Dividends and Constellation’s next step: expansion through larger takeovers

Large profitable companies often remain large and profitable because they constantly buy smaller companies and integrate them into the larger company. It is the nature of the beast, when companies have excess cash flow they can reinvest in the company, buy back stock, increase their dividend or wait for opportunities to buy another company.

In an article by Andrew Willis of the Globe and Mail, a software company called Constellation Software is one of the leading software companies in many niche or specialized markets and is worth over $40 billion. Over the past quarter of a century it has bought over 90 companies. The company specializes in vertical market software. For example 10,000 libraries around the world use a firm called Softlink International, Constellation owns it.

Constellation was looking to do more acquisitions of over $300 million, however they found they had a problem. The company tracked every major software acquisition over the past 6 years which is between 40 and 70 companies a year. Most of these companies were sold by investment bankers at an auction, but Constellation was not being invited to the auction. The company’s research showed they were being asked to bid on just 16% of the sales.

The reason is investment bankers viewed Constellation as tied to high returns for the acquisitions or hurdle rate. The bankers believed private equity funds were likely to pay a higher price and went to them as they can and did pay premium prices. (if the premium price is paid, commissions to the investment bankers are higher). The reason why private equity firms pay higher prices is the expectations of the company. The funds hope to bring the company to an initial public offering (IPO) within 5 years and when the company trades on the public markets the private equity can sell its holdings and do the process all over again. In contrast, Constellation makes it money by making the company better over the long time. (think about if you went to a charity auction and bid on something, are you going to use it, keep it, donate it to something else or sell it?)

Constellation wrote in their annual report, which investment bankers read, they were dropping its hurdle rate, accepting a lower return on the $1 billion they generate each year. In the past, Constellation was expecting to generate $30 in cash for every $100 invested or Return on Invested Capital (ROIC) on 30%.

To maintain the higher cash margins it can invested, the company stopped making special dividends, but can keep expanding using a 20% ROIC. It also spun out a subsidiary as a public company marking the first time it had gone through the process.

Linking to dividend paying stocks, one of the reasons for owning dividend paying stocks is to allocate the dividends when they come in during the month or the excess cash. As dividend owners you have time and patience or the ability to be disciplined in what you do with the cash. As the total gets larger you have more options and that is a good thing. Time and patience are on your side to buy what you want rather than what is hot. There are many shareholder meetings at this time of the year, maybe you want to know what is your company’ s expected ROIC?

There are more questions than answers, till the next time – to raising questions.

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