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I’ve recopiled the 75th best business and investment lessons from Mark Leonard, Constellation Software’s President.
Constellation Software (#CSU, or #CSI, as Mark Leonard calls its own company) is a Canadian company especialized in ERP software and which has an impressive M&A history. With an extraordinary ROCE and business ecosystem, and a singular management of its business units, Constellation has been called as “the best company in the world”.
Whether or not, the truth is that its trajectory has been brilliant. If we had invested in the IPO in 2006, we would see our initial capital multiplied by 63 times, which represents an annualized return of 35%.
These are some of Mark Leonard’s best lessons, which explain the success achieved by Constellation Software. After each one, I incorporate the link of the letter in which it’s included, in case you are interested in enjoying it in greater detail:
1/ Our favourite single metric for measuring our corporate performance is the sum of ROIC and Organic Net Revenue Growth (“ROIC+OGr”), (…) which represents the annual increase in Shareholders’ value.
2/ The implicit assumption when you ignore Amortisation, is that the economic life of the asset is perpetual. In many instances (for our business) that assumption is correct.
3/ Constellation’s objective is to be a perpetual owner of inherently attractive software businesses. Part of a perpetual owner’s job, is to make sure that energetic, intelligent and ethical general managers (“GM”) are running their businesses and that the GM’s are incented to enhance shareholder value over the very long term.
4/ We have the same objective when we buy a piece of a business as when we buy 100%.
5/ Concurrently, and for some of the same reasons, quite a number of vertical market software businesses are for sale at attractive prices. We may not be the successful bidders for these assets, but if we are, we will almost certainly be increasing Constellation’s financial leverage.
6/ When economic times are tough, and bonuses are tied to financial performance, there’s a strong incentive for the managers of any business to aggressively recognise revenue. (….) We should be able to see any such movements in our Tangible Net Assets/Net Revenue metric.
7/ Forecasters are calling for GNP contraction in North America. Constellation can’t hope to be immune, but we anticipate faring far better than most software companies due to our high and growing Net Maintenance Revenue.
8/ Why did Constellation do so well in such a difficult environment? The facile answer is that we have robust businesses with inherently attractive economics run by good managers whose compensation is tightly aligned with that of shareholders.
9/ We don’t often spotlight an individual acquisition. Partly this is because we do a lot of them. In 2007 we made 17 acquisitions and in 2008 a further 21 (…). Partly it is because we don’t like sharing sensitive information with competitors.
10/ The toughest challenge in the software business is intelligently trading off profitability and organic growth. Many entrepreneurs have a huge bias towards growth at the expense of profits. Most private equity owned software firms have the opposite bias. At Constellation we try to find an optimum position where incremental investment still generates good incremental long term returns.
11/ In a capital intensive business you couldn’t just add Organic Net Revenue Growth to ROIC, because growing revenues would require incremental Invested Capital. In our businesses we can nearly always grow revenues organically without incremental capital.
12/ It seems intuitively appealing that as we go through an economic cycle there will be good times to organically grow maintenance revenues and good times to buy maintenance revenues, and that those events will rarely coincide. I only wish we had acquired more maintenance during the recession before acquisition prices rebounded.
13/ In aggregate our intangibles appear to be steadily increasing in value.
14/ The majority of the Constellation board believe that our stock price does not adequately reflect the company’s fundamental performance and its ability to deploy retained capital at high returns. They speculate that the complexity of the company creates a discount because only enterprising investors are willing to do the work to understand our business.
15/ We coach the managers of our newly acquired businesses in how to grow their businesses and make them even better. As long as we compensate these managers appropriately, and are not tempted to meddle too much, then I think we can scale up Constellation for many years to come.
16/ An alternative strategy that we’ve discussed with the board, is concentrating our activities in a fewer number of larger verticals. This would likely mean paying higher multiples for larger acquisitions and paying strategic premiums to accelerate the number of tuck-in acquisitions that we do in any one vertical. Despite the higher multiples (and hence lower returns on investment) associated with such acquisitions, we’d end up with fewer and larger businesses and Constellation would be easier to manage and understand.
