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TIVP066: Valuing Constellation Software's Spinoffs: Topicus, Lumine and co. w/ Daniel Mahncke & Shawn O’Malley
01:20:52
Daniel Mahncke and Shawn O'Malley take a deep dive into Topicus, Lumine, Sygnity, and Asseco Poland.
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- [00:00]
Daniel Munka
Constellation software has been one of the most successful compounders of the last decade. But every business at that scale faces a similar problem, the law of large numbers.
- [00:10]
Sean O'Malley
But Constellation is a programmatic acquirer, and that means there are other much smaller businesses out there following the exact same playbook. And many of them are even managed by Constellation, since they were spinoffs or acquisitions.
- [00:24]
Daniel Munka
And they could be the next big thing. And that's what we look for today. We analyze for four Constellation spinoffs and acquisitions and basically see which one is the best equipped to compound over the next decade.
- [00:41]
Podcast Announcer
You're listening to the Intrinsic Value Podcast by the Investors podcast network. Since 2014, with over 180 million downloads, we've learned directly from the world's best investors. Now we're applying those lessons to analyze businesses and investment opportunities every week, helping you uncover intrinsic intrinsic value. And now here are your hosts, Sean o' Malley and Daniel Munka.
- [01:12]
Sean O'Malley
At the end of our Constellation episode a couple of weeks ago, we couldn't shake the feeling that our money might be better off invested in smaller companies running the exact same playbook. These Constellation copycats spin offs, and some companies where Mark Leonard is actually personally invested too. And so in the last few weeks, Daniel, I know you've dug into a handful of these companies, and in today's episodes, we'll be digging into all of them. And those companies are Topicus Lumine Group, Signity and a Seiko Poland. And knowing that we usually need about 90 minutes for just one company, I'm a little scared of how long we'll go for today. But, yeah, they all follow the same playbook, so hopefully we can kind of keep it at a high level for each one.
- [01:55]
Daniel Munka
Well, obviously we can't go as in depth as we usually do, right? I mean, the investment case, or better said, the business case, is also pretty similar for all of them, but there are very important nuances that kind of make them different, and some of them actually more appealing than others, at least in my opinion. And you have companies like Topicus Alumine, which will be known by most Constellation investors because they are direct Constellation offspring, kind of spun out of the Constellation mothership, essentially. And then others are what I would call spiritual descendants. So basically, companies that started by themselves, but are now shaped by people who learned directly for Mark Leonard, or at least his inner circle. And I can only spoil that. Mark Leonard has significant stakes in some of these companies himself. And if it's not him, he actually has a son that manages money and they also buy some of these companies and we will also value all of these companies today. But I do want to emphasize, even more so than we do in our usual episodes, that you need to do your own due diligence on these names if you want to dig deeper and if you find any of these names interesting. So some of these companies are in pretty early stages of their life cycle and that means that things can change quickly. So the setup might look great or attractive today, but you know, then the CEO leaves maybe a year later or just the M and A engine comes to a halt. And there's so many things that can stop a company at this stage from compounding. So really the main objective is to today find some really interesting setups, then basically see how they differ, and then assess their potential for future compounding.
- [03:25]
Sean O'Malley
It's going to be a fun one. I'm excited. Before we get there, though, I do want to mention just solicitors at home while I think of it, that Omaha is coming up fast. Daniel and I will be there for the Berkshire Hathaway shareholder meeting on Saturday, May 2, and we would just absolutely love to have folks from the audience meet up with us there. And actually we'll be hosting what we call an intrinsic value mini conference on Friday, May 1, at Hotel Indigo in downtown Omaha. I N D I G O hotel Indigo from 1 to 4pm local time. And Daniel and I will be doing a special stock pitch. We do a Q and A session and then we'll open things up for a social hour a bit. And just one last point there, the intrinsic value community of investors that we run, they will have reserved spots for anybody who can come, but there will be a handful of spots open to the public for free on a first come, first serve basis. So we hope to see you there.
- [04:23]
Daniel Munka
So if you haven't yet decided whether you should visit Berkshire this year, we hope this can be maybe yet another reason to actually go. I think last year was just a whole lot of fun. It was actually my first time at the Berkshire meeting. And I do feel that, you know, with the conference this year, I pretty confidently can say that will be even better.
- [04:40]
Sean O'Malley
I think so. I think it will be. It'll be a ton of fun. So yeah, that's enough. On Berkshire weekend, maybe we should revisit the VMS vertical market software playbook or the investment thesis for listeners who might be coming to this episode without having heard our deep dive on Constellation. Because everything we discussed today is an extension of that thesis that Constellation follows in their playbook. And so if you don't understand why Vertical market software is special. The rest of the episode might not be as useful as it could be. So let's just start there and clarify it.
- [05:14]
Daniel Munka
Right, so the short version is that vertical market software, you know, VMS refers to software built for a very specific niche. So not Excel or Salesforce, which serve everybody, but Cemetery management software, which I know is like this popular example that everybody's talking about. But you also talk about bus scheduling systems, software that runs dental practices, tools that manage fishing permits for local governments, or even simulation tools that oil companies use to decide where to draw. So you're just talking about all kinds of niches, but it's not just about being niche. It also has to be in an industry where the software that you provide is actually a mission critical part of the business and so deeply integrated into the workflow, basically to the point where switching to a different provider is just incredibly hard and almost impossible. So generally I would say that's the case where you have pretty high regulatory hurdles to actually entering the industry or even when it's about companies, data that also prevents AI from coming in and taking over because there's so many concerns about privacy and also AI's ability to be 100% correct, not only 90%. And in part I think that was our problem of consolation. So not only did it reach a size where it has become difficult to acquire enough companies to actually still move the needle, but, but you also have just a huge portfolio of companies that is a bit more difficult to assess. Although, and I want to add to that, I don't believe AI will do lasting damage to Constellation. And I'm not saying that from a perspective of naivety. I actually think we spend about a couple of dozen hours talking about Constellation and you know, the AI risks in our intrinsic value community of investors. So I do feel like we have gotten a pretty good picture of what exactly AI is threatening. And still coming out of all of that, I would still say Constellation is probably in, in a pretty good position for the years to come.
- [07:02]
Sean O'Malley
I'm going to go out a limb and say a dozen hours talking about AI risks is an understatement because we've had lots of debates about how AI is going to disrupt especially software in our intrinsic value community. But I'm still waiting to see some real evidence of these AI disruptions beyond the narratives and you know, like, where are all the job layoffs if agents are already so good? But I don't want to get into it. It's like a whole nother. It's a whole Nother conversation that will derail us. So I'll just leave it there.
- [07:34]
Daniel Munka
Yeah, I mean there are definitely a lot of uncertainties, but I think my main concern long term for CSI now is that acquisitions have to be larger every year to move the needle. We actually just saw another large Constellation deal. They build a 10% stake in the travel company Sabre, and since that stake is public, the company's market cap has basically doubled. However, over the last five years it has still lost over 90% of its value. So it's kind of a typical Constellation investment in terms of its strategy to basically buy a bombed out company and then turn it around. And there have been some, I would say problems at the beginning of the process though, because, you know, when Saber was acquired or kind of Learned about the 10% stake of Constellation, they actually threatened to activate what's a so called poison pillar to shield itself from a takeover by Constellation. For anyone who doesn't know what a poison pill is, it's basically an option that the management can pull that is diluting shareholders. So what it does is if Constellation bought a 10% stake and you're now diluting all the shareholders, obviously that's nothing that you as a shoulder want, but it does reduce the stake that Constellation holds in the business and therefore it reduces the likelihood of being taken over as an entire company. So that's what they threatened to do. But now there is an agreement in place and you know, I assume the long term goal of Constellation had been to take over the company completely. But in their latest earnings call they actually mentioned a new strategy which is called P E M S and that stands for permanent engaged minority stakes. So Constellation won't take over the entire company, but will more or less take like an activist world. So with the caveat obviously that they want to own companies forever still. So they're not only going in there, do a couple of changes and be in there for the quick buck, they still want to own the company basically forever. So point being, Constellation has to focus on these larger acquisitions going forward. And they obviously come with a different risk and return profile.
