Constellation Software CSU stock has rallied more than 44% in 2024, fueled by strong income and revenue growth. However, the firm’s business strategy relies on acquisitions to drive that upward trajectory, and after two years of big gains, Morningstar believes the stock is trading at lofty levels.
Constellation stock has been marching steadily higher since late 2022, when it was changing hands south of C$2,100. It’s now at C$4,642. Eric Compton, a director of equity research at Morningstar, points to several factors behind the rally. He highlights how Constellation’s revenue grew at an almost 30% pace annually from 2021 through 2023. Most notably, the company’s operating income compounded at about a 15%-16% rate over the last four years, after adjusting for some one-time items.
Compton also says Constellation’s profile has been rising among investors outside Canada, and points to the overall bullish environment for stocks. “Stock indexes have done well since the start of 2023. Many stocks are up a lot, including Constellation,” he says.
The key to the stock’s gains has been the company’s ability to grow revenue. Notably, almost all of it is driven inorganically by Constellation’s acquisitions of other companies. This makes their capacity to allocate capital for more deals a critical variable for the stock.
Compton says Constellation has been deploying around C$1.6 billion cash annually in acquisitions. “That will have to keep going up in the future,” he says. The firm usually aims to acquire companies for 1.25 times sales or less, though recently the deals have been closer to 1 times sales. “As long as those things hold, growth should keep going,” he says.
Can Constellation Sustain Its Growth?
This source of growth also presents a risk to the stock. “As Constellation grows bigger, they need to deploy more cash on acquisitions each year to maintain the same growth rate,” he says. “There are questions about how long they can keep doing this before they run out of companies that are large enough to move the needle at this same pace,” Compton explains.
He continues: “There are also questions about when the pricing of these acquisitions will start to go up, and that could be driven by more companies trying to copy the same strategy/more PE money moving into the space, and/or as Constellation moves up in the size of company they typically acquire, those deals will naturally be more competitive. If either of those metrics [the capital deployed on deals and the pricing of those deals] deteriorates, the valuation would likely fall materially.”
Key Morningstar Stats for Constellation Software
- Fair Value Estimate: C$3,260.00
- Morningstar Rating: 1 star
- Economic Moat: Narrow
- Morningstar Uncertainty Rating: Medium
Constellation’s Valuation
Against this backdrop, Constellation stock looks expensive. Morningstar assigns it a fair value estimate of C$3,260 per share. “It’s a solid company with good management, and their current strategy still has some room to run, but the stock is richly priced,” Compton says.
Underlying this assessment is a gradual slowdown in inorganic growth and a rise in deal prices, “which both lead to a slowdown in revenue growth,” Compton says. Morningstar pegs the firm’s 2023-28 revenue rate of growth at 19%, while for 2028-2033, it’s estimated at 14%.
The concerns about Constellation running out of acquisition fuel for growth “might take a few years [to] play out, as they are likely to keep trading at a similar premium until growth decelerates and their inorganic growth strategy decelerates,” Compton says. “In other words, it will be hard to predict when the valuation may unwind, but we think it’s simply too high, and eventually it will.” For investors, “we don’t see any margin of safety or sustainable outperformance from here.”
The following are highlights of Eric Compton’s outlook for Constellation Software and its stock. The full report and more of his coverage are available here.
Fair Value Estimate
Our fair value estimate for Constellation is C$3,260 per share, which implies a fiscal 2025 price/earnings ratio of 52 times. Our discounted cash flow model uses a weighted average cost of capital of 7.4%. We estimate revenue will see a compound annual growth rate of 19% (16%) over the five (ten) years to fiscal 2028 (2033), driven by low-single-digit organic growth and mid-teens growth from acquisitions. Over the same period, we expect adjusted operating margins to expand to about 15%, from 14% in 2023.
Read more about Constellation Software’s fair value estimate.
Economics Moat Rating
We assign Constellation a narrow economic moat. The conglomerate has amassed a portfolio of mission-critical vertical market software companies, which we believe benefit from high customer switching costs. We also believe the firm leverages intangible assets in the form of an extensive proprietary database, acquisition expertise honed over many decades, and strong brand assets to source and acquire businesses at attractive valuations. We expect the firm to continue to acquire firms with durable competitive advantages at reasonable valuations, allowing returns on invested capital to comfortably exceed our estimated weighted average cost of capital for at least the next decade.
While we are impressed by the firm’s remarkable mergers and acquisitions engine, we expect Constellation will be forced to pay higher deal multiples for larger businesses over time as it seeks to deploy a growing pool of capital, undermining our confidence in the durability of economic profits required for a wide moat rating.
Read more about Constellation Software’s economic moat.
Financial Strength
Constellation is in a strong financial position. At the end of 2023, the firm’s net debt/EBITDA was about 1.6 times. While leverage is modest, in our view, the firm’s debt structure is complex, consisting of corporate-level debt and ring-fenced debt with recourse against the assets of underlying operating businesses. Nevertheless, given the company’s decentralized capital allocation process, we believe this structure incentivizes operating managers to take accountability for leverage decisions and de-risks the corporate balance sheet.
Read more about Constellation Software’s financial strength.
Risk and Uncertainty
We assign Constellation a Medium Uncertainty Rating. As a highly diversified conglomerate operating in over 150 verticals globally, Constellation is exposed to a wide variety of risks, including cybersecurity and software product launch failures.
Given that most of Constellation’s growth is contingent on acquisitions, a key risk is finding a high volume of suitable targets at reasonable valuations. Constellation’s M&A strategy faces several risks, including poor execution, overpaying for acquisitions, misreading the perceived quality of a target’s growth profile or company management, and competitive threats. Constellation has an impressive record of picking and growing high-return businesses, and a failure to maintain such momentum and incidentally abandoning the disciplined M&A engine curated by founder Mark Leonard could be value-destructive.
Constellation’s environmental, social, and governance risk is low and immaterial to our uncertainty rating. Across the firm’s portfolio, the potential ESG risks we’d highlight include cybersecurity risks and difficulty attracting skilled engineers.
Read more about Eric Compton’s thoughts on Constellation’s Risk and Uncertainty.
CSU Bulls Say
- We expect Constellation to continue to execute its highly successful playbook of using excess cash to acquire cash-rich businesses at reasonable valuations.
- We believe Constellation can leverage brand assets and an expansive proprietary database to source and identify quality targets.
- Constellation’s exposure to the public sector should support defensive earnings during economic downturns.
CSU Bears Say
- Constellation’s acquisition-heavy model presents significant execution risk, and the firm may struggle to find attractive targets.
- We expect Constellation will pay incrementally higher deal multiples for larger businesses over the coming decade as the firm looks to deploy a growing capital base.
- Constellation’s multiple seems far too high. Eventually, the company’s growth will have to slow down as acquisition targets become fewer or too expensive, and the multiple will fall.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
