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Word: All currencies are denominated in USD except in any other case said.
For these readers who usually are not that conversant in Constellation Software program (OTCPK:CNSWF, TSX:CSU:CA), which I’ll abbreviate as CSI, I might recommend reviewing my earlier article the place I deeply lined the corporate’s background, its enterprise mannequin, anticipated development, and administration.
On this article, my focus will likely be on the third quarter’s outcomes, the latest acquisitions, and the issuance of debentures.
Funding Thesis In A Nutshell
CSI has been constructing a extremely defensive and well-diversified enterprise mannequin for over 20 years within the vertical market software program (VMS) trade by buying over 800 completely different enterprise models.
The corporate remains to be led by its founder Mark Leonard together with an excellent and well-experienced administration staff, which has set the precise incentives for its workers and adopted greatest practices to pursue new acquisitions on the proper hurdle charges.
One of the vital widespread issues traders face when analyzing CSI is the corporate struggling to deploy all of its free money movement into new acquisitions as its dimension expands, however as I am going to present on this article, this isn’t one thing we should always fear about but, and I anticipate development charges above 20% within the coming years.
Q3 Outcomes Evaluation
Last quarter’s results introduced us an excellent 8% income natural development (6% foreign money adjusted), properly above its historic common (1.4% since 2007), and one of many highest natural development charges lately:
You will need to be aware that the irregular natural development in Q2 2021 (14%, 8% foreign money adjusted) was considerably impacted by the U.S. greenback appreciation towards the opposite currencies through which the corporate operates.
Remarkably, the upper natural development has been achieved with out growing the R&D bills over the past quarters, which has stayed round 14%, in step with the historic common. One of many explanations for the upper natural development could possibly be the higher-than-average inflation charges we had throughout final 12 months. Since lots of CSI’s contracts incorporate clauses to regulate costs based mostly on inflation, the corporate has been in a position to go a rise in costs to its prospects.
I consider this pattern may persist throughout subsequent quarters as a result of mission-critical nature of CSI’s merchandise, restricted churn charges, and the strategic strategy to extend costs progressively. Lots of CSI’s relationships with its purchasers have been constructed over a few years, a long time in some circumstances, and it is likely to be simpler to extend costs by 4-5% throughout three years than translating a one-time 10% worth improve.
Typically, you may have these very massive prospects which have contracts that restrict the quantity of will increase. And likewise, it is the managers. Typically the managers are on the client aspect they usually do not wish to give them a rise that equals or exceeds inflation, particularly since we have gone by the final decade or extra at form of 2%, 2.5% inflation and to go and abruptly give your buyer a ten% improve or 8% improve.
Source: Dexter Salna (Member of the Board of Administrators at CSI and Perseus). Analyst Name Could 2023.
On the acquisitions aspect of the enterprise, which I am going to cowl intimately within the subsequent part, there are some necessary changes to be made.
The most important acquisition realized throughout final quarter was the Optimum Blue enterprise and the Empower mortgage origination system (LOS) from Black Knight, Inc. (BKI) for a complete consideration of $742M.
Of the total consideration, $40M has been paid in money for the Empower LOS, and $201M for the Optimum Blue enterprise (plus a $1M money holdback). The remaining $500M has been paid by a promissory be aware issued to Black Knight, which isn’t mirrored within the money movement assertion as money utilized in investing actions.
When trying on the quantities spent on acquisitions, we should always embrace the $500M to get a greater image of the acquisition tempo throughout the quarter.
When including the be aware issued to Black Knight, this Q3 has been the second-biggest quarter in CSI’s historical past relating to capital deployed into acquisitions following Q2 2022 with the Allscripts acquisition. Mixed, the income development throughout the quarter was at 23%, reaching over $2.1B.
Relating to bills, employees prices elevated by 20%, barely behind the income improve, leading to an enchancment in working margins from 13.8% a 12 months in the past to the present 15.5%. Non-cash bills such because the redeemable most well-liked securities of Lumine Group (LMN:CA) (OTCPK:LMGIF) and the Topicus (TOI:CA) (OTCPK:TOITF) legal responsibility continued growing throughout the quarter, which is optimistic given CSI’s pursuits in each corporations.
The $1M impairment is nothing to be involved about since it’s associated to the Optimum Blue acquisitions, the place CSI recorded an allowance for money flows not anticipated to be collected.