- [09:27]
Sean O'Malley
Yeah, the idea is that focusing on these smaller VMS acquirers is like getting all of Constellation's advantages, but without taking on the risk that Constellation can't continue to deploy capital at similar rates to the past just due to the law of large numbers as the business scales up. And so back When Constellation had a 5 billion market cap, it was compounding at 30%. But as the company grew, Mark Leonard himself even made it clear that he Expected, especially from all time high prices in the stock. The stock would probably only compound at 8% a year, which is a very average return. And now given the decline in Constellation stock, though, that return would probably be much higher, at least the expected return. And if you think about the prospects, about nothing about the underlying business has fundamentally changed, just the valuation. But a business at $3.5 billion like Lumine, in theory, they have decades of Runway left before the math of growing at these rates becomes a problem for them.
- [10:28]
Daniel Munka
The important question is whether you can find the same quality at the smaller scale, right? I mean, obviously there are scale advantages in this game too, and Constellation is benefiting from them. But the spinoffs can, at least not to the same extent. And one of them might be that Constellation can spend money on the parent company level to actually prevent getting disrupted by, for example, AI. They actually have started investing into AI tools and also AI companies many years ago, before it actually was this huge topic that it is today. But I would say this is also something that their spinoffs can benefit from. So to some extent you are getting the scale benefits by being part of Constellation. You're just not paying for them.
- [11:08]
Sean O'Malley
Well, perhaps we should start with Topicus, since it's closest to Constellation in terms of size and culture. And if there is a company that you could call a baby Constellation, it's definitely Topicus. It was separated from Constellation in February 2021. And it's the public company that sits on top of tss, which stands for Total Specific Solutions. Great company name. And that's the actual operating group that goes out. It acquires these VMS businesses across Europe. And so Constellation owns approximately 30% of the economic interest in that business. And then another 30% is held by the Vanpoolja family, the original TSS founders and public shareholders that own the rest. And so Constellation owns the majority of voting shares though, so they will effectively have control over the company. Meaning when you buy Topicus, you're also buying into TSS's acquisition machine with the backing and expertise of Constellation implicitly. And so TSS itself has actually been around for I think 20 years. So it predates the Constellation spinoff by quite some time. And Ramon Zander is the CEO of one of TSS's main units, expanded TSS into one of the most respected VMS consolidators really in all of Europe before Constellation ever got involved. And so I think that's a great example for, for a company like Chapters Group and where we already own a position in it that you don't necessarily have to be part of the Constellation family or universe of businesses to be successful running this serial acquirer, programmatic acquirer playbook. And so by the way, I just want to mention, according to insiders, TSS has been the best performing operating group within Constellation for quite some time.
- [12:54]
Daniel Munka
When you look at topical financials, it also shows why we want to consider these smaller versions of Constellation. I mean, revenue has compounded at over 30% annually for many years and it's now in the 15 to 25% range. There's a bit of volatility because it very much depends on how many acquisitions they actually do per year. Because acquisitions are what primarily drive the top line growth. And they've been doing roughly 25 to 30 acquisitions a year across all of their European operating units. And the EBITDA margins are close to 30%, which is pretty respectable too. The recurring revenue percentage is in the low to mid-80s, which is very solid for a business that's still growing fast. And the market cap is roughly 12 billion Canadian dollars. So it is certainly the largest company that we will look at today. But it's still only about a quarter of the size of Constellation. And tss, which again is one of the operating units of Topic is, is also the entity behind two of the other companies that we will discuss today, which are Signity and the Seiko Poland. So I can tell you that it will get somewhat complicated today. But you know, Ramon Sanders has been, and you mentioned that a minute ago, kind of the architect of the Central European expansion strategy, so basically moving aggressively into Poland, Lithuania and also other Central and Eastern European markets that are seeing actually rapid digital transformation. So the EU cohesion fund deployments, the banking sector modernization, and even just the government digital service programs, all of this is driving huge demand for pretty much exactly the kind of software that Topicus and TSS actually go out and acquire. And even though Xanders is playing an important role in that direction, just as Constellation, Topicus and TSS are highly decentralized, so capital allocation decisions do not primarily run through Ramon Zanders. And geographically it operates across the Benelux countries which are the Netherlands, Belgium and Luxembourg, the Dach region, which is Germany, Austria and Switzerland. And then you still have all these Central and Eastern European nations and as well the Nordics, the UK and Ireland. So generally it's just a huge market. It's basically all of Europe. So in total I think we're talking about 30 to 40,000 potential targets, with the majority of them actually coming from the D region and specifically Germany, there's
- [15:01]
Sean O'Malley
a lot of acquisition targets across Europe and like you said in Germany, and that is why we own Chapters Group to take advantage of that.
- [15:08]
Daniel Munka
Right, Exactly. I mean, the Dach region is highly attractive to VMS acquirers right now because first of all, I mean, it's a high value market with many potential targets and also an aging cohort of founders. So it's pretty much the perfect hunting ground for companies like Cheptis or tss. And the European VMS market generally has historically been extremely difficult to consolidate at scale for mostly three reasons. So the first is, you know about the fragmentation mostly of languages, but also of cultures and certainly also regulation. So instead of building VMS and then basically deploying it across the entire industry in Europe, your market is often limited by country lines. That's something you don't see in North America. If you have a VMS company that works pretty well in the U.S. first of all, it works well in all parts of the US and probably you can also expand into Canada. That's not the case in Europe. And due to this limitation, you also had few acquirers that even had both the capital and also the operational capability to execute these pan European deals, basically deals spanning all of Europe. And you could argue that TSS is now at a point where they could be this company, especially with the backing of Constellation. Right. In fact, if you compare them to any of the companies we will look at today, they already reached that point probably many years ago. I mean, currently it operates in 26 countries by now. And then the third and last point though is that European founders, and I think we also mentioned that in our chapters episode, have historically been very skeptical of financial buyers and mostly preferred to sell to buyers who would actually maintain employment and also just the cultural continuity of the business.
- [16:43]
Sean O'Malley
It's a pretty subtle point, but I do think that's one of the main reasons culturally why private equity and competition from private equity has not been as widespread in Europe for doing these kinds of business models compared to what we see in the US. And so even if this changes to some extent and more founders are willing to start selling their companies to these financial buyers, they will, I think, prefer companies with the kind of culture that Constellation has compared to, you know, private equity buyers that are just mostly in it for a quick buck. And so I think it's really something that is hard to understand and I wouldn't be able to remotely understand it if I hadn't met a lot of business founders myself. But when you've built or run a business For a long time. It is truly your, your life's work. And so maybe in the same way you might care about what happens to your kids as they grow up and go off on their own, you care about what happens to the company you built. And so yeah, there's a huge difference between getting a buyout offer from some PE firm that's going to fire half the staff in like six months versus selling to a company like Constellation, where you know for a fact they have a very well proven legacy of acquiring companies successfully and managing them very well.
- [17:55]
Daniel Munka
Constellation's philosophy of being a long term home for these companies is certainly more attractive to founders than just selling to private equity. And TSS's philosophy is basically the exact same. In fact, Ramon Zanders kind of reminds me a lot of Mark Leonard. I mean, he doesn't give media interviews, he doesn't attend any investor conferences, and he does not publish any personal commentary on social media or elsewhere, which is something that we see more and more with CEOs nowadays. And anyone who watches this on Spotify or YouTube, you can actually see that despite being like him, personality wise, he doesn't really look like Mark Leonard. I mean, there is no Santa Claus beard. And that's something that you do see with Mark Leonard and which might be the most prominent feature of him. And unsurprisingly, Topicus and TSS as well, they are as decentralized, as I mentioned, as Constellation. So each geographic operating unit has its own deal source and capabilities and known management team. And what that basically means is we discussed that for consolation, there are these huge lists within the company where you have thousands of companies on that list and basically someone in the company is reaching out to all of them at least two to three, maybe even four times a year, just kind of keeping in contact with them, figuring out at what point they might want to sell their business. So that whenever that happens, TSS or Topicus would be the company that they first reach out to. And this means that the organization can scale acquisitions without a corresponding increase in central overhead. And even more important in this case is that you have experts who actually understand the regulations and the cultural differences of every country they operate in. I mean, you and I often joke about the cultural differences between Germans and Americans, but also about the differences just between Europeans. So I think with that in mind, I could imagine that deal making would be more complex if someone from the Nordics had to make deals with people living in the south of Europe.
