It may come as a surprise to some, but there’s more to Canada’s technology sector than a certain smartphone company based in Waterloo, Ont. Over the past five years, while shares in BlackBerry lost 85% of their value, Toronto’s Constellation Software has seen its share price skyrocket by more than 400%. How has this company achieved such stellar returns? By doing what many U.S. tech companies have done for years: aggressively grow through acquisition.
Since opening its doors in 1995, Constellation has purchased more than 160 firms. It bought more than 20 last year and scooped up three others since January. The company sells what it calls “mission-critical software” that helps certain industries run their businesses. Its technology helps public transit operators organize bus routes and golf-course pro shops track inventory. It provides software to law courts, home builders, window manufacturers and many other sectors.
In some ways, Constellation isn’t a tech company at all. “The best way to think about them is as a private-equity shop operating in the software industry,” says Jeff Mo, a portfolio manager with Calgary’s Mawer Investment Management, which has a 12% stake in the company. It rarely develops its own programs. Instead, it buys the No. 1 or No. 2 business in a particular field and then continues to operate the enterprise nearly as is. Save for sharing best practices, there’s almost no integration between the businesses it owns and, says Mo, that’s why this $800-million-a-year operation has done so well. “They give the entrepreneurs of these companies the tools to succeed,” he says.
Most of the companies it purchases are in the $5-million to $10-million revenue range and already have strong client bases and a proven product. Essentially, Constellation starts making money off an acquisition the day after buying it. There’s also little competition for these assets, so it rarely overpays. Tom Liston, a technology analyst with Cantor Fitzgerald, points out that Oracle, a much larger enterprise software company, is too big to bother with these operations, while the companies themselves are too small to consolidate within their particular industry.
While this acquisition strategy has helped Constellation achieve an impressive 30% compound annual growth rate, it’s only part of the story. The company is a cash cow—it has about $200 million in free cash flow and pays a 3.4% yield—thanks to recurring revenues. Because of the high cost of switching to a new software provider, its clients are often there for life.
The question facing investors is whether Constellation can maintain its upward momentum. It’s possible the company will get too big and its decentralized model won’t work anymore, says Mo. There’s also a chance that it’ll run out of companies to buy or will move into sectors it’s unfamiliar with. And with just 21 million shares outstanding, it’s not as liquid as BlackBerry.
But even if these concerns do materialize, it won’t be for a while. Mo isn’t planning to dump any of his stock in the near future, and Liston has a 12-month price target of $135—about $20 higher than where it’s trading today. “It’s still a great investment,” says Mo. “The only reason we’re not buying more is because we’re already pretty full.”