Good morning, ladies and gentlemen. Welcome to Constellation Software Inc. Q1 Results Conference Call. I would now like to turn the meeting over to Mr. Mark Leonard.
Please go ahead, Mr. Leonard.
Thank you, Melanie. Good morning, everyone. Welcome to the call. As you know, we generally go directly to questions. So Melanie is going to take up those questions.
Go ahead, Melanie.
Thank you. We will now take questions from the telephone lines. The first question is from Paul Steep of Scotia Capital. Please go ahead.
Great. Thanks. I guess, Jamal, maybe the first question for you. If we look at the margins in the quarter, if the are the full new bonus plan is the full new bonus plan fully reflected in this current quarter's margins? Or is there still some extra costs that we should be thinking about?
The impact of the new bonus program is not as material as we had originally expected. There is an amount that went through in Q1 and there'll probably be some accruals throughout the rest of the year, but it's not the reason for the decline in margins in this quarter. The decline is really because of the payroll taxes associated with the payment of our 2015 regular bonus.
What happened last year was the bonus the share purchases were made over Q1 and Q2, right? Right. Which had a more it spread out the cash flow. And did it also spread out the payroll taxes? Or was that
Because yes, the payroll taxes maxed out when we pay the bonuses for many of our employees. And so if they maxed out in this year, they would a lot of people maxed out in Q1 versus last year, that maxed out would have happened over Q1 and Q2. Okay. That helps. The other question just related to the quarter itself.
The maintenance mix picked up. Is there anything to read in that? Is there a more fundamental shift that's gone on or that would be driving that? Or is this more just a quarterly anomaly? And if so, what sort of drove the shift there because it was meaningfully higher than prior periods?
We do say Q1, there is seasonality in our Q1 versus Q4 numbers specifically. In Q4, there's always a push sort of get some projects over the goal lines and you will see that in professional services sort of go up in Q4 and then come down to Q1. And then you also had that large hardware sale or sales in Q4. And again, so if you're just looking at percentage of gross revenue, then if that hardware sale was an anomaly in PS banks in Q4, then you'd always expect excluding the impact of acquisitions that maintenance is going to be a higher percentage in Q1 than it would be in Q4. Great.
I guess the last one for me, Mark, is related to your letter. If I take a look at Table 3 on the maintenance revenues, a couple of things sort of leap to mind to your questions come up generally. One is the sustainability of the price increases that you've been able to drive across the base clearly over time, maybe some thoughts around that. And then also customer losses, if we look at the attrition from lost customers, it sort of ticked up to sort of a 5% level and it's persistently been there for the last 3 years now. Thoughts around what you're seeing on that front and concerns or not on that?
Well, first of all, the normal preamble of whenever you look at aggregate numbers, you don't really get the picture. You've got to drill down to the individual business unit to understand what's going on, which we can do in our data, but obviously don't share with the shareholders and competitors. Vis a vis customer loss, I think some of that is the fact that we are in some verticals where there is much higher attrition now than we were, let's say, 5 years ago. Many of the SaaS businesses that we're in have brutal 1st year attrition, infant mortality as they refer to it in the SaaS space. And that's just a part and parcel of that particular business model.
Other than that, as I think of our individual business units, I don't think we're undergoing higher customer loss in most of our traditional businesses than we have in the past. And vis a vis price increases, this is really price increases and other. We used to have FX, for instance, in this bucket. We have in here a bunch of transactional business as well, which has tended to be fairly significant grower for us. And then prices in software are an odd thing.
1 of the operating groups took one of their products and displayed all of the features and functions added to that product over an extended period of time in a graph for us all at the general managers meeting yesterday. And what we could see is that the customers were getting enormously increased functionality. And that's for long periods of time, 5 or 6 years, they would get no price increases. And then finally, you would come to a head and we put through a single price increase. And then for the next 5 or 6 years, we didn't put through any price increase.
So I think what tends to happen a lot of the time in our businesses is you add incrementally to the product, you don't necessarily break out new modules and sell them separately. But then at some point, the economics of supporting a much larger product as such that you put through a price increase. And so it isn't just straight price, it's really you created something much newer and better than they had 5 or 10 years ago. So as to the sustainability of that, I think that's always going to be there. I think people will always want new integrations, new features, new functions.
