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Business Lessons from Mark Leonard

(Constellation Software)
April 7, 2018

Mark Leonard reminds me of Warren Buffett. Anyone who likes reading

Berkshire shareholder letters will very likely enjoy Leonard’s shareholder
letters and his answers on earnings call transcripts. The Globe and Mail
describes part of what Leonard has accomplished at Constellation
software:

“With an initial $25-million investment from OMERS and his old

associates at Ventures West Capital in 1995, Mark Leonard has
built Constellation into a world-leading consolidator of vertical
market software (VMS) companies—firms that create products to
help run businesses in specific industries. Over the years,
Constellation has made scores of acquisitions and, through its six
operating groups, now provides software to over 60 industries, from
health care to law to public transit…. Typically, Constellation’s
acquisitions are small—in the $2-million to $4-million range—but
add them all up, slip in a dose of Constellation’s financial and
operational discipline, and you have [a company with a market cap
of $18 billion….In this age of zero privacy, Mark Leonard has
managed to maintain a practically unthinkable level of anonymity for
just about any individual—let alone an IT executive who runs one of
Canada’s most dynamic, fastest-growing and most acquisitive
software companies, and who has been compared favourably with
Warren Buffett and Prem Watsa.”

This an impressive looking chart for Constellation:

1. “Unlike most people, we would be hoping that there would be a

major correction in the stock markets because the multiples are as
heavy as we’ve seen in a very long time. If I have the access to
capital and there is a downturn, we will buy as much as we can.
That was the lesson we learned from the last one. We did terrific
doing that [in the] ’08, ’09 period. We just didn’t deploy enough
capital.” “As we sit on cash and people start clamoring for it to be
distributed either via dividends or share buybacks. And I think you
know my views on most share buybacks. And so my preference
would be to hang on to the cash. We seem to be ramping our M&A
activities and to some extent it seems to be paying off. And so
rather than returning it to shareholders, rather hang on to it at least
for the time being and see if perhaps we can deploy it.” “The high
ROIC achieved over the last decade suggests that we have very
good businesses. If ROIC starts to erode significantly, then either
we’ve damaged our existing businesses, or our new acquisitions
are less attractive than those that we have made in the past. 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.”

Leonard is an investor who uses “value as an analytical style” to buy

businesses that sell software to vertical markets. Like Buffett, Leonard
think about moats, uses return on invested capital as a touchstone,
prefers concentrated investments to diversification and likes it when
assets he wants to own for a long time “go on sale.” Of course, he is not
exactly like Buffett, but they do share certain attributes and approaches.

Leonard has a superb record as an allocator of capital. In his classic

book The Outsiders, William Thorndike writes about the capital
allocation process:

“CEOs have five essential choices for deploying capital—investing

in existing operations, acquiring other businesses, issuing
dividends, paying down debt, or repurchasing stock—and three
alternatives for raising it—tapping internal cash flow, issuing debt, or
raising equity. Think of these options collectively as a tool kit. Over
the long term, returns for shareholders will be determined largely by
the decisions a CEO makes in choosing which tools to use (and
which to avoid) among these various options. Stated simply, two
companies with identical operating results and different approaches
to allocating capital will derive two very different long-term outcomes
for shareholders.”
 “Essentially, capital allocation is investment, and as a result all
CEOs are both capital allocators and investors. In fact, this role just
might be the most important responsibility any CEO has, and yet
despite its importance, there are no courses on capital allocation at
the top business schools. As Warren Buffett has observed, very few
CEOs come prepared for this critical task: The heads of many
companies are not skilled in capital allocation.”

The founders of the businesses Constellation acquires are not often

skilled in capital allocation and in addition do not have access to best
practices in operating a software business. Leonard has demonstrated
that by applying these new skills and processes to the acquired
businesses Constellation will be able to create new value.

2. “We are the anti-economies of scale company. We believe in

small teams outperforming large teams, and so given the choice of
taking a 200-person business and buffing it up into two smaller
ones, we would much prefer to do that and believe that the benefits
are there as opposed to ramming businesses together, firing a
bunch of people and moving a bunch of work offshore.” “There are
a couple of hundred business units and every one of those
managers has their own competitive environment in which they are
competing. And they are making decisions around investments
and whether they be rewrites or add-ons or things of that ilk and or
improving coverage or allocating between farming and hunting,
those role decisions that they are making individually and what
you’re seeing is the sum total of those decisions. If marketing and
R&D are going down as a percentage of the revenues or expenses,
then I guess they aren’t seeing the returns on those investments.”

