Constellation Software: A People Business
One of my largest personal holdings is Constellation Software. The company is a serial acquirer of software businesses, which in turn serve an enormous range of highly unique industries, and in turn over 125,000 customers. The share price of Constellation has declined roughly 30% from all-time highs this past May for two reasons. One is due to the uncertainty of the impact of artificial intelligence (“AI”) tools on Constellation’s businesses. The other reason is Constellation’s founder and CEO, Mark Leonard, stepping down as CEO for health reasons. I’ll address both of these concerns and why I think they are not as bad as they seem for Constellation.
AI Tools and Software Development
The big concern surrounding AI and Constellation is it might lower the barrier to entry for new competitors into Constellation’s industry-specific software businesses. Constellation hosted a call on September 22 to field questions on this topic. Mark Leonard opened the call with the following:
Before we get going with the Q&A, I’d like to tell a story. It’s a true story. And it illustrates a useful but unsatisfying lesson, which I think we should all understand. In 2016, Jeff Hinton made a long-term forecast. For those of you who don’t know, Jeff, is known as the godfather of AI and is a Noble Prize winner for his work in the field.…
Jeff’s forecast in 2016 was that radiologists were going to be rapidly replaced by AI. And specifically, he said people should stop training radiologists now. And in the intervening nine years since he made that forecast, the number of radiologists has increased from 26,000 in the U.S. … to 30,500, or a 17% increase. Now, that’s outpaced the population growth in that period. So the number of radiologists per capita is up from 7.9% to 8.5%.
Now, Jeff wasn’t wrong about the applicability of AI to radiology. Where he was wrong was that the technology would replace people. Instead, it’s augmented people. The quality of care delivered by radiologists has improved and the number of practicing radiologists has increased.
My takeaways from Leonard’s introduction mirror his own. First, even if you’re a Nobel prize-winning expert, it is still nearly impossible to make long-term predictions. This is especially true if it deals with new and supposedly “game-changing” technologies. Second, it is still too early to know whether the business of software development will face, as Leonard said, a renaissance or a recession.
Furthermore, Leonard and several other Constellation leaders confirmed that most of Constellation’s software businesses have been experimenting with the latest AI tools for the last several years. They have been measuring productivity gains and determining whether these tools produce a good return on investment. The range of success is varied, but it sounds it’s been net-positive. However, there has not yet been a step-function improvement for any of Constellation’s thousand-plus businesses. At the very least, Constellation is not resting on its laurels.
In terms of Constellation suffering from a deluge of new competitors resulting from a reduced cost to build highly-specific software for niche industries, this is an unlikely outcome. Here are my three core reasons…
Industry Knowledge
An industry-specific software solution can only be developed by people with many years of experience within that specific industry. One must know the industry itself, and then one must also have a mastery of the workflows and processes that participants within that industry consider to be vital. As far as I know, it is human interaction and the slow accrual of experience that can best generate this knowledge.
Human Relationships Matter
While an organization can use AI tools to augment sales productivity (e.g., tools to increase the width of a sales funnel or to prioritize the most valuable potential customers), to sell almost any product or service will always require humans. Trust and personal relationships will always be a crucial differentiator in the sales process. The mission-critical software provided by Constellation cannot be sold without humans and neither can the AI-coded software from potential new competitors.
Continuous Improvement and Evolution
Businesses within Constellation will intelligently adopt the best AI tools and they will share and spread best practices to all the other businesses within Constellation just as they have done over the prior decades. In other words, any benefits from AI tools that potential new competitors might enjoy will be equally available to Constellation.
Mark Leonard Stepping Down as CEO
Although it is extraordinarily sad Leonard had to step down as CEO for health reasons, it does not change my investment thesis about the company. For Constellation’s first two decades of existence, Leonard was highly involved in allocating capital, searching for and likely approving every acquisition. As Constellation grew its annual free cash flows into the hundred of millions of dollars, Leonard recognized that for capital allocation to continue at a rapid pace, he needed to push down authority and responsibility for making acquisitions to lower levels of business unit leaders. As a result, the majority of Constellation’s acquisitions over the last decade have been made by people who are not Mark Leonard. In contrast, Leonard has devoted more of his time in the last decade developing the people of Constellation who will lead the business into the future. Although Leonard will be missed, Constellation will continue to thrive despite his absence.
Constellation’s new CEO will be Mark Miller. Miller was originally part of Trapeze, Constellation’s very first acquisition in 1995. Since then, Miller has grown as a manager, a leader, a developer of people, and as a capital allocator. Miller is absolutely on the same page as Leonard. He is a Constellation “lifer” and there is nothing to suggest he is incapable of guiding the continued success of Constellation.
My Final Thoughts
Constellation is literally its namesake: a constellation of niche, software businesses run in a highly decentralized fashion, but with basic principles that binds them all together. Constellation reinvests nearly all of its cash flows generated from its current businesses to build, buy, and grow software businesses.
If one had been able to recognize Constellation’s unique business model and extraordinary founder, they could have purchased shares for $16.66 CAD per share on 10/23/07. Then, if they had the fortitude to hold for the next 18 years, Constellation’s share price would then compound to $3,694 CAD per share. That’s an annualized return of 35%, which excludes the regular and special dividends its shareholders received over the years. Compare this to the 10.7% annualized return of the S&P 500 index over the same period.
Let me end my thoughts on Constellation by quoting Bob Kierlin, founder of Fastenal, a maker and distributor of the basic nuts, bolts, fasteners, and other supplies needed by other manufacturing businesses. Kierlin left an incredible legacy for future Fastenal employees, managers, and investors:
“If I had to pick one of the most satisfactory moments during my years at Fastenal, it would be when I stepped away from a leadership role. The satisfaction came not from a sense of having more time for other interests, but rather from a realization that Fastenal would continue its success without me. The success of Fastenal comes not from its founders, but rather from their belief in the potential of good people to accomplish great things.”
Mark Leonard only stepped down as CEO due to health concerns, but I am certain he would echo Kierlin’s sentiment. Leonard, along with the help of many long-time Constellation managers and directors of its board, purposefully built Constellation to outlast any one person.
Although it builds, acquires, and permanently owns, niche software businesses, Constellation at its core is a people business.
It requires people to: understand the requirements and specifications of its software; develop the software; test the software; sell the software; support the software; and continually improve the software based on the ever-changing needs of its customers.
AI, at this point, is more an opportunity than a threat.
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Disclaimers for this Substack
The content of this publication is for entertainment and educational purposes only and should not be considered a recommendation to buy or sell any particular security. The opinions expressed herein are those of Douglas Ott in his personal capacity and are subject to change without notice. Consider the investment objectives, risks, and expenses before investing.
Investment strategies managed by Andvari Associates LLC, Doug’s employer, may have a position in the securities or assets discussed in any of its writings. Doug himself may have a position in the securities or assets discussed in any of his writings. Securities mentioned may not be representative of Andvari’s or Doug’s current or future investments. Andvari or Doug may re-evaluate their holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
Data sources for all charts come from SEC filings, Koyfin, and other publicly available information.
Thanks, Doug 💚 🥃
I agree, a lot of people not familiar with VMS underestimate how much industry knowledge is required to do a good job, and how little incentive there is for most customers to transition away the software on which their core operations run in favor of something else of unknown reliability and performance... and the upside is what, saving low single digit percentages of expenses, if that?
Great read, thanks. I was wondering if you had an opinion on the speculation that CSU may not be able to carry on acquiring businesses as it has done in the past, thus leading to a big slowdown in growth and performance?