Mark Leonard reminds me of Warren Buffett. Anyone who likes reading Berkshire shareholder letters will very likely enjoy Leonard’s shareholder letters and his answers on earnings call transcripts. The Globe and Mail describes part of what Leonard has accomplished at Constellation software:
“With an initial $25-million investment from OMERS and his old associates at Ventures West Capital in 1995, Mark Leonard has built Constellation into a world-leading consolidator of vertical market software (VMS) companies—firms that create products to help run businesses in specific industries. Over the years, Constellation has made scores of acquisitions and, through its six operating groups, now provides software to over 60 industries, from health care to law to public transit…. Typically, Constellation’s acquisitions are small—in the $2-million to $4-million range—but add them all up, slip in a dose of Constellation’s financial and operational discipline, and you have [a company with a market cap of $18 billion….In this age of zero privacy, Mark Leonard has managed to maintain a practically unthinkable level of anonymity for just about any individual—let alone an IT executive who runs one of Canada’s most dynamic, fastest-growing and most acquisitive software companies, and who has been compared favourably with Warren Buffett and Prem Watsa.”
This an impressive looking chart for Constellation:
1. “Unlike most people, we would be hoping that there would be a major correction in the stock markets because the multiples are as heavy as we’ve seen in a very long time. If I have the access to capital and there is a downturn, we will buy as much as we can. That was the lesson we learned from the last one. We did terrific doing that [in the] ’08, ’09 period. We just didn’t deploy enough capital.” “As we sit on cash and people start clamoring for it to be distributed either via dividends or share buybacks. And I think you know my views on most share buybacks. And so my preference would be to hang on to the cash. We seem to be ramping our M&A activities and to some extent it seems to be paying off. And so rather than returning it to shareholders, rather hang on to it at least for the time being and see if perhaps we can deploy it.” “The high ROIC achieved over the last decade suggests that we have very good businesses. If ROIC starts to erode significantly, then either we’ve damaged our existing businesses, or our new acquisitions are less attractive than those that we have made in the past. ROIC isn’t one of those metrics that is necessarily subject to ‘reversion to the mean’. Some businesses seem to be able to widen their moats at reasonable cost.”
Leonard is an investor who uses “value as an analytical style” to buy businesses that sell software to vertical markets. Like Buffett, Leonard think about moats, uses return on invested capital as a touchstone, prefers concentrated investments to diversification and likes it when assets he wants to own for a long time “go on sale.” Of course, he is not exactly like Buffett, but they do share certain attributes and approaches.
Leonard has a superb record as an allocator of capital. In his classic book The Outsiders, William Thorndike writes about the capital allocation process:
“CEOs have five essential choices for deploying capital—investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock—and three alternatives for raising it—tapping internal cash flow, issuing debt, or raising equity. Think of these options collectively as a tool kit. Over the long term, returns for shareholders will be determined largely by the decisions a CEO makes in choosing which tools to use (and which to avoid) among these various options. Stated simply, two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders.”
“Essentially, capital allocation is investment, and as a result all CEOs are both capital allocators and investors. In fact, this role just might be the most important responsibility any CEO has, and yet despite its importance, there are no courses on capital allocation at the top business schools. As Warren Buffett has observed, very few CEOs come prepared for this critical task: The heads of many companies are not skilled in capital allocation.”
The founders of the businesses Constellation acquires are not often skilled in capital allocation and in addition do not have access to best practices in operating a software business. Leonard has demonstrated that by applying these new skills and processes to the acquired businesses Constellation will be able to create new value.
2. “We are the anti-economies of scale company. We believe in small teams outperforming large teams, and so given the choice of taking a 200-person business and buffing it up into two smaller ones, we would much prefer to do that and believe that the benefits are there as opposed to ramming businesses together, firing a bunch of people and moving a bunch of work offshore.” “There are a couple of hundred business units and every one of those managers has their own competitive environment in which they are competing. And they are making decisions around investments and whether they be rewrites or add-ons or things of that ilk and or improving coverage or allocating between farming and hunting, those role decisions that they are making individually and what you’re seeing is the sum total of those decisions. If marketing and R&D are going down as a percentage of the revenues or expenses, then I guess they aren’t seeing the returns on those investments.”
