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Constellation Software sets its sights on bigger acquisitions Add to ...

If you missed out on one of the most successful Canadian growth stocks to emerge from the recession, despair not. Constellation Software Inc. appears to be far from done.

Having just announced its largest deal to date, the Toronto-based company is showing signs of taking its growth-through-acquisition strategy to a new level.

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Its takeover of a Dutch company has lit a fire under its share price, which has surged more than 10 per cent over the past week. Constellation stock had already been a top-10 performer among the companies on the S&P/TSX Composite Index over the last five years.

Prospective investors may be reluctant to dive into a stock that’s up 750 per cent over that period, but the company’s valuation is still quite reasonable given its history of double-digit revenue growth, supporters say.

“Don’t let the share price scare you off,” said Jason Donville, president of Donville Kent Asset Management. “If I was starting a brand new fund today, this would be one of my top-five holdings right out of the gate.”

In many ways, Constellation is more of a private equity firm than a technology company. It typically buys small, private companies that produce software geared to the needs of specific industries and runs them for maximum profit.

“Constellation’s corporate structure and investment bent are akin to Berkshire Hathaway or Onex, which own portfolios of whole businesses that are unrelated to each other, and are left to be handled by operations executives without much disruption from head office management,” Ralph Garcea, an analyst at Global Maxfin Capital, said in a recent report.

The company’s management has proven itself to be a master of the strategic acquisition, having accumulated 125 companies across 50 industries. “They do their homework and haven’t had many mess-ups over the years,” Mr. Donville said. “[The acquisitions] tend to be very accretive and represent little risk to the company.”

Until this week, the company’s hunt for targets had focused solely on small companies, ones with less than $25-million in revenue.

This incremental approach was showing its limitations as Constellation neared $5-billion in market capitalization. “It’s harder to buy good businesses that have an impact on the top line when you’re that big,” said James Telfser, portfolio manager at Caldwell Investment Management.

This week, the company made a bet that better reflects its size, acquiring Dutch software company Total Specific Solutions for about $350-million. The deal should increase Constellation’s 2014 earnings by 13 per cent, Stephanie Price, an analyst at CIBC World Markets, said in a note. It also more than doubles the company’s exposure to Europe.

Constellation is taking on new debt to fund the acquisition, but analysts generally approve of the strategy. The company’s “acquisition growth trajectory warranted a change in capital structure,” Ms. Price said. “We believe levering up to fund larger-sized acquisitions was necessary.”

Constellation’s new willingness to stalk bigger game has raised its growth prospects and possibly extended its stock run, Mr. Donville said.

“The box they were operating in is now bigger,” he said. “These guys really could be at a $10-billion market cap in 24 to 36 months. And in Canada, that’s a big name. When you start getting to that size, you start getting into the TSX 60.”

A long-time owner of the stock, Mr. Donville said he can see Constellation shares hitting $300 by the end of next year. The average target price among analysts covering the stock is $225, according to Bloomberg.

The company itself has said it aims to keep growing at the same rapid pace it has achieved during recent years. “Does Constellation Software have the ability to scale at the rates which it achieved during the last decade?” Mark Leonard, founder and chairman, said in the letter to shareholders in May. “I don’t think we are sufficiently humble not to try.”

But competing for bigger acquisitions will require the company to maintain its financial discipline, Mr. Telfser said. “As you get into larger deals, you definitely have more risk that you overpay for something.”

Investors trying to avoid overpaying for Constellation’s stock have to assess the likelihood of the company maintaining its brisk growth.

With its shares trading at 17.6 times 2014 earnings, Constellation doesn’t appear cheap until you consider the company has achieved growth of 30 to 40 per cent over the last two years, Mr. Donville said. “We think this company will grow in 2014 by at least 35 per cent, and in a fairly low-risk model.”



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