We’ve decided to continue with our original “many verticals” strategy, but we are monitoring our ability to keep on scaling up the number of verticals in which we compete. Management are not currently feeling overtaxed, and hate the prospect of paying premiums for larger businesses and tuck-in acquisitions. So for the time being, at least, our shareholders and board will have to contend with increased complexity, and our management will focus on maximising the long term return on capital.
17/ We traditionally report on our Maintenance Revenue as part of this letter. Maintenance is the most profitable part of our business and can provide an insight into whether the long-term intrinsic value of our business is increasing or decreasing.
18/ We lost only 4% of our customers in 2010, a number that has been remarkably consistent over the last 5 years. Some of these customers we lost to bankruptcies or acquisitions… others to competitors. No matter how you look at it, our customers stay with us for a very long time, suggesting both the high switching costs and the real customer loyalty benefits that are inherent in our businesses.
19/ As a rule, I prefer to use these letters to write about our business, not our stock.
20/ When short term results seem unusually good, it is worth examining other measures of intrinsic value that are not as subject to short-term swings (…), such as the Maintenance Revenue.
21/ I hope you’ll join me in thanking the CSI employees for a wonderful decade. It is a rare company that consistently increases its per share financial fundamentals by 25% or more for such an extended period.
22/ If our stock price strays too far (either high or low) from intrinsic value, then the business may suffer: Too low, and we may end up with the barbarians at the gate; too high, and we may lose previously loyal shareholders and shareholder-employees to more attractive opportunities.
23/ A respected investor told me, “You end up with the shareholders you deserve”. I’m hoping that’s true.
24/ How do we keep these multi-talented managers? Hopefully we provide an environment that is fulfilling, colleagues that are both challenging and entertaining, and work that is meaningful. We also pay them well.
25/ I don’t think it will be difficult to keep our stock price marching in lock-step with the intrinsic value of our company.
26/ Our long-term shareholders, our board, and our analysts all seem concerned about CSI’s ability to scale. I haven’t spent a lot of time worrying about the issue, except in response to their enquiries.
27/ We didn’t get to that point with central edicts or grand plans. We just had a hunch that our internal ventures could be better managed, and started measuring them. The people involved in the Initiatives generated the data, and with measurement came adjustment and adaptation.
28/ Our favourite and most frequent acquisitions are the businesses that we buy from founders. When a founder invests the better part of a lifetime building a business, a long term orientation tends to permeate all aspects of the enterprise.
29/ Our business units are small for a reason… that the advantages of being agile and tight far outweigh economies of scale.
30/ Does CSI have the ability to scale at the rates which it achieved during the last decade? I don’t think we are sufficiently humble not to try. I do think we will be pushing our luck.
31/ If you are a long-term lender and would like to do business with a company that has consistently generated strong and increasing cash flows, and are willing to work with us to design a novel lending instrument, please give me a call.
32/ Eliminating the dividend would disenfranchise a group of shareholders to whom we owe our independence. That wouldn’t sit right with me and many of the senior management team, so I don’t see it happening.
33/ ROIC isn’t one of those metrics that is necessarily subject to “reversion to the mean”. Some businesses seem to be able to widen their moats at reasonable cost.
34/ Our favourite businesses are those that are growing just slightly faster than their markets, gradually adding market share and customer share (i.e. “share of wallet”), while generating a good return on the capital that they have invested to produce organic growth.
35/ We’d prefer the price to be high enough to discourage a takeover bid and low enough so that our sophisticated long term oriented investors are not tempted to sell. It takes lots of time and effort to attract and educate competent shareholder/partners.
36/ Buybacks are tempting to management and boards: they tend to improve the lot of managers and insiders, while being applauded by the business press. I think they are frequently a tolerated but inappropriate instance of buying based upon insider information. Instead of shareholders being partners, they become prey.
