Note: All currencies are denominated in USD unless otherwise stated.
For those readers who are not that familiar with Constellation Software (OTCPK:CNSWF, TSX:CSU:CA), which I will abbreviate as CSI, I’d suggest reviewing my previous article where I deeply covered the company’s background, its business model, expected growth, and management.
In this article, my focus will be on the third quarter’s results, the most recent acquisitions, and the issuance of debentures.
Investment Thesis In A Nutshell
CSI has been building a highly defensive and well-diversified business model for over 20 years in the vertical market software (VMS) industry by acquiring over 800 different business units. The company is still led by its founder Mark Leonard along with an outstanding and well-experienced management team, which has set the right incentives for its employees and adopted best practices to pursue new acquisitions at the right hurdle rates.
One of the most common concerns investors face when analyzing CSI is the company struggling to deploy all of its free cash flow into new acquisitions as its size expands, but as I’ll show in this article, this is not something we should worry about yet, and I anticipate growth rates above 20% in the coming years.
Q3 Results Review
Last quarter’s results brought us an outstanding 8% revenue organic growth (6% currency adjusted), well above its historical average (1.4% since 2007), and one of the highest organic growth rates in recent years:
Author (Data from Constellation Software’s Financial Statements)
It is important to note that the abnormal organic growth in Q2 2021 (14%, 8% currency adjusted) was significantly impacted by the U.S. dollar appreciation against the other currencies in which the company operates.
Remarkably, the higher organic growth has been achieved without increasing the R&D expenses over the last quarters, which has stayed around 14%, in line with the historical average.
One of the explanations for the higher organic growth could be the higher-than-average inflation rates we had during last year. Since many of CSI’s contracts incorporate clauses to adjust prices based on inflation, the company has been able to pass an increase in prices to its customers. I believe this trend could persist during next quarters due to the mission-critical nature of CSI’s products, limited churn rates, and the strategic approach to increase prices gradually.
Many of CSI’s relationships with its clients have been built over many years, decades in some cases, and it might be easier to increase prices by 4-5% during three years than translating a one-time 10% price increase.
“Sometimes, you’ll have these very large customers that have contracts that limit the amount of increases. And also, it’s the managers. Sometimes the managers are on the customer side and they don’t want to give them an increase that equals or exceeds inflation, especially since we’ve gone through the last decade or more at kind of 2%, 2.5% inflation and to go and all of a sudden give your customer a 10% increase or 8% increase.”
Source: Dexter Salna (Member of the Board of Directors at CSI and Perseus). Analyst Call May 2023.
On the acquisitions side of the business, which I’ll cover in detail in the next section, there are some important adjustments to be made.
Author (Data from Constellation Software’s Financial Statements)
The biggest acquisition realized during last quarter was the Optimal Blue business and the Empower loan origination system (LOS) from Black Knight, Inc. (BKI) for a total consideration of $742M. Of the total consideration, $40M has been paid in cash for the Empower LOS, and $201M for the Optimal Blue business (plus a $1M cash holdback). The remaining $500M has been paid through a promissory note issued to Black Knight, which is not reflected in the cash flow statement as cash used in investing activities.
When looking at the amounts spent on acquisitions, we should include the $500M to get a better picture of the acquisition pace during the quarter.
Source: Constellation Software Q3 2023 Financial Statements
When adding the note issued to Black Knight, this Q3 has been the second-biggest quarter in CSI’s history regarding capital deployed into acquisitions following Q2 2022 with the Allscripts acquisition. Combined, the revenue growth during the quarter was at 23%, reaching over $2.1B.
Regarding expenses, staff costs increased by 20%, slightly behind the revenue increase, resulting in an improvement in operating margins from 13.8% a year ago to the current 15.5%. Non-cash expenses such as the redeemable preferred securities of Lumine Group (LMN:CA) (OTCPK:LMGIF) and the Topicus (TOI:CA) (OTCPK:TOITF) liability continued increasing during the quarter, which is positive given CSI’s interests in both companies.
The $1M impairment is nothing to be concerned about since it is related to the Optimal Blue acquisitions, where CSI recorded an allowance for cash flows not expected to be collected.
On the less positive side, finance costs increased during the quarter, from $29M the same period last year to the current $50M. The increase is related to a higher amount of debt under its credit facility and higher interest rates during the period. Given its debentures are linked to inflation, the company is paying higher than ever interests, which will reduce next year as inflation decreases.
Constellation Software Q3 2023 Financial Statements
On the bottom line of last quarter’s financials, cash from operations and free cash flow available to shareholders increased by 60% to $513M and $367, respectively.
Issuance of Debentures
In October, CSI issued an additional tranche of its unsecured subordinated floating rate debentures Series 1 maturing in 2040, a product the company has used in the past. The proceeds were allocated to pay down indebtedness under its existing credit facility, which totaled $686M at the end of the quarter, nearing the $840M limit.
Before explaining the characteristics of the product, I’d like to provide a bit of background. The initial issuance of the debentures was in 2014 at a price of C$95 per C$100, providing investors with a 5% discount to face value and receiving total proceeds of $81.2M, which were used to pay down debt related to the TSS acquisition. In 2015, CSI issued another tranche, this time with a premium at C$115.00 per C$100 principal, collecting $159.7M. The principal amount outstanding under the unsecured subordinated Series 1 stood at $208M before the latest issuance.
With the latest tranche, CSI collected $209M issuing at C$133.00 per C$100.00 principal amount, increasing significantly the premium paid at subscription.
Terms and Interests
CSI issued one subscription right per share, entitling to a subscription of C$100 principal amount for every 3.03 rights. To make it simple, shareholders were entitled to subscribe C$100 for every three shares owned.
Since the debentures are redeemable at the option of CSI, the company distributed to its shareholders a warrant that neutralizes the redemption rights, which was necessary to guarantee that some debt was subscribed. Otherwise, it would be risky for an investor to subscribe debt at a 33% premium to par value, knowing it might not have time to receive enough interest to cover the premium.
The debt carries a variable interest rate calculated as a fixed 6.5% interest plus the annual average percentage change in the CPI Index. From issuance to March 2024 it carries a 13.3% interest rate, and then it is reset every March until maturity in 2040.
Although it could look like an abnormally high interest rate, there are a few points to take into account. The first is the high premium to par value, and the second, is the nature of the debt, which is unsecured, meaning that if the company was going bankrupt, it would come after the Credit Facility.
The debt is trading in the TSX under the symbol CSU.DB, and as shown in the chart below, it has been trading above par since the first issuance.
TMX Money. Data from QuoteMedia
Interests are payable quarterly and if the change in CPI is negative, it will be deducted from the fixed 6.5%, but the interest rate applicable will never be less than 0%. During 2023, until November, the average change in CPI has been at 3.9%, so for the next year I expect the interest rate to be reset to 10.4%.
The expected return is presented in the table below, although it is assuming the subscription during the offering, and it would be higher if the debentures are bought now…
