Good morning, ladies and gentlemen. Welcome to Constellation Software Inc. First Quarter 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. Welcome to the Q1 conference call for Constellation Software. We, as you know, go directly to questions and Melanie is going to tee those up for us. Melanie, please?
Thank you. We will now take questions from the telephone lines. The first question is from Richard Tse of Cormark Securities. Please go ahead.
Yes. Thank you. Mark, so just noticed on your filing here last night that it seems like you're stepping up some of your investments according to your MDAs or staff new investments to grow new initiatives. Can you sort of maybe talk about why that's sort of happening now? It seems like it's a new thing or maybe I'm wrong, but maybe give us a bit of background on that.
You're probably at
a bit of a disadvantage Richard in that we filed the President's letter late last night. Yes. And I talked a little bit about the initiative investment cycle and what's happened over the years. And I think you'll find the data interesting. So definitely worth pulling that and having a look.
A synopsis would be we introduced a way of measuring initiatives that allowed people to learn from what they were doing. And it led to a drop in the amount of initiative investment hopefully becoming more rational in terms of what we're doing on the initiative side. That happened over a period of 5 or 6 years. And then over the last 2 or 3 years, we've seen a gradual uptick in the initiative investments. And some of it is sort of anecdotal as we get out there and talk to folks.
We hear about this initiative and that initiative is starting to gather steam. And some of it you can just sort of see in the macro numbers. And I believe that our folks have learned a lot about initiatives and are doing them better than they've ever done them before. And I think it's just a gradual accretion of knowledge and experience that's led them to be more confident about investing more in initiatives.
Okay. Fair enough. In regards to some of the more recent acquisitions, has the profile of your ability to sort of turn those margins over to sort of a fairly positive number changed in any way from what it was maybe a year or 2 ago? Meaning are they easier or harder to integrate?
Again in the President's letter, I talked to this a little bit.
Okay. I guess I should read that.
No, no. Just I'm really saying it for other people rather than for you. There's a couple of different classes. The founder type businesses that we buy tend to be from a values and culture perspective very close to what we espouse at Constellation and those tend to be pretty easy acquisitions and integrations. And in fact, we don't sort of tightly integrate many of them.
We keep them as stand alone businesses. The larger businesses that we pick up have often come through a different set of hands and have a different set of values or beliefs. And they take longer to acclimate to how we think about running a business. So the bigger they are, I'd say, the longer they get them sort of chunky along doing the things that we do, some of which will affect the short term many of which will affect the long term.
Okay. And then just one quick one on the obvious question is what's the environment right now
for acquisitions? And you know my answer to this one, it's always we think we can see a whole 2 or 3 months into the future when we look at acquisitions. And right now, it's fine.
Right. Okay, great. Thanks a lot.
Thank you. The following question is from Tom Liston of Central Fitzgerald. Please go ahead.
Good morning. Thank you. Mark or Jamal, I think we saw 5 announcements in the quarter for acquisitions and it looks like you made 7. Is it a couple of small ones? And can you describe those businesses?
Or did we just miss something along the way?
I think there's probably a couple of small ones that didn't get announced. I don't know exactly what a cutoff is these days, but we tend to announce both the larger ones and the ones that a particular operating group wishes to advertise so to speak.
Sure. Okay. So if it's small enough that they won't necessarily move the needle? Yes. And just on I mean
And Tom it really has nothing to do with moving the needle. It's just the sort of materiality for reporting purposes for the securities people. But for us, the little ones are a very, very important part of what we do.
Sure. And the leading part of that question might have been if there was any new interesting subverticals, if you will, that you're expanding to or more of the same?
Yes. There are some fascinating new verticals either done or about to be done. Okay. Okay. Good.
Doesn't mean they're big by the way.
No. That's that could be a sin edge of the wedge, right?
So Yes. But these what we tend to do a tiny little vertical. I took that driving holiday through the U. S. With my dad and my brother late last year.
And the fascinating thing now is I drive around and this is very different from 10 or 15 years ago is as I go through small towns or drive along the road, I can see customers. I can see people who use our software and that's starting to be all over the place.
Yes, very good. And on the public sector, you know pretty clearly that most of the decline was hardware sales. Was there anything else going in the public sector in terms of retrenchment or delays? Obviously, we're seeing a little bit more macro. Are you seeing that specifically?
Or is it just really more just about hardware sales in the quarter for organic growth?
I don't think we've seen any macro trends in the U. S. Of significance. In Europe, we've seen the public sector suffering more.