There are tens of thousands of providers of vertical market software which are potential targets for Constellation. Raymond James wrote about the opportunity which Constellation is harvesting in August 2016:
“Our analysis of software vendors indicate substantial fragmentation with approximately 38,000 VMS vendors spanning more than 12 vertical markets, with the highest concentrations in Retail and Media & Services verticals – see Exhibit 8. Constellation has also expanded their database of potential targets with now well over 30,000 targets (adding 4k+ targets per year for the last 3-4 years). Each target has a contact name next to it, with the expectation of staying in contact 3-4 times a year.
…with limited access to capital to pursue growth opportunities and typically lack the professional management found in larger software vendors. VMS also has high barriers to entry as they provide mission critical enterprise level software with high switching costs (relatively expensive and time consuming to replace) and long product development cycles (not many opportunities for competitors to displace you). Maintenance renewal rates are usually quite high (>90%) – customers are sticky. As a result, most of Constellation’s acquired businesses carry a large maintenance revenue base. Maintenance represented ~64% of Constellation’s total revenue in 2015.”
Constellation has created a business development team that is constantly trying to find more software businesses to buy. They are always prospecting for new acquisitions. Capital allocation at Constellation is centralized but the actual operation of the businesses is very decentralized. What is unique about Constellation is that they have acquired so many companies (more than 330). This acquisition skill set is part of Constellation’s special sauce. Leonard has admitted that this gets harder to but businesses at an attractive price as Constellation gets larger. Like Buffett, Leonard wants the businesses he buys to have a moat. Unfortunately, sometimes good moat builders are not the optimal managers of a business. I saw this first hand when I made my first investment in a vertical market software business in the mid 1980s. It took over 15 years to generate a financial exit and the return was for that reason moderate. That investment was a learning experience for me to be sure.
Constellation has set out its criteria for buying businesses on its web site:
- A mid- to large-sized vertical market software company (a minimum of $1-million earnings before interest and tax)
- Consistent earnings and growth — generally EBITDA/revenue + revenue growth of 20 percent or more per year
- Experienced and committed management
- Number 1 or Number 2 market-share holder in a niche vertical market
- Revenues of at least $5-million
- Hundreds or thousands (not dozens) of customers
- Unimposing competitors
3. “There are two components to Constellation’s growth, organic and acquired. Organic growth is, to my mind, the toughest management challenge in a software company, but potentially the most rewarding. The feedback cycle is very long, so experience and wisdom accrete at painfully slow rates.” “Growing organically while generating a high ROIC is, to my mind, the toughest task in the software business.”
What Leonard calls “organic growth” is revenue that is generated by existing businesses. Organic growth is not the glamorous part of Constellation, but it is important. Raymond James said in a report linked to in the End Notes that “Constellation’s organic growth has averaged a respectable ~3% per year which is in-line with US Gross National Product (GNP) growth of ~3% over that same period.” In his 2009 Constellation shareholder’s letter Leonard wrote:
“If you add Organic Net Revenue Growth to ROIC, you get what we believe is a proxy for the annual increase in Shareholders’ value. In a capital intensive business you couldn’t just add Organic Net Revenue Growth to ROIC, because growing revenues would require incremental Invested Capital. In our businesses we can nearly always grow revenues organically without incremental capital.”
The significantly larger source of revenue and profit growth for Constellation has been inorganic increases via acquisitions of new businesses. This inorganic growth is where Constellation particularly shines and generates the lion’s share of its attractive financial returns. The Constellation formula is relatively simple: buy a diamond in the rough in the form of a vertical market software business and then apply polish to make it shine.