- [19:46]
Sean O'Malley
Yeah, the first problem of that would probably be just about how Differently people define what it means for a meeting to start on time. We got a taste of that, of what on time means in Lisbon last year for a conference. And actually I see that Daniel's wearing your Lisbon shirt that we got there. But on a more serious note, a couple of weeks ago you hosted a call on our intrinsic value community of investors, and one of our members asked how exactly you ensure that the quality of acquisitions remains high in an organization as decentralized as Constellation or spinoffs. And so just maybe one totally unrelated example that I think came up during the call was McDonald's, where you have tens of thousands of stores in the world, but they all have more or less the same quality menus and feel. And so we don't want to like get into the weeds of McDonald's franchise model, but maybe you can explain the sort of incentive system at Topicus, just to give us an idea of how they are able to do it compared to Constellation.
- [20:47]
Daniel Munka
I would say they're generally very similar. So the incentive system is one of the things that made Constellation so successful, and therefore it's one of the first things that they implement in their subsidiary. So the two key drivers are the generated returns on invested capital, ROIC and net revenue growth. So you need both because you would certainly run into problems if you only incentivize one of them. So let's say you only incentivize top line growth, so then basically the quality of acquisitions will suffer. And then if you incentivize based on returns only, there's a pretty good chance that managers won't invest a lot of capital because they only go for the very obvious bets that just don't come over your desk that often. So I think we discussed the problem of incentivizing mainly on returns on invested capital in detail in our consolation episode as well.
- [21:32]
Sean O'Malley
And the short summary for anybody who missed it is that once the original investment amount has been earned back, these VMs businesses don't need a lot of ongoing reinvestment. So the returns based on the invested capital tend to become astronomically high over time as you get further and further away from that initial purchase price. And so, I mean, there are different things you can do to tackle this problem. But Mark Leonard decided to simply keep the capital in these subsidiaries and make them reinvested. And I think that is one of the best ways to make returns revert to the mean and incentivize more and more deal flow on the margins. And so when we look at the incentive structure for the management team of Topicus and tss, since it is such an important thing to how they'll be encouraged to make capital allocation decisions going forward. How does that look?
- [22:22]
Daniel Munka
As you know, my co host Sean and I are obsessed with analyzing companies. But you probably have noticed from personal experience that talking stocks is not everyone's favorite hobby. And I'm reminded of that every time I bring up investing at dinner or when I'm out with friends. They tolerate it for about 10 minutes, but then I get this look, the one that says, we get it. You love stocks, but this is not the place. So Sean and I thought, why not build that place? And we did it. It's called the Intrinsic Value Community. Our members range from pilots and farmers, firefighters to lawyers and engineers, but also hedge fund managers, actual rocket scientists and CEOs. And despite those different backgrounds, what connects all of us is the passion for value investing and continuous learning. And each week we host live calls covering everything from vetting the group's best stock pitches to analyzing portfolios, investing case studies, and conversations with expert guest speakers who are either prominent portfolio managers, CEOs or authors. And the best thing is that if you ever miss a call, we have a library of recordings for watching back every single call we've ever hosted. And if you prefer reading over watching, well, then we have dedicated spaces in the community to share write ups, discuss investing ideas, or just your thoughts on the general market. And multiple times a year we bring the community from the virtual world into the real one, including private dinners in Omaha for Berkshire Weekend and meetups in New York City to explore, hang out, and most importantly, talk stocks. Our last cohort of members brought together 20 incredibly thoughtful people, some of the sharpest investors that Sean and I have ever met. And if you want the chance to learn alongside people like that, you should join our waitlist@theinvestorspodcast.com intrinsic value community. That's theinvestorspodcast.com intrinsic valueCommerce unity the three CEOs that we should focus on are Ramon Sanders of TSSBlue, Han Knorren for TSS Public, and Dan Dykhuisen for the Topicus Operating Group. So each has their own bonus tied to the performance of their specific group. But there is a detail that I found generally interesting. For Djkhausen, the growth metric is organic revenue growth only, so acquisitions don't count toward this bonus on the growth side, which is kind of interesting because generally always feel that all the constellation companies mainly grow through M and A. So that should be the main part of Incentivizing. And for Zanders and Konorran, it is total revenue growth. So including acquisitions. The reason for the difference in the incentive is that the legacy Topic as a business is expected to compound organically, not through acquiring more and more companies. So basically playing the M and A game. So the basic structure is always the same. There are these little twists, like this one for example, that adjusts incentives basically where it makes sense. And to make that point again, I think that's why you want decentralized organizations where the operating units have the most control, because they know best when these little changes in the incentives actually make sense.
- [25:23]
Sean O'Malley
And then there's the share purchase requirement where 75% of the cash bonuses have to be invested in their own company stock. So in this case Topicus. And is that the same as with Constellation?
- [25:36]
Daniel Munka
Yes. Instead of any stock grants or options, 75% of the after tax bonus must be used to buy Topicus on the open market. And I think those shares sit in an escrow for a minimum of four years.
- [25:48]
Sean O'Malley
Gosh, I love that model. Compared to just giving out stock based comp and giving people options for free or whatever it is, it just feels so dilutive to other shareholders. And whereas this way you're really forcing people to truly have skin in the game and want to use their own cash to buy into the business, which just seems to perfectly align incentives. But anyways, let's go through the numbers, right? How does Topicus look on the valuation front?
- [26:19]
Daniel Munka
Yeah, one last point to the incentive there of buying shares. I think one thing that we criticized when we talked about consolation has been the fact that you need to buy these shares with 75% of your bonus. What I thought about afterwards is that at least it's a great signal that basically if you would see many people leave the company, you would know they actually think the company is in danger. Because basically you invest so much of your capital into the stock of the company that if you think the future is not looking good, you actually have to leave the company. So as long as you don't see people leaving the company, and those are the people that are the closest to the operation. I think this kind of incentive structure also shows to investors that hey, it cannot be that bad AI cannot be that disruptive if nobody here is kind of leaving the boat. But that's just one thought that came up in my mind after we discussed it. So getting to the numbers, since Topic is is part of the Constellation universe, we are focusing on free cash flow to shareholders here, which is this metric that Constellation is using. And it basically adjusts for a whole lot of acquisition costs. And also the fact that not all the companies Constellation owns, and in this case topicus, are 100% owned by the company. And the basic idea of the model is to say that free cash flow to shareholders is growing at a rate equal to the returns on invested capital multiplied by the reinvestment rate plus organic growth. And I know that might sound a bit more complicated than it actually is. I would say it just captures the two ways that Topicus actually creates value. And that's one, deploying capital into acquisitions with a certain return threshold and then growing the existing portfolio organically. And for some reason, I gotta say I find it timely to start with the bear case. So in the bear case, I assume ROIC on new acquisitions of 15%. And despite topicus relatively large size, I don't see them putting down the return on invested capital hurdle so meaningfully that you would get below this level anytime soon. However, in a bear case, I could imagine that it will become more difficult to deploy capital at those rates. So first of all because of its size, but you know, also because you already see more similar business models coming out and perhaps private equity expanding and potentially driving up multiples as well as just competing directly for some acquisitions. And of course, all the considerations can be named here as well. And long story short, because of all that, I calculated the valuation with a reinvestment rate of only 60% in this case, which is well below the typical reinvestment rate of Topic is. Then if you add to that organic growth of about 2%, you get a free cash flow available to shareholders per share, CAGR in the lower double digits. And if you would then say, okay, let's use 20 times exit multiple in year 10, then the returns you could expect are about 6 to 7%. So basically mid single digits. I would say that's not too shabby if you ask me, but that could mean that the Stock drops another 20 to 30% in the short term.
