Good morning, ladies and gentlemen. Welcome to Constellation Software Inc's Q3 2014 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 Q3 conference call. As you know, we go directly to Q&A. Melanie's going to tee up the calls now.
Thank you. We will now take questions from the telephone lines. If you are using a speaker phone, please lift your headphones before making your selection. To ask a question press star one on your telephone keypad and if you wish to cancel your question, please press the pound sign. Please press star one at this time if you have a question. Please be hold while we compile our roster. Thank you for your patience. Once again please press star one on your telephone if you have a question.
The first question is from Scott Penner of TD Securities. Please go ahead.
Well, thanks. Maybe first of all, on the TSS business, the EBITDA margins as reported at 17.5% are obviously a big jump from 10% last quarter. Wondering, Mark, if you can help us understand why the big increase there and whether any of the one-time items are specifically related to TSS.
Well, certainly, there are some seasonal items in there, so my suspicion is that we will see this Q3 pattern again with TSS.
That's the vacation accrual was the CAD 2 million that I was referring to that was TSS-related.
Yeah. That probably, though, is one of those seasonal items that we'll see year after year after year. It's one time per annum, Scott, as opposed to one time.
On the CAD 4 -CAD 6 million expected severance in Q4, I don't know to what extent you can discuss that, Mark, really what is expected to be the annualized saving off that type of investment, what time- period should we phase it in?
It varies all over the map, Scott, depending upon the particular instance, and there are, I believe, 16 separate businesses that we're tracking under TSS. Very hard to give you a hard number, but they do look at, obviously, the payback and return on such expenditures and are pretty scientific about it.
Okay. Just to Jamal, can you give us a sense of what we should see as far as the current tax rate over the near term? Just curious as to whether you have any sense of what level of M&A investment is required to sustain that kind of rate.
I mean, the rate, as you'll see this period bumped up to, I guess I always look at that current tax as a percentage of any before tax, and you say it's, you know, it's 24% this period. However, if you exclude some of the one-time items, like the CAD 2.5 million prior period stuff, it's down to 18. The anomaly you're going to get now is the, or at least in 2000 or materially in 2014, is the SR&ED application. We've built up these R&D tax credits in the past, and what we're trying to point out, I try to point out in the M&A there, is you're going to have about CAD 13 million that we'll utilize of R&D tax credits to shelter current tax expense.
That won't show up in the current tax expense line. It will just, you know, reduce what we actually pay the government. If you take that into account, then you're back down to sort of the 15%, you know, cash tax rate. Assuming we don't pay or make any more acquisitions, that number will gradually increase, and, you know, if we don't make any acquisitions over the next few years, I mean, that number will, you know, bump up to, you know, we'll start paying full tax in Canada, so you'll be somewhere in the mid-20s or so as a CSI rate. I mean, I couldn't tell you what I mean, we don't forecast acquisitions, the number will likely go up.
I mean, if we make some huge acquisitions and bring that IP into Canada, we'll be able to bring it back down, right? As of right now, we just, you know, it is 15. It'll creep up towards mid-20s if we don't make acquisitions.
Okay. That's helpful. Just one last one, Mark, and that is the status of the any minority investment discussions ongoing with the prior TSS investors. Where does that stand?
The discussions are ongoing. I think we've got most of the major items ironed out, and it's just a question of getting them papered as we have time.
Okay. Appreciate it. Thank you.
Thank you. The following question is from Thanos Moschopoulos of BMO Capital Markets. Please go ahead.
Hi, good morning. Mark, your organic growth accelerated a little this quarter. I was wondering how much of that might be currency. Do you have an estimate as to what the organic growth rates would look like on a currency adjusted basis?
I don't. Maybe Jamal does.
Yeah. I mean, I do calculate that on a CSI level basis. The number wasn't material enough for me to disclose it. Individually, like say TSS, for example, I think the hit was about a 3% hit to their organic growth. Again, that was offset by positives in other currencies at the CSI level. Yeah, that's why I don't disclose it. It shouldn't be drastically different at a CSI level.
Okay, that's helpful. License growth in particular looked a little weak. I think in the public sector it might have actually been down organically. Anything you'd highlight there, Mark, or just some quarterly volatility?
Yeah, you know, I don't really look at licenses. I don't find them very indicative because the world is changing. There's a lot of SaaS model stuff happening out there, particularly in the add-on world. Plus, when discounting happens, it tends to happen on licenses, not on maintenance and services. I'm afraid I didn't spot that, Thanos. You did.
