Topicus: Another Great Compounder Part II
In Part I of this analysis, we covered:
If you haven’t read that release, I’d suggest hitting this link and reading that before moving to the second part, as it will make more sense. You’ll get a feel for why the company is so attractive, what needs to happen in order for the company to succeed, what its debt situation is, as well as more info on its capital allocation strategy.
In this second installment, we’ll be covering the following
This is one of the most attractive areas of this business. In order for a company to generate returns over a long period of time, it helps when it can reinvest capital back into its business at high rates of return. This is literally the purpose of the company and it’s embedded in its DNA even before it was acquired by CSU.
The company can only grow if there are well-priced VMS companies to acquire that will generate revenues for the company long-term. In part 1 of my hypothesis, I forecasted they’d ramp acquisitions up to ~83 acquisitions in the year 2032. This would track their current 18% acquisition growth rate. One way of looking at the total available market (TAM) is to look at what the global and preferably European VMS market looks like now.
These aren’t the most accessible statistics, but there are sources. A Crozdesk report analyzed over 19,000 VMS companies. Here are some of the most important parts of that report:
Nearly 89% of the world’s SaaS and cloud financing went to US companies
Companies based in California received about 45% of the global funds (9x the European total).
As of 2017, Europe was home to 22% (4,180 companies) of the world’s cloud companies, but only received 5% of the funding
From 2016 to 2020, the SaaS revenue grew at a 19% CAGR
We can glean some very important information about the future growth of Topicus. Europe is clearly underrepresented in funding. This means that Topicus will have much less competition in acquiring new companies. There are also larger tech companies in the US than in Europe, so we can assume that means the average size of SaaS companies in Europe is much smaller, which is also great for TOI, as that’s their wheelhouse.
So with the assumptions made in part I of this analysis, we can see that Topicus will barely make a dent in the European market share for VMS. I think the VMS industry will only grow. As more businesses move to the cloud and better solutions to companies’ problems are created through innovation, I assume there will be plenty of VMS acquisitions for them to put on their radar, for a long time.
I like to see large insider ownership stakes. Topicus ownership doesn’t own a tonne of shares, but it’s nice to see them accumulating shares. Insider ownership is currently sitting at ~2.3%. However, there have been large amounts of insider buying over the last few months:
These are all decent-sized positions, and it’s nice to see the CEO dropping a million dollars on shares. There hasn’t been any insider selling I can see in the past year, showing that management isn’t trying to time the market and is long-term oriented. It’s worth noting that CSU only has 7% insider ownership, which isn’t particularly high either.
This is one of the few blemishes on a great company. I think with all the insiders and board members having a decent part of their net worth in either Topicus or Constellation stock, management and shareholders are well aligned. So I don’t see the low insider ownsherhip as much of a worry. I expect insiders will keep buying on share price weakness, and insider ownership will only go up from current levels as they accumulate more and the share price grows.
We want management that cares about the long-term over the short-term. Here is a blurb about acquisitions straight from the TSS website: “At Total Specific Solutions (“TSS”), we believe that acquiring businesses is about more than just buying companies. It is about investing in people and doing what it takes to help manage and grow businesses for life. To accomplish this, we operate a decentralized model, pushing decision-making down to the front lines where the people who know the industry best can do what is right for clients. This is why TSS has a buy-and-hold-forever strategy, and why we challenge our employees in all our businesses to try and do new things every day.”
Their goals are clear: buy and hold excellent businesses for life.
Below is the Annual compensation program, which is very low, and nothing that would make a shareholder or employee upset in my opinion.
Topicus has one of the best incentive programs out there. They’re following in the footsteps of CSU. Basically, they pay bonuses based on return on invested capital (ROIC) and revenue growth to their executives. You only get compensation based on your Operating Group (OG), and not the company as a whole (besides the CEO). If your segment doesn’t beat the hurdle rate, you get no compensation. This is the best incentive program I have seen, and I wish more companies did this. Here is the kicker: “Executive officers are required to invest 75% of their after-tax incentive bonus into Subordinate Voting Shares. The shares are held in escrow for a minimum average period of four years.”
So the Topicus MO is: manage your OG to produce income on invested capital. Get rewarded with compensation. Use compensation to purchase shares in the open market. Hold your shares for at least 4 years. If you continue doing your job well, you’ll get more compensation money to invest, and the value of shares should go up. This keeps management aligned with shareholders, and keeps them long-term oriented. Hard to ask for anything more.
Management is clearly adept at capital allocation; has skin in the game; is long-term oriented; isn’t overly compensated, and is completely aligned with shareholders.
The VMS industry isn’t the easiest to get concrete data on. As previously mentioned in the Growth Opportunities section, we are left with getting as much info from indirect sources as possible to get a clearer view of the industry that Topicus operates in. Let’s start with an interesting chart by Fractal Software:
Clearly, the value of these companies is skyrocketing. This tells me that the industry is competitive, and there will be many new entrants, trying to get a piece of those juicy revenues. Unfortunately, most of these VMS companies will fail to go public or have billion-dollar evaluations. This is great for Topicus, as they prefer to buy smaller companies anyways.
If you look at some of the companies in their portfolio, growth isn’t the most important aspect for Topicus. They are ok with getting more beaten-down companies, that will sell at a good price, as long as they sell a product that is deeply embedded into their customer’s operations.
