Constellation Software Inc. (CSU) Earnings Call Transcript & Summary

Good day, and welcome to the Constellation Software Conference Call and Webcast. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Mark Miller, President of Constellation Software. Please go ahead.

Thank you. Good morning, and thank you all for joining our Q2 call. Before we get to questions, 2 things I wanted to put on the table upfront. The first is AI. It is changing 2 things for us. Our customers are asking our software to do more for them while our businesses are finding new ways to build better products faster. We are seeing both. What we are not doing is running an AI program out of head office. Our business unit managers to understand their verticals far better than we do, and they are making those calls themselves at their own pace, funded out of their own P&Ls. Some of that work will pay for itself and some of it will not. And we will find out the same way we find out about everything else we fund, which is slowly. As many of our businesses have been adopting AI, we are seeing them use the tools to rapidly move through our customer-driven product road maps and augment our products with AI functionality. Let me be direct about what that means to you. We are not going to give you an AI target, an AI revenue line or an AI time line. If we start reporting a number like that, we will start managing to it. Our software is primarily mission-critical. It is embedded in how a customer runs their businesses every day. AI is something we add to make that software more valuable. The second thing we've been working on is verticalization. We have been grouping our businesses and our prospects into coherent verticals where possible. The purpose is simple. We want to be the obvious permanent owner of a niche so that when a founder starts thinking about the next 20 years and selling their business, we are the first call. That kind of reputation takes years to build. It will not show up in this quarter's results or next year, but I would ask you not to look for it there. The constraint is not structured. It is having the right leader for each vertical, and leaders of that caliber take a long time to develop. We are setting the pace accordingly. The 2 are connected. Depth in a vertical is what lets you tell the difference between an AI product that matters to a customer and one that merely demonstrates well. We would rather have that judgment sitting close to the customer and understanding their needs. So thank you very much, and I'll turn it over for questions.

[Operator Instructions] Our first question comes from Thanos Moschopoulos with BMO Capital Markets.

I want to ask for an AI metric, but just qualitatively, as you look across the portfolio, are you seeing a growing number of examples of businesses that are starting to see an uptick in organic growth driven by AI product enhancements, the way we heard some of the case studies at the AGM? Is there more and more of that happening in the portfolio that you can see too?

What we're seeing, Thanos, is we're seeing our development process is getting much better. They're moving faster through backlog. So we're seeing a productivity increase, I think, across the group, not everywhere, but it's starting to adopt because we spend a lot of time working on training up the -- all of our resources on how to use AI tools better for development. And right now, they're working to talk to customers about potential add-ons or additions to their products that are using some of this functionality to develop the software, but we still haven't seen a real pickup in organic growth from it. I think that's a ways out. what I always say, you can build products fast, but selling them is a whole other thing. A customer has a budget for them and see -- and you have to be solving a need that they're willing to put some money on the table for before it's going to impact our organic growth. So I think that's consistent with what we've seen in previous quarters. I'm just really happy to see our teams adopting the tools to develop software faster and more efficiently than ever before.

Great. And then we've seen some acquisitions you've done recently with Derby Soft Touch [indiscernible]. Is that indicative of a broader trend with respect to valuations coming down on larger assets? Or kind of more of a case-by-case thing?

I think it's the latter. It's Bernie here. It's more on a case-by-case thing. And we're finding acquisition opportunities across the spectrum from owner managers to PE, to carve-outs. So those are still coming through. It just so happens that we had significant volume this past quarter and the beginning of the third quarter. So we're still seeing all of these opportunities proliferate, but it takes a lot of time, and we've developed these relationships over the long term. It just so happens that some of them happened and just took place this quarter. So we were very fortunate that we're the first ones that they called. And we managed to close a whole [indiscernible].

Our next question comes from Stephanie Price with CIBC.

I just wanted to circle back on your comments around grouping businesses into verticals. It's a little bit different than CSU's historical focus on kind of not integrating these acquisitions. Just curious if you could talk a little bit about what's changed in the market that led you to evolve into a potentially more vertical market focus and whether the verticals will be between different operating groups or how you think about those verticals?