There are tens of thousands of providers of vertical market software

which are potential targets for Constellation. Raymond James wrote
about the opportunity which Constellation is harvesting in August 2016:

“Our analysis of software vendors indicate substantial fragmentation

with approximately 38,000 VMS vendors spanning more than 12
vertical markets, with the highest concentrations in Retail and Media
& Services verticals – see Exhibit 8. Constellation has also
expanded their database of potential targets with now well over
30,000 targets (adding 4k+ targets per year for the last 3-4 years).
Each target has a contact name next to it, with the expectation of
staying in contact 3-4 times a year.

…with limited access to capital to pursue growth opportunities and

typically lack the professional management found in larger software
vendors. VMS also has high barriers to entry as they provide
mission critical enterprise level software with high switching costs
(relatively expensive and time consuming to replace) and long
 product development cycles (not many opportunities for competitors
to displace you). Maintenance renewal rates are usually quite high
(>90%) – customers are sticky. As a result, most of Constellation’s
acquired businesses carry a large maintenance revenue base.
Maintenance represented ~64% of Constellation’s total revenue in
2015.”

Constellation has created a business development team that is

constantly trying to find more software businesses to buy. They are
always prospecting for new acquisitions. Capital allocation at
Constellation is centralized but the actual operation of the businesses is
very decentralized. What is unique about Constellation is that they have
acquired so many companies (more than 330). This acquisition skill set
is part of Constellation’s special sauce. Leonard has admitted that this
gets harder to but businesses at an attractive price as Constellation gets
larger. Like Buffett, Leonard wants the businesses he buys to have a
moat. Unfortunately, sometimes good moat builders are not the optimal
managers of a business. I saw this first hand when I made my first
investment in a vertical market software business in the mid 1980s. It
took over 15 years to generate a financial exit and the return was for
that reason moderate. That investment was a learning experience for
me to be sure.

Constellation has set out its criteria for buying businesses on its web
site:

Exceptional Businesses

A mid- to large-sized vertical market software company (a

minimum of $1-million earnings before interest and tax)
Consistent earnings and growth — generally EBITDA/revenue +
revenue growth of 20 percent or more per year
Experienced and committed management

Good Businesses

Number 1 or Number 2 market-share holder in a niche vertical

market
Revenues of at least $5-million
Hundreds or thousands (not dozens) of customers
Unimposing competitors

3. “There are two components to Constellation’s growth, organic

and acquired. Organic growth is, to my mind, the toughest
management challenge in a software company, but potentially the
most rewarding. The feedback cycle is very long, so experience
and wisdom accrete at painfully slow rates.” “Growing organically
while generating a high ROIC is, to my mind, the toughest task in
the software business.”

What Leonard calls “organic growth” is revenue that is generated by

existing businesses. Organic growth is not the glamorous part of
Constellation, but it is important. Raymond James said in a report linked
to in the End Notes that “Constellation’s organic growth has averaged a
respectable ~3% per year which is in-line with US Gross National
Product (GNP) growth of ~3% over that same period.” In his 2009
Constellation shareholder’s letter Leonard wrote:

“If you add Organic Net Revenue Growth to ROIC, you get what we
believe is a proxy for the annual increase in Shareholders’ value. 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.”

The significantly larger source of revenue and profit growth for

Constellation has been inorganic increases via acquisitions of new
businesses. This inorganic growth is where Constellation particularly
shines and generates the lion’s share of its attractive financial returns.
The Constellation formula is relatively simple: buy a diamond in the
rough in the form of a vertical market software business and then apply
polish to make it shine.

Not a lot has been written about Leonard since he does not like to be
interviewed, but one blog post I found on the web written by Jana
Vembunarayanan points out:

“Constellation revenue consists primarily of software license fees,

maintenance and other recurring fees, professional service fees and
hardware sales. Customers pay license fees for using Constellation
software products. Around 7 percent of Constellation revenue
comes from license fees. Maintenance and other recurring revenue
primarily consists of fees charged for ongoing support of software
products post-delivery. It also contains recurring fees derived from
software as a service, subscriptions, and other transaction related
revenues. Most of the maintenance revenue is annuity based.”

The mix of revenue that Constellation generates has changed over time.
Raymond James notes:

“One trend that is more sustainable is the shift of revenue mix

towards higher margin segments, most notably maintenance – and
 we expect the mix shift to continue to buoy margins to some extent.
Revenue from professional services has essentially flatlined…
maintenance revenue has increased to 64% of revenue (from 54%
in 2010) and professional services have shrunk to 21% of revenue
(from 27% in 2010).”

