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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good morning, ladies and gentlemen, and welcome to the Constellation Software Inc. Fourth Quarter 2017 Financial Results Conference Call. [Operator Instructions] Please note that this call is being recorded today, February 15, 2018, at 8:00 a.m. Eastern Time.I would now like to turn the meeting over to your host for today's call, Mr. Mark Leonard, President and Chief Executive Officer of Constellation Software Inc. Please go ahead, Mr. Leonard.
Thanks, Matthew. Good morning, everyone. Welcome to the Q4 call. I'm joined on the call by Jamal, our CFO; and Bernie, our Chief Investment Officer. As you know, we go directly to questions, so Matthew is going to tee up your questions now.
[Operator Instructions] Our first question comes from the line of Thanos Moschopoulos with BMO.
Mark, organic growth clearly ticked upwards in the quarter, license growth was the strongest that you've had in a while. And I realize there might not be any specific reason for that given that you have an extremely diversified business. But generally speaking, would that be reflective of a better macro environment? Or is there some other dynamic you might be able to point to?
Yes. When we talk to the business unit managers and to the operating group managers, there is a sense of optimism out there that I think probably does reflect the macro environment, Thanos. Also, got a pretty good FX tailwind in Q4.
Okay. And as I look at your capital deployments recently, it seems to have skewed a bit more internationally. Is that just a function of better coverage internationally? Is that just kind of a random event? Might it be reflective of maybe more challenging valuations in the U.S. market given the macro dynamics there?
Bernie?
We've certainly seen a little bit more of an uptick in international. We have hired some M&A folks outside of North America. But I wouldn't say it's an anomaly. It will go up and down. Obviously, Québec was a big one in Q1. No more than that.
So maybe random scattering, Thanos.
All right. Question for Jamal. What should we be thinking about as far as the tax rate for 2018 on the back of the U.S. tax reform?
It's probably going to be low 20s now. I think I've been saying it's going to tick up to sort of mid-20s previously, the U.S. tax reform. My rough estimate is about a 300 basis points benefit at the moment.
300 basis points, okay?
Yes.
All right. And maybe just one last one. On the last call, you'd mentioned that the plan was to take a pause in your M&A hiring for the time being while you absorb the extension you had in your team recently. Is that still the plan for 2018?
There was never really a pause. We just will fill seats as we see fit, as we need them. So it will go up, it will go down, sideways. There's no real plan, no grand plan. It'll just be as the portfolio managers feel the need to hire more resources.
There's always time to reflect in these things, Thanos, and you've got to figure out what the feedback cycles are so that you're incorporating the newest information into your decisions. Sometimes you will jump ahead of that and speculate that you might get a particular effect from applying fuel to the fire now versus once you've got results. But ideally, you've got results in hand and then you adjust course and on you go.
Our next question comes from the line of Paul Steep with Scotia Capital.
Mark, maybe you could offer some views or, Bernie, some views on the M&A organization and the build out. Obviously, you deployed what looks like a lot of capital in the first quarter of this year and the large deal with Acceo. What's the thought in terms of your comments, Mark, from maybe almost a year ago in the letter in terms of pushing further down in the organization and ramping things up in terms of volume as to how you're seeing that?
So pushing capital deployment down has the advantage of incorporating more people into the process, making them more committed to it, in all likelihood, being able to handle more transactions. It has the disadvantage of putting capital deployment in the hands of people who are less experienced. So obviously, we're trying to do more. My suspicion is we will have more hiccups in that process, but we think it's well worthwhile, and we think it's a way that people can develop their careers. They can initially become very good managers, real craftsmen in the management of a vertical market software business. And then with any luck they can do a little tuck-in acquisition. And having done that and learned about that, they'll, hopefully, do an acquisition where they set it up as a stand-alone acquisition and coach that acquisition and then, hopefully, over time, grow into managing a portfolio of such businesses. And that career path isn't for everyone. It takes you ever further from operation. But it does create people who have experience deploying capital and can add value to that capital. So that's what we're hoping for some of our people, but it won't be for everyone. Some will just run a fabulous little business that gradually grows and, hopefully, takes a little bit of market share over time and creates jobs and income for the team and does a great job for their clients.
