Canadian-based Constellation Software is an interesting combination of B2B software businesses and a Berkshire Hathaway type holding company. It has some really good tech investing lessons.

A Quick Intro to Constellation Software

Based in Toronto and listed on the Toronto Stock Exchange (TSX: CSU), Constellation Software is a big portfolio of B2B and B2G software solutions. These are mostly specific to certain verticals (including government) and the company has 7 operating segments. Here’s the summary from Wikipedia (not a great source but ok for this discussion):

• Volaris Group – which focuses agri-business, financial services, education, and other verticals. It has more than 150 software businesses.
• Harris Computer Systems – which serves the public sector (utilities, education, healthcare) and business (retail, payment, and insurance). It has over 100 software businesses.
• Jonas Software – which focuses on B2B and has +140 companies in +40 verticals (especially hospitality and construction sectors).
• Vela Software – which focuses on industrial sector, including oil and gas and manufacturing.
• Perseus Operating Group – which has +50 companies in industries such as home building, pulp and paper, dealerships, finance, healthcare, digital marketing, and real estate.

Constellation was founded in 1995 by Mark Leonard. Mark is still the president and chairman. Prior to founding Constellation, Mark was in venture capital. So, he has a +30-year track record of investing in and buying software companies.

Overall, Mark appears to be an adherent of the Berkshire style of value-based investing. With its focus on long-term ownership. Basically, he likes to:

• Buy great companies with great management.
• Hold for the long-term.
• Delegate lots of authority to the management.

Constellation says they “acquire, build, and manage”. They have made over 500 investments / acquisitions in their history. Currently, Constellation has +50,000 employees.

Constellation Is All About Recurring Revenue

Their financials look pretty good. I’ve posted their Q1 2024 income statement below.

But keep in mind, these are like the financials for Berkshire. They are the sum of lots and lots of individual companies, each with different returns. So, you really have to look at it company by company. Or at least for the really big companies.

For Q1 2024, Constellation had group revenue of $2.5B. So, think $8-10B in revenue per year. And Q1 2024 revenue grew by 23% yoy.

The operating margin was 11%. That’s not surprising. These are mostly software plus service companies. So, asset lite digital economics plus a significant amount of labor for services.

As mentioned, their businesses are most all in B2B (and B2G) software. So, the revenue has a lot of one-time fees for:

• Software licenses
• Hardware sales. Mostly the resale of 3^rd party hardware. Plus, any customization and assembly.

But these one-time fees are a small part of revenue (about $140k of the $2.5B Q1 revenue). There are also professional services, which is at $470k.

The interesting part is the recurring revenue. This is where most of their revenue comes from ($1.7B of $2.5B Q1). It’s also where most of their growth is. Recurring revenue includes:

• Hosted SaaS
• Managed services for software
• Transaction revenue
• Software support contracts.

Here are their Q1 financials for 2024.

The big expenses are hardware COGS, 3^rd party licenses and staff (especially for professional services, maintenance, R&D and sales and marketing). That is what you would expect. But taking these apart in the operating groups is a bit difficult.

Ok. That’s a quick introduction.

So, what are the 5 lessons here for tech investors.

Lesson 1: Constellation’s “Investor Plus Operator” Structure Enables Endless Growth. It’s Similar to Berkshire.

Constellation’s corporate structure is (somewhat) similar to Berkshire Hathaway.

At Berkshire, the acquisition and capital allocation decisions are made at the corporate level (i.e., by Warren). And new businesses can be added to the holding company, or they can be bolt on acquisitions for the operating entities (energy group, railroad group, insurance group).

That’s a nice separation of management and capital allocation expertise. Most investors are not great managers. And most managers are weak at M&A. Here is the Berkshire structure. It also has insurance float as a component.

One problem with separating ownership and management is you need great companies. In rule of law countries.

If you are buying mediocre companies, ownership often gets pulled into operations. It’s hard to have extreme delegation of authority to management if management and/or the business isn’t great. We almost never see this structure in developing economies.

The big benefit of the “investor plus operator” structure is the endless growth potential. It can basically grow forever. It can have organic growth in the various component businesses. Plus, it can have growth by acquisition. There is no real limit.