Not a lot has been written about Leonard since he does not like to be interviewed, but one blog post I found on the web written by Jana Vembunarayanan points out:
“Constellation revenue consists primarily of software license fees, maintenance and other recurring fees, professional service fees and hardware sales. Customers pay license fees for using Constellation software products. Around 7 percent of Constellation revenue comes from license fees. Maintenance and other recurring revenue primarily consists of fees charged for ongoing support of software products post-delivery. It also contains recurring fees derived from software as a service, subscriptions, and other transaction related revenues. Most of the maintenance revenue is annuity based.”
The mix of revenue that Constellation generates has changed over time. Raymond James notes:
“One trend that is more sustainable is the shift of revenue mix towards higher margin segments, most notably maintenance – and we expect the mix shift to continue to buoy margins to some extent. Revenue from professional services has essentially flatlined… maintenance revenue has increased to 64% of revenue (from 54% in 2010) and professional services have shrunk to 21% of revenue (from 27% in 2010).”
4. “In 2004 we separated our Research & Development and Sales & Marketing spending (“RDSM”), into two buckets: Initiatives and everything else. Initiatives are significant long-term investments required to create new products, enter new markets etc. In the mid to high ticket vertical market software business, Initiatives usually require 5-10 years to reach cash flow break-even. We felt that they should be both measured and treated differently than our other, sustaining, RDSM expenditures. The ethos of software companies requires the regular launching of visionary new products by steely-eyed tenacious developers (substitute software architects, product managers or founders in this sentence, as the specific instance requires). We work… hard to keep the early burn-rate of Initiatives down until we had a proof of concept and market acceptance, sometimes even getting clients to pay for the early development; we triaged Initiatives earlier if our key assumptions proved wrong; and we created dedicated Initiative Champion positions so an Initiative was less likely to drag on with a low but perpetual burn rate under a part-time leader who didn’t feel ultimately responsible.”
Some people would say that Constellation is very disciplined about R&D spending. Others would argue that this a nice way of saying that Constellation cuts R&D once they buy the business. Leonard said that once way he gets managers to think intelligently about things like R&D spending is by creating “company-wide metrics that rank each acquired company among its peers, and which fosters peer interaction as they try to improve their relative ranking.” The company web site lays out it’s approach to improving operations:
“…we offer coaching and resources in a number of areas including establishing values and capital allocation processes, profit-sharing programs, benchmarking against our other businesses, the chance to share best practices with other CSI companies, formal management training and ongoing mentoring. CSI will not take over the day-to-day management of its businesses. We continue to rely on the managers and employees of our subsidiaries to run their businesses well.”
5. “Models are only as good as the assumptions that go into them, and there’s no substitute for thinking through scenarios on your own, with your own underlying assumptions.” “The more interesting part … was using the [model] to do some sensitivity analysis and to look at alternative strategies. In all of the following examples, we assume that only one variable changes. In reality, our businesses are dynamic and changing one variable has an impact throughout the business.” “We use a multi-scenario approach to forecasting and I’m struck by how frequently, even outside of our outlier forecast, we end up with actual performance, both at the low and the high end of the outliers. And so you do get a real spread on these things, and this happened to be a spread on the upside.” “Just to give you some color on that impossibility of prediction. We have a sort of funnel of acquisition prospects and we can add that up, we’ve figured out how to use that function in Excel. And we do so periodically, and I went back and looked at those totals that we had over time, and the amount of acquisitions we actually closed during those periods, and I found the correlation between our funnel and the actual acquisitions closed was zero. And not just zero it was so close to zero that I’m thinking of commercializing our sales funnel as a random number generator.”
Everything Leonard says above about modeling I have said myself hundreds of times in the same or different ways. For example: A model is only as good as the assumptions. Garbage in means garbage out. Do the modeling runs to get a sense of how sensitive the model is to changes in assumptions and model many scenarios.