Topicus’ main competition in acquiring companies is Private Equity (PE). However, Topicus has multiple advantages of PE when a potential seller is looking for a suitor:
Topicus is fine keeping management in place and not firing anyone. PE often wants to cut costs and install new management that is more in line with their vision for the future of the company.
Topicus will buy and hold their company forever. PE will often try to run up the earnings short term to make the company more attractive to potential suitors to sell for even more money. As a software company, being constantly sold means major uncertainty, and can cause large shifts in culture and unhappy employees.
Topicus doesn’t micromanage. They don’t need their acquisitions to produce short-term profits at the expense of the long-term. They will often let the management continue to run the company as is, as they know that the companies they buy are well run and understand their industry better than anyone. Sounds like something a certain person whose name rhymes with Stuffett would do!
A CSU Partner named Marcin Szelag recently said he saw 2000-4000 acquisition targets in his market (Europe) which aligns with the numbers we have above. He also says there are tonnes of legacy, lower growth type businesses out there, that aren’t necessarily as attractive as the hyper-growth names that get all the attention.
Let’s have a look at some of the underlying economics of the VMS-type businesses as a whole. Since most of them are software companies they don’t have large input price variability. This is a huge plus, especially in these high inflationary times. Topicus’s last three months’ expenses for 2022 were €22,978,000 vs 2021: €20,411,000. So inflation isn’t having much of an effect on the inputs of the business. I think there is a high probability that this is the way it will be for them moving forward.
Another important business aspect is if demand variability will adversely affect the company, which can happen to entire industries in the case of recessions or inflation. This is yet another strength of Topicus, as its VMS businesses are weaved into “education, healthcare, social services, local and central government, retail, financial services, and accountancy, legal services, real estate, automotive, maritime and professional associations.” This means that much of the software names they own are literally required (as they say “mission-critical) to provide services to their customers. If you have a company that has embedded software into the education system, that teachers rely on to perform their jobs properly, there isn’t really an option to get rid of said service. You can either stick with it or look for a replacement.
But if you’ve suffered through trying to change the software you work with, you probably know it’s annoying as hell to learn how to adopt new stuff. A company with a large base of employees has to re-train all its employees to use different hardware, which is time-consuming, and costly. So even if you dislike the software you’re using it’s often easiest just to “stick with the devil you know, rather than the devil you don’t!”
So overall the industry varies in attractiveness. If you are trying to buy the biggest names with the largest top-line growth, it’s incredibly competitive. You’ll end up spending a tonne of money on acquisitions. On the other end, you have the low to no growth area, where Private Equity isn’t particularly interested. Here you’ll find much more reasonable valuations on companies with massive moats. Here is where Topicus plays. Because they don’t have to butt heads with PE, they’re able to make acquisitions with better prices and can reap the benefits of the company's profits by buying more un-sexy companies to keep the cash flowing in.
Let’s check the competitive position of Topicus itself, in the industry. Its direct competitors are Constellation Software (CSU) and Private Equity. I think CSU saw that Topicus would have more value if it was separated from the parent company and that’s why they spun it out in the first place. So I do think Topicus has a very competitive position in the industry and has a long track record of happy acquisitions.
I can’t see their competitors making life super hard on Topicus. If anyone could it would be Constellation Software, but I would assume they would try to stay out of their way to the best of their abilities. Since both CSU and Topicus don’t like paying up for companies and have similar hurdle rates, I don’t see Constellation bidding up on acquisitions. As for the PE companies, I covered why I don’t think they’re much of a problem for Topicus. The management at Topicus is perfectly fine letting PE duke it out to pay large revenue multiples.
Given the size of the market that Topicus plays in, I see no reason they can’t sustain value creation using their current business model. They know it works, and they have the blueprint to execute it from CSU. I don’t think they are riding any type of major tailwind that could end abruptly to derail the model.
I think Topicus has a great competitive advantage in a field, in which they are very knowledgeable. They have a competitive advantage because they aren’t incentivized to look for the hottest names out there. They are not interested in getting involved in expensive bidding wars. All they need is a company that will produce cash over their hurdle rate for a long period of time. They are as Buffett would say “jumping over 1-foot hurdles.”
This will do it for my Topicus analysis. I will be keeping constant tabs on the company to make sure they keep doing what they’re doing, but I have a high degree of confidence they’ll execute incredibly well for the next decade-plus. I’ll also be writing about them in quarterly portfolio updates, so if you want to stay up to date, hit the subscribe button and you’ll get the updates as they are released!
I follow the fundamentals of Constellation very closely, but not so much on the price. I can see now that Constellation is trading around 27x free cash flow TTM. Topicus is at 31x FCF TTM. I think the main reason for the premium is the share issuance. It’s deflating cash flow per share even though FCF is going up steadily. I assume it will come in line with a constellation over time. How long? No idea.
Hi - enjoyed the write up! Wanted to see if you have any thoughts on the valuation discrepancy between TOI and CSU? I'm trying to better understand if the TOI premium is maybe due to technical reasons like the spin or complexity in the structure or anything else even? Or whether it's down to the runway / size constraint being much more favourable for them? Would be great to get your thoughts on this, thanks