Constellation Software (CSU) Stock is a Steal

Constellation Software (CSU) stock continued to fall, dropping 5% more after reporting a strong Q3 with 16% revenue growth and 46% free cash flow growth. In my recent portfolio update, I have explained in detail why AI disruption and the resignation of previous president Mark Leonard is not a concern for me. You can read it here.

If we take a look at CSU's current valuation (C$3235 per share) and try to run a DCF valuation with very conservative assumptions below:

1. 12% annual free cash flow growth. This assumes no efficiency gains from AI, and the growth rate slows to 12% (This is the long term growth rate mentioned in 2018 president letter)

2. P/FCF ratio of 20 in 5 years (avg was 26)

3. Discount rate of 10%

This gives a intrinsic value of C$3546 per share as shown in the figure below, or a 12% annual return, which is not bad.

Considering the company was able to grow revenue by 15% per year currently by re-investing only about half of the cash flow — $955 million out of $1944 million invested in recent 9 months (See Figure 2) — a slower future growth rate would indicate a failure of finding sufficient acquisition targets, which will result in $1 billion ($1.4 billion) or more of excess cash flow per year. This excess cash will potentially be distributed to shareholders via special dividends (this happened before), and this amount will likely increase over time, resulting in a 1-2% long term dividend yield. Adding the possible dividends to our return projection, we can reasonably expect a long term annual return of 13-14%, which is pretty good.

Now if we try to be a bit more optimistic about the company, which I believe is reasonable given CSU's track record, we can expect the company to re-invest most of the cash flows into larger acquisition deals, albeit at lower hurdle rates. To reflect this scenario I will adjust my DCF assumptions to the following:

1. 15% annual free cash flow growth.

2. P/FCF ratio of 25 in 5 years (avg was 26)

3. Discount rate of 10%

This projection gives an intrinsic value of C$5051, or a 20.3% annual return for the next 5 years (See Figure 3). In summary, investing in CSU stock at current prices could potentially generate 13% - 20% annual return. I personally believe the return could be even higher if CSU can utilize more AI and continue to improve its efficiency. I plan to continue buying this high quality company at current prices whenever I have cash available.

Further Readings

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DISCLAIMER: Solofire is not a registered financial advisor. This post contains author's personal opinion only and it should NOT be considered financial advice.