Mark Leonard is hardly a household name. He’s not even particularly well known in the world of finance. But the long-bearded reclusive founder of Toronto-listed Constellation Software – known to his admirers as Software Santa – is arguably one of the greatest capital allocators of this generation.
A dollar invested in Constellation Software’s initial public offering in 2006 is worth 25 times more today as the firm’s earnings have expanded by gobbling up smaller firms.
Constellation has acquired more than 1000 businesses, and now owns software platforms that do everything from weather forecasting to sales and commodity trading.
Roll-ups – in which companies increase profits through serial acquisitions – tend to fail in most industries. But Constellation and others show they can work well in software.
In fact, software has been a deal maker’s battleground, attracting consolidators, venture firms, private equity players and hedge funds as the sector faces its own reckoning.
“Software companies are meant to be acquired,” says Sumit Gautam of Dallas-based hedge fund Scalar Gauge, which specialises in buying software stocks that are likely takeover targets.
Gautam is among the fund managers presenting at the Sohn Hearts & Minds investment forum this year. Rest assured he’ll pitch a cheap software play.
So what is it about software companies that allows them to add value almost immediately to acquirers? Gautam says one reason is that acquirers can sell that software to existing customers without having to hire more sales staff.
Every sale drops right through to the bottom line in a way that is just not possible for companies in many other sectors – from retailers to restaurants, Guatam says.
Software companies also have the added advantage of being capital light and highly cash flow generative. This affords them the financial firepower to acquire other businesses, often at attractive multiples, or to borrow money to snap up smaller peers.
That’s why bigger software firms keep buying smaller ones, increasing their profits and market valuations. Constellation is one example, but Guatam points out that Oracle has bought more than 150 companies. Microsoft? More than 225 companies.
Growth split
In Australia, our closest equivalent to Constellation is Richard White’s WiseTech Global, which started in logistics software and has bought up more than 40 businesses since it went public in 2016 at $3.35 a share (they are now worth $131).
WiseTech has increased its earnings per share from 8.5¢ to $1.30, a 15-times increase, and delivered a compounded annual growth rate for shareholders of 33 per cent. That growth comes from rolling out more products to its largest customers, followed by receiving higher fees. Then there’s the natural growth in its customers.
This kind of split in where growth is coming from gives WiseTech bulls faith that the company can continue to expand and deliver gains for shareholders.
Constellation’s long-term compounded annual growth rate is also 33 per cent. But there are differences. Leonard has been playing the serial acquisition game since the 1990s, snapping up small firms operating in specific niches on low multiples.
Constellation doesn’t centrally integrate the firms but does sweep the capital to be redeployed to make the highest return, in a similar vein to Warren Buffett at Berkshire Hathaway.
Constellation is the largest holding of Sydney-headquartered global equities fund Constantia Investment Partners, which argues that the extraordinary value the company has created is in its processes to deploy capital to generate shareholder returns.
But roll-ups or aggregators can also go wrong.
Constantia’s Etienne Vlok says the most important quality of serial acquirers in any sector is faith that deals are done in the name of long-term shareholder returns.
Most analysts agree that, on conventional measures of value, WiseTech and Constellation are expensive. High valuations have made the sector unpalatable for most Australian investors. In the United States, there has been a brutal correction.
SaaS goes south
SaaS – software as a service – was once the hottest acronym on Wall Street as investors embraced the high margins and recurring revenue of these stocks. Even mining prospectors were touting their recurring revenue – as a service.
But the boom, which peaked in 2021, turned to a bust as sales underwhelmed and orders dried up. The sector has also been on the wrong end of the hype around artificial intelligence, with fears that products sold by the likes of Salesforce, which makes customer relationship management software, could be rendered obsolete.
It turns out software isn’t all that special. In fact, global stock pickers GQG Partners compare software to the US shale gas industry, where a flood of capital chasing a hot opportunity ultimately depleted returns for investors.
By their maths, $US300 billion of debt and equity was ploughed into shale from 2010 to 2020. Venture funds alone have spent that amount of money on software since 2015. That’s before anything invested by listed companies.
GQG has shifted away from software in the view that the industry is being crowded by too much capital. Instead, it is investing in more capital-intensive parts of the technology complex such as semiconductors – a winning trade.
Now, fund partner Brian Kersmanc believes that space is crowded, too. GQG is casting its eye towards traditional power companies that were assumed to be dull, capital-intensive businesses. The market’s idea of a great investment has come full circle.
Stock-based compensation has been a big talking point as the software boom turned to a bust. To attract and retain talent without having to fork out big dollars, software companies have showered their engineers with stock as part of their remuneration.
Most listed companies are simply doling out the payments every quarter without linking them to any particular outcome.
When the share price is going up, that’s wonderful. Engineers are getting rich, the company is conserving cash and its dilution is modest. But when the share price is falling, staff are losing money and things get ugly.
By some measures, about 8 per cent of sales revenues were spent on stock-based compensation at listed software companies, distorting their economics and certainly killing the notion that these are capital light businesses.
Gautam says he’s all for putting in place incentives for staff to drive growth. That worked well during his time in private equity. But most listed companies are simply doling out the payments every quarter without linking them to any particular outcome.
On this point, Constellation is different.
Leonard sets his management targets based on returns on capital so that employees are rewarded for conserving cash when they’re not growing and investing it when they are. They’re paid bonuses in cash that must be used to buy stock, thus avoiding dilution.
For these reasons, Constellation is revered by the value and growth investors who have been handsomely rewarded.
The wayward capital allocation in private markets, on the other hand, is a real problem. As former Macquarie banker Ben Brazil told this column, a lot of cheap equity and debt was used to overpay for assets that aren’t worth a fraction of the purchase price.
That’s especially so in the software sector.
Companies that are privately owned or funded by debt have been starved of cash needed to reinvest in their offerings. But this means they risk falling further behind their competitors in a sector where failures to innovate are fatal.
Constellation told shareholders it is waiting in the wings, ready to snap up the software firms that venture funds will ultimately have to sell.
But Guatam believes that moment may never come. That’s because private owners won’t face up to “the truth” that the public markets would value their business at one-tenth of their last fund valuation. “It’s going to be a bloodbath,” he says.
The Australian Financial Review is a media partner of Sohn Hearts & Minds.
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