4. “In 2004 we separated our Research & Development and Sales &
Marketing spending (“RDSM”), into two buckets: Initiatives and
everything else. Initiatives are significant long-term investments
required to create new products, enter new markets etc. In the mid
to high ticket vertical market software business, Initiatives usually
require 5-10 years to reach cash flow break-even. We felt that they
should be both measured and treated differently than our other,
sustaining, RDSM expenditures. The ethos of software companies
requires the regular launching of visionary new products by steely-
eyed tenacious developers (substitute software architects, product
managers or founders in this sentence, as the specific instance
requires). We work… hard to keep the early burn-rate of Initiatives
down until we had a proof of concept and market acceptance,
sometimes even getting clients to pay for the early development;
we triaged Initiatives earlier if our key assumptions proved wrong;
and we created dedicated Initiative Champion positions so an
Initiative was less likely to drag on with a low but perpetual burn
rate under a part-time leader who didn’t feel ultimately
responsible.”

Some people would say that Constellation is very disciplined about R&D
spending. Others would argue that this a nice way of saying that
Constellation cuts R&D once they buy the business. Leonard said that
once way he gets managers to think intelligently about things like R&D
spending is by creating “company-wide metrics that rank each acquired
company among its peers, and which fosters peer interaction as they try
to improve their relative ranking.” The company web site lays out it’s
approach to improving operations:

“…we offer coaching and resources in a number of areas including

establishing values and capital allocation processes, profit-sharing
programs, benchmarking against our other businesses, the chance
to share best practices with other CSI companies, formal
management training and ongoing mentoring. CSI will not take over
the day-to-day management of its businesses. We continue to rely
on the managers and employees of our subsidiaries to run their
businesses well.”

5. “Models are only as good as the assumptions that go into them,

and there’s no substitute for thinking through scenarios on your
own, with your own underlying assumptions.” “The more
interesting part … was using the [model] to do some sensitivity
analysis and to look at alternative strategies. In all of the following
examples, we assume that only one variable changes. In reality,
our businesses are dynamic and changing one variable has an
impact throughout the business.” “We use a multi-scenario
approach to forecasting and I’m struck by how frequently, even
outside of our outlier forecast, we end up with actual performance,
both at the low and the high end of the outliers. And so you do get
a real spread on these things, and this happened to be a spread on
the upside.” “Just to give you some color on that impossibility of
prediction. We have a sort of funnel of acquisition prospects and
we can add that up, we’ve figured out how to use that function in
Excel. And we do so periodically, and I went back and looked at
those totals that we had over time, and the amount of acquisitions
we actually closed during those periods, and I found the
correlation between our funnel and the actual acquisitions closed
was zero. And not just zero it was so close to zero that I’m thinking
of commercializing our sales funnel as a random number
generator.”

Everything Leonard says above about modeling I have said myself

hundreds of times in the same or different ways. For example: A model
is only as good as the assumptions. Garbage in means garbage out. Do
the modeling runs to get a sense of how sensitive the model is to
changes in assumptions and model many scenarios.

7. “Our favorite 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: employee selection and
development, establishing and building symbiotic customer
relationships, and evolving sophisticated product suites. Founder
businesses tend to be a very good cultural fit with Constellation,
and most of the ones that we buy, operate as standalone business
units managed by their existing managers under the Constellation
umbrella. We track many thousands of these acquisition
prospects and try to regularly let their owners know that we’d love
the chance to become the permanent owners of their business
when the time is right for them. There is a demographic element to
the supply of these acquisitions. Most of these businesses came
into being with the advent of mini and micro-computers and many
of their founders are baby boomers who are now thinking about
retirement.”

Like Robert Smith at Vista Equity, Leonard has a proven operational

system that Constellation can implement to improve ROIC at the
acquired businesses. How has Leonard accomplished this? Raymond
James writes:

“Constellation’s targets have to be VMS businesses with

experienced and committed management, high market share with
rational competitors, and no customer dependency (hundreds or
thousands of customers). With decades of acquisition experience
and hundreds of operating businesses providing proprietary data on
base rates (for organic revenue growth, typical margins, and
potential market share improvements in specific niche markets),
Constellation is in the unique position of being able to test
hypotheses on M&A targets’ forecasts and subsequently get more
comfort on cash flow projections and whether they can hit their
hurdle rate. This unique database of knowledge highly differentiates
Constellation from other potential software acquirers.”