This structure can also move to different opportunities easily. It is like an amoeba that can move into more attractive areas over time. Its growth is not limited to the verticals it is currently in.

So, Constellation could achieve growth B2B and B2G software for decades. Just like Berkshire.

Lesson 2: Constellation Prioritizes Predictability and Competitive Advantage. Also, like Berkshire.

Constellation is in the business of acquisitions. So, like Berkshire, they are very public about their acquisition criteria. They list them in the filings and on their webpage.

Constellation says they are the business of “mission critical software solutions” that address “specific needs” in “particular markets”.

They say they want exceptional businesses in vertical markets. They want businesses with a proven record of consistent profitability. And with exceptional managers.. I’ll list their specific criteria in Lesson 5.

But that’s kind of vague.

The term they use they catches my attention is their focus on “critical” services. Buying critical B2B (and B2G) businesses is right out of the Berkshire Hathaway playbook. It’s why (in my opinion) Buffett invested in companies like Wabco and Axalta. I’ve written and spoken a lot about this.

• Switching Costs, Wabco and Buffett’s Critical Companies (Tech Strategy – Podcast 85)

I put business spending into three categories:

• Strategic costs
• Critical costs
• Necessary costs

And, as a supplier to businesses, you want to be considered one of the first two. You want to be a strategic cost (like marketing or R&D), where their goal is to outspend competitors in an area.

Or you want to be a critical cost, where a business is afraid to switch because it could have larger ramifications. Such as when buying the airframe for a commercial jet. If you are considered a critical cost, you often have a lot more pricing power as a seller. You can sometimes get longer-term contracts. And overall, the business becomes a lot more predictable (another word Constellation uses). It’s a type of switching cost.

I’ve posted part of my checklist for critical B2B products and services at the below link.

• My Checklist for Critical B2B Products and Services

In the Constellation annual reports, you’ll see a lot of discussion about critical software services. You’ll also see the phrase “consistent predictability”. That is a very different objective that growth.

And this is very similar to Berkshire Hathaway.

Like Berkshire, Constellation says it wants “exceptional businesses” with great managers. But that is not really about finding the next Amazon or Google. When they talk about “exceptional”, they are really looking for competitive advantages. Not 10x growth and impressive innovation. They want businesses that are protected – and are therefore more predictable. Critical B2B services, with their significant switching costs, are far more predictable than other software companies.

I don’t even call these types of businesses “exceptional”. I call them “consistent compounders”.

Keep in mind what Buffett wants (in my opinion). He want to capture increasing economic value by compounding. Buffett is a compounder at heart. The goal is not big growth. It is stable growth, without decreases. The key to compounding is not having down years.

And that is very different than investing in high growth tech companies. Famed investor Philip Fisher wanted spectacular growth business. That is different than Buffett’s focus on “consistent compounders”.

Constellation prioritizes predictability and competitive advantage. That is much closer to Buffett than Fisher.

Lesson 3: Constellation Does Focus More on Growth than Typical Value Investors

In Constellation’s filings, you’ll also see the phrase “consistent predictability”. But you’ll also see lots of references to “above average growth”.

This is different than Buffett. They are definitely investing more based on growth than Berkshire.

Constellation says they look to acquire businesses with “growth potential”. They want to capture more growth than what Berkshire or typical value investors go for.

That makes sense.

If you’re going to be in software, you really want to capture growth if you can. Digital goods can grow faster and more profitably than just about any other business. There’s no point in being in software if you’re not going for growth (in operating cash flows).

So, Constellation prioritizes predictability and competitive advantage. But it also clearly has growth more in the equation than Berkshire. They want both predictable and “significant cash flows” and “revenue growth”.

Lesson 4: Acquiring Exceptional Private Businesses Is Hard. And Requires More than Capital.

It was Charlie Munger who convinced Buffett to stop buying and selling crap companies. And to focus on holding exceptional companies for the long term.

Here’s my summary of Buffett’s approach.

Buying and holding exceptional businesses is a great investment approach. Everyone wants to do it.

