Summary
On January 5th, 2021 Constellation Software (CSI) concluded the spin-out of Topicus.com (or Topicus/TOI). TOI’s main subsidiary is Topicus Coop, which fully consolidates TSS and Topicus.com BV, along with other entities such as Sygnity and GeoSoftware.
They all are VMS - in full, vertical market software - companies. Unlike horizontal software, which is designed to be used across a wide range of industries and applications, this type of software is tailored to the unique requirements of a particular industry, such as healthcare, finance, or manufacturing.
As a result, the total addressable market for each of Topicus’ business units is quite constrained, leading to stable market share and not much attraction of new competition. Just like CSI, Topicus should be viewed as a perpetual accumulator of cash-minting VMS businesses.
We believe that Topicus.com is somewhat misunderstood by investors, due to the absence of conference calls and the unique manner in which the company was incorporated being CSI’s first-time spin-out and the existence of significant non-controlling interests (Topicus.com shareholders vs. direct owners of Topicus Coop). When relying on stock screeners, chances are that serial acquirers like Topicus.com won’t make the cut to receive the compounding quality label. That’s precisely why we don’t use stock screeners to base our decisions.
For those of you who aren’t yet familiar with Constellation Software’s long-term vision, we recommend reading all of Mark Leonard’s annual letters to shareholders.
This deep dive will cover the following topics:
Introduction to Topicus.com
Seeing through the tough comps and one-offs
The TSS and Topicus.com BV Deals - how they were structured (including a reconciliation of the forward 8-to-9-year cash ROIC on the Topicus.com BV acquisition)
Under CSI’s wings, profitability is everything
Organic growth drivers and profitability
Acquisitions, cash Flows and NFP
Base Case valuation model, drivers and risks
Introduction to Topicus.com
First off, CSI purchased the Netherlands-based TSS in December 2013. It was somehow a game changer: CSI’s M&A expertise lies primarily in doing smaller roll-ups. Nonetheless, TSS had plentiful characteristics that Mark Leonard found appealing: it had already built a dominant position in some Benelux’ verticals, it focused on the rollout of successful customized products and TSS was no stranger to decentralization. CSI praised the very long-term thinking by its management team (Robin van Poelje) and its local reputation as a permanent home for (family-led) VMS business. After completing the merger, CSI managed to dramatically improve TSS’ M&A scaling opportunities and profitability metrics by applying the proven decentralized playbook and sharing best practices.
Then back in 2020, TSS and Topicus.com BV both being seated in the Netherlands agreed to join forces, paving the way for a new CSI tactic: structuring the two larger companies as a public standalone entity. The acquisition of its smaller VMS peer by TSS was finalized through a combination of a cash payment and the issuance of new equity. CSI distributed nearly all of its Topicus.com subordinate voting shares, which it already had through its longstanding ownership in the Coop, to its shareholders. The shares of Topicus.com got publicly listed on the market on February 5th, 2021.
In May 2021, the Topicus.com BV vendors (IJssel BV) reinvested 20.7% of the cash proceeds by paying an additional subscription amount to Topicus.com. Surprisingly to note that despite this reinvestment, their economic interest in Topicus.com (or the Coop) remained unchanged at 9%.
Fully according to plan, Topicus was brought to market at a generous multiple (roughly 40x NOPAT), exceeding CSI’s typical 30x. That’s the icing on the cake: a notable valuation step-up so that the return on CSI’s remaining economic ownership exceeds its hurdle rate. Floating shares at their intrinsic value multiple simply doesn’t provide the kicker Mark Leonard, CSI’s founder and CEO, is aiming for.
That valuation wasn’t even stretched enough: the 2021-everything-bubble pushed it to excessively high multiples of more than 80 times realized 2021 NOPAT. Undoubtedly, the hindsight bias proves to be extremely useful in illustrating the severe consequences overvaluation can have on one's short-term returns. However, it cannot be denied that investors flocked to Topicus.com with the belief that they had stumbled upon the new CSI gold.
Frankly, there is only one CSI, just as there is only one Topicus, Lumine, Harris Operating Group, and others. And there is nothing wrong with that. Each of these entities possesses their own legacy business, return on invested capital (ROIC), and pool of reinvestment opportunities, among other factors.
In summary, we believe that investors did not properly assess the value of TOI at the time of the spin-out.
Seeing Through the Tough Comps and One-Offs
The 2021 bubble burst, but for Topicus’ stock there was more than meets the eye: it was CSI’s first-time spin-out. Ergo, what should we expect from CSI’s European VMS “baby”? TOI has a quite low free float. There was confusion around the diluted vs. basic shares outstanding, the one-time preferred dividend cash overhang and conversion into ordinary shares. On top of that, investors were fretting about TOI’s lower organic growth during the COVID-19 period. After a span of two years, we finally have lapped difficult comps and one-off financial items.
The performance of TOI in the past and its anticipated returns will always be compared to its parent company, CSI. To cut to the chase, the investment case for TOI can be described as:
Achieving high ROIC on acquisitions (20-25% based on NOPAT), exceeding that of CSI.
