All participants, please stand by. Your meeting is ready to begin. Good morning, ladies and gentlemen. Welcome to Constellation Software Inc.'s second quarter conference call. I would now like to turn it over to Mr. Mark Leonard. Please go ahead, Mr. Leonard.
Thank you, Ruth. Good morning, everyone. As you know, we go directly to questions. Please, Ruth, if you could tee up the calls.
Thank you very much. We'll now take questions from the telephone lines. If you have a question and you're using a speakerphone, please lift your handset before making a selection. If you have a question, please press star one on your telephone keypad. You may at any time cancel your question by pressing the pound sign. Please press star one at this time if you have a question. There will be a brief pause while participants register. Thank you for your patience. Our first question, give it one moment, is from Thanos Moschopoulos from BMO Capital Markets. Please go ahead.
Hi, good morning.
Thanks.
Mark, I know you generally don't like talking about individual business units, but just given the size of the acquisition, is there any color or commentary you can offer around QuadraMed with respect to the health of the asset when you acquired it, whether it's a fixer-upper or a business that was strong to begin with, what the growth trajectory looked like? Any color would be helpful. Thank you.
Yeah, as you say, we don't usually comment. I guess the one observation is we're organizing the business into four separate business units that will have distinct strategies, and we're really excited by the quality of management and the businesses that we acquired.
Okay, fair enough. Generally speaking, how would you characterize the pipeline for larger opportunities at this point?
We, as a rule, don't have a whole lot of larger opportunities because we don't play in the multi-hundred million dollar range. The pipeline, as we reviewed it yesterday for the board, was a bit on the sparse side in general, whether big or small. We tend to look at the higher probability, closer to closing type acquisitions at the board level. If you go further up the funnel, what you'll find is lots and lots of activity and then the issue is just sort of how much of it translates into acquisitions at the end of the day. Those processes, those pursuits, can last a very long time. Very hard to predict, Thanos.
I think we've heard that comment before, based on having followed your company for some time. I guess overall though, you'd say on a near-term basis where you have a bit more visibility, your comment is that pipeline a little smaller than usual?
I would say there are less opportunities in the pipeline than usual.
We saw organic growth looked pretty good this quarter. Anything that you'd highlight there? Is that just a function of an improving macro environment? What's driving that, if you can provide any color?
As you know, we are the sum of our parts, and there are 137, I think, of those parts this quarter. It's very hard to sort of make a commentary over 137 separate business units with 137 separate strategies, business unit managers, and sets of competitors. The economy does feel a wee bit better, but as I've also said before, we tend to be a lagging indicator on the economy, and so I wouldn't read a whole lot into that if you're thinking about other businesses.
Okay, fair enough. Okay, just the last one from me. If the economy is feeling a little bit better, any change in the deal pricing environment or not appreciably so from your perspective? It seems like you are still getting good rates. You are paying good valuation for your acquisitions based on my math at any rate.
Yeah. I don't find that the values of businesses, the intrinsic values of businesses vary hugely from quarter to quarter. It's the discounted present value of the future cash flows to infinity. What happens this quarter or next doesn't hugely swing that number except perhaps in the market size. We don't see pricing, at least the pricing that we offer, change a lot.
Okay. Well, thanks, Mark. I'll pass the line.
Yeah.
Thank you. Our next question is from Scott Penner from TD Securities. Please go ahead.
Thanks. Good morning. Just again, on the large deals, just I'd be interested in your comments of really what brings these type of assets to market and makes them available for you. Are they typically private equity-owned assets that are either at the end of their life or have become orphaned within a portfolio? Just any comments there would be useful.
I'm not sure there is a typical, Scott. I think it's atypical, the larger transactions that we do. In this particular case, it was a private equity firm. They had put together a number of assets to create QuadraMed, and one in particular was sought by a competitor. They sold off that piece of the business, and we bought the remaining business units. They had an opportunistic sale of a piece of their business at a very high price. I think that was why they were selling off the remainder of the business.
Okay.
That's atypical. I can't say I've ever seen that before, and I don't really expect to see it again.
Next topic, just on the acquisitions. We can see with a calculator or a ruler that this pace of investment is unsustainable on the current capital structure. I guess the question is, do you feel any closer to securing the type of capital that you want? Is this becoming more of a limiting factor in what you can look at or the hurdle rates that you're applying on acquisitions?
