Constellation Software (TSX:CSU) stock has grown consistently for the last two decades. Had you invested $10,000 in this stock at the start of 2003, today, it would be $224,131. If you take the 20-year average, you earned compound annual growth rate (CAGR) of 16.8%. After growing at 16.8% CAGR, does this stock has more room for long-term growth? To find the answer, let’s understand software stocks and how Constellation sees them.
Something you should know about software stocks
Software companies earn by licensing their software to companies. While licensing is a one-time revenue, they also earn recurring revenue for maintenance and professional services like software updates. The biggest expense for these companies is staff salary as software developers develop and maintain the product.
The software industry has a low entry barrier, as the asset is one’s coding skills. Hence, you see many small software companies spring up.
If these companies take a loan, it is probably for acquisitions. But most software companies fund their acquisitions by giving shares of their company. An all-share deal may sound good in the short term as the acquirer doesn’t have to give cash. But it could be expensive in the long term if the acquirer’s stocks grow significantly.
Imagine Amazon making any all-share acquisitions back in 2007. The company that received Amazon shares as acquisition proceeds would be rich as US$690,000 worth of Amazon shares in 2007 are worth over US$25.4 million today. Hence, when a software company makes an all-share deal, it talks a lot about the company’s current financial health and future growth.
Why am I discussing all these basics about the software business? It’s because the tech titan I am discussing today studies the software companies and acquires the ones that earn high recurring revenue from maintenance and professional services in an all-cash deal. The cash payment limits its liability and secures a regular cash flow for the long term.
How Constellation’s business model ensures stable long-term growth
Constellation doesn’t share its methodology to choose its acquisition targets, as that is its trade secret. But it uses the method of compounding to generate stable long-term growth. It acquires small vertical-specific software (VSS) companies with low competition and regular cash flows. Constellation doesn’t take significant debt to fund the acquisition. It reinvests the cash flow of its acquired companies to acquire more companies, compounding its earnings.
To give you a hypothetical scenario, John acquires company A for $100 to earn $10 cash flow. In 10 years, the acquisition will be fully paid up. Any further cash flows from the acquired company are 100% profit for John. Now, John uses $10 cash flow from 10 companies to buy an 11th company, without using any of his money. He used the invested income to buy the 11th company, thereby compounding the returns of previous acquisitions.
Constellation has been acquiring VSS companies since 1995 and has operations in over 100 different markets worldwide. Whenever there is a market crash or a tech stock meltdown, Constellation accelerates its acquisition as it gets companies at a bargain price. Hence, its revenue and earnings per share grow faster after a crash.
| Year | Revenue (in Billions) | YoY growth |
| 2015 | $1.84 | 10% |
| 2016 | $2.13 | 15% |
| 2017 | $2.48 | 17% |
| 2018 | $3.06 | 23% |
| 2019 | $3.49 | 14% |
| 2020 | $3.97 | 14% |
| 2021 | $5.11 | 29% |
| 2022 | $6.62 | 30% |
When tech stocks were booming in 2019-2020, Constellation’s revenue surged 14% annually. But the 2022 tech meltdown boosted its 2021-2022 revenue growth. The software market keeps evolving. With the evolution of 5G, you will need software even for cars, robots, mapping, and more. This constant buying and selling of companies will keep increasing Constellation’s size driving its stock price for another decade or more.
How to make the most of Constellation stock
You can keep buying Constellation stock in the coming bear market and when you have money. Keep holding this stock, as there is more growth for it. You can consider partial withdrawals as and when you need money. Having a resilient growth stock like Constellation in your core portfolio will help your investments recover strongly after every dip, making up for losses in other stocks.