On the much less optimistic aspect, finance prices elevated throughout the quarter, from $29M the identical interval final 12 months to the present $50M. The rise is said to the next quantity of debt underneath its credit score facility and better rates of interest throughout the interval. Given its debentures are linked to inflation, the corporate is paying greater than ever pursuits, which is able to scale back subsequent 12 months as inflation decreases.
On the underside line of final quarter’s financials, money from operations and free money movement obtainable to shareholders elevated by 60% to $513M and $367, respectively.
Issuance of Debentures
In October, CSI issued an extra tranche of its unsecured subordinated floating fee debentures Collection 1 maturing in 2040, a product the corporate has used up to now.
The proceeds had been allotted to pay down indebtedness underneath its current credit score facility, which totaled $686M on the finish of the quarter, nearing the $840M restrict.
Earlier than explaining the traits of the product, I might like to offer a little bit of background. The preliminary issuance of the debentures was in 2014 at a worth of C$95 per C$100, offering traders with a 5% low cost to face worth and receiving total proceeds of $81.2M, which had been used to pay down debt associated to the TSS acquisition.
In 2015, CSI issued one other tranche, this time with a premium at C$115.00 per C$100 principal, gathering $159.7M. The principal quantity excellent underneath the unsecured subordinated Collection 1 stood at $208M earlier than the most recent issuance.
With the most recent tranche, CSI collected $209M issuing at C$133.00 per C$100.00 principal quantity, growing considerably the premium paid at subscription.
Phrases and Pursuits
CSI issued one subscription proper per share, entitling to a subscription of C$100 principal quantity for each 3.03 rights. To make it easy, shareholders had been entitled to subscribe C$100 for each three shares owned.
For the reason that debentures are redeemable on the possibility of CSI, the corporate distributed to its shareholders a warrant that neutralizes the redemption rights, which was mandatory to ensure that some debt was subscribed. In any other case, it might be dangerous for an investor to subscribe debt at a 33% premium to par worth, figuring out it may not have time to obtain sufficient curiosity to cowl the premium.
The debt carries a variable rate of interest calculated as a hard and fast 6.5% curiosity plus the annual common proportion change within the CPI Index. From issuance to March 2024 it carries a 13.3% rate of interest, after which it’s reset each March till maturity in 2040.
Though it may seem like an abnormally excessive rate of interest, there are a couple of factors to take note of. The primary is the excessive premium to par worth, and the second, is the character of the debt, which is unsecured, that means that if the corporate was going bankrupt, it might come after the Credit score Facility.
The debt is buying and selling within the TSX underneath the image CSU.DB, and as proven within the chart beneath, it has been buying and selling above par for the reason that first issuance.
Pursuits are payable quarterly and if the change in CPI is detrimental, it is going to be deducted from the mounted 6.5%, however the rate of interest relevant won’t ever be lower than 0%.
Throughout 2023, till November, the average change in CPI has been at 3.9%, so for the subsequent 12 months I anticipate the rate of interest to be reset to 10.4%. The anticipated return is offered within the desk beneath, though it’s assuming the subscription throughout the providing, and it might be greater if the debentures are purchased now out there as a result of present worth of C$129.
As a result of excessive premium to par worth, the yearly common fee of return assuming a 2% inflation (in line with the common since 1998), could be 7.12%.
Fitch has assigned a BBB ranking to the debt, the 4th highest of Fitch’s 11 ranking classes, which I discover fairly conservative considering CSI’s defensive enterprise mannequin, recurring revenues, and monetary ratios.
Buying At A Good Tempo
Over the last quarter, CSI was in a position to deploy a major quantity of capital because of the opportunistic acquisitions from Black Knight, but when we exclude this huge acquisition the variety of smaller corporations acquired has barely decreased in comparison with the primary half of the 12 months or 2022.
Based mostly on the press releases and information revealed by CSI’s working teams, I estimate the whole quantity of acquisitions has been round 25 throughout Q3. When excluding the most important acquisitions, CSI has deployed $164M into the acquisition of smaller software program corporations with a mean worth of ~$8M, being Harris and Jonas probably the most energetic working teams with 7 and 6 acquisitions introduced throughout the quarter respectively.
Though the variety of smaller corporations acquired has barely decreased in comparison with the primary half, CSI’s third quarters have on common the bottom spending on acquisitions. Over the last 5 years, the third quarter spending on acquisitions is on common 35% decrease in comparison with the second quarter, which tends to be probably the most energetic.
Black Knight’s divestitures
CSI was in a position to pursue an opportunistic acquisition over the past quarter, which I consider is the results of a few years of constructing sturdy enterprise relationships and turning into a trusted firm within the trade.