We haven't yet jacked up the hurdle rates to control the amount of capital being deployed. We are seeking capital, as I mentioned in the president's letter. We are toying with sweetening the dividend reinvestment program so that we get higher participation in that program, and exploring how we can do that. We're also exploring a preferred share issue with a number of the investment bankers. Those are the two avenues that right now appeal most to the board. We'll see how they turn out.
Just lastly from me is, entering the first quarter not too long ago, relative to the guidance at that time of 14%-18% EBITDA margins, just wondering if you could help put this quarter's 19% in a bit of context. For instance, have the margins on some of these European deals come up as quickly as you had expected or more quickly, or are you doing more or less deals in Europe, or any other factors related to why the increase over the past couple of quarters?
We do tend to get a seasonal bump from Q1 to Q2. It relates to some payroll taxes, and also I suspect the revenues in Q1 on the professional services side tend to be down a little bit in a seasonal pattern. In addition to that, we saw pretty good organic growth, much better than we had in previous years in Q2, which was pleasing. In terms of Europe, no massive improvement quarter to quarter. It's a sort of a gradual process, and it's more gradual in Europe than it tends to be in North America when we buy new assets. I wouldn't say that there have been either happy or particularly sad surprises in Europe. It's just work as usual.
Okay. Appreciate it. I'll pass it off.
Thank you. Our next question is from Paul Sety from Scotiabank Capital. Please go ahead.
Just to actually go back to that, Mark, on the European situation on integration, any thoughts on timeline as to bring those margins sort of on plan? Just trying to sort of clear through a little bit of the noise in the quarter. It looked like they popped to Scott's question, but looks like there might've been timing. Where do we sort of end up?
Yeah, I don't really know. Haven't done as much in Europe previously and have never generated as good margins in Europe as we have in North America. We don't see a whole lot of structural reasons why that should be the case, but others have told me that Europe is harder.
Stick to the original comments out of Q1, where you sort of brought the Street back down a little bit in terms of thoughts on margin there.
We were talking about Q1 in Q1. We weren't talking about perpetuity.
Fair enough. Okay. The one other question I'd have is just around the healthcare segment. Maybe you could position that for us a little bit in terms of how we should think about what you're doing in healthcare post-QuadraMed. You had other pieces of healthcare sort of scattered around the business groups. You brought that together. What's the future look like in terms of a focus on healthcare?
Yeah, I wouldn't say there is a focus on healthcare. We will do healthcare. We see the healthcare segment as having lots of sophisticated, competent competitors, and that is a good and a bad thing. The good news is that they tend to be rational in terms of their investing in R&D, sales, and marketing, and competing for market share. The bad news is that they tend to be rational and hence you have a harder time finding little pockets within the industry where you can generate superior rates of return on capital employed. It'll be opportunistic, Paul. Obviously, anything close to any of our existing businesses, we will focus on. Any of the segments that we're already in inside of healthcare will be where we look most. We'll look more broadly as well.
We'd love to have more healthcare assets in Canada, but there are a couple of competitors who are voraciously consuming such assets right now.
Is it fair to think, though, in healthcare, Mark, given that historic valuations, at least on the software side for these companies, certainly would be well above, I think, what you would have considered or paid or would have met your hurdle rates? That you'd be more tempted towards more of a processing type model if we're thinking about where you go down that path?
Processing has its pros and cons, we're learning about sort of that business. It isn't our mainstream. I believe it'll be years before we are as good at processing type businesses as we are at vertical market software enterprise, capture every seat in the house type businesses. I wouldn't see us jumping with both feet into processing at this stage.
Okay. The last one for me, just to wrap up and sort of go back to the original point Scott brought up about the capital structure. How should we think timeline on sort of a decision out of this? Is this next quarter or two, or is this next year before we sort of get resolved on where the capital structure's at?
It's one of those things that you work away at constantly. I find that very rarely do capital structures swing enormously unless you go out trying to make very large acquisitions, and that's not our forte. I anticipate we'll just sort of nibble away at things, Paul. There'll be a little bit here and a little bit there, and there won't be dramatic shifts.
Great. Thanks, guys.
Thank you. Our next question is from Nikhil Thadani from National Bank Financial. Please go ahead.