Okay. And finally, just is there a quantum you can kind of give us, you obviously telegraphed the margins in the quarter, but just about how much of that seasonal weakness goes away in terms of whether it's bonuses and what have you?
I think you can go back to the previous years and look at the Q1s and you'll get a pretty good sense of how much is got bonus related, payroll deduction related stuff.
So everything you feel is on trend?
Yes. Nothing remarkable other than the acquisitions that we did in the last couple of quarters that drove down the margins and a little bit more initiative spending.
Okay. Thank you. I'll pass the line.
Thank you. The following question is from Scott Penner of TD Securities. Please go ahead.
Thanks. Good morning. Doug Taylor on for Scott Penner. From your disclosure, it appears that the last acquisition in Q1, which I believe maps to the club solutions business of Fiserv, was over $40,000,000 might be one of your largest acquisitions ever. Can you provide first, can you tell me if those assumptions are correct?
And could you go into a little detail about that business, how you expect it to impact near term results?
We, as a rule, don't like to disclose acquisition pricing, but I think your math is correct. And I can't remember the second part of your question.
Well, could you if it's correct, I mean, could you just describe that business and how you think it will impact near term results if it is as big as I think it is?
Yes. I mean, look at our business. How much will a $40,000,000 acquisition impact our business? Not by leaps and bounds, that's for sure. But very interesting business, quite different than some of the other businesses that we've engaged in.
It's a player in the fitness space and we're becoming increasingly large in that particular space. I don't think we're the largest, but we certainly have ambitions over the course of the next decade to become one of the largest in the fitness software space. And it has a very large component of payment processing in the value chain that they deliver to their clients. This is we've muted in the past is something that we think may be increasingly important for vertical market softwares of all kinds market software companies of all kinds. And it's something we want to explore and understand.
Okay. Thanks. You signaled in your shareholder letter that we shouldn't expect the same level of capital deployment to continue. At the same time, you just said that the environment is still fine for the next 2 or 3 months. So yes, you've only done a couple of small deals since quarter end.
Could you just reconcile, I mean, has there been is it any change in the environment? Or is there is this just a function of near term capital that you think there'll be a decline in capital deployment?
I don't envy you your job. I think you're in a position where you have to try and read the tea leaves on quarterly moves. And the signal to noise ratio out there is horrible. I think the noise in individual quarters can make it very, very difficult to read what's happening. What I've seen is that we've had 2 or 3 really good quarters and we rarely string together that many if you go back 15 odd years.
And hence, I'm fairly confident predicting that it will be difficult to have another 3 that have been as good. So that's the basis for what I was saying as opposed to an environmental change of any kind.
Okay. Last one for me. Should we infer from your decision to provide guidance last quarter to manage expectations and not provide it this quarter that you believe the expectations out there are more reasonable?
I think what happens when the stock price goes up is the analysts end up having to chase it to some extent. And so they drop their wax and they extend their projections and they throw in more acquisitions. And so bringing everyone back down to Earth last quarter was just to me a sort of sensible correction. And I think the systems get out of whack 1 quarter at a time. And so I think you need to intervene to adjust expectations only infrequently.
The following question is from Nikol Taddani of National Bank Financial. Mark, just going back
to the shareholder letter, there's a comment in there about changes to the capital structure. I was wondering if you could maybe help us reconcile that in terms of equity and debt and sort of what your perspective on that was given that it may be hard to get debt on the terms you'd like?
So I think the letter sort of says how I feel about all of the slices of the balance sheet that one could hope to work with. Do you have a more specific question?
Well, more specifically, I mean, I was wondering what sort of issuing new stock is that on the table? Because it sounds like, I mean, from your comments in the back that we shouldn't really expect any changes to the existing dividends. And so just extrapolating from that, just wondering what your thoughts were.
Well, let's do some math. What do you think our weighted average cost of capital is currently? Just give or take a few percent.
I wouldn't want to guess. Well, at
the margin, obviously, we can go out and borrow from the bank. I'm not even sure what it is, but like 3%. So incredibly low marginal cost of capital. And if you factor in our equity multiples, the number of the analysts seem to be talking about weighted average cost of capital at a WACs of somewhere between 8% 12%. And then you look at what we've done with the capital that we've had and it appears that we're generating somewhere in the 30s.
So there's a pretty big margin there on what we can do with incremental capital. So if I saw good opportunities and if the people in the operating group saw good opportunities, I think it would be very hard not to take advantage of them. And so raising equity is for sure one of the alternatives that we would consider. Obviously, we'd like to do it with the cheapest source of capital that is secure that we can lay our hands on. At the same time, I can't guarantee that we will be sufficiently overwhelmed by the supply of wonderful investments that we'll need to do anything.