- [29:06]
Sean O'Malley
I just got to say for Topic is to generate 15% returns on invested capital. And to have that be part of the bear case might sound really optimistic to some listeners, but I think it is a reflection of how well the business has been run in their track record and how there's been plenty of room also for them to just rinse and repeat and keep running that same playbook looking forward. But it also just intuitively tells me that Topicus is not priced at a huge bargain, right? It may still be a decent value but the market has high expectations for Topicus that are very much baked into the stock price. And so let's just pivot a little bit and talk about the base case in terms of the range of most plausible outcomes. What strikes you as the most pragmatic assumptions to make when modeling this company's intrinsic value?
- [29:54]
Daniel Munka
Yeah, first of all, I mean you're right about the hurdle rate of 15%. It doesn't really seem like a bear case. However, I think it's important to see both things. So also the reinvestment rate that is the main part here, I just don't See topicus accept ROSCS below 15%. We talked about the magnetism effect in our Constellation episode. So once you lower your hurdle rate, you just can go back. And that's why I see them keeping the hurdle rate but not being able to find many opportunities at that rate. So that's basically the bear case setup. The base case I would say is quite compelling. I estimate returns on invested capital of 20%, reinvestment rate of 75% and then organic growth of 4%, which is consistent with today's levels. And if you do that, you know the free cash flow that is available to you as a shareholder would compound at about 20%. And if you then say, you know, that company, if it's compounding at 20% is worth maybe 22 times exit multiple to you in year 10, that would imply that you have a cake off somewhere in the mid teen range. So let's say 14 to 17% of returns and then the bull case obviously looks even better here. I actually assume a return on invested capital of 25%, which is certainly a lot, especially given that you look out 10 years here and I do increase the reinvestment rate from 75 to 90%. And then if they would actually be able to do that, you could certainly say this is a company worth 25 times free cash flow and that gives you a 10 year cake of roughly 25%. It sounds somewhat ridiculous, honestly. You know, part of the truth is that Constellation and topicals have compounded at these rates for decades. And the reason that models look quite attractive today is, is that prices are still well below all time highs. And yet this is certainly a very bullish case. I mean, you know, achieving 25% on returns on invested capital is something that usually only the smaller companies can do.
- [31:41]
Sean O'Malley
The reinvestment rate thing is a really subtle but important point that I think we should touch on. I think it's really easy to hear that and think why wouldn't they just have a 90% reinvestment rate at all times, if that's what needs to happen for the bull case to come through? And, and you know, they could attain a 90% reinvestment rate anytime they want if they lower their threshold for investment opportunities. If you're willing to accept less attractive opportunities, you can invest as much as you want. The hard thing, when you're working with tens of millions or hundreds of millions of dollars to allocate, is consistently identifying enough attractive opportunities to invest in. Because as you scale, the law of large numbers is working against you. You either have to do more and more small deals every single year, or you have to start doing bigger deals where there's just going to be a lot fewer choices to pick from naturally. And so I don't say that because I think your bull case is unrealistic, but it just strikes me as being really difficult to not only achieve such a high roic, but also do so at such a high reinvestment rate. And, you know, I think they're sort of at odds with each other in a way because it's not impossible. But more often than not, if you're increasing your reinvestment rate, you're probably accepting investments with lower expected returns. Unless you're maybe Warren Buffett. But you know, we'll be looking at three more companies today, so why don't we save our investment decisions until the end rather than after each valuation section? And yeah, so let's stay close to the Constellation family of serial acquirers and actually make our way back to Canada to talk about Lumine.
- [33:28]
Daniel Munka
Lumine was a 2023 spin off of Constellation Software. So in contrast to Topicus, Lumine is not focused or bound to a certain geography, but more so to a vertical. And that vertical is media and communications. So it's still a pretty young company. It was only founded in 2014, and up until now it has acquired only a bit more than 30 companies. 34 companies to precise. So part of the spin off in 2023 was also the acquisition of White Orbit, which was a quite sizable 490 million dollar acquisition that was officially made by Lumine. And this acquisition has somewhat lifted Lumine to a new level, and thus the spin off has followed. And the media and communication vertical might sound like a small market at first, but it does consist of many different and quite sizable verticals. It's. So the biggest one is telecommunications, which has an estimated TAM of about $50 billion. And if you add telecom, cloud services, satellite and government telecom, broadcast and media Management and even radio and streaming automation. You're quickly talking about a TAM that's worth well over $60 billion. Although lumines realistic target universe. So you know these small to mid size VMS niches within this broader market price below, let's say 200 million USD is considerably smaller. So after listening to the management team, it appears that the realistic universe is in the low thousands and they are in touch with companies in the low hundreds.
- [34:55]
Sean O'Malley
The pipeline is something that always feels really hard for me to judge with these programmatic acquirers because two weeks ago we talked about Kelly Partners and one of your main concerns was about just how many companies would actually meet their acquisition criteria going forward. And I don't think that will necessarily be an issue in the immediate future. It's not a problem today, it may not even be a problem in five years. But beyond that, right, when you think about the terminal value of the stock, right, Companies are valued off of the next 20 to 30 years of expected cash flows. Well, it does start to become a problem if the market thinks that down the road you're going to run out of opportunities. And so to me, this market does already sound significantly smaller than the market opportunities we discussed with these other vertical agnostic acquirers like Constellation or Topicus.
- [35:48]
Daniel Munka
Yeah, we discussed before that one of the attractive things about software companies is that they are spawning. So for example, if we look at the bullish case for Topicus and we expect the reinvestment rate to go up and the ric, the idea would have to be that, for example, AI is actually such a huge push for the market, there's suddenly way more opportunities to invest at good prices. So kind of like a re acceleration of what we've seen in the last couple of years. But you are right, this vertical is significantly smaller. But Lumina also takes a bit of a different MA approach, which is why I don't consider that to be a huge problem, at least not for now. So for context again, Lumen currently owns only 34 companies and they tend to have a larger deal size than what we are used to with other VMS acquirers, especially at the size of Lumen. So the average deal size of lumen is around 11 to 12 million dollars. And as you saw with Wide Orbit, it can go much higher than that. Although I would certainly add that this has certainly been an exception. And you know, part of the reason is that this was so huge that they spun off just because of that acquisition. And the reason for these generally larger acquisition or deal sizes, among others, is that Lumine is doing a lot of carve out deals. So they basically look for these often parts of larger companies and then they buy them out. So the advantages of this approach are that these deals generally have very little competition just due to the technical skills required to actually execute them. But they're also a lot more difficult to source. So, you know, they come at high ticket sizes. And it's hard to assess just how many acquisitions Lumine will actually do or need in any given year. So 2021, for example, was a year where they actually were highly active and they acquired six companies. Then in 2022 they only acquired two companies, 2023 was back up to five. And in 2024, Lumine only acquired a single company. So assessing reinvestment rates is basically impossible for any given year with this company. What's important to note is that these carve outs, despite being larger in size than other VMS acquisitions, they don't necessarily need to be more expensive. In fact, they tend to be cheaper. Again, there's little competition in that space. And the parent company of the potential carve out is just not interested in that part of the business anymore. So that's why they want to sell it. Right? So you can kind of get relatively cheap businesses at sizes where they actually move the needle in a very meaningful way.
- [38:05]
Sean O'Malley
One of the things I noticed with Lumine is that their organic growth is very weak. And so there are actually these years where it's negative. And Constellation, Topicus and most other VMS acquirers do show relatively slow organic growth typically. But I mean, usually it's not negative. Daniel, why, why, why is that the case for Lumine? Is that something that concerns you?
- [38:28]
Daniel Munka
Well, it's also part of the carve out mechanics, right? So when Luman acquires an offhand division from a larger corporation, that business has usually been cross subsidized for years. Shared IT systems, shared back office staff, and maybe even sales team with the parent company. So when it then gets carved out, Luma naturally has to rebuild all of that from scratch. And in the process, they often clean house on, you know, unprofitable customer relationships on low margin revenue streams. And those are the ones that the parent tolerated. But Lumine simply doesn't want that because they really want to turn around the business. And that's where you have more headwinds in terms of organic growth than Constellation or Topic when they acquire business. And the Wide Orbit acquisition was the big one. That explains most of the pain that you are seeing in 2024. Wide orbit alone was nearly the size of the rest of Lumine's entire portfolio when they acquired it. So integrating something that large while simultaneously restructuring customer contracts, it can just cause significant short term organic drag. And if you look at maintenance revenue only the organic growth is more similar to Constellation or Topic, so still more volatile, but generally in the low single digit range. And these are the metrics that will probably average out over time when a single acquisition doesn't have the same major impact anymore as it currently still has. For Luminance Financials, let's talk about the
- [39:49]
Sean O'Malley
acquisition engine in itself. How do you actually think about their ability to sustain excess returns on the capital they deploy over time?