Mark and Jamal, it looks like, if I look at my math, it looks like 2013 acquisitions contributed about CAD 35 million in terms of revenue. Does that sound right in the ballpark, and should we expect a similar sort of contribution for the rest of the year, or was there anything special in Q2?
We haven't done that math, and we usually don't do that math for you. We're only really good at adding here. We sort of add up the 137 business units once a quarter, so that would require dividing.
Okay. Then just on the four separate business units, I was wondering if you could maybe provide some more color on that in terms of what that might entail for your priorities in terms of deploying capital for acquisitions versus internal initiatives. Does that change your approach overall, or how should we think about that?
We encourage our managers to look at the two as competing activities. You can either deploy capital on acquisitions, or you can deploy capital on initiatives, and you should seek to get equally high rates of return on both, taking into account all of the factors. We have no particular preference. We think that internal initiatives are very, very hard, require a degree of vision that isn't required for acquisitions. Hence, we'd love to be really good at the internal initiatives. We're getting better, and we think we do it far better than most software businesses. If I could see all the capital go into that and generate similar returns to acquisitions, I would be delighted.
I think you end up with a stronger business when you get to choose what products you add to the portfolio and how you can sort of fill out the needs of the customers as opposed to when you do an acquisition, which tends to be more opportunistic and tends to leave some holes in the portfolio. I'd love it to be initiatives, but my guess is the bulk of the capital that we invest will go into acquisitions.
Right. Just one last one for me before I pass the line here. We're about a month into Q3 right now, and I was just wondering what your take was on public sector versus private sector so far for Q3 and how that kind of stacks up against Q2.
I have no sense of that at all. Increasingly, our public and private sector are becoming less public and less private. We have within Trapeze now a number of businesses that are private sector, even though we categorize, excuse me, Volaris, even though we categorize Volaris as public sector when we're totting up the numbers. It's a distinction that I think is becoming less relevant, and we're actually thinking of eliminating it going forward in the reporting.
Right. Okay, great. I'll pass the line. Thank you.
Thank you. Once again, please press star one on your telephone keypad if you have a question. Our next question is from Paul Treiber of RBC Capital Markets. Please go ahead.
Thanks very much. Mark, could you provide some historical perspective? Since the inception of the company, have you raised or lowered your hurdle rate for acquisitions?
Yes, we have.
Is it raised or lowered?
I think we've done both.
Recently, I think you sound like you've kept it constant. Is that a safe assumption?
We have, although we've sort of introduced a quality modifier in that if you come pitching an acquisition that is just a lovely company, no customer dependence, literally thousands of clients, low attrition, obviously that goes into the math when you do the multiple scenario look that we do when we're acquiring these businesses. It's also influenced our hurdle rate a bit. We're probably willing to take a few points off the hurdle rate for a lovely business.
Have you revised your hurdle rate in relation to your cost of capital in any way?
Nope.
What are your thoughts on keeping those two decisions or two metrics independent?
It's a really good question. Historically, we felt that we wouldn't run with leverage for any length of time. We'd basically go into the bank line, pay it down, et cetera. It was really a return on equity kind of question. We felt that if you wanted to have high returns on equity and you were a perpetual shareholder, as a shareholder, you couldn't get a rate of return that exceeded our return on equity inside the corporation unless you were buying and selling, and we weren't looking for those kind of shareholders. We kept our ROE targets really high and didn't vary a whole lot, except if we had sort of an oversupply of cash at the head office. As we're starting to contemplate using the capital markets, we've started to rethink that.
It's certainly going through our minds, particularly when it comes to large leverage transactions. I talked a little bit about that in the president's letter. There are some lovely larger businesses that we can't compete on based on the prices at which they transact unless we use a weighted average cost of capital that includes some debt. We're poking away at that issue. I wouldn't anticipate that we'll do anything imminently, but it's something we're thinking about.
Thank you. That's very informative. Just one small, well, the minor item that I noticed in your DRIP filing, I hope you can comment on it. It just indicated that you may be able to acquire the shares on the open market or issue them from treasury. Now, you've never really been fond of issuing shares from treasury in the past. For example, the bonus plan. Does that also reflect a change in your view, or am I reading too much into that filing?