Right. So it's a very dynamic sort of situation.
Okay. Okay, fair enough. And then just sort of changing traction a little bit. What's your sense on the ground in terms of the organic revenue growth scenario for Q2 and perhaps the rest of the year, just given the macro picture and given your sort of entrance into Europe and the situation that part of the
world? I'm not very good at macro pictures. I'm pretty good at micro pictures. And so if you picked any one of our verticals, I'd probably have a view on what the prospects hold. It wouldn't be one that would provide tremendous illumination for anyone who was already spending time in that vertical.
But I really don't know. I certainly know that we would like to see organic growth at rates higher than we achieved in Q1.
Okay. Okay. And then just a housekeeping question on the tax rate. The consolidated rate is around 22% this quarter. So how should we think about that going forward?
Is the low teens sort of still appropriate or perhaps high teens? How should we think about that rate?
I've got Jamal with me. Why don't I lob that one over to him and then I'll add some color.
I mean, I just looked at current tax as a percentage of any before tax. It was around 12%, which is in line with prior quarters. And I mean, there's nothing that would suggest that it's going to change materially in the short term.
We tend to look at cash tax Okay. As opposed to total tax, because a lot of the deferred taxes will never turn into cash tax.
Right.
They occur because of the goodwill statement on our book. Okay, great.
I'll pass it on line. Thank you. Thank you.
Thank you. The following question is from Paul Treiber of RBC Capital Markets. Please go ahead.
Thanks very much. I just wanted to go back to the capital structure question or debate. If you hypothetically speaking, if you were to leverage up and lower your WACC, could you at the same time lower your hurdle rate for acquisitions? And could that open up a number of potential acquisition opportunities for you? And is that something that you may consider going forward?
So this is a really interesting question because there are obviously varying qualities of companies and sizes of companies. When we compete to buy large vertical market software companies that have low customer dependence, good recurring revenues, etcetera, etcetera, etcetera, we're competing against a much larger group of potential buyers and the prices tend to be much lower. With a lower WACC, you can obviously participate in those auctions if you so wish. Is it the best use of our distinctive competence, which let's say is working with these smaller, slightly harder to understand and manage businesses greater complexity etcetera is really the question. And so at the margin we tend to buy larger deals with a little bit of hair on them or these lovely small founder owned and created businesses.
If we were to move up the spectrum and start participating in the larger auction oriented broker led transactions, I think we could certainly deploy capital and I think we could do a good job. It isn't a place we've gone to date. If we had lots of excess capital and we were looking for places to go, we'd probably end up going there. But haven't decided to go there yet, Paul. We also have a concern that leveraging up does create risk and does create an aversion to risk.
You when I was going through school, they talked about Toys' Law of Constant Concern. It was the sum of the financial risk and the business risk. I think we tend to take a fair amount of business risk when we initially buy. Over time, we bring that risk down. We de risk the companies.
If you were to take both financial and business risk at the front end of a large transaction, I think you'd be changing the risk characteristics of Constellation per se. We have a lot of employees whose only tradable equity instrument and significant portion of their net worth is tied up in Constellation. There is a sort of paternalistic feeling that leveraging up and going for the gusto would not be serving our employees and increasingly a constituent of our shareholders particularly well.
And on that point, so following several larger acquisitions that you made like Fiserv and A and W and using your words maybe that they're hairy, So you have that operating risk now. And then with the balance sheet, I think it's $60,000,000 or so net debt. There's a little bit of financial risk as well. Would it be safe to say as you move forward over the next year, you'll reduce the operating risk as you clean up those acquisitions and reduce the financial risk as well by perhaps deleveraging a bit?
The financial risk really ties back into the opportunity set that we confront during the course of the next 6 months and that's very hard to predict. The operating risk I think every business that we buy we try to make them an inherently better business. And 5 years or 10 years from now, I think they'll be a much better business no matter what the business is, Because we tend to invest for the long haul, we tend to get closer to the clients, we try and capture every seat in the house of the clients. We try and get increasing spots of our revenues to be recurring all the things you would obviously do to make a business better. And because we don't buy and sell, because we buy to own forever that approach, that philosophy permeates everything we do.
So yes, absolutely, I think business risk will go down in everything that we own.
And then moving to the recently acquired European businesses. Are you pleased with the progress your teams are making so far on integrating and the restructuring of those businesses?
