Constellation Software (CNSWF) (TSE: CSU) is a Canada-based company that develops and customizes software for public- and private-sector markets. The firm acquires, manages, and builds vertical-specific businesses. Its operations are organized into two segments: Public Sector and Private Sector.
Its companies serve various markets including communications, credit unions, beverage distribution, tour operators, auto clubs, textiles and apparel, hospitality, and community care. It operates in North America, Europe, Australia, South America, and Africa.
We are bullish on the stock because it has a measurable competitive advantage, which allows it to create value for its shareholders. In addition, the stock is currently undervalued.
Constellation’s Competitive Advantage
There are a few ways to quantify a company’s competitive advantage using only its income statement. One of our favorite methods involves calculating a company’s earnings power value (EPV). Please note that all numbers in this article are in USD.
Earnings power value is measured as adjusted EBIT after tax, divided by the weighted average cost of capital, and reproduction value (the cost to reproduce the business) can be measured using total asset value. If the earnings power value is higher than the reproduction value, then a company is considered to have a competitive advantage.
The calculation is as follows:
EPV = EPV adjusted earnings / WACC
$11,986 million = $863 million / 0.072
Since Constellation Software has a total asset value of $6,500 million, we can say that it does have a competitive advantage. In other words, assuming no growth for Constellation Software, it would require $6,500 million of assets to generate $11,986 million in value over time.
The second method to figure out if a company has a competitive edge is to look at its historical gross margins. This is because the gross margin represents the premium that consumers are willing to pay over the cost of a product or service. An expanding gross margin indicates that a sustainable competitive advantage is present.
If an existing company has no edge, then new entrants would gradually take away market share, leading to a decreasing gross margin as pricing wars ensue to remain competitive.
In Constellation Software’s case, its gross margin has remained flat in the past several years, ranging from about 36 to 37%. This indicates that a competitive advantage is present in this regard as well.
Economic Spread – Constellation Software is a Value Creator
Great companies often have great management teams that can effectively allocate capital to profitable projects. For a company like Constellation Software with an acquisition strategy, management’s ability to allocate capital is especially important.
Fortunately, we may be able to get a good picture of management’s effectiveness by simply looking at the numbers. A metric we like to look at is the economic spread, which is defined as follows:
Economic Spread = Return on Invested Capital – Weighted Average Cost of Capital
The idea is very simple; if the return on invested capital is greater than the cost of that same capital, then the company is creating value for its shareholders through well-thought-out projects. Otherwise, the company is destroying value and would be better off simply investing money into risk-free bonds.
For Constellation Software, the economic spread is as follows:
Economic Spread = 24.3% – 7.2%
Economic Spread = 17.1%
As a result, the company is creating value for its shareholders, implying that management is efficiently allocating capital.
Valuation
To value Constellation Software, we will use the H-Model, which is similar to a three-stage DCF model. The H-Model assumes that growth will decelerate linearly over a specified period of time. We believe this is a reasonable assumption as companies gradually slow down as they mature.
The formula is as follows:
Stock Value = (CF(1+tg))/(r-tg) + (CFH(hg-tg))/(r-tg)
Where:
CF = cash flow per share
tg = terminal growth rate
hg = high growth rate
r = discount rate
H = half-life of the forecast period
For Constellation Software, we used the following assumptions:
CF = $59.93 per share
tg = 2.996% (used 30-year U.S. Treasury yield)
hg = 23.3% (based on analysts’ estimates)
r = 7.4%
H = five years (we are assuming it will take 10 years to reach terminal growth)
As a result, we estimate that the fair value of Constellation Software is approximately $2,783 under current market conditions. Again, this is in U.S. Dollars.
Dividend
For investors that like dividends, Constellation Software currently has a 0.26% dividend yield which is below the sector average of 0.73%. When considering its payout ratio of 10%, the dividend payment looks safe.
Taking a look at its historical dividend payments, we can see that its yield range has trended downwards in the past several years.
At 0.26%, the company’s dividend is near the lower end of its range, implying that the stock price is trading at a premium relative to the yields investors have seen in the past.
However, as demonstrated in the valuation section above, Constellation Software is a company that intends to keep growing based on the growth estimates. This means that it needs to retain capital in order to deploy it into growth projects.
As a result, the company is not suitable for income-oriented investors that rely on dividend payments for their everyday activities.
Wall Street’s Take
Turning to Wall Street, Constellation Software has a Moderate Buy consensus rating based on three Buys, two Holds, and zero Sells assigned in the past three months. The average Constellation Software price target of $1,921.09 implies 22.9% upside potential.
Final Thoughts
Constellation Software is a great business that has a measurable competitive advantage and is also undervalued. In addition, analysts believe the stock price has strong upside potential as well. Therefore, we are bullish on the stock.
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