And have there been any trends? Obviously, we've seen an uptick -- what looks like an uptick in the amount of capital being deployed beyond that one large deal in the last -- but this current quarter, what looks like the quarter we're in, is there any trend going on there in terms of -- are we seeing more capital being deployed by these newer people that you've sort of highlighted, Mark? Or is it the same team just sort of -- the law of numbers showing up that odds are falling more on your side?
No, I think there's certainly some new capital deployers who are experiencing their first acquisition.
Okay. And then the last one for me this morning. Bernie, I know you're likely hard at work or having the team hard at work on pulling some of the data from Mark's annual letter here. Is there any view on sort of the IRRs you've seen or trending, if we think back? And I know we've got to look back maybe 3 to 5 years on deals. But are there any insights that are starting to come out in terms of what you've seen out of the results from those past capital deployments over that period of time?
Don't know if I could say that there are any real trends. Maybe over time, it will drop slightly. Certainly, with the new folks that are out there deploying capital, we're not going to get it all perfectly right every time we go out and make these acquisitions. But in the past few years, it's been rather stable. Prices out there are still really sky high for larger businesses. For smaller ones, it's still been reasonable.
Our next question comes from the line of Paul Treiber with RBC.
I was just hoping, could you disclose the number of acquisitions that are completed in Q1 -- sorry, Q4 and Q1? I didn't see it in the MD&A.
Yes. Paul, it was decided not to disclose that information.
Okay, that's fair. What's -- just what's the rationale for that?
We think it's the responsible thing to do for long-term shareholders.
Okay, that's fair. The -- I didn't see a disclosure on ROIC as well. Is there -- could you outline your thought process behind that?
Yes. If you think back, I think it was a couple of years ago maybe. In the President's Letter, I pointed out that ROIC can gradually deviate from IRR over time in asset-light business where you have organic growth. And so its utility as a measure can decrease. And then if you combine that with keep your capital, which is a incentive scheme whereby, if we are measuring people's performance on an ROIC basis, we are going to compound the capital as well. Then a really good business that doesn't deploy its capital will start to experience a radical drop in ROIC. Its utility to talk about the quality of a business is decreasing. So we want to deemphasize it with shareholders and get people increasingly focused on free cash flow. Because we think it's probably a better measure of the increase in intrinsic value, the increase in free cash flow. Internally, the single best measure that we have is IRR when we're looking at our acquisition discipline. And Bernie basically debates this with the managers of the business units every quarter for every transaction based on the incremental new information that comes in. And so we rely hugely on him and them to get that right, so that we're getting feedback into the system.
So I think the follow-up question to that is, have you changed how you base your performance internally for evaluating bonuses? I think in the past, it was based on ROIC plus organic growth as a kicker. Are you changing that methodology?
I had speculated that ROIC plus organic growth was perhaps the best method I could think of for vertical market software businesses to base compensation on. KYC, keep your capital, changes that equation, right? The ROIC, the denominator, starts mounting at a fairly torrid rate if you've got high-return investments. So you could easily see the denominator double in 3 to 4 years, which would half your ROIC. And so if you base your compensation on that, it could half your compensation. Now because we use total growth, not organic growth as the kicker, if you're actually deploying that capital, you've got to look at the calculation and do some modeling, and what you'll find is that you -- the growth kicker partly offsets the fact that you're carrying more capital assuming you're deploying it in good acquisitions. And so obviously, we've gone through this and thought through how keep your capital works in our incentive system, and we've made some adjustments for those managers who run keep your capital. So yes, there have been changes to the incentive system. We are trying to take operators and convert them into capital deployers, and we hope very much that it works.
So to summarize from an investor perspective, how do you see investors evaluating the performance of the company? Is it just purely on growth and free cash flow?
Well, I would think those would be very good ways to assess intrinsic value. Can you think of any others?
I think that's a fair way to do it. On free cash flow and cash flow from operations, the -- this is probably a question for Jamal. But the entire year for 2017, cash flow from operation was up 8%, whereas EBITDA -- or EBITA was up 18%. Just what was the divergence between those 2? And should that divergence reverse in 2019?