- [40:00]
Daniel Munka
So since Lumine is a public company, the return on invested capital has been about 30% on average, which is significantly higher than Constellations and Topicus Ric in recent years. And the main driver is a metric that has the very simple acronym nplatpa, which stands for net operating profit, less adjusted taxes plus amortization. And using this profit metric kind of makes sense for a company that is doing a lot of M and A. And the margin on that metric is close to 40%, which is only possible due to all of these carve out advantages that we have discussed previously. And not only can you buy companies relatively cheaply, which is good obviously for returns, but you also have plenty of room to grow the margins since these businesses were mostly run highly inefficiently and oftentimes also under monetized. And yet I would certainly not expect the return on invested capital to stay at those levels. We can already see that it's coming down in the last two years, and I would guess that probably 25% is more reasonable long term goal. And 25% return on invested capital on acquisitions is exactly the level that Constellation itself operated at when it was younger. So you're not asking Luma to do something that hasn't already been proven by the parent company. And yet, as you mentioned before, just assuming 25% return on invested capital is everything but bearish.
- [41:21]
Sean O'Malley
Speaking about the parent company, how big actually is the stake that Constellation still owns in Lumine?
- [41:28]
Daniel Munka
So Constellation owns a little more than 60% of lumine still. So they have the majority stake and I wouldn't expect that to change in the future.
- [41:36]
Sean O'Malley
I know we spent a lot of time in our Constellation episode talking about the potential for AI disruption and and obviously some of those concerns apply to Lumine too. So do you think being limited to the media and communications vertical, is that an advantage or a disadvantage regarding the AI risk that they have if you
- [41:57]
Daniel Munka
look at the stock prices of Constellation, Topicus and Lumine, I think the market didn't seem to think Lumine vertical makes makes any difference. The stock was down about 70% at peak drawdown, and while it's already up almost 40% from its lows, there's still a long way to go. And generally Luma is insulated from the risks. I would say in the same way that I believe Constellation all topics are. So there's an argument to be made that it helps to be in the relatively old school media vertical. The software Lumine owns tends to manage things like broadcast scheduling, traffic management and billing. And again, would it be technically possible to offer an AI native solution? Likely yes. Would it make sense for lumind's customers? Very likely no. And again, if you want to dig deeper into this, I would advise you to listen to the consolation episode and especially read our newsletter because I've dove even deeper into the AI question there because generally you should really subscribe to the newsletter. It's free. And since we have a bit of time between recording and uploading an episode, the newsletter often features new insights that are not yet part of the podcast episode. So getting back to Lumine, the more legitimate concern for Luma specifically, I would say is pipeline shrinkage. So yes, there are hundreds if not thousands of potential targets, and due to their deal size relative to the market cap, they don't need dozens of acquisitions to move the needle. But I'm not an expert on this vertical, so it's difficult for me to judge the quality of the potential targets a couple of years out. But a lack of insight is something you will have to accept as a shareholder of all of these companies. I mean, part of the decentralization is that nobody can overlook them really much in the same detail that we do usually with other companies. So that's where you have all these experts responsible for certain niches of the market.
- [43:42]
Sean O'Malley
I've got to say, Daniel, this episode has me feeling inspired to go out and start looking for some niches that we can follow the Constellation blueprint with ourselves. Why not? Maybe we should make the Constellation software of podcasts to start buying up some of our favorite shows out there. Maybe we needed to launch like a serial acquirer ETF and just make it really easy to buy shares in all of these companies, running this playbook in one fell swoop. But. All right, that's, that's enough of that. Let's go to the valuation. Why don't you walk me through your financial model here.
- [44:14]
Daniel Munka
We'll Discuss the rest of the serial Acquirer ETF after our meeting here. But yeah, I mean, once again we have a DCF focused on free cash flow available to shareholders here. You know, with the disclaimer that due to Lumine size, the range of possible outcomes is just much wider than it was for Topicus and it certainly is for Constellation. So while my bear case assumptions are basically the same as for Topicus, except for a lower organic growth rate of just 1%, I'm less confident in underwriting these assumptions here than it was for Topicus anyway though with these assumptions and at an 18 times exit multiple in year 10, the implied return would be about 7%. So once again, mid single digit range in the base case I assume RSC reaches 20% and there is an argument to make for 25% just because of the really early stage in the lifecycle that Lumen still is in. And we know that the hurdle rate of lumen is about 25%. Again, given their size and the track record of Constellation companies, I think they can clear that. Still, I would like to be a bit more conservative here. And again, this is a 10 year model, so we have to assume a much larger company in five, six or even seven years from today, which makes M and A more difficult with every single year. So for the reinvestment rate, I'm going with 80% and organic growth of 2% and that would give you a cash flow cake of about 18%. And at an exit multiple of 20, that would mean you could once again expect mid single digit returns. In my model now it's 16%, but that's really just, you know, a number to focus on. I would say generally mid teen returns are what you could expect. And then last but not least, the bull case, I'm assuming 22% RIC is slightly lower than Ficus just because we lack a bit of track record here. 100% reinvestment rate and 2% organic growth. That would give you a cash flow cake of 24%. And at 22 times free cash flow, that would be a price target of close to $70, which is significantly higher than we currently are, and an annual return clearly over 20% per year.
- [46:13]
Sean O'Malley
Topicus and Lumana are two companies that most of our audience should probably be familiar with as both companies have been also pitched or at least covered on our sister podcast. We study billionaires, but the ones that we will cover now are definitely going to be lesser known. And so I personally had never heard of one of them. One of them is a company called Signity and we actually mentioned this one earlier. I think it's part of Topicus now. And so Signity, as I have learned, was founded in 1991. And so it's a relatively old for a software business. Right. And then it was originally called Computerland Poland, which is a great name. And for the first three decades it was this very typical IT integrator and revenue was project based and implementations were custom built for clients. So it was really not yet the typical VMS playbook that we've been talking about.
- [47:06]
Daniel Munka
Yeah, we already discussed all the advantages of VMS businesses and Synity really shows why the traditional software or IT business model is not that attractive. There are advantages to building custom software for clients, but generally it's just not a very good business to be in. You can only deploy that software to one client, so it's not scalable. And it's also expensive and time intensive to keep building these custom solutions. So that's why the business historically was growing only at low single digits and margins were actually pretty low too. But then in 2022, TSS, so topicus acquisition arm stepped in and bought more than 70% of signately.
- [47:47]
Sean O'Malley
So what made TSS interested then? Because Signity doesn't obviously fit the profile of the small founder own VMS businesses that they normally like to look at.
- [47:57]
Daniel Munka
I would say there are three things that made Signity interesting to Topicas or TSS back then. The first thing is the relationship that Signity has built over 30 years with some of Poland's biggest and most important organizations. So we are talking banks, utilities, the Ministry of Finance and even the National Tax Agency. So kind of exactly the type of industries that are highly regulated with high barriers to entry. When Signidi goes to, let's say a Polish bank and then proposes deepening the software relationship, there's a much higher likelihood of success than when you cold call via a small unknown VMS company. The second advantage is that you have a listed vehicle on the Warsaw Stock Exchange, which makes founder sellers of smaller Polish software companies more comfortable being acquired. They can get an idea of how Signity operates, whether they actually followed up on promises to earlier sellers. And there's also an established price for the shares, if equity should ever be used as a deal currency in an acquisition. So for someone who basically operated solely in much more illiquid private markets in Poland before, that might also just be a pull factor to sell to Signity instead of any other company. And then last but not least, TSS has gained access to a platform to basically build a Mini Constellation in Poland and just the broader Central and Eastern European region. Basically replicating the success of they have already seen in Western Europe through TSS over the last 20 years.