It's a good question, Stephanie. It's really -- we're not integrating businesses. There's no business integration going on in it. We're just trying to make sure where there's a chance to, let's say, I like to use a Constellation expression, put them in the same orbit together, where they're not, if they're across operating groups, we'll move a few businesses in order to try to make sure that there's someone who oversees a particular vertical. And it allows us to use some of these tools that we're seeing with AI that we might be able to use across some of those verticals. But that's the hypothesis. Time will tell. We've had good success when we've had vertical-focused leaders inside of Constellation that have created, for example, a lumen and things like that. So I really do -- I'm just trying to refine that a little bit and get the businesses that should be closer together, closer together, but I do not plan on, or we don't have any plans to integrate them in any way functionally or in any other way. But if they're a little closer together, they might be a little bit more from each other and a position them better for the next 5 to 10 years.

Okay. That's good color. And then maybe on Altera. So Altera's organic maintenance and recurring growth decelerated in the quarter. Just curious if a large client decided not to renew like, how should we think about the Altera organic maintenance growth and Altera going forward?

Yes. I try to put it in the MD&A there is set, that it was a very -- like in Q2 '25, they had a very strong quarter. So they actually had a couple of new name sales. And the way IFRS makes us account for things now. If you have a large contract, you have to recognize a certain amount upfront. So they actually showed it was positive 1% organic growth in Q2 of '25, yet the trend line for this business is going to be a slow shrink for the next year or so or a couple of years, I would say. And so that is the driver of it. So if you normalize for that strong Q2 '25, things are -- there's nothing terrible going on. So I'd expect that organic growth to revert back on a full year basis to sort of what it has been trending at recently.

Our next question comes from David Kwan with TD Cowen.

Just echoing on that last comment on the organic growth, Jamal. So even if you exclude Altera from the maintenance of the recurring revenue growth in constant currency, it came out at 4%, which is below the historical range of 5% to 6%. So was there other stuff out that you call out, I guess, as it relates to the organic growth?

Yes. I mean there's a couple of other items like it's tough because you don't talk to specific BUs in the MD&A. But we had a couple of larger acquisitions like a dark matter where a similar thing, where in Q2 '25, they actually recorded organic growth of -- it was 10%, right? And again, this is a business that we're still fixing has negative organic growth right now, but you had this huge Q2 '25, and this so therefore, you've got like a negative 18% in Q2 '26 because of that comp. But the other thing, if you look at some recent acquisitions, so Lumin is broken out. You can see that they've made some large acquisitions recently that they're pulling out. Their organic growth in the quarter was 1%, right? So again, a drag on CSI, but things that they're expecting to turn around. And then there was another large -- or a business that we had in South America, where they lost a large customer. But this is an example of business that we knew at the time we acquired it, that, that customer is leaving, has nothing to do with AI. The customer has now left, but it was sizable. And I mean that customer loan was like a 30-basis-point drag on CSI's numbers, right? So there's a few of these like one-offs that are causing it. Many -- or the 2 that I talked about, like the Altera and the dark matter are purely accounting related and should revert back next quarter. The Lumen thing is like they're fixing these businesses. I don't know the exact time line of when they expect to turn around, but yes, that -- I could -- if you back out those 3, 4 things, could you'd normalize back down to that sort of 5% number that we've always trended at.

No, I appreciate the color. And are there any of these kind of whether it's tougher year-over-year comps or maybe some customer -- larger customer attrition that we should be looking out for in the coming quarters? Or does it look a little bit more normalized?

Like my expectation based on what we own today, it's normalized, like we were so making a lot of large acquisitions. And I have not analyzed those to see what their impact will be in the next quarter or so. And -- but yes, based on what we own today, I would say, yes, I would expect these anomalies to sort of revert back. I'm not expecting another large customer leaving or anything based on what we have today.

