Constellation Software Inc. (TSX:CSU) has been an example of a winning tech stock. Up 186% in the last five years and 73% since the end of 2023, shareholders of Constellation Software stock are clearly happy with it. But what should we do with it at this point? Is there room to move higher?
Let’s explore.
Constellation Software: Strengths
The most obvious strength that Constellation Software has is strong revenue growth that has been sustained over the long term. In the last five years, revenue has grown 141% to $8.4 billion. This equates to a very strong compound annual growth rate (CAGR) of 19%. In the company’s latest quarter, revenue increased 26%, at a 5% organic growth rate.
At the same time, net income has increased 70% to $565 million and EPS has increased 81%. In the company’s latest quarter, EPS came in at $6.64 versus $7.19 in the prior year. However, cash flow numbers came in strong again. Operating cash flow was up 28% to $511 million and free cash flow increased 12% to $35 million.
The business
This growth has been the result of Constellation Software’s mission to acquire, manage, and build software solutions to address industry needs. Today, Constellation has a strong “constellation of companies with a large, diverse customer base”. The company’s six operating groups service customers in 100 different markets worldwide.
This growth has been primarily achieved through acquisitions. While there are risks to this strategy – debt being a major one, the company has done this while maintaining a relatively low debt balance. With the recent rise in interest rates, it’s been especially important to keep debt levels under control.
As at the end of Q4, Constellation has a debt-to-total capitalization ratio of 65% – not excessively high, but something to watch. In fact, in the last year, Constellation’s debt has markedly increased to $2.5 billion from $1.3 billion. The company’s strong cash flows lessen my worry about this increase. But at some point, this might be a problem as the company continues to acquire software firms.
Valuation
Now on to the final point that we must consider when analyzing Constellation Software stock – valuation. As far as tech stocks go, Constellation has really outperformed the group with respect to revenue growth and stock price performance. This is a good thing, as it has made its shareholders plenty of money in the last few years.
But today, the stock seems to have hit a tipping point of sorts. The question is, can Constellation Software’s stock price continue to rise higher given the lofty valuations it’s trading at?
Constellation Software’s stock price currently trades at 100 times earnings, and 51 times cash flow. While the company has been growing quite rapidly, this valuation comes with some big downside risk if and when something goes even a little bit wrong. On top of this, we have the liquidity hit that comes with a stock with such a hefty price tag. Trading at $3,642 at the time of writing, the stock would be disqualified from many investors’ buy lists based on this alone.
In closing, while Constellation Software stock has a bright performance history, I would be more comfortable sitting on the sidelines at this time.
