Constellation Software’s growth engine is slowing, National Bank Financial says

National Bank Financial’s Richard Tse has his doubts about Constellation Software (Constellation Software Stock Quote, Chart TSX:CSU) after its latest quarterly earnings, but the analyst is maintaining his “Sector Perform” rating, nonetheless, saying that at current levels, the stock is reasonably valued.

Vertical market software company Constellation brought in its first quarter fiscal 2019 results on Wednesday, which included revenue of $819 million, a 14-per-cent increase year-over-year, and Adjusted EBITA of $179 million, a 13-per-cent year-over-year increase. (All figures in US dollars unless noted otherwise.)

In an update to clients on Friday, Tse judged the quarter as having soft results, with revenue slightly higher than his $815.2 million estimate and Adjusted EPS of $5.97 per share coming in lower than his $7.85 per share estimate.

Tse pulled a number of takeaways from the quarter and from management’s comments at the recent AGM, namely: Constellation deployed approximately $70 million in capital over its first quarter, while Tse is expecting about $650 million in total capital deployment for the fiscal year in order for the company to maintain its growth rate in the mid-teens, thus leading to his conclusion that capital deployment is behind his growth expectations; management has indicated that debt rather than private equity is its favoured approach to accelerate the pace of acquisitions; and management is keeping with its approach of being cautious when it comes to taking on SaaS businesses.

“Constellation indicated that it would be lowering its hurdle rate (on bigger) acquisitions,” says Tse. “This follows last quarter’s special dividend and a capital deployment rate that’s tracking below what we believe is required to maintain the Company’s forecast growth rate and Management’s own commentary on the slowing pace of acquisitions at their AGM yesterday. Given all that, it shouldn’t take much to think that Constellation’s primary growth engine (acquisitions) is slowing.”

“Yet, the stock was down 1.6 per cent yesterday. For most companies in our coverage, there would not be such leeway but then this is not most companies – it’s Constellation, one of the best performing stocks on TSX since its IPO. The reality is that we’re not ignorant to the mechanics of the stock (tightly held, low trade volume) that’s underscored by a loyal following – that’s something we can’t discount. Bottom line, it’s for those reasons why at 20.6x EV/EBITDA – it’s still reasonably valued and why we maintain our Sector Perform,” he says.

Tse is also maintaining his target price of C$1,200, which translates to a projected return of one per cent at the time of publication.

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