37/ Our employee bonus plan requires that all employees who make more than a threshold level of compensation invest in CSI shares and hold those shares for an average of at least 4 years. In practice, their average hold period has been much longer.
38/ Varying the organic growth assumption has a tremendous impact on the intrinsic value of a CSI share. Add in another 2.5% organic growth to the base line assumption and you get more than double the intrinsic value. Subtract 2.5% from the base line organic growth assumption and you lose almost half the intrinsic value of the stock. You can see why so many software company CEO’s are growth junkies.
39/ In assessing CSI’s value, it is tempting to look at cash flows after tax, interest and capex as the “real” return on shareholders’ capital. However, you should only do that if you can convince yourself that the underlying (mostly intangible) assets of our businesses are not deteriorating.
40/ Last year I asked the board to reduce my salary to zero and to lower my bonus factor. CSI had a great year, so despite those modifications, my total compensation actually increased. This year I’ll take no salary, no incentive compensation, and I am no longer charging any expenses to the company.
41/ I’ve traditionally travelled on economy tickets and stayed at modest hotels because I wasn’t happy freeloading on the CSI shareholders and I wanted to set a good example for the thousands of CSI employees who travel every month.
42/ I’m your partner in CSI, not your employee.
43/ My experience with long-term compensation programs is that they require many years of consistent application before employees believe in them enough.
44/ CSI does have a compelling asset that is difficult to both replicate and maintain: We have 199 separately tracked business units and an open, collegial, and analytical culture.
45/ Each quarter we try to study an admirable company and discuss it with our Operating Group managers and board members. We focus on high performance conglomerates that have demonstrated at least a decade of superior shareholder returns.
46/ For the same price you can purchase a high profit declining revenue business or a lower profit growing business. (…) We care about IRR, irrespective of whether it is associated with high or low organic growth.
47/ To date there are over 100 CSI employee/shareholder millionaires. Ten years from now, my hope is that there will be five times as many.
48/ We have a number of businesses where their current EBITA now exceeds their original purchase price (…), and hence ROIC to infinity.
49/ When really good companies start trading at 5 and 6 times revenues, it’s time to start worrying. I hope our shareholders are never in that position.
50/ A number of journalists and analysts have hinted (…) that our performance will revert to the mean. (…) I don’t disagree with their observation. Our goal, however, is to have our return on Total Capital revert to the mean as slowly as possible.
51/ CSI is still an exceptional company by most standards, but we are clearly not performing as well as we have in the past.
52/ Currently, we have 26 Operating Group and Portfolio Managers who spend >50% of their time on M&A, and another 60 full-time M&A professionals spread across CSI. We are trying to ramp up our M&A capacity from the 40 acquisitions that we did last year, to 100 per annum.
53/ If a small investment with a borderline hurdle rate is proposed, we sometimes allow it to proceed. Our rationale is that if the investment goes sideways, then it becomes a “lesson” for the Operating Group or BU personnel that proposed it. If the investment goes well, it becomes a “lesson” for Bernie and me.
54/ We would like to see the company investing all of its FCF (and perhaps more) in acquisitions.
55/ CSI’s strategy is to be a good owner of hundreds (and perhaps someday thousands) of growing autonomous small businesses that generate high returns on capital. (…) We recognise that economies of scale, centralised management and world class talent competing in large and growing markets can be a great business-building formula. But, it isn’t what we do.
56/ In a Business Unit, all the employees know each other, and if a team member isn’t trusted and pulling his weight, he tends to get weeded-out. (…) Priorities are clear, systems haven’t had time to metastasise, rules are few, trust and communication are high, and the focus tends to be on how to increase the size of the pie, not how it gets divided.
57/ The larger a business gets, the more difficult it becomes to manage and the more policies, procedures, systems, rules and regulations are generated to handle the growing complexity. Talented people get frustrated, innovation suffers, and the focus shifts from customers and markets to internal communication, cost control, and rule enforcement.