Yes. That's helpful. And maybe 1 question on Bernie. I think you kind of talked about some of the deal flows and more increased deal flows of, say, larger deals, $100 million, a few hundred million dollars. So it sounds like you're seeing more of that. Are you obviously seeing better win rates for those deals? Like how is the competition for them?

Yes, I think the competition is still very robust. No one is giving up on vertical software, whether it's large or small. We're seeing some weaknesses at the high end, but -- in pricing, but very, very competitive. So it's not like we're increasing our win rates or anything like that. It's same old try to get as much as we can. I don't see any improvement, but we had so many people out there looking for acquisitions across the board or across the globe. And it's a matter of developing those relationships over the long term.

Can you comment -- have you seen any changes within the kind of the competitors for the businesses, whether they're [indiscernible], strategics, financial buyers?

The copy cats are still out there. I don't see any new ones that are pumping up really. It's more of the ones that have popped up in the last 5 to 10 years, and those still exist, and they're still competing for businesses. And I expect that to continue for still quite some time until maybe some of those portfolios decide that it's time to move on and they don't want to go public and they just want to sell because it's PE backed and there's a limit to their funds. So I don't see any changes there. I don't hear of new ones popping up or if there are they're very small, and we hope to pick those up at some point in the future, if at all possible. And hopefully, at some point in the future, the number of coffee cat starts to reduce, but we just don't -- we can't predict that. We don't know.

And one last question maybe for Mark. When you were talking about the verticalization, are you changing in terms of the M&A and the BD teams for that? And how do you see an impact on potential movements in the portfolio for these, or the companies within the pipeline for the personnel there?

Well, we've seen a lot of -- when we have vertical groups that are larger inside of Constellation, we've seen a lot of success deploying capital in those vertical groups. So definitely, some of the M&A resources will be better aligned to verticals than stepping outside of them in some cases. So there definitely will be some changes related to that.

Our next question comes from Paul Treiber with RBC Capital Markets.

Just hoping, could you speak to the profitability of the 2026 cohort of acquisitions? Is it fairly typical and comparable to other cohorts? Or do you see a change there?

Yes. I mean, I think I called it out last quarter that it was like negative margins, but there were a couple large -- it's more the purchase accounting, like there were some bonuses that we couldn't put as part of the purchase equation to be an expense, et cetera. But that cohort in Q2 meant from being, I think it was negative 16% in Q1 and it's now positive 16% in Q2. So it's going to trend up. The 2025 cohort, similar to thing, like I think it started off around 16%, 17%, it's up to 20%. So it's moving up. So -- but all the -- it's not these businesses will continue that way, like it's just taking time to improve them to the levels, but if you look at all the cohorts prior to that, like they're probably in the 30s or high 20s, right? And so it's just taking longer for them to go there. But no, it's not not going to be inherently lower forever.

Okay. That's helpful. Second question is just specifically on Derby Soft, I mean there are some disclosures in the MD&A. Is it fair to annualize the revenue -- the disclosed revenue in the MD&A and you get to roughly the $100 million and the purchase price is $400 million. The multiple seems high. Is there anything wrong with my math, one? And then secondly, is there any reason for the multiple being higher than typical?

You want to talk to the multiple?

Yes, it is a high multiple, but it's a very successful organization. It's growing nicely, good profitability. It can always be a bit better, but that's what our expectations are of the business. It's a very solid business.

I mean we did use leverage as well, right? And so remember that helps us pay a little bit more but...

We've been grade also have a great team at compensation working on that in Paul as well.

the punchline on the multiple is that you still expect the IRR to be in line with acquisitions with similar size?

Absolutely. Merge rates aren't changing

Our next question comes from Douglas [indiscernible] Dairy Associates.

All I've got 2 topics I'd like to ask a few questions on each. First is Altera. And I just want to thank you for the ongoing disclosure for that asset. It's been very helpful, and I'm very appreciative of that to be able to track the progress on Altera. So we've crossed the 4-year anniversary. We acquired it in May 2022 and since then, according to my math, that's generated a cumulative $400 million in free cash flow, all while revenues have declined from a little over $800 million, so you now about [ $646 ]million in 12 months. First question is, do you think these results have tracked your initial expectations?