- [49:20]
Sean O'Malley
I think you framed Signity as the example of what Constellation, or Topicus in this case can do to companies where they take over control. And so it obviously worked out perfectly with the Stock Becoming a 10 bagger since Topkis took over, or at least it was before the recent 30% sell off. And one thing that we love to see and talk about is a company that that's expanding their profit margins. Signity's gross margins went from 28% to 47% and correspondingly their operating margins more than tripled, going from 8% to 26%. So that's just, that's incredible. And what exactly did TSS do to improve Sign these business that much? How is that even possible? Why would they have not just done that themselves?
- [50:06]
Daniel Munka
So the first thing that happened was that Topicus brought in some of its people. So you had a former portfolio manager of TSS came in as president of the board and the supervisory board was rebuilt with Ramon Sanders himself, the CFO of tss, the head of TSS Eastern Europe team, and the director of TSS's legal and M and a function. So long story short, there were a whole lot of Topicists and Constellation expertise basically coming into the company. The next step is to fix the core business. And TSS identified a series of unprofitable contracts that Signity had been carrying for years. So you're talking public sector deals where you know, the pricing had been agreed before inflation spiked and where Signity had no contractual ability to actually pass through cost increases. They exited those contracts deliberately, even at the cost, of course, of short term revenue. And they also shut down two entire business units that haven't been profitable yet. They basically began a systematic renegotiation of contract terms across the entire portfolio. So adding inflation indexing clauses to new agreements so that prices do increase, and that happens automatic. Rather than actually requiring a confrontation with each client whenever you want to renegotiate the contract. And this alone just meaningfully changed the economics on basically the recurring revenue base.
- [51:24]
Sean O'Malley
And that explains why the revenue growth initially looks more modest than the way they've been able to accelerate margin expansion and profit growth. You're essentially choosing to shrink the bad parts of the business to focus on and accelerate the much more profitable parts of the business.
- [51:42]
Daniel Munka
It's the same pattern you see when any Constellation operating group inherits a business with a mix of High quality VMS revenue and then low quality services revenue. So the instinct is to grow total revenue when you're a company. But the right move is often to exit the commoditized portion and watch your margins step up dramatically on the business that's left. And I know this sounds very logical and you basically just ask, why is Signity not doing that before TSS came in? But no, if you own the business, it's just not as simple in reality. If you manage a business that is just generally doing well, you won't just close down business units and fire people because nobody wants to rule over a smaller kingdom. And also letting go of your people and employees that you put in place there for maybe decades isn't easy either. Consolation topic is, though, they don't really care about that. They have a neutral view on the business and they don't care whether the businesses they are buying is smaller on paper because it loses revenue. They solely focus on how much cash the business can return to them. Of course they do, you know, talk to the founders and they do promise them to not fire half the company, as we discussed before, but they have to be certain things put in place that they are allowed to do.
- [52:50]
Sean O'Malley
I think it's really easy to forget, and this is going to sound super obvious, but it's easy to forget that companies are run by real people. And so things as simple as two people having known each other for a long time could be the reason that you have this entrenched bureaucracy where it's like, well, we can't fire them. We got to find it's just real people. You know, we say business categorically. We think of, you know, Amazon as one entity and really it's thousands of people on the margins making decisions that are biased by emotion. And so it doesn't surprise me. Yeah. That there is a chance to come in with kind of fresh eyes and you don't have any of these strings attached to you and you can see maybe the business more soberly and make perhaps better decisions. And that's true for really any company. That's a hard thing to resist. But let's go through the actual business. What does Signity own today and which verticals are the most valuable in your opinion?
- [53:49]
Daniel Munka
Signidly operates across four segments. So you have the financial services unit, which is somewhat of the crown jewel of the company. So it basically handles central bank systems, transaction infrastructure, capital market platforms, banking automation for Polish financial institutions, all that sort of stuff. And this is where Signity owns the source code outright on Most of these contracts, which basically means that clients are dependent on Signity for all future development and support, which kind of makes switching close to impossible. A bank can just migrate its transaction processing system without risking regulatory consequences and also operational disruption. And because of that, these relationships basically extend for decades and they just hold for basically forever. And the revenue they generate is as close to recurring as pretty much anything in the IT services world. It's a similar picture in the second important segment of Signity, which is Energy and Utilities. In this segment, Signity provides billing systems, energy management platforms, network planning tools and regulatory reporting for utilities. And I know I sound like a broken record, but again, highly defensible business with high switching costs. And then you have the public sector, which is the third segment and to some extent the most complicated one, because Signity has, you know, these deep relationships with the Polish public administration, which is great. So for example, the National Tax Agency, Social Security systems and labor market platforms. And just as with the other business segments, the revenue is sticky. However, there are some structural issues to this business. So many public contracts now include clauses that basically give the client ownership of the ip, which basically means that Signity can leverage that code across multiple clients, which is what you usually do as part of a VMS business. So it's one to one software rather than one to many. And that's just not a good thing for the scalability of that product. And any public procurement in Poland has historically also attracted a lot of litigation. Long story short, TSS has been deliberately moderating exposure to at least the most commoditized public tender work. And then last but not least, Business Solutions is the fourth segment. So you're talking ERP implementation, library management systems. This is kind of the most integrator like part of the business, and also the area where TSS is most focused on transforming or de emphasizing over time. So the goal is basically to shift the revenue mix progressively toward the financial services and the utility segment, which have the best combination of recurring revenue and also proprietary ip.
- [56:23]
Sean O'Malley
And the acquisitions are the mechanism for that shift, is that right? With the idea being that each new acquisition adds a software asset and a more or less unrelated industry rather than a services contract.
- [56:37]
Daniel Munka
That's the idea. Three acquisitions have been completed so far and the fourth is closing right now or has been closed in the last couple of weeks. Iduana Baltic is a Lithuanian company doing again erp, HR and payroll software for mostly public sector organizations in the Baltic states. And it basically extends Sign's reach beyond Poland for the first time and kind of adds a recurring product revenue stream with the kinds of public sector switching costs that we already discussed and that Signature just loves throughout all of the operations they have, it was acquired for about 8 to 9 times earnings with 20% sales growth. So to me that seems like a very attractive multiple. Although you generally cannot compare these to public companies. Right? If you buy a company in the private market, it's a small company, it's a concentrated company. You're not paying 20 times earnings for a company just because it's growing 20%. So the fact that they pay about 8 to 9 times earnings doesn't mean that it's a huge bargain for the acquisition. The second company is Sacred Technology. It's a SaaS business providing Salesforce, automation and analytics for FMCG companies. So basically consumer goods firms managing large field sales teams across Poland. So the company was acquired for about 10 times EBITDA with mid teen margins but essentially no top line growth. So that kind of seems to have changed and it shows you the impact that Signity by now also has on the companies that they acquire. So revenue last year went from basically no growth to 10 plus percent growth and profits actually grew over 30%. So at least it seems like the fact that you have so many people coming from Topicus into the business, it shows you that Signity now has the same DNA of kind of buying businesses and then making them better businesses than they have been in the past. And then the third and smallest acquisition yet has been another Lithuanian company which is called Doglogix, which is basically documented workflow management software for enterprises and government agencies. So you really know they are buying a lot of companies in this public sector and space. And they do that because that's basically a market that is getting a direct regulatory tailwind from all of these EU mandated e invoicing requirements rolling out from 2025 onwards. So the deal was worth about $2 million. So we really talk about a very small company and it seems to have been below one time sales too. So once again close to a bargain. The fourth one, on which we basically do not have a lot of information right now is actually the biggest one yet which is a positive sign and it only closed in December of 2025. So the acquired company is called Comarch his and it's once again a Polish company and it's focused on electric health records, mostly selling to hospitals. So basically public sector healthcare sector, those are the main focus or the main focus area for Signity.
- [59:23]
Sean O'Malley
And how do you think about the acquisition pipeline going forward? Because three or four deals in three years is a very different pace from what Constellation and Topicus are doing.
