A 36,000% return since IPO : CSU Case Study
A boring business model that built a $100 billion empire.
CSU has delivered a total shareholder return of 36,000% since its 2006 IPO by simply buying and holding vertical market software companies.
That's not a typo.
36,000%.
So what's the deal with CSU?
Was it just lucky timing? Some kind of financial engineering trick?
Let's dig into the numbers and figure out what made this the investment of a lifetime.
The Man Behind the Magic
Information about Mark Leonard is scarce.
There are few photos of him, and he has never given an interview.
No conferences.
No podcasts.
No interviews.
His colleagues have described him as "probably the most intensely private individual in IT." He's allegedly 6'5" 280lbs and has a Gandalf beard.
But here's what we know:
He waived his salary to zero in 2014.
He travels economy class - even though he could easily afford business class.
He thinks like an owner - Leonard has 6.76% of the company, worth about $400 million.
This is not your typical public company CEO.
The Constellation Model
What They Actually Do
The company's business strategy is to acquire software companies, and then hold them for the long term.
It has acquired over 500 businesses since being founded. It focuses on vertical market software companies (i.e. those that create software for a particular industry or market, as opposed to creating software usable for a wide variety of markets).
Think about it this way: every industry needs software.
But most industries are too small for Microsoft or Oracle to care about.
Who makes software for:
Golf course management systems?
Library check-out systems?
Marina management platforms?
Public transit scheduling?
Funeral home operations?
These are vertical market software (VMS) companies. They serve tiny niches that big tech ignores.
But they have incredible economics:
High switching costs - Once you've integrated software into your daily operations, switching is a nightmare.
Recurring revenue streams - Maintenance revenue accounts for about 60% of annual revenue, and this is of course recurring revenue.
Predictable growth - Businesses need these tools to operate. Demand is stable.
Pricing power - Limited competition means you can raise prices.
Most importantly, they're too small for big competitors to bother with.
Most of its acquisitions are relatively small (for less than $5 million), though the company has indicated it may pursue larger acquisitions in the future.
The Economics That Matter
The Real Magic: The Reinvestment Machine
Here's what makes Constellation special: The company currently spends 88% of its operating free cash flow on acquisitions.
They generate cash, buy more software companies, which generate more cash, which they use to buy even more companies.
It's a compounding machine.
Leonard wrote:
"In our businesses we can nearly always grow revenues organically without incremental capital."
This is key.
Most businesses need capital to grow.
Software doesn't.
Leonard believes that long term shareholders will generate a return on their Constellation shares that cannot exceed the sum of long term ROIC plus Organic Net Revenue Growth.
The Formula: ROIC + Organic Growth = Shareholder Returns
The KPI used at Constellation Software to measure company performance is "ROIC + organic growth."
As communicated in Leonard's annual letters, ROIC is the cash return from the acquisitions that CSI makes.
ROIC + organic growth" combined is the increase in value of CSI.
Our senior managers consistently generate rates of return in excess of 25% on the capital that they deploy.
Think about that.
25%+ returns on invested capital.
Year after year.
Most companies would kill for 15% returns.
The Decentralized Secret Weapon
Most roll-ups fail because they try to create "synergies" and centralize operations.
Fire redundant employees.
Combine systems.
Cut costs.
Constellation does the opposite.
Leonard outlines the counterintuitive tao that undergirds Constellation's management:
"Head office provides the Operating Groups with capital allocation assistance and decisions, and tries to disseminate some best practices, a few clear rules, a bit of coaching, and coughs up the occasional partly trained employee for the Operating Groups. Compliance, investor relations, and handling the finance function round out the head office duties. Whenever we feel stretched at head office, we download more of our work to the Operating Groups."
Now, the business units operate as independent M&A engines that can do acquisitions themselves without board approval.
Each software company maintains its autonomy.
Leonard's team provides capital and best practices but stays out of day-to-day operations.
Leonard is a firm believer that autonomy produces better results and motivates employees.