But few can.

The first problem is there just aren’t that many of truly great companies. And people generally know who they are so. So, you can’t get a good price on a public market.

And trying to outright acquire them is even more difficult. Because the owners of great businesses don’t want to sell. And usually, they don’t need to. Great businesses tend to throw off a lot of cash (by definition).

To acquire a truly great business, you usually have to bring something more to the table than capital. I find there are usually 5 tools for doing this (reputation, political access, management, local capabilities, and foreign capabilities). Buffett’s primary tool for his private acquisitions is his reputation.

If you have spent your life building your business and are ready to retire, you want someone to take care of your life’s work. And not just chop it up and sell off the pieces. So, you sell to Berkshire Hathaway.

If you are Bear Stearns and absolutely have to sell, you might as well sell to Warren Buffett. Better him than a private equity chop shop.

Constellation’s acquisition approach appears similar to Buffett’s. They say they look for great businesses that are selling because of health or estate planning issues. Or because they are shifting their focus is elsewhere. They look for sellers that want the business to continue in accordance with its history and its values. Those are all situations where the reputation of Constellation will be a major factor in the sale. It won’t be just about who pays the highest price.

Lesson 5: Tech Investing Has Greater Uncertainties. Constellation Deals with this By Combining “Buy and Hold” in Exceptional Businesses with “Buy and Sell” in Good Businesses.

Software changes faster than other business. Technology itself is always changing. So are business models. And so is customer behavior.

It’s just a more dynamic space.

As mentioned, Constellation focuses on critical B2B (and B2G) services, which change slower and more predictably than B2C. But they still change faster than Buffett-type companies like Coca Cola.

So, what how do you invest with such increased uncertainty?

Constellation’s solution is to also focus on buying and selling “good” (not exceptional) businesses. If there is greater uncertainty, you limit your exposure to it by being able to jump out of a business if you need to. You have to be more a deal maker. You have to be able to enter and exit more rapidly.

In this, Constellation is more similar to Softbank than Berkshire. Softbank does tons of deals. They are very good at entering and exiting. And they are really good at protecting themselves with deal terms.

As mentioned, Constellation has acquired more than 500 businesses since its founding in 1995. They are really active deal makers. And most of these were not “exceptional” businesses. In fact, most appear to have been under the $5M range. Although they are now doing large acquisitions.

Why does this approach work?

• You deal with the uncertainty by doing lots of buying and selling in the shorter term. That means moving into “good” companies, which are available in much larger volumes.
• Within this larger volume of buying and selling good companies, you occasionally find a great business to buy and hold for the long-term.

You basically combine Warren Buffett-type buy and hold of “exceptional” businesses. With Softbank type buy and sell of “good” businesses.

And on the Constellation webpage, they actually list their criteria for both “exceptional” and “good” companies. Here’s what they say.

• Exceptional businesses
  • Mid-to-large vertical market software businesses. With greater than $1M EBITDA.
  • Consistent earnings and growth. Constellation has a good equation for this:
    • EBITDA/Revenue + Revenue Growth = 20%
  • Experienced and committed management.
• Good businesses
  • #1 or 2 in a niche vertical market
  • Revenue over $5M
  • Hundreds or thousands of customers
  • “Unimposing” competitors

And they say they prefer to buy 100% of businesses if the management will still be involved. Like Buffett, they want to acquire the business and its management.

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Ok. That’s it.

Constellation is an interesting company to follow if you invest in tech companies. Just follow their transactions. They do lots of them and you can learn a lot.

Cheers, Jeff

• My Checklist for Critical B2B Products and Services

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I write, speak and consult about how to win (and not lose) in digital strategy and transformation.

I am the founder of TechMoat Consulting, a boutique consulting firm that helps retailers, brands, and technology companies exploit digital change to grow faster, innovate better and build digital moats. Get in touch here.

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This content (articles, podcasts, website info) is not investment, legal or tax advice. The information and opinions from me and any guests may be incorrect. The numbers and information may be wrong. The views expressed may no longer be relevant or accurate. This is not investment advice. Investing is risky. Do your own research.