Yes. I mean I'm not closely involved with the business, but I have the CEO of Harris has talked to it at the Board meetings, and he has said, yes, it is aligned with sort of what they expected from the investment thesis, and it's aligned. It's actually just operating ahead of what the expected IRR was in the original investment so...

Got it. And also on Altera, I was curious if anyone could share any general learnings that you've had since acquiring it? What has surprised you good or bad since acquiring all tariff from Allscripts? And have you been able to buy any of those learnings to acquisitions since then?

I would think generally just -- it's a very large acquisition, and it's something we've been learning how to do better over the last 5, 6 years. We've done a bunch of larger acquisitions. And one of the key learnings is driving best practices is harder to larger acquisitions. You can't drive them as fast. So the ability to maybe break the business up into, let's say, what you would call smaller business units is something that we're trying to do faster when we can, when we acquire an above average sized acquisition for us. And so that's how quickly can you do that is really defined so we believe you can improve the business. So -- but that's just ongoing. And that will probably be the biggest focus to be bringing on a add something to that. It's just driving best practices is harder in large acqujisitions.

The complexity of larger businesses is really the challenge. And the various groupings different product lines, you have to manage them as a portfolio. And because we do that on a portfolio basis in CSI, we have that experience already, but there's -- there are cultures that are just different from what we're used to at CSI and some things have to change, and it's just a little more difficult to change them.

Back when we were doing smaller acquisitions or there are sort of $5 million in size, $4 million or $5 million in size, looks really easy for 1 person to wrap the head around what had to be done to do that acquisition, how it should be improved, what best practices you could apply to it. When you're working with a much larger acquisition like an Altera or even a [indiscernible] or any of these, you have to really be thinking about a team of people helping you think through what to do there and implement it, which you didn't have to do in earlier days when you're doing smaller acquisitions. One of the nice things about us is as we've learned how to do that a lot better and more people are able to think that way than we would have, let's say, 10 and 15 years ago.

Yes. All right. So second Second topic for me is continuing on the corporate carve-out. So I guess, in general, I mean, like the difference between a small acquisition and a big acquisition, you have to change how you approach things and try the best practices, but, on carve outs, is there any reason that they're a bit [indiscernible]? Can you talk about those reasons? Are there -- when it comes to analyzing it as an investment opportunity, what sorts of financial adjustments you have to make with sort of qualitative adjustments you have to make? Are there different risks? Are they greater or lesser and other types of risks? I just appreciate some more thoughts there.

Yes. I mean we'd get better than every time we do. I mean, Bernie might want to might want to add on this, but they're interesting because it isn't they're not clearly all of their financial statements aren't fully separated out. In a lot of cases, they're interwoven together. You have to separate them from internal systems that they're on. There's, yes, there's a whole bunch of carve-out things that really you have to manage carefully. And plus whoever you're buying the carve-out from, they really care where their customers end up in a lot of cases, right? So you've also got to balance that as well. So there's a lot of things you do differently with a carve out that you wouldn't with a stand-alone acquisition. Bernie, what would you add to that?

The same goes for the way we look at businesses in terms of return on investment. And every decision that we make within our business is based on return on investment. And if we can't see that return, we just won't do it unless it's really, really strategic as it were -- and a lot of the businesses that we do get from carve outs don't look at their businesses that way. And so that's a bit of an infusion that we give them. And we try to set their minds towards measuring that investment. And so -- and there are lots of decisions that these businesses make on a regular basis. And when it's a larger business with various product lines, you have to take that decision, make them more granular and infuse that kind of thinking into the people that make those decisions.

But generally not very balance sheet driven, right? They're not thinking about their balance sheet and that's -- the balance sheet is obviously something pretty important to understand and us figuring out what that is and getting them to think about managing the working capital is harder than it would be for a standalone business because it's not using not a separate balance sheet for that particular carve-out.