"One of the fundamental beliefs at CSI, is that autonomy motivates people, and bureaucracy does the opposite, so we try to do as many of the important monitoring tasks with as light a touch as possible."
It's like Berkshire Hathaway for software.
The VMS Advantage
Mark Leonard, the CEO of Constellation Software, famously conducted a study of 12 serial acquirers including Danaher, Jack Henry and Roper.
He concluded that vertical market software (VMS) was by far the best fit for the business model.
Why is VMS perfect for this model?
1. Sticky customers with high switching costs
Constellation enjoys high customer switching costs inherent in software.
Once a golf course implements Constellation's tee-time management system, they're not switching to a competitor. The integration costs, training costs, and operational disruption would be enormous.
2. Predictable, recurring revenue
Mission-critical software isn't optional. Customers pay maintenance fees year after year.
3. Limited competition
CSU's VMS operate in non-competitive markets (competing with horizontal solutions not suited for the vertical, with pen & paper and with in-house cumbersome tooling) in which they have market leadership.
4. Capital efficient growth
Industry focus gives VMS unfair unit economics (e.g. lower CAC and lower churn rate) which enable them to have a great growth/profitability balance early on in their journey.
5. Pricing power
When you're the only game in town, you can raise prices. And customers will pay because switching isn't realistic.
The Acquisition Machine
How They Find and Buy Companies
CSU has successfully scaled its M&A machine. Its core model is to make many small acquisitions (below $5m) at a cheap price (below 1x EV/Sales).
Since 2005, CSU made over 780 acquisitions deploying $6.6bn in capital.
CSU managed to scale annual acquisition pace from 12 deals to deploy $29m in 2005 to 134 deals to deploy $1.7bn.
What They Look For:
For a good business, they list the following criteria:
Number 1 or Number 2 market-share holder in a niche vertical market.
Revenues of at least $5 million.
Hundreds or thousands (not dozens) of customers. Unimposing competitors.
An offering price that has been determined.
Data Advantage:
CSU operates 800+ VMS and has a database of 40k VMS targets.
As a result, it has a unique data advantage which can be leveraged to make more successful acquisitions and to operate VMS more efficiently compared to other players.
They know what good looks like.
CSI own 900 software businesses which gives them an amazing bank of data to work out what good or rubbish looks like and can share best practices.
They know who is the best at professional services so they can teach the rest of the group. Such a spread allows them to have core KPIs for software businesses in all sectors.
The Long-Term Relationship
More often it takes years, even decades, before an owner is ready to sell. When the time is right the acquirer, with its long-standing relationship and promise of perpetual ownership, holds an advantage.
This isn't transactional. They build relationships for decades before buying.
The Employee Millionaire Factory
In the 2013 President Letter, Mark Leonard writes:
"Our employee bonus plan requires that all employees who make more than a threshold level of compensation invest in CSI shares and hold those shares for an average of at least 4 years"
As of 2015, CSI reportedly had over 100 employee millionaires, with Leonard noting his intention to bring that figure to 500 over the next decade.
Instead, executives are required to take 75% of their after-tax bonus and buy Constellation common shares on the open market, which are then held in escrow for an average of four years.
This creates incredible alignment.
Everyone thinks like an owner because they literally are owners.
The Competitive Moats
Why This Model Is So Hard to Replicate
1. Data and Experience Moat
After 25+ years and 800+ acquisitions, Constellation knows more about VMS businesses than anyone else on the planet.
They can look through the same lens to measure the efficiencies of professional services and support teams, and cost of R&D, G&A and sales and marketing.
They can tag every individual and pound spent or made into those five buckets, and know professional services revenue should be this ratio of professional services spend.
That's what it should be, which means they can immediately spot weak spots in target businesses.
2. Reputation Moat
VMS business owners know Constellation. They know they'll be treated well and maintain autonomy.
Some founders sell to Constellation because the career prospects for themselves and their employees are better within Constellation.