Following the announcement of the acquisition of Black Knight by Intercontinental Change (ICE), the Federal Commerce Fee (FTC) sued to dam the transaction claiming it might give ICE a major place out there for mortgage origination software program.
To maneuver ahead with the acquisition, the FCT and Black Knight agreed to divest a few of its property, which led to CSI buying a high-quality enterprise at an important worth.
Optimal Blue’s software permits market contributors to cost, lock, hedge, and commerce mortgages, and is the trade chief utilized by hundreds of originators to lock roughly 40% of mortgages within the U.S. The enterprise was initially acquired by Black Knight for nearly $3B (60% in 2020, and the remaining 40% in 2022).
Empower is a cloud-based mortgage origination system that automates repetitive processing duties based mostly on the lender’s configurations, displays for any knowledge adjustments throughout the mortgage course of and triggers a separate work merchandise when an exception happens, which alerts the person that extra evaluations are wanted.
CSI has been in a position to purchase each corporations for simply $742M, paying 2x 2023 sales and lower than 6x EBITDA. The market was valuing the 2 corporations at $3.3B as a part of Black Knight, and the divestiture reduced the worth paid by ICE by $1.4B.
I anticipate these acquisitions to generate revenues of $370M throughout the subsequent 12 months and working money flows of ~$125M with considerably greater margins than the common CSI enterprise.
Anticipated Development
Whereas Q3 has been comparatively quiet relating to smaller acquisitions, to this point the corporate has been in a position to deploy nearly $1.8B in acquisitions with one quarter remaining, the place I anticipate one other $340M to be spent in acquisitions, reaching $2.14B for the complete 12 months (in comparison with $1.6B in 2022).
In This fall, there was an identical quantity of smaller acquisitions alongside the medium-sized acquisition of Medhost, Inc. by the Harris working group. Although the worth paid has not been disclosed, based mostly on revenues I anticipate the whole cost to be round $180M.
Topicus accelerated its acquisition tempo in Europe throughout This fall in comparison with final quarter, since there have been already six acquisitions announced in verticals such because the digital element distribution market, debt restoration, parking administration options, healthcare, native authorities, and safety.
For the second half of the 12 months, I felt quick in my earlier article, the place I anticipated whole revenues for the 12 months of $8.1B, whereas they are going to most likely be above $8.3B.
Waiting for 2024, I foresee a considerable improve throughout Q1 with the acquisitions of the Curbside Administration and Public Security Companies for ~$260M (8x TTM EBITDA) from Conduent Inc. (CNDT), and Nokia’s System and Service Administration Platform for €185M (plus a contingent consideration of as much as €35M).
As for now, there have already been bulletins for $464M deployed into acquisitions throughout Q1, main me to anticipate an acquisition spending above $2B for the complete 12 months. This projection contains a 20% acquired development plus a 3% natural development, above historic common charges based mostly on the present momentum.
Closing Remarks
All through the latest quarter, CSI has been in a position to maintain an important tempo buying VMS corporations at a great worth. Though the second half of the 12 months tends to be much less energetic relating to acquisitions, the corporate deployed a great quantity of its working money flows (with out reducing its hurdle fee) because of the opportunistic acquisitions of Optimum Blue and Empower, capitalizing on the FTC’s intervention within the ICE/Black Knight transaction.
Whereas finance prices have seen a rise, a decline in rates of interest and inflation may ease the curiosity funds for the subsequent quarters. So long as CSI continues to seek out nice companies with a dominant place of their specific area of interest at an affordable valuation, this strategy stays probably the most optimum capital allocation.
CSI has not too long ago introduced the retirement of Dexter Salna, who has been with the corporate since 1995 and was a key contributor to the event of the Perseus working group. He’ll stay on the board of administrators and for the reason that enterprise tradition is properly unfold throughout the group, I’m certain the precise particular person will likely be discovered to proceed main CSI’s excellent development.
Lastly, on the natural income aspect of the enterprise, CSI can also be rising properly above its historic common, and I anticipate this pattern to proceed for some quarters forward. Given the latest developments and opportunistic acquisitions, I anticipate the corporate to proceed rising its revenues above 20% throughout the subsequent two years and ship common returns of ~16% CAGR over the subsequent 5 years.
Editor’s Word: This text discusses a number of securities that don’t commerce on a serious U.S. change. Please pay attention to the dangers related to these shares.
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