Whatever the shiny new toy is, they will want built into the software.
Great. I'll pass the line. Thank you.
Thank you. The following question is from Thanos Moschopoulos of BMO Capital Markets. Please go ahead.
Hi, good morning. I know you don't provide guidance, but as we look out towards the rest of 2016, are there any structural reasons
that you're aware of that would cause full
year margins for 2016 to be any weaker than
what we saw last year?
I don't know of any structural reasons, no.
Okay. And Mark, historically, you've provided some disclosure, I think, annually in terms of your mix of SaaS revenue. Would you have that metric for 2015?
We didn't do it. It's a bit of a pain. And the distinction between SaaS and non SaaS is fuzzy because frequently the add on products we generate are SaaS products even though we may have on premise core systems. And so I'm afraid we just didn't go through the exercise this year, and it's not that meaningful to us. We run all of our businesses that try and make money and grow and service our customers irrespective of whether they're hosted or SaaS or cloud or whatever the term is that you want to use.
Okay. And then finally, in the shareholders letter, you talk about the notion of having the business unit managers more actively involved with M and A. And so I wanted to get your thoughts as to how much of a challenge that may or may not be as far as training them
to do that. Based on your very extensive experience, is M
and A primarily an art, which might be a little challenging to teach? Or is it really a science based on a very well established playbook that
you've developed over the years?
I think it's a bit of both. But you can, like most things, use base rates to refine your forecast. And so if you have extensive experience in buying companies, you can look at that experience and go organic growth, consistent organic growth above 10% happens very, very infrequently. Therefore, if you're forecasting it and everyone you're bringing to me, you're probably wrong. EBITDA margins above X happen very infrequently.
It looks to me like you're being optimistic, etcetera, etcetera, etcetera. So as long as we provide those base rates to our managers and then give them the opportunity to explain why they're going to be top decile versus the base rate, I think we give them a terrific tool and then their level of commitment to actually delivering top decile performance will be enormous. And so I don't think it's that tough. And then the underlying decision making tool is IRR and that's a wonderful thing to teach because it teaches people how to think about cash and all of the things that affect cash inside of a business, which is the essence of business. So no, I don't think it's going to be a problem.
I think it's something that anyone with mathematical ability can pick up. And I think if we provide them with the tools, I think they'll embrace it.
The following question is from Andraj Kaneta of Echelon Partners. Please go ahead.
Good morning. Thank you for letting me on. My question is on cash deployed on acquisitions. Mark, last year, cash deployed on acquisitions vastly upstaged that of any prior year, bar 2013 when you acquired TSS. Would you say or maybe you can offer your thoughts what the key reason here would be?
And is it sort of can we assign that to the lowering of the hurdle rate on bigger transactions? And should that hurdle rate remain where it is through 2016? Do you think that's the new normal for the opportunities that exist out there for you?
I have a feeling that competition is probably our toughest metric to forecast. We saw, I think roughly 10 large VMS transactions in Q1. We got to participate in 0 of them even though we followed roughly 70 2% of them, 7 of them before they went into the process. What that tells me is that there's lots of people out there with lots of money pitching for these larger transactions. So I don't see right now that that market is as attractive as we would prefer.
And we have to wait for very special situations within that market to come along, companies that perhaps are underperforming or have something about them that doesn't fit the normal model that the PE firms in particular are looking for. This quarter, we were looking at a couple of larger transactions where they came with enormous debt staples and maybe these PE firms can operate vastly better than we can. But when we model out the numbers, we just can't make them work. They must be targeting, assuming they're like us, fairly low rates of return. And as long as they're willing to do that, we'll probably get outbid on these larger transactions.
The baseline, however, of smaller transactions where the PE firms generally don't play is a place where we should be able to consistently deploy capital and then occasionally we'll get a troubled situation where we'll be ideally able to deploy significant dollars.
That's helpful. Thanks. And the second question is something you brought up in your letter. It seems like you're warming up to ceding some more autonomy to your BUs and pursuing organic growth. And we know that organic growth has been gradually declining.
