constellation’s software will say:
“If AI has made coding this easy, let’s just try to develop and maintain the software ourselves. It will save us some costs.”
In Constellation’s AI-related conference call, they acknowledged this risk. However, they also acknowledged something else:
AI is not good at debugging and maintaining code.
This is where I believe investors are overreacting. Sure, these companies could, in theory, build out a system that executes the task. However, the difficulty with this is that these pieces of code will always need to be maintained, fine-tuned, and debugged.
The difficulty with creating code through artificial intelligence is that AI trains itself through publicly available information. This means that it will source its coding methods through public repositories.
These pieces of vertical market software are hyper-specific, and solutions to these particular bugs and maintenance of these programs are not likely to be available publicly.
Constellation mentioned that yes, a company could, in theory, code its own platform. But all the benefits of that might be offset by the reliance on AI to test and debug the software. In this instance, Constellation Software provides a critical service.
They know how the software works, having coded it themselves, and they know how to maintain and debug it.
Highly regulated sectors such as healthcare or public administration probably won’t replace critical systems overnight. They just cannot risk a piece of mission-critical software going down due to a bug and not being able to diagnose it.
However, in non-critical verticals like hospitality or customer service, AI-related platforms could certainly cause some disruptions.
Constellation has stated that, thus far, it has not noticed AI having an impact on any industry outside of customer service.
On the flip side, Constellation can integrate AI into its portfolio of companies, boosting support, code maintenance, and implementation. The company could also utilize its flexibility from a cash flow perspective and purchase AI-related tools that it believes would improve client experience and integrate them into the software.
I think the market is being overly pessimistic here, and AI could realistically turn into a tailwind if the company executes well. One of the main benefits here is that we have one of the best management teams on the planet, which gives me confidence that they can manage effectively.
The acquisition story will certainly change
Constellation’s edge has always been buying small, profitable vertical software firms at reasonable prices. The core companies aren’t growing fast, so they need to be able to acquire to justify valuations.
That acquisition engine still works, but the pool of attractive deals is definitely shrinking. The problem starts with the fact that more and more private equity companies are now buying vertical market software. Also, sectors that will likely be disrupted by AI in the future shrink the pool of companies Constellation might find “attractive.”
So what exactly does this mean? It means that due diligence is going to become much more difficult. AI and cloud transitions mean legacy code bases can quickly lose their value. If Constellation misjudges these companies it acquires, the company could end up with wasted capital.
Again, with this situation, I revert back to the belief that we have one of the best management teams in the country at the helm. Make no mistake about it, this is a management play. The VMS market is becoming increasingly difficult to navigate, and if I did not have confidence in Constellation’s team to navigate this well, I would move on.
This is not a company that can simply benefit from a positive macro environment or a particular movement in the economy. This is a company that requires extensive human involvement in finding deals that can provide positive returns.
The situation has changed, but the price is certainly more attractive
Let’s sum this up in a couple of sentences.
Constellation Software is facing headwinds right now that have not existed in the prior 19+ years the company has been publicly traded. For the better part of 2 decades, it executed flawlessly in a market that had few competitors.
Now, we rely on management not to overhaul their strategy, but to make fine-tunings and adjustments to adapt to a changing world. So why did I buy, and why will I continue to buy? I have complete faith in this team’s ability to manage a changing world.
The company is now trading at 24x free cash flows. Outside of the COVID pandemic, the company has not traded at this valuation since 2017, and it is now at a double digit discount to its historical averages.
Yes, the company has mentioned that the days of 20%~ compound annual growth rates are likely over. This company is too large at this point in time and the scale of acquisitions it would need to make in order to maintain those returns would be vast.
However, even if the company grew at half that rate moving forward, it would likely lead to strong results. Few publicly traded companies can compound free cash flow per share at a 10%+ pace.
The market is euphoric when it comes to artificial intelligence. Constellation could have come out during its AI conference call and talked about how AI will be revolutionary for the business, and sent the stock up. However, management was open and blunt about both the potential downsides and potential benefits.
This is the exact mentality of a management team you want with the companies you own.
No fluff, no BS, just honest results and analysis. They’re focused more on driving long-term returns for shareholders, rather than delivering short-term narratives that temporarily boost share prices.
Make no mistake about it, Constellation now has uncertainty in its future results, uncertainty that just didn’t exist even a year ago.
However, the market has punished the company for this uncertainty, and it is much more attractive from a pricing perspective today than it was even 5-6 months ago.