7. “Our favorite and most frequent acquisitions are the businesses that we buy from founders. When a founder invests the better part of a lifetime building a business, a long-term orientation tends to permeate all aspects of the enterprise: employee selection and development, establishing and building symbiotic customer relationships, and evolving sophisticated product suites. Founder businesses tend to be a very good cultural fit with Constellation, and most of the ones that we buy, operate as standalone business units managed by their existing managers under the Constellation umbrella. We track many thousands of these acquisition prospects and try to regularly let their owners know that we’d love the chance to become the permanent owners of their business when the time is right for them. There is a demographic element to the supply of these acquisitions. Most of these businesses came into being with the advent of mini and micro-computers and many of their founders are baby boomers who are now thinking about retirement.”
Like Robert Smith at Vista Equity, Leonard has a proven operational system that Constellation can implement to improve ROIC at the acquired businesses. How has Leonard accomplished this? Raymond James writes:
“Constellation’s targets have to be VMS businesses with experienced and committed management, high market share with rational competitors, and no customer dependency (hundreds or thousands of customers). With decades of acquisition experience and hundreds of operating businesses providing proprietary data on base rates (for organic revenue growth, typical margins, and potential market share improvements in specific niche markets), Constellation is in the unique position of being able to test hypotheses on M&A targets’ forecasts and subsequently get more comfort on cash flow projections and whether they can hit their hurdle rate. This unique database of knowledge highly differentiates Constellation from other potential software acquirers.”
8. “The most lucrative acquisitions for us have been distressed assets. Sometimes large corporations convince themselves that software businesses on the periphery of their industry would be good acquisitions. Rarely do the anticipated synergies accrue, and frequently the cultural clashes are fierce, so the corporate parent may eventually choose to sell the acquired software business. The lag is often 5 to 10 years as the proponents of the original acquisition usually have to move on before the corporation will spin off the asset. Our most attractive acquisitions from corporate vendors seem to have happened during recessions. Occasionally, we also acquire portfolio companies from a private equity fund that is getting long in the tooth. These will have been well shopped but for some reason will not have attracted a corporate buyer. While both corporate and PE divestitures tend to be much larger than the founder businesses that we buy, they are usually more of a cultural challenge for us post-acquisition.”
Buffett believes that “turn arounds seldom do.” Leonard has been able to make turn arounds happen at Constellation regularly via careful due diligence and the application of proven systems. Leonard believes the data they collect from the other operating businesses gives them a real advantage not only in improving the operations of the businesses they buy but also in picking the right investments. Leonard describes Constellation’s advantages in this way:
“What we can offer is a degree of autonomy that people don’t tend to get inside of PE companies. And the opportunity for mastery of their craft that they probably don’t get inside of most PE companies. If you’re focused on a playbook that requires you to, in a 2 to 3-year period, make dramatic improvements to profitability, then settle it down for a year or 2 and then flog it to some unsuspecting buyer, which seems to be the PE model. You’re not going to be learning how to invest for the long haul, learning how to build a team for the long haul.”
Leonard is disciplined in terms of what they buy, which means that sometimes cash can pile up as it is right now for Buffett. Leonard did say in May of 2017 about having too much cash:
“What do they call that type of problem? First world problems? You’d obviously like to be patient and wait for your opportunities, and the issue is, if cash is sitting around doing nothing, it isn’t earning returns for your shareholders, and you could return it to them, and let them invest it. I’ve categorized it previously as the amount of embarrassment that the board is willing to put up with as we sit on cash and people start clamoring for it to be distributed either via dividends or share buybacks. And I think you know my views on most share buybacks. So my preference would be to hang onto the cash. We seem to be ramping our M&A activities, and to some extent, it seems to be paying off. And so rather than returning it to shareholders, I’d rather hang onto it at least for the time being and see if perhaps we can’t deploy it.
9. “Over the last few years we have purchased a number of software businesses (usually SaaS) that have a much higher ‘churn’ in their client bases because of factors inherent in their industry. By high churn, we mean that they acquire a greater proportion of new clients each year, and lose a higher percentage of existing accounts, than our average business. Sometimes the higher churn is because the clients’ switching costs are low. Sometimes the higher churn is because lots of new potential clients are being created, and old ones are going bankrupt and merging. If it is the latter, these software businesses may be very attractive. If it is the former, then the software businesses are likely to be unpleasant, requiring tremendous effort to stay in much the same place.”
