Constellation Software – Not really a dividend stock

Constellation Software is a leading global provider of software and services. It acquires, manages, and builds vertical market software (VMS) businesses. It caters to both public and private clients with the public sector generating almost two-thirds of its total revenues.

The company has developed into a constellation of companies with a large, diverse customer base comprised of over 125,000 customers operating in over 100 countries around the world. Constellation aggregates its six operating segments (Volaris, Harris, TSS, Jonas, Vela, and Perseus) and reports under one segment.

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Key Investment Data

 

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Revenue Growth & Market Exposure

The software companyis known for developing market-leading solutions to address the specific needs of clients in particular industries. Constellation caters to a diversified group of industries ranging from advertising and marketing, asset management, automotive, aviation, communications, compliance to construction, education, healthcare, hospitality, legal, logistics, industrial distribution, mining, and oil and gas, real estate brokers and agents.

The company has a presence in both public and private sectors and serves businesses focusing on government and government-related customers, and commercial customers. Constellation is well-positioned to sell a combination of software, maintenance, professional services, and hardware to its customers and hence enjoys sticky customer relationships. 

Constellation Software’s consolidated revenues totaled $3.9 billion in the last year. The revenues primarily comprise of fees – maintenance and other recurring fees (~70% of 2020 sales), professional service fees (~19%), software license fees (~6%), and hardware sales (~5%).

The company has been growing organically and also through strategic acquisitions focusing on vertical market software companies for growth. Constellation has acquired more than 500 companies since its inception in 1995 but made only three large VMS acquisitions during its entire history. The company will now focus on pursuing large VMS acquisitions.

Total revenue for the year increased by 14% primarily due to growth from acquisitions. It did not make any significant acquisition during the first nine months of 2020 but acquired Topicus during the year, a Netherlands-based diversified vertical market software provider. The company’s revenues have grown at more than 26% CAGR in the last ten years.

Dividends

Constellation sports a modest dividend yield of 0.26% and a very low payout ratio of 19%. A low payout ratio signifies enough room for future growth. Constellation’s objective is to invest its free cash flow (that is available to shareholders) in acquisitions that meet its hurdle rate, overpaying dividends, or repurchasing shares.

The company has historically paid three special dividends, and also paid a regular quarterly dividend for the last decade. Its last dividend increase was in 2012. However, the board has taken the decision to stop its special dividend payment and can also suspend the quarterly dividend if it finds better uses for its FCFA2S. Constellation will continue to invest its FCFA2S in small and mid-sized VMS acquisitions at its traditional hurdle rates.

Constellation’s businesses provide mission-critical software solutions that address the specific needs of customers in particular markets. Customers enter into multiple-year/ perpetual arrangements and pay fees for ongoing customer support and support for software products post-delivery, etc. Its focus on acquiring businesses with growth potential also grants safety and predictability to the company’s cash flows and has generated revenue growth over the years. Constellation’s presence in different industries diversifies its holdings and makes it less susceptible to negative impacts in any industry at a given point in time. 

The business shareholders received 1.85 subordinate voting shares of Topicus.com (the spin-out shares) for each common share of Constellation. Its TSS business was spun out upon the acquisition. TSS is one of Constellation’s six operating group companies, focusing on the European vertical market software industry.

The market for software and hardware service and support should grow as people opt to work from home and manage chores online. Constellation Software developing customized applications and programs for a particular client forms a deep moat around its business. Moreover, its customers typically purchase a combination of software, maintenance, professional services, and hardware.

Hardware sales that include the resale of third-party hardware forming part of customer solutions, as well as sales of customized hardware add a good source of complementary income. It is difficult for newcomers to design similar programs and makes it near to impossible for Constellation’s clients to opt-out.

The software company sports a modest dividend yield of 0.35% and a very low payout ratio of 22%. A low payout ratio signifies enough room for future growth. The company declared a dividend of $1 per share payable in January. Constellation’s objective is to invest its free cash flow (that is available to shareholders) in acquisitions that meet its hurdle rate, over paying dividends or repurchasing shares.

Competition

Constellation Software is a component of DOCKS similar to US’s FAANG stocks. It competes with the likes of Enghouse Systems, Open text Corporation, and Computer Modelling Group.

Enghouse‌ ‌Systems‌ ‌is‌ ‌a‌ ‌software‌ ‌and‌ ‌services‌ ‌company‌ ‌engaging‌ ‌in‌ ‌developing‌ ‌and‌ ‌selling‌ ‌enterprise‌ ‌oriented‌ ‌applications‌ ‌software, OpenText Corp is another leading Enterprise Information Management (EIM) company providing software and solutions to companies, while Computer Modelling Group is a leading software technology company that focuses on reservoir simulation research and development, and the delivery of technical solutions.

Constellation Software is subject to seasonality due to the timing of annual maintenance contract renewals. It relies heavily on acquisitions for its growth which might increase the company’s debt burdens.

Enghouse‌ ‌Systems‌ ‌is‌ ‌a‌ ‌software‌ ‌and‌ ‌services‌ ‌company‌ ‌engaging‌ ‌in‌ ‌developing‌ ‌and‌ ‌selling‌ ‌enterprise‌ ‌oriented‌ ‌applications‌ ‌software, OpenText Corp is another leading Enterprise Information Management (EIM) company providing software and solutions to companies, while Computer Modelling Group is a leading software technology company that focuses on reservoir simulation research and development, and the delivery of technical solutions.

Bottom Line

Constellation Software witnessed some hiccups and expects that COVID-19 might continue to have an adverse effect on its customers and its results. COVID-induced travel restrictions have negatively impacted the ability to implement software and many customers have also delayed buying.

However, the company has exhibited tremendous success led by acquisitions in the last few years. Its growth-by-acquisition strategy has been a major growth driver. Constellation’s focus on acquiring companies with consistent profitability, a track record of above-average growth, and a strong management team should continue to support its cash flow and capital allocation strategies for future growth. 

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