Just if you do decide to move on that, would that sort of phase in gradually across few units? Or would that be a more a sweeping change across the corporation?
Yes. The way I describe it, it sounds like it was some master plan, but what happens inside of Constellation is we gradually drift. And so we gradually drifted in the direction of pushing more and more autonomy down first to the operating groups and subsequently to the business units. And some of those business units have been consistent strong organic growers for years years, sometimes decades. And so it's not like something dramatic has changed, a switch has not been flipped, but our expectations of business unit managers are now being raised.
Used to be you could run your business unit, generate a good IRR and cruise along. Now we're saying, well, you've got to deploy some capital too, if you've shown the capability for running a business unit well, And you've got to do some organic growth if you've shown a capability for running the core of your business well, you've also got to run initiatives on top of the core. And so that is going to put more pressure on some of the BU managers who may not have been doing that in the past. But it's not like everyone suddenly is going to have to start doing it. Some will obviously have been doing it.
Others will just do more and others will be learning for the first time.
That's helpful. Thanks. And maybe a follow-up to that is, do you think that those units where you envisioned that for, do you think they have enough capacity to change that balance and have the capital allocation balance out more towards initiatives for organic growth? Because as I said, it's been on a declining trend.
Yes. What I tried to explain in the letter is we have a bunch of businesses that do not have a declining trend. And then we have a bunch of businesses that we bought that we knew were shrinking businesses, contracting businesses, but that we thought were really good rates of return, so we bought them. And so I think what you've seen is a mix shift as much as anything else. It's not like we decreed at any point, thou shalt not invest in initiatives.
We did show after tracking for 4 or 5 years, the general managers that the rates of return that they were generating on initiatives weren't great and therefore they had to get better at generating good rates of return on initiatives. And I think that discourage them from embarking on a whole pile of nuance. But I still think there's something inherent in our business when you're close to your clients, you're servicing them every day, they ask you for stuff. And so you build add on products all the time. It's just part of the business.
And so all of our guys are practicing initiatives all the time. They may not be formal ones that are broken out, but they're implicit.
Thanks for answering my questions.
Thank you. The following question is from Stephanie Price of CIBC. Please go ahead. Good morning.
Good
morning. In your President's letter, you talked about hurdle rates and the fact that lowering them in 2015 was a bit more expensive than you thought. Can you talk about just expand on that and talk a bit about your thoughts on hurdle rates at this point?
Yes. I didn't mean to suggest that lowering them in 2015 was more expensive than we thought. And what I was trying to suggest was when we lowered them twice before, it was more expensive than we thought. And in 2015, we tried to be clever and say, we're not lowering the hurdle rates on these classes of acquisitions, but we are lowering it on large and leveraged transactions. So hopefully, that's what I wrote and it just wasn't as clear as it might have been.
And then when you look out at these large transactions, I mean, as you mentioned, in terms of the PE firms, it's tough to compete. Like would you consider lowering the hurdle rate again? Or do you think this is a good level you're at right now?
I think it's pretty good level that we're at right now.
All right. And then just in terms going back to the Keep Your Capital, and the previous question, organic growth obviously has been relatively flat for the last couple of quarters. I mean, where do you think a good organic growth level would be for Constellation? Or where do you think the Constellation is going to get to in sort of the medium term?
I've always wanted to do 2 or 3 points better than GMP. That's always been my objective. We're a fairly diversified business across many sectors of the economy. And I would hope that we can do that, obviously, because we are, in essence, a capital goods business, it's going to be volatile. And so in good times, it should be better than that.
And in rough times, it will be worse.
Okay, great. Thank you. Thank you. The following question is from Paul Treiber of RBC Capital Markets. Please go ahead.
Thanks very much. I just I was curious about the study that you've done, high performance conglomerates, particularly in regards to the how Constellation's hurdle rate or IRR investments compare against the conglomerates over time?
So it's impossible to get at the individual investments of the conglomerates because they usually don't break out individual amounts and financials associated with them. What you can see is sort of what their incremental return on incremental capital has been. And it has been in the on shareholders' investment for the most part has been in the mid to high teens. There are some outliers obviously where they use lots and lots of financial leverage. And when you break it down to EBITA type numbers, I would say it's in the again, in that sort of mid-nineteen kind of area.