So I'm not on top of what's happening there. They are certainly on top of what's happening there. We're a high trust, low touch kind of organization where only by exception do we get involved. I will be going out to do the annual review a year after we've done the acquisitions of some of those European transactions later on this year. And that way that'll be an opportunity to get deep on them and the progress that we've made.
But certainly what I'm hearing from the team is that progress is being made. Things are going reasonably well. Obviously slower in Europe than we would see in North America, but that's the nature of the beast.
Okay. Thanks very much. I'll leave it at that.
Yes. Thanks, Paul.
Thank you. The following question is from Paul Steep of Scotia Capital. Please go ahead.
Thanks. Good morning. Good morning. I guess the first thing Mark, maybe talk a little bit about you talk in the letter a lot about prior initiatives. You discussed it a little with Richard.
Is there a way to maybe think about this slightly differently in the sense of if we put the initiatives you're undertaking into categories and we think about it, is there not sort of a base rate there that really is just sustaining you in the market and the core viability that drives that maintenance line? And how should we think about just sort of the core level of investment and then maybe new initiatives on top of that or new markets, new product on top?
And so I was very careful when we launched the initiative program to say an initiative was a long term investment. You can pull out whatever you want and call it an initiative. The quid pro quo is that you have to leave the spotlight on it for multiple years. And so if you want to consume cash, run your core business profitably, but consume cash in the initiative, you got to go through the justification for it. And that was really useful because it made people think out multiple years and be very explicit about their assumptions and how these might pan out.
And we deliberately made them think through what's graceful failure look like and what wild success look like and what their expected case was etcetera. As we got into the initiatives, there were all kinds of them that were really core and sustaining work that should have perhaps been inside the core, but they had broken them out so that they didn't have as much pressure to make money inside the core. And then vice versa also happened. If there were things that they discovered that were going to take much longer than they thought then they would tend to pull them out. I don't think it's important to be perfect in terms of where you use the intellectual knife on parsing out the initiatives.
I think it's just important to measure them and treat them and think about them differently than you do debugging the code or adding an extra feature to your report generator, because that's something that your clients expect. They give you a list of the top 10 enhancements they want this year and you bang away at them and each year you create more value in the software and you add an occasional module. So I don't think I answered your question, but I don't think it's a necessary element of the analysis. It's just the Hawthorne effect, the effect of having someone look at, including yourself, what you're doing daily that is long term oriented that I think adds the value.
And I guess if we think about that and take maybe one other step, doesn't if we sort of look at that Exhibit 2 and we think about the trend, can't we really think that there's just underlying cycles? There's particularly within the public sector, I'm thinking of a couple of your verticals there where really they're likely line extensions or other things that were tied to the cycle that whether we call them core or not, they're likely not brand new disruptive innovation, but they actually leave you in a sustained way in the market. So the answer is or the question I guess is around that Within public, where are you in that cycle now in terms of investment and sort of the product set that's coming forth?
So I think the concept of cycles is incredibly dangerous. It sort of implies that R and D and sales and marketing should be directly driven by revenues that you're experiencing today. And the whole point of the initiative exercise is to say that they should be driven by revenues you expect 5, 10, 15 years down the road. And so it's disconnecting that short term orientation.
Fair enough.
If you accept that, where are we in these cycles? We don't tend to look at the public sector as one group. Obviously, if here's an example. In the utility space, we saw a lot of smart meters put in during the course of the recession. It was one of those stimulatory investments that governments embarked upon.
That led to tremendous demand for media data management and smart meter related infrastructure. And that has led to magnificent growth in that particular area. This of course has also attracted new entrants into the space and so there's been a few 100,000,000 of venture capital going into it. We also have as one of our fastest growing divisions a meter data management business. So there are specific trends in particular divisions that absolutely you jump on and take advantage of and provide your clients with what they need.
But it's not like public sector as a whole is exactly booming and has lots of new requirements. We're doing a lot of stuff with mobility as you'd expect. There was a phase where all of the back office systems were being pushed out to the Internet. There are some ways that tend to permeate multiple verticals and multiple segments of the public sector etcetera. But I think it's the sum of a lot of small parts.
And what you want are intelligent focused people deep in the vertical managing their own R and D resources responding to opportunities.
Good. If we think a little bit and maybe actually just grab one number as we go through here. How much of the business today would be SaaS based? Because you talked about that in the letter as part of the change to the model. What sort of percentage of revenue on a trailing 12 month basis would be sort of be at rather than on a quarterly basis?
