Software stocks are often associated with losses in their initial years, followed by consistent cash flows as they mature. However, Constellation Software (TSX: CSU) is not exactly a software company but enjoys the perks of one. When you learn about its working style, you will know why it is a tremendous buy today when it trades 11% below its all-time high of $5,040.
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What can investors expect from software stocks?
In the enterprise software business, where software is designed specifically for a company, the initial revenue comes from software licensing. The recurring revenue comes from annual maintenance contracts and professional fees. Once a software company achieves breakeven with a certain number of contracts, any new contract brings in higher profits and cash flows for years.
This software tends to be sticky, as it’s designed to suit the company’s needs. Moreover, the company has invested a lot of money in developing the software and training the staff. Moreover, their data is aligned with the software. Switching to another software needs a strong business case, as a significant initial cost goes into it. When the software is for mission-critical services, such as parking and traffic management systems, companies prefer updating or enhancing the existing software rather than switching to a new one.
Why are we talking about this?
Because such companies generate regular operating cash flow from maintenance contracts. Constellation Software and its subsidiaries acquire niche software companies that cater to a specific vertical with little competition. Because there aren’t many alternatives, the operating cash flow is even more sticky.
Constellation Software enjoys the perks of a software company
Circling back to the start, I said that Constellation Software enjoys the perks of a software company: it enjoys the maintenance cash flow of acquired companies. Constellation Software acquires these small companies and lets them operate as they did before the acquisition. It helps them achieve cost synergies in administrative expenses. As the owner, the free cash flow uses that cash to acquire more such companies.
This process of making money out of money is called compounding. For instance, the bank uses your deposited money to lend to others and gives you interest in return. It makes money from your money, and if you reinvest the interest, that part is called compounding.
In 2024, Constellation obtained US$164 million in cash from the US$1.79 billion spent on acquisitions. If we consider acquisitions as investments, Constellation got a 9.2% cash on its acquisitions. Over the years, Constellation has made acquisitions and earnings recurring cash flow. After investing the cash to acquire new businesses, its annual free cash flow stood at $1.47 billion in 2024, up 27% from the previous year.
Constellation gives negligible dividends as it reinvests the money in acquisitions to give a better return on investment to shareholders.
Constellation Software is not exactly a software company
Although Constellation earns through maintenance contracts and professional fees, it is not exactly a software company like Microsoft or Adobe. Unlike other software companies that focus on scaling by acquiring new customers, Constellation scales by acquiring new companies. Organic growth is just 1-2%.
Constellation is constantly looking for companies that meet its criteria and can generate cash flows for years. Assuming it earns 9% free cash flow from its acquisition, the acquired company is fully paid up in eight years, and any cash flow beyond that is profit. Constellation makes all-cash acquisitions and funds them from its cash flows, giving it the flexibility to buy whenever it gets an attractive deal.
Constellation Software presents a compelling investment for today
Imagine if you had $1.47 billion to invest. A bear market could present an attractive opportunity to make the most lucrative acquisitions and lock in higher yields. Constellation’s revenue and earnings per share (EPS) growth have accelerated after every market downturn (2013 and 2020).
The 2025 bear market presents Constellation with an opportunity to beat its 10-year EPS compounded annual growth rate of 15%. A 20-30% EPS growth could push its stock price upwards, creating a compelling case for buying the dip.