Okay, fair enough. Maybe as a broader question, as you talk to your business units, any commentary that you can share with us with respect to what they're saying about the spending environment and how that's evolved over the last three months?
They forecast optimistically while saying depressing things. It's a combination of. When it comes down to putting it in numbers, the numbers are reasonably encouraging. When it is words, you know, it's all doom and gloom are just around the corner.
Well, I guess my question is, we've heard from some other companies that there's been maybe a deceleration in the past quarter. I'm just trying to figure out if you guys are seeing that from what you're hearing.
I really believe that professional services are your best weather in software companies. Just keep an eye on what all of the software companies' PS is looking for like year-over-year. As things start to decelerate, they obviously do everything they can to keep that PS, professional service business, going. It tends to start slowing down as they move on to more and more marginal projects. Accounting can do magnificent things for license recognition; it's a somewhat untrustworthy thing to look at. I just encourage you to sort of focus on the PS revenues and how they're tracking. My sense is that we aren't seeing any great panic in the professional services groups across the board. Obviously, there will be spots where people aren't as happy as others.
Okay. Great. Thanks, Mark. I'll pass the line.
Thank you. The following question is from Paul Steep of Scotia Capital. Please go ahead.
Great. Morning. Mark, maybe give us a little update on where the overall business is in terms of SaaS as a percentage of maybe both in public and private. We talked, I think, now a couple quarters ago about initiatives in that area.
Yep. We are using SaaS economic models in a lot of places. We're tracking it. The challenge that we have is understanding the COGS that go against it, because I like to understand what the net revenues are from both maintenance and SaaS type activities. We had intended to start disclosing that information, but the numbers just aren't crisp enough for my comfort at this stage. Let's just say that it's a growing and rapidly growing, compared to the rest of the business, piece of what we do. You are forced to go that route by the enthusiasm that the world has for cloud and SaaS type products and positioning. I think it's going to be a trend for probably the next four or five years until the economic success become, I think, obvious to everyone.
Are there any of the business groups that seem to be sort of, I guess, leading the charge that we can look at where the customers sort of, you know, understand the operating model is challenging on the COGS side, but in terms of customers sort of pushing in that direction where you're, you know, looking to maybe offer a change to them in terms of delivery method? Is it sort of across the board, you're looking at this as an option to sort of change things up?
Well, I'd say across the board, our add-on products tend to be both hosted and SaaS economic models preponderantly. More than half of the add-ons would be going that route. That's irrespective of vertical. In terms of the verticals where you get the fastest traction for SaaS models, they tend to be low-ticket and low professional service requirement verticals. It's not hard to figure out which of those inside of our 60-odd verticals would be most likely to end up with a model of that nature. The problem with low- ticket, low PS, low professional services businesses is that they also tend to have fairly high attrition. You're hopping on a treadmill where you're adding clients as quickly as you can, but they're also dropping off the other end.
SaaS becomes a race where the cost of customer acquisition is offset to some extent by customer attrition.
Okay. Great. The other one for me, it's a small one, just on hardware. I know over time you've moved away from it, and you called out the one-timer from last year in QuadraMed. Maybe how are you thinking about, you know, hardware and sort of transitioning that out or not, as the case might be, in terms of the various verticals?
I think it varies an awful lot. When you service a customer, you provide a bundle, and that bundle, in our case, always consists of some software. Around it, we may hang services. It could be a call center; it could be all kinds of things. You also hang hardware in some very specific vertical markets. To be a viable competitor, you just have to have that offering, sometimes. I've no problem with hardware. I just prefer that it be hardware that can't be easily unbundled, and that does provide value to the client as part of the bundle.
Okay. Great. Thanks, guys. I'll pass the line.
Thank you. The following question is from Paul Treiber of RBC Capital Markets. Please go ahead.
Thanks very much. Just historically, what's been the relationship between profitability and acquisitions? Do you typically see a higher profitability in periods of lower acquisitions?
I have a couple of questions in there. When we acquire a business, it seems to go through a two or three-year period where the profitability improves. I'm generalizing here. Sometimes we acquire businesses that are highly optimized and that you couldn't hope to continue to run at the level of profitability that we buy them at. That's quite rare, though. Most of the time, the businesses do improve their profitability over a two-to-three -year period. We actually just finished studying this for the acquisitions that we've done over the course of probably the last 5 or 10 years. It's a pretty good data point. When we're busy doing acquisitions, that could be during a time of depressed economics. It could be when the GNP has contracted.
In which case, it's going to be hard for us as a capital goods business to make a lot of money during those periods. Very hard to talk about how profitability and acquisitions as a whole relate.