So we embarked on trying to capture this information just over a year ago. And so we said, you've got your maintenance, you've got your annual licenses, We'd like to have a SaaS category. And of course, people said, so what's SaaS? And we ran into the problem that I think all analysts run into, which is that SaaS is flavor of the month and so everything is SaaS. Anything that isn't conventional license maintenance is SaaS.
And so we've broken it out into multiple categories. And I think we're calling it other recurring revenue now. And it's a growing and relatively significant portion of our total maintenance and other recurring revenue. My observations are that the gross margins on a lot of these SaaS like or other recurring revenue like businesses are really poor compared to conventional maintenance revenues. And I believe there will be a paradigm shift in people's thinking.
It may take another 5 or 10 years where folks will recognize that conventional maintenance is way more attractive than a lot of SaaS revenue. But for the time being, it's a hot topic and hence we're tracking it. Once we get a pretty good handle and we're comfortable reporting it separately, we'll start to provide it to you.
Okay. So along the different revenue type argument and we talked a little earlier about the move into payment processing. Maybe talk a little bit about how you're thinking about that because that actually implies down the road a potentially significant shift in size, scale economies as well as the ability to lift that to some of the other verticals?
So we do have an initiative to go cross vertical with payment processing inside of Constellation. Getting our own divisions to play together in a nice manner is nontrivial, but we're giving it a shot. I think there are and you can see this in some of the horizontal software companies. I think there are opportunities to provide ancillary services and outsource business processes to clients. When you get in deep with the particular spaces, I think you'll see us doing that.
Do I think it will be as good a business as the core vertical market software business? The answer is probably no. But coupled with the core vertical market software business can we make good returns on capital? I believe so, but it's very early days.
And what do we think the timeline on sort of learning through that likely is Mark? Is it a couple of years, 5 years?
Nothing is a couple of years.
Fair enough. Last one for me. You've given a sense around the debt. I think it's just worth maybe revisiting what sort of the band of comfort would be around leverage within the business? And I recognize that's dependent on the deals you're doing, but maybe even whether you just provide a historical perspective and whether something has changed from that view in terms of leverage multiple?
Thanks.
Yes. I don't have the answer. We're feeling our way on this. It very much depends on the terms of the debt. No easy answer.
No problem. Thanks guys.
Okay. Thanks. Cheers.
Thank you. The following question is from Varun Chhoya of CIBC. Please go ahead.
Hello, good day. Just a quick question on, I guess, the initiatives that you're planning. Within your commentary that you're hiring staff to support new initiatives. So should we expect a ramp up in organic growth later on in the year or maybe next year?
Again, I'd refer you to the President's letter. We sort of talk through what an initiative looks like. For us, it consists of burning cash for multiple years and then at some stage sort of gradually eking our way through to making a little bit of money. And then at the tail starting to generate significant revenues and profits from recurring revenue. And if you model that out, what you'll see is you invest long before you reap and hence trying to tie increased R and D and sales and marketing expenditure this quarter to increases in revenue and profits in any foreseeable quarter is impossible.
It's something that you have to do down at the detail level and track over long periods of time literally years to understand whether you're doing a good job or not. You won't be able to see it in the macro numbers.
Okay. Fair enough. And you mentioned you made a comment earlier about the guidance you had given last quarter was sort of bringing down the analyst community to a more prudent level in their forecast. But how should we look at the margin profile going forward? Would it just follow the typical seasonality that we've seen in Constellation?
I think, yes, there's certainly seasonality there. I think there's a whole host of other factors that you have to try and work in including acquisitions, which are almost impossible to forecast. So I don't envy you your job.
Fair enough. And one final question for me. In the European front, last quarter you mentioned that the integration activities of recent European acquisitions are taking longer to incorporate and return to a profitable level. Can you comment on that integration activities? Is it still going to be a drag going forward?
They take longer than North American companies because you can't make adjustments as quickly. There's more of a consultative process with the workers councils and the employees. So it's just a feedback cycle issue rather than something fundamental I believe.
Okay. I'll leave it
at that. Thanks a lot. Thanks.
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. We have our Annual General Meeting tomorrow at 11. We'd love to see you there. We're going to have a number of our senior managers, directors, officers at the meeting to answer your questions. I don't know if we're having cupcakes this year, but you're welcome to come and drink the coffee.
So hopefully, I'll see a number of you tomorrow and we'll be available on the call 3 months from now. Thank you. Bye bye.
Thank you. The conference has now ended. Please disconnect your lines at this time.