We've done better historically. As you can see from our ROIC numbers that we report. But if we deploy lots of capital at lower rates of return and our hurdles are lower than our ROIC right now, then it will likely go down unless we use lots of financial leverage.
And just as a follow on to that and maybe a little bit of a hypothetical question, but please these conglomerate you looked at, I mean, they've delivered fantastic performance of the years with probably lower return on invested capital. If you can't deploy capital at your existing hurdle rates, hypothetically speaking over time, would
you rather lower the hurdle rate or
would you rather return that capital to shareholders?
It's a really good question and there is a diversity of opinion around the Board. I think what we do, generating really high rates of return on capital is very, very special. And I hate to undermine it by dropping total rates. And so I would rather personally return capital. Many of our investors wouldn't like to see that.
I admire what Jack Henry did in one of the companies I profiled in the letter. In this, they only deployed roughly a third of their free cash flow on acquisitions and they had the discipline to return 2 thirds of that capital to their shareholders via dividends and share buybacks. I love discipline on hurdle rates. Otherwise, if you follow finance theory and race down the curve towards your weighted average cost of capital when you're buying companies, it's just a matter of time to if you believe the hurdle rates are magnetic, the whole company ends up down there, not just the incremental acquisitions that you do.
Somewhat as a follow-up to that, the comment on making public company investments, in the majority of cases, you haven't ultimately acquired those companies. And so you do end up getting the capital back in the future, not still at a high rate of return. But that doesn't doesn't that really just kick the can down the road, so to say, in terms of pushing out the too much capital to allocate challenge?
For sure. No, it's a byproduct of what we do. And like many by product businesses, if it has high margins, it's very tempting to prosecute it. And so I think we'll do it. It isn't going to come to dominate what we do unless we get the recession to end all recessions, in which case it could well account for the bulk of capital we deploy.
There's no one else to sell the business during a recession, but lots of people want to sell stock during a recession.
Okay. Thanks. Good to understand.
Thank The following question is from Miraj Kania of IWD Capital Management. Please go ahead.
Hi.
My question is, if you could talk about the notary industry vertical that PSS has acquired to businesses in Q1. If you could give some color around what type of software this is used for? It basically populates documents with publicly available information, so that the notaries can prepare them and present them to their clients. And then does billing and all the other associated things that a notary would take. So think of it as the core system that a notary would use.
Okay. Thanks.
Thank you. The following question is from Matt Pickering of Select Equity. Please go ahead. Matt Pickering, your line is now open. Please go ahead.
Sorry, I was on mute. Thank you for taking my call questions. Can you quantify the payroll tax impact please for the Q1?
No, it's not within a few different accounts. All I can say is we expected this debt, but like Mark said, we don't expect the margins for this year to be different than last year. So we'll read into that as you move it.
Okay. And disproportionately, I mean, I'm not trying to hold you to a firm answer, but is it $2,000,000 $5,000,000 $15,000,000 I would presume is obviously not that higher. And I'm just trying to
get an idea of magnitude if somebody can't give a precise number. I mean, I would assume it's like a couple of 100 basis points that from sort of what the average would be is a lot of that has to do with
Okay. That's helpful. Thank you, Jamal. The last couple of years, you guys have not disclosed in the accounts the annual run rate of the acquisitions you've performed. And I appreciate they haven't met some statutory materiality hurdle.
But that's always been useful just to try to gauge the revenue multiple of the capital you're committing for shareholders. Mark, can you give us a broad perspective of kind of how aggregate revenue multiples have moved from the actions that you've taken in light of the acquisition environment that you've helped us understand better?
We put that graph together for our quarterly managers meeting, and it looks like we're paying increasingly high multiples over time, over long periods of time. Individual years bounce around, but there is an upward trend, clearly.
And you still used to describe that trend relative to maintenance revenue. I presume that's still how you're thinking about it internally or has your thinking changed?
No, it applies to both maintenance and total revenues. The correlation of intrinsic value with maintenance, we think, is slightly better than with overall revenues.