- [59:33]
Daniel Munka
Yeah, it's a fair point and it kind of reflects on where Signiti is in its development. So the M and A infrastructure is still being built. TSS has given Signity a dedicated acquisition team and also a proprietary deal pipeline modeled directly on the TSS Eastern European sourcing approach. But it does take time to develop the relationships with potential sellers in Poland and also just the broader CEE region. And the current deals, I would say mostly demonstrate to the market and basically to potential sellers that Signity is a credible acquirer and they give the internal team experience in integration and also due diligence. They do establish a track record that will attract more inbound interest over time. So I would expect that the pace should accelerate as the platform matures, but I also would expect that starts to acquire more businesses and hopefully at a faster pace going forward. So looking at Signity share price, you mentioned that it was basically a 10 bagger for a long time. The idea certainly is that Signity will be able to become an M and A machine and just transforming its own business into won't be good enough for future returns.
- [60:39]
Sean O'Malley
It seems like a good time to take a step back and look at the macro backdrop because Poland's position in the EU right now is a pretty interesting tailwind. But I think you can speak better to that than I can, so I'll
- [60:52]
Daniel Munka
let you address is certainly one of the most compelling structural tailwinds for any software company operating in Europe generally. So Poland is receiving about 76 billion euros in cohesion funds from basically 2021 to 2027. So it's still ongoing. And that's the largest single allocation of any member state in the eu with digital transformation of public administration and critical infrastructure explicitly identified as a core objective for where that money is supposed to go. And within the European funds for digital development programs alone, they basically try to allocate around 2 billion euros specifically to to IT modernization. And that money basically flows into exactly the verticals that Signety serve. So we are talking state agencies upgrading legacy tax and Social Security platforms, utilities, you know, modernizing billing and grid management systems, banks refreshing core infrastructure. And also, and that's the even more macro backdrop, Polish GDP is growing faster than almost any other EU economy.
- [61:54]
Sean O'Malley
I just read the other day that they're now I think the 20th largest economy in the world. So that is, it's been a very impressive economic turnaround story there since really like the 90s. But what are the risks we should flag with Signity, I think the main
- [62:11]
Daniel Munka
one would be that we have already seen the margin expansion and the restructuring of the business and the stock has already followed. So there could still be great returns, but that would now depend on the M and A engine. To a larger extent it feels like the low hanging fruit has already been picked. And also Signet is not yet a true VMS play either. Again, a meaningful proportion of the business, particularly in the public sector segment which is where they focus on, consists of customized one to one software where the client owns the ip. So that's not scalable, it's not a leverageable asset. That proper VMS product represents and that transition toward productized repeatable revenue is happening, but it will still still take some years to complete. And you could also see those things as opportunities. Of course it's always the way. It could be a risk, could be an opportunity. Kind of depends on how you look at it. But the company is still relatively cheap, so I tend to view it more as an opportunity than a risk.
- [63:09]
Sean O'Malley
Just talking about valuation, how would you think about Signity's intrinsic value compared to Lumine or Topicus?
- [63:15]
Daniel Munka
This one's harder to frame the same free cash flow available to shareholders. Compounder framework we used for Topicus and Lumine because again Signity is not yet an M and A machine that Topicus and Lumine are. So it currently trades at cash flow multiples in the mid teens and if you adjust for the most recent M and A, it's likely closer to low teens, maybe even 12 times cash flow. So that's pretty cheap already. But I could still see a bear case in which let's say the stock could be more or less flat in the future. So that would happen when you assume that mid single digit revenue growth, slight EBITDA margin declines of maybe about 1 percentage point per year and then an exit multiple of 14, which seems cheap. But again you're buying a small cap in Poland here, so 14 times cash flows is certainly nothing that you would call a bargain. And this would basically assume that again M and A won't become a driver of growth in the years to come and you are more or less only getting the organic growth which is not high. So I don't consider that to be likely judged by the acquisitions that we have seen in the last two years. But as a bear case, I even like it because it shows that despite a quite bearish view, it at least seems difficult to lose a lot of money in this case and then in the base case I assume 13% revenue CAGR, roughly 7% of that is organic growth plus 6% as acquisition driven. If we assume the M and A program actually matures EBITDA margins reaching about 35% which is essentially today's level. So no more expansion here and then 20 times free cash flow exit multiple and that would produce a 5 year IRR of about 16% beyond the numbers. I think the thesis here is that the TSS playbook will keep being successfully implemented beyond just margin expansion and definitely include successful and continuous M and A in the years to come. And then you know, if you want to have a bull case in which Signature reaches a growth and margin profile of basically more established TSS operating groups, that would mean a cake in the high teens and a 40% EBITDA margin at the end of the five year period. Currently the entire Constellation universe has seen significant multiple contraction. But if we assume that reverts as we should in a bull case, come on. I think it's fair to calculate with a 25 times multiple for a company of this quality and in that case Signity could compound at about 30% from here. My gut feeling though is that Sydney probably offers the most uncertainty of all the companies that we've looked at yet. The business turnaround again has been more than impressive, but it also is priced into the stock. On the other hand though, I would have expected to see more M and A than they have done in the past two years.
- [65:49]
Sean O'Malley
Yeah, I was joking earlier about the etf, but maybe it's not such a bad idea. To me it's gosh, it's very difficult to pick and choose between these businesses. But I do see why it would be attractive to own a basket of these companies altogether because you're not taking any of the idiosyncratic risks, the key man risk that we talked about with Kelly Partners Group a few weeks ago and you're just generally betting on this Constellation inspired playbook being able to work. And to me that is very attractive. Since we've been talking about Poland, there is one last company we need to get to today and it's a company that TSS has just recently built a stake in. And so that company is a Seiko Poland and it is a much bigger company than Signity. So there are really differences here, but is there enough Runway for them to also be an attractive investment?
- [66:39]
Daniel Munka
I do think this is the opportunity that's most exciting to me today. I mean Signidy has been more of a turnaround candidate and with the Seiko it's definitely not a struggling company at all. It's actually closer to the M and a model that TSS and Topic is outperforming themselves. Seiko is the sixth largest software vendor in Europe by revenue and it already operates in 62 countries, employs nearly 30,000 people and has completed over 140 acquisitions of its own. So it started its more aggressive expansion Strategy in the 2000s under the founder and still CEO Adam Gorell. And the core philosophy was always kind of similar to what Constellation did. So basically buy vertical software businesses, leave them decentralized, preserve local expertise and collect the cash flows. And another great thing about a seiko is that 80% of revenue comes from proprietary products and IT services. So that's certainly a competitive advantage that matters a lot, especially in today's SaaS world.
- [67:38]
Sean O'Malley
The size comparison to Topicus or Lumine is quite striking though, right? I mean this is really no small company at all. And for reference, Topic has 1.5 billion euros in revenue last year. AO Poland at the group level is roughly three times larger by revenue than. So is there not a concern that maybe we're running into a size problem just from the get go with a Seiko?
- [68:03]
Daniel Munka
Well, you might think that, but I think this is where Seiko's company structure is important because a Seiko Poland is itself again a holding company with three distinct segments. So for us as potential shareholders, it matters what exactly you would be buying into. And there is a domestic Polish business which generated about 2 billion Polish zloty in revenue in 2024 with an operating profit margin of about 15%. Then you have a Seiko International, which is their central and Eastern European arm, contributing about 4 billion Polishlotti in revenue with slightly lower but still double digit margins. And then you have Formula Systems which is actually in Israel, Italy listed holding company, that is Seiko Controls. And this company makes up almost 65% of overall revenue. But it does operate at significantly lower margins than the Polish and the central Eastern European businesses. So now a seiko doesn't own 100% of any of those three segments. So the numbers that you see on these consolidated financial statements are not what you as a shareholder actually getting. And if you look at all the different subsidiaries that each of these segment owns, you quickly realized that this is a huge company, similar in terms of complexity probably to Constellation itself, although of course a bit smaller. The point being though, it would be impossible to fully understand all the details of this operation. I spent some time and digging into this. You could probably spend 50 hours. You still don't get it. So when we look at these serial acquirers, we have to focus primarily on their incentive systems. And I know I sound like a broken record because we say this every single time, but we cover about four to five companies here today. So it is important for all of them. We have to look at their corporate structure, you have to look at their track record because it is essentially impossible to deep dive into the details of these operations.