Yes. If you look at the differential between current tax expense and cash taxes paid and normalize for that, you'll get -- I think it's a 17% growth in cash flow versus 18% in any -- or something very close to that. The reason for that differential, it was just an anomaly. We were not cash tax payable in Canada in 2015. And as a result, in '16, we weren't paying a lot of installment payments, then we had to actually catch up for that in '17 plus pay installment payments in '17. So there was a big cash tax hit in '17. That will now sort of normalize, I would expect. And so I'd expect current tax and cash tax to be much more closer in 2018.
[Operator Instructions] Our next question comes from the line of Stephanie Price with CIBC.
On ACO, can you talk a bit about how the deal was sourced? And if you've changed your strategy for the larger deals at all?
Bernie?
We've known the folks at Acceo for about 10 years, give or take a couple of years; I'm based in Montreal. Gilles Létourneau, the CEO -- former CEO of Acceo, is based in Montreal. What about prospecting? We met him several times over the years and finally came time to sell the company, and I think we had developed a decent enough relationship with them, and we were able to buy them.
Okay, great. And in terms of the strategy of kind of pushing down the M&A autonomy, can you talk a bit about how the business units have responded and if the strategy has been working or started to work as expected?
Well, the people who've not previously employed capital are deploying capital. And so I guess that's indicative of the fact that it's working. In a few years' time, we'll know if those are as good investments as the ones that we've done historically and have generated similar IRRs.
Fair enough. And then just finally, on organic growth. It ticked up a bit this quarter. Wondering if there was anything driving that or anything you want to talk about on the growth organic side.
I mean, if you look at maintenance organic growth, you'll see it was pretty stable. The license and PS organic growth, there's multiple business units driving that, but no one material amount that I can talk to.
And our next question comes from the line of Ralph Garcea with Echelon.
Just a couple of questions. If you look at the deals, I guess, you've done earlier this year, pretty broad range of geographies, Denmark, Sweden, Croatia, the U.K., Canada. Should we expect more of geographically spread across the -- Eastern Europe, Western Europe? Or where are you seeing the better opportunities geographically?
I don't know that you could say better opportunities. Certainly, North America has been combed over. But we're still finding lots of very nice businesses in North America. So while we've added more M&A resources internationally as well as domestically, I think it's just a natural progression that we'll find more international acquisitions.
And as you're doing more international deals, I guess, on a EBITDA margin, I mean you've been at 25% the last 2 years. Do you see room there to get some operating leverage and we could see those margins expand 50 bps or 100 bps?
So the -- one of the best practices we use is to take larger business units and divide them up into smaller business units. And so I'm not sure where you get operating leverage out of that.
As you're doing more in region -- I mean, if you do more in Scandinavia, is there any operational leverage either from a G&A side or headcount or sales? Or do you get anything on the leverage side? Or should we just be modeling sort of 25% as a baseline going forward?
We don't really think there are huge economies of scale in software. We differ from other people and so we don't tend to expect it unless it's a tightly integrated acquisition where a 5% or 10% acquisition is coming in as a product line in some other business unit. There doesn't tend to be much.
Okay. And then from the Asia perspective, anything on the joint venture side? Or do you see any opportunity that you can disclose over the next couple of quarters?
As we've said before, it's very hard to predict the wins of acquisitions. But they are consistently adding prospects to the funnel in Japan.
Our next question comes from the line of Howard Leung with Veritas.
Just wanted to ask about the process in which the BU managers are now deploying capital. How much oversight or how much autonomy have you been giving these managers? And are they -- are the deals reviewed by the head office, the operating groups? I just want to find out more about the process there?
Bernie will talk about the process, but I just want to correct a misconception that probably was authored by me. I would love to have business unit managers doing capital deployment and driving acquisitions. I believe they will eventually get that. The bulk of our acquisition activity happens at the portfolio manager or player/coach level inside our organizations right now. Bernie, maybe you could talk about process.