In looking forward and relating to that, I think in the past, you commented that there aren't economies of scale in your business. Outside of TSS, just looking at the margin expansion over the last year, like is a lot of that coming from the gross margin line or gross margin has been fairly consistent over history, or is it more from the OpEx line?
I don't really think about gross margin at all in our businesses. I tend to think about people-related costs, which are the vast majority of our costs. Of course, you can argue those are fixed or variable depending upon what school you come from. As to economies of scale, I said that they were modest, and I think you have to drill down into individual business units. I believe that teams of 40, 50, maybe up to 100 tend to be eminently manageable and nimble and do wonderful work. I find that when you get up to 400 or 500 people, you need to have rocket scientists inside those teams because it's really hard to coordinate the activities of that many people in a single pursuit or business unit.
I'm constantly amazed by people who run, you know, 1,000-person or 10,000 single business units. We don't have many big ones. We have lots and lots of 40-person and 50-person and 100-person business units. I'm not sure that when you start pushing past there, that you get tremendous economies of scale. If you're addressing a large vertical where the total available market is sufficient that you can push past there without hitting diminishing returns, then I think what happens is you either sub-segment the market and come up with differentiated positioning and make good money out of doing that, or else you figure out how to manage the complexities of scaling up the business. I think either of those are viable strategies. They, I just think the latter, the scaling up the business is inherently difficult and sometimes dangerous.
You probably can get bigger economies of scale. If you seek them out, you can slap together two or three businesses in similar spaces, eliminate some product lines, drive everything through a single product line, have a smaller R&D group, have a smaller support group, have a more coordinated sales organization. I think the challenge is that you're going to get sub-segmented by your competitors.
Okay. Thank you. One more from me. You're generating quite a bit of more free cash flow this year than you deploy in acquisitions. You know, in lieu of acquisitions, what would you do with the cash? Just related to that, could you just revisit the dividend and then your thoughts on the appropriate capital structure just in regards of leverage or not?
Dividend is definitely a board matter as opposed to a what would I do with it, matter. I do not particularly like share buybacks, and I'm on the record as saying that it's an opportunity for insiders to take advantage of outsiders, particularly those who are least informed. My preference, if you had to redeploy capital to shareholders, would be dividend over share buybacks. As to capital structure, I don't believe all leverage is made the same. There are banking facilities and debt facilities that have hair trigger covenants and make you act very differently than other kinds of debt or fixed return instruments. I don't think one can answer your question without specifying the kind of instrument that you're using for leverage.
Fair enough. Gee, I'll pass the line.
Thank you. The following question is from Ralph Garcea of Global Maxfin. Please go ahead.
Good morning, gentlemen. Just two quick ones. I guess on the DSOs, it looks like it's been the lowest in a while, which is a great sign. I thought it would have ticked up given the addition of the TSS business. What are you doing differently from a collection standpoint, I guess, other than happy customers, that you've been able to get the DSOs down here, which has obviously helped the cash flow, and what sort of targets would you have going forward for DSOs?
Working capital generally, and I think you have to look at it generally because there are trade-offs between deferred revenues and AR. Working capital generally is one of the areas where we can optimize our businesses, where we can try to run them better. We have had programs at all of our businesses to focus on working capital over the course of perhaps three or four years. Before that, obviously, we cared about it, but we just weren't as focused on it. It's now part of our primary report card. What I tend to see happen is the businesses that have the largest projects also tend to have the largest AR and WIP and inventory and deferred revenue type numbers. They're the ones that are the most challenging.
As I've told you before, when bad things happen in software companies, it's usually WIP and AR where they go to hide. Obviously very pleased with the numbers coming down and would like to see them come down further. The metric that we actually follow suggests that they've been pretty flat at when you take into account all the working capital accounts over the last little while, and we wouldn't mind seeing them improve a little bit further.
Okay. Just to follow up, I guess on the severance cuts in Q4 and stuff going forward, would it be across the board at TSS or are there specific countries or products that would take the brunt of the cuts?
TSS has almost entirely their revenues in the Netherlands, so that would be where they apply.
Were there any product weaknesses after you took over that you sort of need to trim either on the development side or within specific sales forces of their broad offerings?
They have so many products, as you can imagine, across that many business units. It's, it's impossible to generalize. The key is to have each of those business unit managers run their businesses in a way that creates a portfolio product. There'll be some that are mature and some that'll be brand new, and it's managing those portfolios that's a big piece of their job.
Okay. Thank you.