8. “The most lucrative acquisitions for us have been distressed

assets. Sometimes large corporations convince themselves that
software businesses on the periphery of their industry would be
good acquisitions. Rarely do the anticipated synergies accrue, and
frequently the cultural clashes are fierce, so the corporate parent
may eventually choose to sell the acquired software business. The
lag is often 5 to 10 years as the proponents of the original
acquisition usually have to move on before the corporation will
spin off the asset. Our most attractive acquisitions from corporate
vendors seem to have happened during recessions. Occasionally,
we also acquire portfolio companies from a private equity fund that
is getting long in the tooth. These will have been well shopped but
for some reason will not have attracted a corporate buyer. While
both corporate and PE divestitures tend to be much larger than the
founder businesses that we buy, they are usually more of a cultural
challenge for us post-acquisition.”

Buffett believes that “turn arounds seldom do.” Leonard has been able
to make turn arounds happen at Constellation regularly via careful due
diligence and the application of proven systems. Leonard believes the
data they collect from the other operating businesses gives them a real
advantage not only in improving the operations of the businesses they
buy but also in picking the right investments. Leonard describes
Constellation’s advantages in this way:

“What we can offer is a degree of autonomy that people don’t tend

to get inside of PE companies. And the opportunity for mastery of
their craft that they probably don’t get inside of most PE companies.
If you’re focused on a playbook that requires you to, in a 2 to 3-year
period, make dramatic improvements to profitability, then settle it
down for a year or 2 and then flog it to some unsuspecting buyer,
 which seems to be the PE model. You’re not going to be learning
how to invest for the long haul, learning how to build a team for the
long haul.”

Leonard is disciplined in terms of what they buy, which means that

sometimes cash can pile up as it is right now for Buffett. Leonard did say
in May of 2017 about having too much cash:

“What do they call that type of problem? First world problems?

You’d obviously like to be patient and wait for your opportunities,
and the issue is, if cash is sitting around doing nothing, it isn’t
earning returns for your shareholders, and you could return it to
them, and let them invest it. I’ve categorized it previously as the
amount of embarrassment that the board is willing to put up with as
we sit on cash and people start clamoring for it to be distributed
either via dividends or share buybacks. And I think you know my
views on most share buybacks. So my preference would be to hang
onto the cash. We seem to be ramping our M&A activities, and to
some extent, it seems to be paying off. And so rather than returning
it to shareholders, I’d rather hang onto it at least for the time being
and see if perhaps we can’t deploy it.

9. “Over the last few years we have purchased a number of

software businesses (usually SaaS) that have a much higher
‘churn’ in their client bases because of factors inherent in their
industry. By high churn, we mean that they acquire a greater
proportion of new clients each year, and lose a higher percentage
of existing accounts, than our average business. Sometimes the
higher churn is because the clients’ switching costs are low.
Sometimes the higher churn is because lots of new potential
clients are being created, and old ones are going bankrupt and
merging. If it is the latter, these software businesses may be very
attractive. If it is the former, then the software businesses are likely
to be unpleasant, requiring tremendous effort to stay in much the
same place.”

Any subscription business is on an “acquisition treadmill.” In other

words, the business must acquire new customers just to remain even let
alone grow (as if it is on a treadmill set to a very fast speed like George
Jetson). I have written a blog post on churn before and I won’t repeat
those points again here since it will otherwise be too long. .

10. “Ideally, we’d like Constellation’s stock price to appreciate in

tandem with our fundamental economics. At any point in time, 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. The last thing
 we want them to do, is sell.”“We
continue to seek longer-term capital
to defuse the fundamental mismatch
inherent in buying permanent assets
with short-term debt.”

This attitude about having

shareholders who understand your
business model is fully consistent with
the Berkshire approach. It takes both work and time to get the right
shareholders. Shareholders who do not trust and share the same
approach to investment as management can be a big source of
problems for a management team. For example, Constellation’s
shareholders share Leonard’s long-term approach to investing
outcomes.

Leonard is also making a point abut leverage in the quote just above.
Borrowing in short term markets to buy assets for the long term is
problematic to say the least. Michael Milken said once about assuming
to much risk in the financial structure of a technology business like
software:

“When your business depends on technology – whether it’s

aerospace, computer and electronics firms in the 1960s or Internet,
telecom and networking companies in the 1990s – volatility is a fact
of life. Unlike slower-changing industries like supermarkets, which
can appropriately assemble a balance sheet with more debt,
technology is an inherently risky business and needs a strong
balance sheet to survive. In fact, risk in capital structure should vary
inversely with business risk.”