Achieving high organic growth with a relatively small spend on R&D, exceeding CSI’s. Constellation’s growth is still somewhat hampered by the Altera shrinkage, which is offset by strong expected growth for the deals that were closed with Black Knight last September. The organic growth runway looks stronger at Topicus.
Benefiting from its smaller scale so that frequent bread-and-butter type acquisitions can continue to move the needle for a long period of time.
Redeploying as much FCF as possible back into M&A and refraining from paying out ‘superfluous’ dividends.
Taking advantage of the fragmented European VMS landscape, sharing best practices, bringing cross-selling opportunities come to fruition (Topicus.com BV exhibits noticeably stronger organic growth than TSS) while still capitalizing on the CSI ecosystem.
The TSS and Topicus.com BV Deals - How They Were Structured
Let’s first start off by reviewing TSS’ financial development. In 2013, CSI closed the acquisition for a total cash consideration of 240 million EUR or 1.36x LTM revenue and 7.7x LTM EBITA. Including a net debt position of 21.7 million EUR, the EV/EBITA lands at 8.4x.
To safeguard continuity, Joday (Strikwerda Family Office), the TSS seller, and CSI agreed on a long-term membership agreement under which Robin van Poelje remained the TSS CEO and Joday retained 33.29% of the voting interests (for which they paid 39 million EUR to CSI). This agreement became effective in Q4 2014.
As per the IFRS rules, Joday’s ownership was (and to this day still is) not being treated in CSI’s financials as a non-controlling interest. Basically, CSI is entitled to retain all of the free cash flow that is related to Joday’s stake in TSS, which means that the free cash flow belonging to CSI shareholders is higher than what you intuitively would have expected.
The cost of including Joday’s cash flows into CSI’s is being reflected in the TSS membership agreement/IRGA liability. The revaluation of TSS membership agreement liability covering different put-call scenarios that grant CSI the option to purchase Joday's stake under highly attractive conditions, occurs quarterly and is based on the growth in maintenance revenues. These charges remain non-cash expenses. Any intermediate preferred dividends or cash distributions are subtracted from CSI's outstanding TSS membership agreement/IRGA liability. It is important to note that the book value of Joday's stake in TSS and later Topicus.com (with a 30.29% ownership) does not accurately represent its underlying economic value.
Fortunately, the above mentioned situation doesn’t interfere with modeling TOI’s intrinsic value.
So back to TSS acquiring Topicus.com BV and the spin-out transaction. Topicus.com BV’s FY2019 gross revenues amounted to 101 million EUR, which presumably translated into 110-114 million EUR for FY2020. The initial total consideration of 217.4 million EUR paid by TSS (CSI/Joday, i.e. the Coop) was structured as follows:
An aggregate cash consideration of 133.6 million EUR (drawn from the Coop’s Credit Facility)
Newly issued Topicus Coop preferred units worth 83.8 million EUR (1-for-1 exchangeable for ordinary Subordinate Voting Shares in Topicus.com). IJssel BV then paid 27.6 million EUR to Topicus.com, thereby reinvesting 20.7% of their received cash proceeds back into the newly combined entity.
In order to create its first-time spin-out company, CSI went ahead with a corporate reorganization to form Topicus.com, the controlling and consolidating entity above Topicus Coop.
To keep things brief (it will all come back in the analysis of the financial statements), CSI used to own 60.7% of the total diluted shares outstanding before distributing half of that direct ownership to its shareholders (they became the public owners).
Today, Joday (the TSS sellers) still retains 30.3%, whilst IJssel holds 9% of the total Subordinate Voting Shares. Therefore, Topicus.com is the listed holdco with Joday and IJssel being the main non-controlling interests (given their 39.3% interest in the Coop, which is 1-for-1 exchangeable with ordinary Topicus.com shares).
Without further ado, let’s now examine the return profile on the Topicus.com BV’s deal. Based on a 23% EBITA margin and assuming no net debt, Topicus.com BV’s 2020 EV/EBITA came in at 8.4x, in the ballpark of the multiple paid for TSS.
Now, this multiple isn’t the sub 4x TSS usually gets up paying for smaller VMS acquisitions. So, the after-tax un-levered ROIC (based on NOPAT) on the total consideration in year 1 seems to be in the high single digits (9%). This ROIC does not properly reflect the underlying ROIC as it neglects four key elements:
Reported net profit is considerably lower than the underlying FCF due to amortization of acquisition-related intangibles (i.e. purchase price allocation).
Topicus.com BV’s organic growth rate is HSD to LDD. For a VMS business, growing organically doesn’t normally consume cash flow. We believe spending on organic growth that’s expensed through the P&L is offset by revenue growth.
The total consideration got reduced by the 27.6 million EUR paid by IJssel 5 months afterwards. This leads to an EV/EBITA of 7.4x.
The cash IRR is much higher. TSS/CSI paid 133.6 million EUR in cash.