3. Scale Moat
Leonard points out that while it is easy to start a conglomerate, Constellation's unique culture and numerous business units provide a competitive advantage that is hard to replicate.
4. Cost of Capital Moat
As a public company with a pristine track record, Constellation can access capital cheaper than private competitors.
The Risks and Challenges
Why This Might Not Work Forever
Let's be honest about the challenges:
1. Competition is Increasing
There are way more players in the space today than there were 10 years ago. This will probably drive up acquisition prices and compress IRR's.
"Externally, competition to buy vertical market software ("VMS") businesses is intense".
2. Scale Challenges
Capital becomes more difficult to deploy at high rates of return as the pile gets larger. Deals get more competitive, multiple arbitrages are harder to find.
3. Organic Growth Pressures
The one real kicker of this model historically was organic revenue growth. The great thing about VMS businesses is that they operate in niche markets that are too small to attract competition.
But that also means they're super hard to grow. Some of these markets are just so small. Once a business saturates its TAM, there's not much else it can do to grow.
4. Valuation Risk
Today's stock price assumes continued exceptional execution. Any stumble could be painful.
The Lessons for Investors
1. Time Arbitrage is Real
"If everything you do needs to work on a three-year time horizon, then you're competing against a lot of people. But if you're willing to invest on a seven-year time horizon, you're now competing against a fraction of those people." – Jeff Bezos
Leonard took this to the extreme with a forever holding period.
2. ROIC + Reinvestment = Magic
The best businesses are companies that have very high margins, a low capital intensity and can reinvest their free cash flow at attractive rates.
Organic growth is the most preferred source of growth and there is plenty of this in the VMS market.
Find businesses that can reinvest at high returns for long periods.
3. Decentralization Scales
Mark Leonard tries to keep the autonomy of his employees as high as possible. Constellation Software has a very decentralized business model and when they acquire a company, they do not seek to take over day-to-day operations.
Don't try to control everything.
Give talented people autonomy and accountability.
4. Boring Can Be Beautiful
The most profitable businesses are often the most boring.
Golf course software isn't sexy, but it generates incredible returns.
The Bottom Line
What This All Means for Investors
If you had bought Constellation at its IPO and simply held on, you'd have one of the greatest investment returns in market history.
36,000%.
Not through options or crypto or day trading.
Just by owning a boring Canadian software company that buys other boring software companies.
The Constellation story illustrates what happens when you combine:
High returns on invested capital - They consistently earn 25%+ returns
Massive reinvestment opportunities - Database of 40,000+ potential targets
Forever thinking - No quarterly earnings pressure
Decentralized execution - Let the operators operate
Patient capital - Built for the long haul
Owner-operator culture - Everyone has skin in the game
You don't need to find the next Tesla or Netflix.
Sometimes the best investments are hiding in plain sight.
Small, boring software companies that solve real problems for real businesses.
Companies that compound value quietly while everyone else chases the shiny objects.
Where to Look for the Next Constellation
If you want to see a stock we recently talked about that we think could be a potential multi-bagger, check this out:
We specialize in finding companies with the characteristics that create 100-baggers:
High returns on invested capital (20%+ ROIC)
Massive reinvestment runways
Owner-operator management teams
Sustainable competitive advantages
Long-term oriented cultures
We will release details of one potential multi-bagger stock each month.
There are simply not enough of these opportunities out there, so we'll only focus on the absolute best candidates we can find. Each stock will meet our rigorous criteria and have the potential to deliver enormous returns over the long run.
In addition to our monthly stock picks, we'll also publish case studies and free content around our investment strategy throughout the year.
For serious investors only, our subscription price is $300 annually or $50 monthly. We're offering a 25% launch discount for early subscribers.
You can get that here if you want:
To be clear: we don't want subscribers who are looking to make a quick buck. We want those who are serious, long-term oriented investors looking to find those exceptional companies that will drive the outperformance of their portfolios for years to come.
The next Constellation is out there.
The question is whether you'll recognize it when you see it.
Thanks for reading,
Nico
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