Any subscription business is on an “acquisition treadmill.” In other words, the business must acquire new customers just to remain even let alone grow (as if it is on a treadmill set to a very fast speed like George Jetson). I have written a blog post on churn before and I won’t repeat those points again here since it will otherwise be too long. .
10. “Ideally, we’d like Constellation’s stock price to appreciate in tandem with our fundamental economics. At any point in time, we’d prefer the price to be high enough to discourage a takeover bid and low enough so that our sophisticated long term-oriented investors are not tempted to sell. It takes lots of time and effort to attract and educate competent shareholder/partners. The last thing we want them to do, is sell.”“We continue to seek longer-term capital to defuse the fundamental mismatch inherent in buying permanent assets with short-term debt.”
This attitude about having shareholders who understand your business model is fully consistent with the Berkshire approach. It takes both work and time to get the right shareholders. Shareholders who do not trust and share the same approach to investment as management can be a big source of problems for a management team. For example, Constellation’s shareholders share Leonard’s long-term approach to investing outcomes.
Leonard is also making a point abut leverage in the quote just above. Borrowing in short term markets to buy assets for the long term is problematic to say the least. Michael Milken said once about assuming to much risk in the financial structure of a technology business like software:
“When your business depends on technology – whether it’s aerospace, computer and electronics firms in the 1960s or Internet, telecom and networking companies in the 1990s – volatility is a fact of life. Unlike slower-changing industries like supermarkets, which can appropriately assemble a balance sheet with more debt, technology is an inherently risky business and needs a strong balance sheet to survive. In fact, risk in capital structure should vary inversely with business risk.”
11.“I’m happy if I find one good book to recommend to friends, family and employees each year. Currently, I’m shamelessly flogging Daniel Kahneman’s Thinking Fast and Slow. His book is about a life (actually two) well spent. He tells the tale of his intellectual journey via a series of behavioral economics experiments. He helped me appreciate the efficiency, speed, and inherent conceit of intuitive judgment, and its infrequent but often abject failures. Understanding the major findings in behavioral economics provides profound insights into investing and managing, and this book is the most pleasant way I’ve found to acquire that knowledge.”
Great investors inevitably are attracted to the work of someone like Kahneman. How can you be an aware participant in the business world without seeing the wisdom of what behavioral economics teaches? Charlie Munger said once “If economics isn’t behavioral, then what the hell is it?” I can’t recall ever meeting anyone who actually operates a real business who believe humans are rational. Anyone like Kahneman who can provide some insight into why people are not rational and when that is most likely to happen, is a valuable resource for anyone in business.
12. “I have a feeling that acquisition multiples, acquisition size and acquisition profitability have all increased over time
Robert Smith of Vista Equity Partners complains that his success has attracted “private equity tourists” to his preferred technology hunting grounds in the private equity market. Leonard also faces increasing competition in his chosen part of the technology private equity market. The entry of new capital into any buyout sector tends to raise prices and increase pressure for investors to consider lowering their hurdle rate. This chart is from 2015, but you can see the price trend is up and to the right in terms of prices paid by Constellation:
In an August 13, 2017 earnings conference call Leonard talked about the prices private equity and others have been paying for businesses:
“everything’s expensive, and things of size, where we can put some dollars at play, all seem to be trading high. I think one of the data points I saw was that the average vertical market software company, with more than a $50 million market cap is trading at 3.8x revenues and those tend to be fairly hefty valuations.”
P.s., “I discovered when I was in the venture business that interviews aren’t for me. What little I have to say, I generally put in my letters to shareholders. I do occasionally speak with students, but usually in the vain hope that I can distract them from pursuing careers in investment banking and private equity.”
Charlie Munger has similarly said several times that he regrets making his living “trading pieces of paper” to earn a profit. What Munger and Leonard are saying is their way of tipping their hats to people who operate a real business, which is a particularly noble calling. Creating and operating a successful business is neither easy or simple. People who do that well deserve some applause.