No, good for you. I'm glad you spotted it. I've always felt that as insiders, as managers and directors, we have a temptation to prey upon shareholders, and I think that is the case in all companies. You've got massive amounts of information as insiders which your outside shareholders don't have. One of the ways to avoid that is to never issue nor buy back shares. I also have the problem that I'm not particularly good at valuing what the market perceives to be the value of a business. I don't know at what price to issue equity. What's the right price? The easy way to still participate in markets, to still buy back shares or issue shares, is to do it with your own shareholders and to do it in tiny amounts.
The DRIP and issuing from treasury doesn't feel like it has the conflict of trying to bang out a CAD 100 million common share issue at a maximum price or a reasonable price or whatever price you choose to bang out a common share issue. It sort of gets around the conflict for me, particularly if you do it over multiple quarters. The idea of issuing from treasury under the DRIP, it feels like we can access markets that way.
Thank you. That's very informative. I'll pass the line.
Yeah, I'm not sure it was informative, and it may not be that clear, but it's sort of how I'm thinking about it.
Thank you. Our next question is from Richard Tse from Cormark Securities. Please go ahead.
Hey, Mark. If you look at sort of your big challenges this year versus last year, can you give us maybe a sense of what the sort of top two or three would be? It sounds like capital constraint is an issue now, you've talked in the past about management attrition, organic growth, and I guess the competitive landscape for acquisitions. What are the sort of the top issues you're facing, and has that changed over the past 12 months from, I guess, the challenge perspective?
I don't think we see the challenges change a lot, Richard. The toughest challenge in software is investments in R&D and sales and marketing that will pay off five to 10 years down the road. We are involved in ground-up rewrites of a number of our packages, they tend to take three or four years of R&D effort. Then as you sell them back into your install base, you're looking at a five or 10-year process of getting people onto the new platform. It's an incredibly long process. The ability to look forward and figure out how quickly people will adopt, how much money, and we're talking multiple millions of CAD when you do a rewrite. How much money to invest up front, what tools to base it on.
Incredibly difficult, challenging issue that requires intimate knowledge of the vertical and of the tools that you have. That's your number 1 challenge in all the software. Now, some people dodge that particular issue by just buying businesses and milking them out. Nothing wrong with that. Someone needs to do that for some businesses that would otherwise just sort of stutter along.
Yeah.
It's not what we try to do. We try to own businesses that will continue to prosper, that will take share modestly, and that will grow for decades to come. That's our single biggest challenge. Having the people who can exercise that ability, that vision, do it in an incredibly disciplined fashion, is tough. So keeping those folks is a very important part of what we do. Then having money to spend on acquisitions, that's just nice to have. It's sort of a byproduct of what we do. If we generate lots of capital and we don't consume much for internal growth because we're not an asset-intensive business, we have some leftovers which we can either pay out as dividends or spend on acquisitions.
Our guys obviously love acquiring businesses and then taking them and nurturing them the same way that they have their own businesses. I'd love to see that continue, but if tomorrow the world told us we couldn't do any more acquisitions, that would be fine, too. I think we'd continue to build a wonderful business.
Okay. You and I have talked about SaaS models in the past. If I look at your base, it doesn't, and maybe you sort of enlighten me, it doesn't really look like your base has kind of shifted in that direction, or maybe I'm wrong. What has changed, or is it just for some reason the verticals you're in or the solutions you have are not conducive to that? I know you're preparing for it at some level, but maybe just give us a sense of what's happening on that side.
We've started tracking all of those slightly unconventional or newer economic and technology models inside of Constellation. We're hoping to be able to break them out for you in next year, Jamal?
Yeah.
You'll get a better view of that, Richard.
Okay.
For the time being, let's just say I don't think it's a particularly good development for the software industry. I'm not particularly sure it's good for clients, but it's happening. It's got a tremendous amount of buzz. You have no choice but to respond. We are responding. We've used SaaS models for literally decades for add-on products. It tends to be a nice model both economically and technologically for add-on products, for taking a core enterprise system and allowing your customer's customers to interact with that system. Now we're increasingly converting our enterprise systems to SaaS as well.
Okay, great. Thank you.
Thank you. Once again, please press star one on your telephone keypad if you have a question. We have no questions at this time. I would like to turn it back over to you, Mr. Leonard.
Thank you, Ruth. Thank you for joining the Q2 call. Look forward to speaking with you all on the Q3 call. Bye-bye now.
Thank you. The conference call has now ended. Please disconnect your line.