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Can this Canadian software firm remain a shining star?

It is on the clearest nights we can best see the brightest lights in the sky. It is a maxim worth remembering for investors who wish to identify the shining stars in Constellation Software, where the view can often be considered cloudy, at best.

Constellation has built its business through a never-ending series of acquisitions and the stock has, mostly, remained highly valued by investors, even as some critics have questioned whether the company can continue to succeed. An emerging thesis, however, is whether Constellation is providing enough information to allow its investors to assess those prospects. The company's boosters point to changes in its most-recent earnings report and say Constellation may have quieted at least some of those critics.

The most recent kerfuffle occurred below the radar of most of Constellation's Canadian investors. In December, a 33-year-old investing newsletter called Grant's Interest Rate Observer – known in the United States for founder James Grant's commentary – published a critical article on the company called "Past Performance, Inc."

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Constellation's shareholders may have noticed the effects of the article without ever knowing of its publication. The stock, trading between $600 and $650 for most of November, fell below $600 around the time of the Grant's publication, and didn't recapture its mojo until after the first-quarter earnings in late February. It closed Tuesday at (The company declined to comment for this article.)

The Grant's article ran through a number of accounting concerns it had with the company, many small, but the thrust of the piece is that the company makes lots of small acquisitions, and "because the small fry furnish the principal source of parental growth, the stockholders have no clear picture of what they actually own." And the company's presentation of "organic" growth doesn't help clear things up, Grant's said.

While Constellation has six business units, Grant's said, it lumps them into just two customer types for its reports to investors: "public," the government customers; and "private," the for-profit ones. It also breaks its revenue into four types of sales, including "maintenance and other recurring" – the recurring, repeatable revenue that's catnip for software investors. (The other three sales types are: licences; professional services; and "hardware and other.")

How is Constellation's business growing, absent the effect of acquisitions? That's where organic revenue comes in. In the retail and restaurant industry, the common metric is "same-store sales," a number that measures sales growth only in locations that have been open for a set period, typically one year.

Similarly, acquisitive companies in a variety of industries can calculate organic growth by reporting revenue gains only for the business units that they've owned and operated for a year. Constellation's "organic growth" number, however, is calculated as the difference between actual revenues, once acquired, and what Constellation estimates the companies booked before it bought the businesses.

This may not seem like much of a big deal, but Constellation does talk up the fact that when it buys software companies, it does its best to raise prices for software and services, given the contracts it inherited. Constellation's method of calculating organic revenue captures that bump in a way a more traditional method of measuring would not. And it may give an inflated picture of the sustainability of those revenue gains.

However: Constellation, pushed on this issue over a year ago by an analyst, says it has examined this issue and there's little practical difference in the results from the two calculation methods. In the company's 2015 shareholder letter, released about a year ago, founder and president Mark Leonard said the results from Constellation's method are "very similar" to the traditional method, and he offered quarterly and annual comparisons for all of 2014 and 2015. While the quarterly results varied by as much as two percentage points, the annual organic-growth numbers came out identical.

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Will there be a similar analysis at the end of this month, when Mr. Leonard releases the 2016 president's letter? Perhaps not, but Constellation's first-quarter results provided some extra help for any investors who may have asked some pointed questions after the Grant's report. The company stepped beyond just an overall organic growth number, presenting it for each of the types of revenue, like maintenance, as well.

To Paul Treiber of RBC Dominion Securities Inc., who is the only analyst willing to look past Constellation's high price-to-earnings ratio and assign it an "outperform" rating, the new disclosures "validate [its] strategy and organic growth … investor concerns regarding the sustainability of maintenance price increases may be overdone."

Perhaps. But there's a lingering, important issue about Constellation's future, which I wrote about a year ago with the assistance of Veritas Investment Research: Mr. Leonard has acknowledged it's getting harder to find good companies to acquire, and some of its recent purchases fall under the "turnaround" category. And while Constellation has provided special disclosure about certain large, problematic deals in the past, it's not as clear as it could be to see how Constellation's acquisition model is evolving, and whether it has quite as many stars as it used to.

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About the Author
Business and investing reporter and columnist

A business journalist since 1994, David Milstead began writing for The Globe and Mail in 2009. During eight years at the Rocky Mountain News in Denver, Colo., he individually or jointly won nine national awards from SABEW, the Society of American Business Editors and Writers. He has also worked at the Wall Street Journal. More


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