And so if the acquisition multiple is increasing as a proportion of total or maintenance revenue, are you buying more profitable day 1 businesses? Or implicitly is the IRR trending
inversely? I would say the IRR is coming down here as we hurdle rates and people stretch
a little more and
are a little more optimistic, the IRS, I think, are coming down.
Okay. You've done a good job building up a very strong vertical market software position across a variety of public sector verticals in particular. At the margin, more of your incremental acquisitions have occurred in the private vertical. Does that reflect an opportunity sense to randomness? I'm just curious when we think about the evolution of the network of businesses going forward, if there's trends there that we should appreciate.
Yes. It's a contrarian philosophy evident in the numbers. In the Internet boom era, the government sector was, for the most part, thoroughly disliked because it didn't move quickly. And so the private sector stuff had higher multiples, and we ended up buying a lot of stuff in the government sector. Once you have a footprint there, you tend to find other things and hence we ended up with a big public sector business.
We do have a preference for businesses where the clients are not spending their own money. When you're dealing with an entrepreneur who's buyer of systems, they tend to be more careful, more frugal than if they're spending their employers' money. So the larger the client base and the more public sector it is, the more likely you are to have better economics.
Yes. Are there any clear pockets of opportunity like that public sector observation that you benefited from the early 2000s that you hope to exploit further today?
Think of any sector where the stock prices have come down 30%, 40%, 50% and there'll be a little consolation fellow attending the conferences.
And lastly, I know you've commented that TSS has worked well relative to expectations. But just to be clear here, how should we judge success there?
It's pretty easy to tease out the numbers from the increases in the value of the minority interests and things of that nature. So I don't think you'll have any trouble judging it.
I don't mean judging on a short
term basis. I'm saying when you think about why you did the deal and what you hope to accomplish from a longer term perspective,
what is success given the way PSS has progressed?
Well, it was a good deployment of a big chunk of capital with people that we like, whom we've come to trust over an extended period of time, who are now in turn deploying capital. It's a unique situation in that we have a significant third party shareholder involved. So that requires some different thinking than we've had previously. Kind of like it in that it creates a discipline and attention and an attention to what one does. And so we would hope to duplicate it elsewhere.
So if there are the opportunities to buy significant positions in larger vertical market software companies or conglomerates, often when they get big, they tend to be conglomerates, we would welcome them.
The following question is from Blair Abernethy of Industrial Alliance. Please go ahead.
Thank you. Mark, just wanted to get your thinking around the transaction processing space. How has that been performing for you? What sort of opportunities do you see there for growth or for consolidating and leveraging up your platform?
So we have a number of businesses where the transaction processing is an important part of what they do, both from the point of view of straight up incremental margin, but also from the point of view of making the business stickier, lowering the attrition rates. Often with small ticket software, the switching costs are fairly low. When you add in transaction processing, it just adds another switching costs, which is sometimes good. The whole payments area to me is a mystery. There is a ton of stuff going on.
I have no idea who's going to win. It's clearly going to be huge. At some stage, I think there's going to be massive amounts of margin compression in portions of it as the market shakes out and the major players emerge. And so it's something that makes me nervous. On top of which, there are all kinds of security concerns about being in the transaction processing business.
So I'd say it's one of the most uncomfortable pieces of our business, but it's an important part of a few of our verticals.
Okay. And would you understand that? Is it seems like there's a fair bit of competition to acquire those kinds of established businesses. Is it something that you're seeing in your M and A pipeline that you think you could do? Or is it or is the pricing too far out right now?
It varies by vertical a lot. There are some businesses where software is 90% of solution payments is 10% and then there are some where it's the flip of that. Obviously, the payment companies like the ones where it's 10% software, 90% payments, And so they tend to compete for those vigorously, whereas we prefer the ones where software is a bigger chunk of the value added.
Okay, great. Thanks very much.
Thank you. There are no further questions registered at this time. I'd like to turn the meeting back over to Mr. Leonard.
Thank you, Melanie. Thank you all for joining the call. We will be holding the AGM Ashish at 10:30 and look forward to seeing some of you there. Thank you.
Thank you. The conference has now ended. Please disconnect your lines at this time. We thank you for your participation.