Thank you. Once again, please press star one at this time if you have a question. The following question is from Brad Dunkley of Waratah Capital Advisors. Please go ahead.
Well, hi, Mark. My question is about the rights issue you did for the notes, and I'm just wondering from your perspective how that's gone and if you see that as a useful tool that you will rely upon more in the future for financing.
It's gone very well, better than I had hoped. I hope there were or are no stranded rights out there and that the vast majority have been exercised. Certainly, was pleased with the first tranche which got the majority of them exercised. I believe it's a useful instrument. It is tax-deductible. It has the long-term orientation that we need because we use capital to buy businesses that we keep forever. Very happy with the instrument. If I'd had my druthers, it would've been a US dollar instrument just to put in some natural hedges. There would've been some slight differences in some of the terms and conditions. Because of rules and regulations and past practice, we sort of ended up with a couple of compromises.
It's very close to what I was looking for. Very pleased that the shareholders supported us and helped make it happen.
Okay. With respect to TSS, looks like year-to-date, in particular in the Q3 , there was a big investment in working capital. Could you comment on that?
What happens at TSS is they have a very strong seasonal pattern to their working capital, with it being very strong in Q1 and then much Sorry, I'm talking about cash flow. Very strong cash flow in Q1 and then negative cash flows in the subsequent quarters. I think you're just seeing the seasonal pattern playing out. Basically, deferred revenues are coming down during the course of the year.
Okay, thank you.
Welcome.
Thank you. Once again, please press star one at this time if you have a question. I'm sorry. We do have a question from Richard Tse of Cormark Securities. Please go ahead.
Hey, Mark. Just wanted to touch base on TSS in terms of, you know, the integration. Where is it relative to where you think it should be right now? Are you kind of halfway there? Three-quarters of the way there? Maybe give us some color on that.
I think history is probably your best guide to that. We find that over a two or three-year period, what we have to teach, the best practices that we bring to the table tend to get taken into the acquired organization. I think that's the same case here. We're dealing with bright, well-educated folks who are keen to learn. Lots of our managers have been over to share with them what we do in certain circumstances, and a lot of their managers are coming the other way. Best practices travel through people. They don't travel through a playbook. I think it will take a while. Very hopeful and very encouraged by the attitudes that we're encountering.
Given the size of TSS, does that sort of change, the way you view sort of acquisitions and the pace of acquisitions here going forward over the next 12 months?
Yeah. It definitely means that I'm not going to be looking for another one for me to spend time on. That doesn't mean that the operating group managers with whom I work won't be out talking to large potential acquisitions. Particularly if it's in a vertical that they know and love, you know, they're always doing that. We actually just had a session on Friday where we had north of 70 people in from all over the world, from all of our organizations, to talk about mergers and acquisitions and how to do them better, how to work the suspects and stay in touch with potential vendors, how to do integrations, what has worked, what hasn't worked.
It's something around which we're trying to put more and more process and around which we're trying to innovate all the time.
Okay. I guess, you know, the last question, I guess, is maybe an update on the acquisition environment in terms of, you know, the levels of activity and maybe, a bit of talk on the valuations out there in the marketplace.
Activity is high, but you'd expect that. We've I think it's 25 people ± 2 who are doing full-time M&A. In addition to that, we've roughly the same number who, on a part-time basis, are engaged in the activity. We're thinking about adding some more. One of the questions that obviously comes up is, "Where do you hit diminishing returns?" Certainly, we are seeing that in terms of the quality of leads being generated and the close rates on those leads. The issue is, have you gone too far? If you experiment around the edges, that's the best way to figure out when you've gotten there. We believe that the environment does affect these things. Certainly, the stock market being where it is tends to create a lot of expectations.
A lot of the excitement around SaaS and cloud creates expectations as well. Most of the verticals are toying with, experimenting with trying SaaS and cloud-type rewrites. Tons of money going into the space right now. People don't like to sell their business when they're investing. They like to sell it once the prospect of rapid growth and profitability is just around the corner. I think that could be contributing to some of the slowness we're seeing. Certainly, if we only invest what we've done so far this year, roughly, let's call it CAD 25 million a quarter, and generate good rates of return on that, we'll be very, very happy. If we could do CAD 200 million per annum, I think we'd be happier.
If periodically we succeeded in doing a large transaction that we found attractive, even better. There are going to be cycles to these things, and it's hard to predict.
Okay, great. Thanks, Mark.
Welcome.
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. Appreciate it. Thank you, everyone, for attending. We look forward to speaking with you once the Q4 results are in. Bye-bye now.
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