11.“I’m happy if I find one good book to recommend to friends,

family and employees each year. Currently, I’m shamelessly
flogging Daniel Kahneman’s Thinking Fast and Slow. His book is
about a life (actually two) well spent. He tells the tale of his
intellectual journey via a series of behavioral economics
experiments. He helped me appreciate the efficiency, speed, and
inherent conceit of intuitive judgment, and its infrequent but often
abject failures. Understanding the major findings in behavioral
economics provides profound insights into investing and
managing, and this book is the most pleasant way I’ve found to
acquire that knowledge.”

Great investors inevitably are attracted to the work of someone like

Kahneman. How can you be an aware participant in the business world
without seeing the wisdom of what behavioral economics teaches?
Charlie Munger said once “If economics isn’t behavioral, then what the
hell is it?” I can’t recall ever meeting anyone who actually operates a
real business who believe humans are rational. Anyone like Kahneman
who can provide some insight into why people are not rational and when
that is most likely to happen, is a valuable resource for anyone in
business.

12. “I have a feeling that acquisition multiples, acquisition size and

acquisition profitability have all increased over time

Robert Smith of Vista Equity Partners complains that his success has
attracted “private equity tourists” to his preferred technology hunting
grounds in the private equity market. Leonard also faces increasing
competition in his chosen part of the technology private equity market.
The entry of new capital into any buyout sector tends to raise prices and
increase pressure for investors to consider lowering their hurdle rate.
This chart is from 2015, but you can see the price trend is up and to the
right in terms of prices paid by Constellation:

In an August 13, 2017 earnings conference call Leonard talked about

the prices private equity and others have been paying for businesses:

“everything’s expensive, and things of size, where we can put some

dollars at play, all seem to be trading high. I think one of the data
points I saw was that the average vertical market software
company, with more than a $50 million market cap is trading at 3.8x
revenues and those tend to be fairly hefty valuations.”

P.s., “I discovered when I was in the venture business that

interviews aren’t for me. What little I have to say, I generally put in
my letters to shareholders. I do occasionally speak with students,
but usually in the vain hope that I can distract them from pursuing
careers in investment banking and private equity.”
Charlie Munger has similarly said several times that he regrets making
his living “trading pieces of paper” to earn a profit. What Munger and
Leonard are saying is their way of tipping their hats to people who
operate a real business, which is a particularly noble calling. Creating
and operating a successful business is neither easy or simple. People
who do that well deserve some applause.

End Notes:

http://www.csisoftware.com/about-us/being-acquired/

https://www.raymondjames.ca/en_ca/equity_capital_markets/equity_

https://www.theglobeandmail.com/report-on-business/rob-
magazine/the-most-successful-canadian-dealmaker-youve-never-
heard-of-and-will-never-see/article18134950/

https://oraclefromomaha.wordpress.com/2015/02/

http://www.csisoftware.com/category/press-releases/

http://www.csisoftware.com/wp-
content/uploads/2011/02/PresidentLetter_2013.pdf

http://www.csisoftware.com/wp-content/uploads/2017/04/2017-
Presidents-Letter-1.pdf

http://www.csisoftware.com/wp-
content/uploads/2016/04/PL_2015.pdf

http://www.csisoftware.com/wp-
content/uploads/2013/05/Presidents-Letter-Final.pdf

http://www.csisoftware.com/wp-
content/uploads/2011/02/PresidentLetter_2013.pdf

https://www.gurufocus.com/news/653391/constellation-software-a-
gem

https://www.nasdaq.com/aspx/call-transcript.aspx?
StoryId=4066679&Title=constellation-software-s-cnswf-
management-on-q1-2017-results-earnings-call-transcript

https://www.nasdaq.com/aspx/call-transcript.aspx?
StoryId=4015652&Title=constellation-software-s-cnswf-
management-on-q3-2016-results-earnings-call-transcript

https://www.google.com/amp/s/www.theglobeandmail.com/amp/glob
investor/investment-ideas/constellation-software-still-reaching-for-
the-stars/article23396301/
https://www.google.com/amp/s/weekherald.com/2018/03/10/constell
software-csu-reaches-new-1-year-high-at-890-81.html/amp

https://janav.files.wordpress.com/2016/05/constellationsoftware1.pd

https://www.google.com/amp/s/www.theglobeandmail.com/amp/glob
investor/investment-ideas/has-constellation-softwares-run-of-
rapid-growth-come-to-an-end/article33824856/

https://www.google.com/amp/s/robinrspeziale.com/2017/03/02/the-
outsiders-ceos-who-excelled-at-capital-allocation/amp/

http://www.takota.ca/a-value-investor-in-the-software-industry/

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