- [69:46]
Sean O'Malley
And that's why we keep focusing on companies with these relationships to the Constellation family, or Universe, whatever you want to call it. And we know their playbook and that it works well. And there are plenty of successful examples of companies like a Seiko that skyrocketed after Constellation and Topicus built a stake in them.
- [70:06]
Daniel Munka
I would call these bets probably sidecar investments. It's something that we talked about last year when we were at the Tip Summit in Montana. A sidecar investment is basically an investment where you are basically riding along in a sidecar pulled by a powerful motorcycle. And in this case that engine is Topicus or tss. So you have to be comfortable with doing that though Chapter Scoop is a bet that I like to take at the right price because it's close to home for me. And you have just better visibility into what's going on due to its smaller size with the Seiko, you have to look at companies like Signity and basically believe that something similar will be pulled off here too. If so, this could be a multibagger. So the question I'm focusing on is what is your margin of safety here for this stock? So we know that TSS will have targeted at least 20% returns when buying a Seiko. And we also know that companies from the Constellation universe don't include multiple expansion into their valuation models. So if you adjust earnings of a Seiko In 2024, the PE was close to 14, which implies an earnings yield of about 7%. If you now add 12 to 13% annual earnings growth, which is Seiko was already delivering and actually accelerated in 2025, you would achieve the 20% returns and no multiple expansion would be needed. Based on the massive fundamental improvements that we have seen with Signity and also many other cases before, you could also make another argument. You could basically say that if TSS targets 20% returns purely from the earnings yield, meaning no growth assumptions, just the yield on what they believe normalized earnings will be after implementing the operational improvements, then the purchase price implies 5 times PE on their target future earnings. That basically means at 85 Polish slotty per share, TSS was effectively saying we believe that with our measures in place, this business will earn about 17 Polish zloty per share. So basically trading at 5 times earnings at today's price of 170 Polish slotty. If you accept that TSS's entry price represented 5 times the target earnings, then the current price translates to roughly 10 times those same target earnings. I admit it's a bit of mental accounting and you would have to buy into the story that TSS will have the same success with the improvements that they have had before. But even if you don't want to assume that, I mean you are buying in at around 19 times earnings for a business with 12 billion policeloading and contracted backlog embedded relationships across 62 countries and a Constellation family shelter actively pushing for improved capital deployment. So to me all of that sounds pretty good and SQL seems like probably the cheapest maybe combined with Signity and most recent option in public markets to participate in Constellations playbook with Topicus or TSS as basically the shareholder alongside you.
- [73:03]
Sean O'Malley
I love the sidecar analogy, but also as someone who would probably literally be terrified for their life if I were strapped to someone's motorcycle, it does raise the stakes when you think about it that way. Like just being affiliated with Constellation in some way might not be enough for me to be willing to invest. And it's definitely possible to do this with smaller companies, but I think you actually have to meet the management team. You have to see how they are in person and then decide, okay, figuratively, how comfortable do I feel being financially strapped to a motorcycle that this person is driving? Because that is really what you're doing in a sense. And anyways, we've looked at all the companies we wanted to discuss today, so I think now it's time to talk about whether any of them are fit for our intrinsic value portfolio.
- [73:52]
Daniel Munka
Just to your last point, I think that's one more reason why I find a Seiko to be the most attractive out of this bunch of companies. Because basically you have a founder and CEO who is already in this business for 30 years and who has been highly successful. That's probably someone you can trust with your money alone. And now he's also got the backing of Topicus. So to me that seems more trustworthy than, for example buying Signity, where I really don't know the management team at all. But again, with all the discussions in our intrinsic value community, I feel like we've spent every day of the last two weeks, maybe even a whole month talking about Constellation VMS companies and certainly SaaS in general. But after looking at all these companies and actually some more that didn't even make it into today's episode, I got to say that Luman is probably the only company outside of Topicus and Constellation that already has a fully functioning M and A engine that you can compare to the aforementioned companies. And that obviously comes at a price even after the current sell off.
- [74:50]
Sean O'Malley
But that price, yeah, as you said, is a lot lower than at any point in the last few years, for sure.
- [74:55]
Daniel Munka
Yeah, that's right. And still I think that in this case it really depends on your personal goals and risk tolerance, which is why I basically gave you this disclaimer at the beginning of this episode. That's the case with every investment that we look at. But it's even more important here and for our portfolio, I think the companies to consider are Constellation and Topic is. But I do think that our opinions have not changed to the extent that we would make a different decision today than we did a couple of weeks ago. Personally, again, I repeat myself here. I find the Seiko to be the most interesting one. It also has a proven MA engine, but not yet the same Constellation DNA that Luminotopicus have. But that gives you the opportunity to not only participate in the M and A playbook adoption, but also in a broader company restructuring. But again, it's a Polish company, it's relatively illiquid and therefore it comes with a whole lot of different risks than Constellation. And it's also a lot harder to follow and to understand. So for all of our small cap investors out there, you want to potentially take a closer look at that one, but I don't see us adding it to the intrinsic value portfolio. So what's your take? I would be surprised if you would want to persuade me to change my mind on that.
- [76:08]
Sean O'Malley
Oh man. I mean, maybe what we need to do is just have a small cap portfolio someday. Because mentally I do not know how to keep Alphabet, Amazon and Uber in the same investment basket as a liquid Polish software companies. And like, like, seriously, when you manage a portfolio, you have to be constantly considering the opportunity cost of capital, which is to say being able to compare the risk reward profile of what you own versus other opportunities in the market. And that also means being able to compare the holdings within your own portfolio against each other. Just having some kind of mental framework to be able to do that. But If I have 5% cash and I'm looking to allocate it across the existing holdings in my portfolio, how do I decide to break that up? Between Alphabet or a Seiko or Lumine, it's just very difficult to think about how wildly different these businesses are and what the implications are at the end of the day, how many dollars you allocate to one and how many dollars you allocate to the other. And this is why you see investors focus on specific types of businesses, industries, market caps, geographies, and all that kind of stuff for the portfolios they run, because it gets incredibly difficult to compare businesses across the full spectrum and to do so in any kind of consistent way that's also accurate. And so I don't know, Daniel, you tease me for my bias towards large caps sometimes, but I think I'd rather go to sleep for 10 years and wake up owning Alphabet than having to choose between one of these VMS companies to bet on instead of. And if we did want to bundle a handful of these Constellation connected VMS stocks into one position, I could get behind that. But I think that's just sort of me copping out back to that, that ETF idea.
- [77:54]
Daniel Munka
It's kind of interesting because if you would have asked me many years ago, I would have also had this mindset of thinking that you just want to own the best investments and doesn't really matter in what sector they are and what industry, and you can just bundle all of them into one portfolio because technically you just only have the best investments. It takes time to figure out that there are many companies that can be the best investment at a certain point in time. Those could be large caps, those could be small caps. There could be international stocks or US stocks. And it's difficult if you mix it up. I mean, Sean and I, we have so many meetings basically discussing our portfolio allocation, discussing the opportunity costs of holding one company and not the other. And again, after all of these discussions, thinking about having to decide whether to allocate to Alphabet or a Seiko, it's just a task that's way too difficult for me to handle. So I do agree that if you buy these companies, you probably have to bundle them into, you know, owning four to five of them and basically viewing them as one position. I do also think that's not the best approach for our portfolio. So I do feel pretty confident in saying, hey, we covered a lot of these companies. If anyone is interesting, please go ahead, do your own due diligence and own them in your personal portfolio. I don't think they are the right fit for the portfolio that we are building here on the show. All right, so let me close it for today with another quote by one of the most famous investors of the 20th century, Shelby Cullum Davis. And he said you make most of your money in a bear market, you just don't realize it at the time. Looking at our portfolio right now and some of the positions, I really hope that Shelby is as wise as this quote sounds and we are making a whole lot of money in the months to come.
- [79:33]
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