Constellation Software (TSX:CSU:CA)(OTCPK:CNSWF) has been an amazing long-term compounder. The company takes its earnings and purchases (mostly small) vertical market software businesses. Think the company that makes the software that a car wash, or doctor’s office, or golf course etc., runs on. These software businesses have individual niche markets. Because the buyers of the software have integrated it into the very core of operating their business it tends to be expensive and disruptive for them to switch providers, which allows Constellation to have very high retention of its clients. And because these businesses are often small, Constellation has been able to consistently buy them at very high expected returns, which has made the stock a home run for shareholders.
Of course, there is no such thing as a free lunch, and the company’s common shares now trade at very high multiples. That doesn’t mean it won’t work out for common shareholders, but it does require they continue to be able to reinvest capital at high rates of return into the future.
CEO Mark Leonard is a free thinker. He came up with an unbelievable idea (rolling up vertical market software businesses) and then combined that with unbelievable execution. Some of his innovations in the field of roll-ups (not compromising on hurdle rates, expanding the team to continue making small acquisitions) are arguably revolutionary. He also has some unique views on fairness. For example, he famously eschews the repurchase of stock, arguing that he and his managers have better information than the public shareholders so repurchases would be taking advantage of them. He also uses very little debt, but the terms of the one debt security they have issued are incredibly interesting.
The company has outstanding debentures traded on the Toronto Stock Exchange under the symbol CSU.DB. The debentures have a lengthy expiry, as they are not due until March 2040. The unusual portion of their terms is how payments are calculated. The interest rate floats at 6.5% PLUS the trailing All Items Canadian CPI inflation rate. The most recently reported inflation figure is 3.8%, so that would imply a 10.3% coupon rate when it resets next March.
Change in Debenture Terms
My previous article on these debentures was a few years ago, and it included a lengthy discussion on whether the company would exercise its right to redeem these debentures. As per their terms, the company can give notice that it plans to redeem them any year on their anniversary, in which case they would be redeemed at par 5 years later. That’s obviously quite an unusual redemption term, but even so I have historically felt that it held down the price of the debentures. It considerably reduced their yield to worst as they have historically (and now) traded well above par. However, in concert with their recent issuance of more of these debentures, they issued warrants to their common stock holders that essentially eliminate the risk of these getting called. Basically, if the debentures get called the holders can redeem a warrant and a debenture for a new debenture with the same terms (except the call rights). They’ve issued many more warrants than their outstanding debentures, and so this was basically just a complicated way for CSU to promise not to redeem the debentures while they were issuing more. That should have made their recent offering more marketable. And that recent issuance of more debentures is reason I think now is an opportune time to buy these.
The firm recently had a rights offering, where shareholders received rights that could be redeemed for debentures at the recent market price. Since the shareholders are largely growth stock investors and the debentures weren’t offered at a discount, the rights traded down to ~0 and the rights offering wasn’t fully subscribed. They raised $283 MM CAD of a possible $700 MM. That’s even though there was a potential arbitrage opportunity for essentially the entire time the rights offering was available. I sold my pre-existing debentures in the market (for a couple of percent more than the $133 per $100 in par value), and then bought rights (which were essentially free) to replace the position in the rights offering. However, that arbitrage trade only really worked for those with a pre-existing position in the debentures, because they can’t be borrowed for short sale (to the best of my knowledge). In any event, the liquidity here isn’t sufficient for a large scale arbitrage, but retail sized lots were possible.
I do think however, that the huge increase in supply has created a buying opportunity. The price of the debentures is down to $127 per $100 in par value, I think because of selling pressure from the rights offering. There would have been some traders who tried to do the arbitrage without hedging it, gambling that they could sell the debentures for more than $133 after the rights offering closed, and some buyers who have just changed their mind. In any case, the debentures haven’t traded this low since 2020 when the price of all securities was deeply affected by the COVID-19 pandemic.
Plus, the risk of the debentures being called early is now all but eliminated, which means they can be valued on yield to maturity and not yield to worst, which eliminates what I previously considered the largest risk to an investment here.
Calculating a yield to maturity here depends on what type of inflation forecast you use. Inflation has been above the Bank of Canada’s inflation target of 2% lately, but that target seems like a reasonable estimate of future inflation to use. Canadian real return bonds are currently trading with a break even inflation rate of just slightly lower than that, which is additional confirmation of that being in the ballpark. With that inflation assumption, the yield to maturity is ~6.3%, which is a decent spread to long corporate bond rates of 5.69%.
In terms of inflation, I think there’s a decent chance it averages more than that 2% forecast as well, which provides some additional potential upside. And in the near term the current coupon rate is 13.3% until March 2024 due to high inflation last year. I also think the credit quality here is probably higher than the average included in that BMO ETF I linked, as CSU is a great credit.
Their credit quality is extremely good here. Of their $69 billion enterprise value, only slightly more than $2 billion is debt. There would be plenty of ability for them to raise equity to avoid default even if their business declined markedly, because they have such a strong reputation among equity investors. Their debt to EBITDA is also well under 2X, so they should have no trouble making their payments, and even paying off their debt in short order if they wanted to. Finally, it’s worth noting that their business is more like a diversified fund of vertical market software operations. Even if one specific company in their portfolio failed, whether due to competition or some other reason, it wouldn’t be likely to affect their other hundreds of lines of business. That diversification means that only a small percentage of their operations need to survive in their current form for the debt to be repaid, and these are generally niche businesses with a moat in their small area, so that is a very low bar.
I think these debentures have sold off recently because of oversupply from the rights offering, and the removal of the issuer’s call option actually makes them more valuable than they were previously. That price decline has given them a yield to maturity higher than the average long term corporate bond in Canada, and I think their credit quality and the inflation protection makes this a more desirable security by a considerable amount than the average long term Canadian corporate bond. I particularly value the inflation protection, as inflation is a big risk for a fixed income portfolio and can otherwise be difficult to hedge.
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