Sure. So the process is, the M&A resources within the operating groups are the ones that are sourcing the prospects. Once there is an NDA in place with the prospect, the gathering of information and putting an offer together stays within the operating group. We're told about in the head office, and we see the numbers, and we see the proposals that are going out. And if we have any feedback for the operating groups, we'll give it to them. If not, it's just go ahead. And it's under the control of the heads of the operating groups themselves. So they manage the entire process up to the threshold of $20 million, where it requires board approval. And offers typically above that number would come to us first to see if we're okay with it. And if we're okay with it, we just go ahead and put up that offer. And then it's natural diligence, legals, and hopefully close.
That makes sense. So right now the portfolio managers, those are the ones who are being kind of groomed to make more acquisitions. Is that correct?
Mandated, I think, perhaps more than groomed.
Okay, that's fair. Just one for Jamal. Just following up on the note in the financial statement about the changes from IFRS 15. I think you mentioned last quarter there would be -- the effect would kind of be offset. There would be one part license fees that would have to be deferred amortized and the other part of license fees would have to be recognized immediately, so be there in offset. There was also a part about commissions and having to defer and amortize commissions now. Would there be any kind of impact on margins or -- especially, EBITA margins?
I don't have the final numbers yet. My thought is, still it's going to be an immaterial impact because of all the netting. We'll have crisp numbers in whatever, obviously, in Q1. But I wouldn't expect any major deviation. Clearly, cash flow is not going to change them.
Just an editorial comment. From my perspective, the changes to the accounting standards around revenue rec in software are a terrible idea. We are going to see tremendous scope for accounting that will reduce the quality of earnings potentially. And it's going to make acquisitions harder to do. It's driving me towards looking at cash constantly as opposed to looking at revenues and EBITAs, which have highly discretionary components in them with the advent of this new accounting. I think over the course of the next year, there's going to be tremendous confusion as we look at the numbers coming out of software companies.
That's fair. There is a lot more judgment in IFRS 15 versus the old standard.
And our next question comes from the line of [indiscernible]. He's a shareholder.
Mark, you mentioned long-term shareholders earlier in the call. Would you mind sharing some insight as to why the board views the current dividend policy as optimal for long-term shareholders?
It's a really good question. So I don't think if we have uses for the capital that we would continue to pay the dividend. And so right now we're sitting on cash, a fairly large chunk of it. And one of the things we have to think through is how we get that back to shareholders if we are unable to deploy it. And I think at some stage, that will inevitably -- not inevitably, obviously, we could ruin the business. But assuming that we can continue to be good custodians of the business, I think inevitably, there will be a time when we have to return cash to shareholders and then it will be a trade-off between buying back shares and paying dividends. The advantage of buying back shares is, the people who want cash, the shareholders who want cash get cash as opposed to those who don't want cash. And the dividends tend to put cash in the hands of everyone, all shareholders. So there's pros and cons to dividends versus share buybacks. I worry about buybacks because they can be done for the wrong reasons. So it's a pony one. In the particular case of the dividend that we currently pay, I think it does allow managers, who are shareholders, to receive some return on their shares without selling shares. And I think a number of them would feel disloyal if they were selling shares. And so it is a way of getting cash into their hands. And so, for instance, I feel that way. And even though I know in my heart of hearts that the dividend is a dumb idea, I wouldn't want to sell shares. It would disturb me. So there are sometimes emotional reasons for doing things. The dividend is becoming increasingly small compared to our overall cash flow and so we're retaining the problem of having it. But it is becoming less of a problem.
Got it. So it's more -- tends to be more -- a little bit more psychological. And I can definitely see the rationale around managers feeling like, hey, we don't want to sell shares, it's nice to get this cash every quarter.
There are no further questions at this time. I'll turn the call back over to you.
Okay. So one comment before we leave you. Thank you for joining us, obviously. The comment is, we're thinking of eliminating these calls. We don't believe they provide a lot of material information to shareholders. We'd love to hear from our long-term shareholders during the course of the next few weeks as to whether they think that's a good idea or not. So please do give Jamal or I a call or send us an e-mail. Thank you. That's it, Matt. You can wrap her up.
Thank you. This concludes today's conference call. You may now disconnect.