$Constellation Software, Inc.(CNSWF)$
Constellation Software is a very interesting company because there's really no other stock like it in the market. They are essentially a serial acquirer, buying numerous businesses. While many companies rely on growth through acquisition, Constellation Software stands out in a few ways.
Fundamental
Firstly, they typically acquire very small software businesses, resulting in ownership of hundreds of companies. Secondly, they adopt a Warren Buffett-like approach, allowing these software units to remain independent. They don't integrate these acquisitions into a larger software suite, which means they avoid the high merger charges that other companies often incur. For example, in 2014, their merger charges were only $13 million, which is relatively low compared to other companies that frequently restructure and integrate their acquisitions, like AT&T.
This business model works for Constellation Software because they don't aim for synergy. Their shares have surged since 2022, and the company is currently valued at a price-to-free-cash-flow ratio of 35, which is quite high. Some might argue that this is justified by their consistent growth in the high 20% range. However, a closer look reveals a different story.
Earning Overview
In their latest earnings release, revenue grew by 20%, but organic growth was only 2%. The impressive revenue growth was primarily driven by acquisitions. They don't issue new shares, and their share count has remained stable over the past decade. They also don't take on much debt. Their operating cash flow and cash spent on acquisitions are almost equal, indicating that they reinvest their earnings into new businesses.
Growth Analysis
While reinvesting at a high return is generally good, the low organic growth rate raises concerns. If all their free cash flow is used to buy new businesses to achieve revenue growth, it suggests that their existing businesses aren't growing much on their own. For instance, in the first quarter of 2023, organic growth was just 2%, and revenue increased by 34%. In the second quarter of 2022, organic growth was negative at -2%, with a 30% revenue increase.
This pattern indicates that while they grow by acquiring new companies, their existing businesses don't contribute significantly to revenue growth. If they were to stop acquiring, their revenue growth would likely drop to 3-4%. This raises questions about the sustainability of their growth model and whether it's worth paying a high multiple for the stock.
Free Cash Flow
Constellation Software generates around $2 billion in free cash flow, but it trades at a 45x free cash flow multiple for a company that grows only 3-4% organically. This multiple is typically reserved for the best companies in the world, which achieve higher growth rates without needing to reinvest all their money and pay out most of their cash to shareholders.
I don't think it's a good investment at these prices. Even Apple, which trades at similar multiples, pays out all its cash and doesn't need to acquire numerous companies to grow. If Constellation Software were turning things around by buying businesses that significantly boost organic growth, that would be different, but that's not happening.
Their business model involves acquiring many small companies across various sectors, which don't always make sense together. They don't integrate these businesses, so they remain separate entities. This approach doesn't lead to significant organic revenue growth. If they stopped acquiring, their revenue growth would likely drop to 3-4%.
If all their free cash flow were returned to shareholders, the organic revenue growth would still be low, around 3-4%. Even with optimistic assumptions of 5% growth for the next few years and an 18x multiple, the stock would be valued at $1,644 per share, far below its current trading price of $3,600.
Technical Analysis
Based on the latest technical analysis, here are the key support and resistance levels for Constellation Software (TSX: CSU):
Support Levels:
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Primary Support Zone: CA4162.69 to CA4181.45. This zone is formed by multiple trend lines on the daily time frame.
Resistance Levels:
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First Resistance: CA4275.47, identified from a horizontal line on the weekly time frame.
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Second Resistance Zone: CA4351.98 to 4504.07, formed by a combination of multiple trend lines and important moving averages across various time frames.
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Third Resistance Zone: CA4734.16 to 4790.30, also formed by multiple trend lines in different time frames.
Valuation
Even if the underlying businesses grew at 10% and 8% with a 20x multiple, the valuation would still not justify the current price. The reality is that their free cash flow is heavily reinvested into acquisitions, which should be treated as capital expenditures. This leaves little actual free cash flow, which is why their dividend is so low.
Conclusion
I'm not going to invest in Constellation Software at these prices $3176. I don't have anything against companies that grow through acquisitions, but they should be priced accordingly. What do you think about it? Let me know in the comments. Have a great day!
Disclaimer: I want to make it clear that I am not a financial advisor, and nothing I say is intended to be a recommendation to buy or sell any financial instrument. Additionally, it's important to remember that there are no guarantees or certainties in trading or investing, and you should never invest money that you can't afford to lose.
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