58/ Some Business Unit Managers lack the humility, some lack the courage, and most lack the time for reflection, to notice that their task is getting too large, and the sacrifices are getting too great. (…) Our favourite outcome in this sort of situation is that the original Business Unit Manager runs a large piece of the original Business Unit and spins off a new Business Unit run by one of his/her proteges.
59/ Something wonderful happens when you spin off a new business unit. With a clean sheet of paper, the leader only takes those he needs. They set up in an open office with good communication and no overheads. They cover for each other. They leave all the bureaucracy and the crap behind. When you get big you lose entrepreneurship.
60/ If the owner-manager wants to transition out quickly, the probability is very high that the successor that he/she designates will end up running the business for CSI. If the owner-manager wishes to stay for several years, perhaps spending less time on day to day management and more on acquisitions, then we are just as happy with that outcome.
61/ They progress to running one Business Unit and coaching others. (…) It starts small. It’s incremental. It’s slow, but over the course of a long career their mastery, satisfaction, wealth and the number of their followers, all compound.
62/ Hopefully we’ll still be having this reversion debate ten years from now.
63/ Some businesses get their unique advantage from government-granted monopolies, some from natural resources, some from large patent portfolios, and some from enormous fixed assets. CSI doesn’t have these advantages. Our employees, and the customer relationships that those employees have built and fostered over many years, provide our competitive advantage.
64/ One of the analysts who covers Constellation recently changed his perennial “sell” recommendation to a “buy”. We lost one of our few critics. Analysts who worry about the quality of earnings and reversion to the mean and the impossibility of trees growing to the sky are valuable.
65/ I’m now leaning towards the growth in FCF per share. This metric takes into account share count, interest expense and capex, but doesn’t include an adjustment for the increase in our minority interest liability. If the minority interest is growing at rates similar to FCF, then that’s not a problem, but they may not always track together.
66/ Almost half of our shares trade each year, which suggests that many of our shareholders are not long-term oriented. These traders are buying our shares because they hope they will be able to sell them at higher prices in three months or six months.
67/ A significant shareholder (…) proposed that we consider limiting board tenure to 10 years. (…) We believe that when you limit a competent Director’s term, you limit their opportunity to learn and hence to add value. (…) It is analogous to firing a high-performance employee on their tenth anniversary.
68/ Constellation has some intelligent, curious and irreverent employees who regularly challenge management’s fondly held assumptions and beliefs. We don’t appreciate those employees enough.
69/ I am suspicious of “vision”. Long-term studies suggest that the underlying predictions or assumptions for visions are nearly always impractically vague or outright wrong. I am not much happier with the term “mission”. It feels too heavily freighted with overtones of hierarchy and unquestioning compliance. I prefer to talk about Constellation’s objective.
70/ The newspaper industry underwent a long period of high growth which attracted many new entrants, followed by local consolidation, conglomeration, and eventual decline. I anticipate that the VMS industry will evolve similarly.
71/ One day Constellation may find that VMS businesses are too expensive to rationally acquire. If that happens, I hope we’ll have had the foresight and luck to find some other high ROE non-VMS businesses in which to invest at attractive prices. I am already casting about for such opportunities.
72/ If we don’t find attractive sectors in which to invest, then we’ll return our FCF to our investors. Even if re-investment opportunities become scarcer, Constellation doesn’t end… it will continue to be a good (hopefully great) perpetual owner of its existing VMS portfolio, and will still deploy some capital opportunistically.
73/ I try to make sure that sycophants, spin-doctors, and mercenaries don’t survive in Constellation’s senior ranks.
74/ Perhaps dividends are perceived as a failure… but to my mind, they are less of a failure than sitting on excess cash.
75/ I used to write quarterly letters to shareholders. After a few, I switched to annual letters. There is an archive of them on our website. It contains most of what I can tell you about investing in Constellation. In the future I will only write to shareholders when I think I have something new and important to communicate.
Finally, in this video Mark Leonard confesses in who was inspired to build the values and philosophy of Constellation Software:
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