April 6, 2017 / 2:41 PM / 4 months ago

Fitch Upgrades Constellation Software's IDR to 'BBB'; Outlook Stable

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(The following statement was released by the rating agency) CHICAGO, April 06 (Fitch) Fitch Ratings has upgraded Constellation Software, Inc.'s (Constellation) Long-Term Issuer Default Rating (IDR) to 'BBB' from 'BBB-'. The Rating Outlook is Stable. Fitch's actions affect $695 million of total debt, including the undrawn $485 million revolving credit facility (RCF). A full list of rating actions follows at the end of this release. The ratings and Outlook are supported by Constellation's resilient, stable business model stemming from its mission critical software, leading positions in niche vertical markets, recurring revenue, end market diversification, low leverage, and strong free cash flow (FCF) generation. The potential to utilize standalone financing for larger, riskier acquisitions provides an important credit protection mechanism for the parent (Constellation - where the rated debt resides), in Fitch's view. Constellation's demonstrated discipline for IRR-based measures should ensure consistent quality of acquisitions. Primary rating constraints include the prospect of higher leverage, operational and financial risk associated with the company's acquisition strategy and uncertain financial impact from SaaS investments. Fitch does not view lack of revenue scale as a significant ratings limitation for software companies, instead emphasizing FCF, profitability, end market diversification, competitive position, retention and organic growth as better measures of financial stability and operational effectiveness. Fitch's assigned ratings and Outlook for Constellation do not reflect any credit risk from the Total Specific Solutions (TSS) entities (other than obligations related to TSS minority shareholders' put rights) based on the strong legal, operational and strategic ring-fencing measures in place (all references to Constellation's metrics exclude TSS). KEY RATING DRIVERS Stable Customer Base Constellation's software enables business processes that are core to customers' workflow, thus increasing customer stickiness and creating high switching costs. Retention has consequently remained between 92%-95% for the past decade, despite the short-term escalation in customer or module attrition that typically results after software acquisitions. Retention is further supported by Constellation's leading positions in niche vertical markets, which limits competition. Recurring Revenue Maintenance and other recurring revenue comprised 66% of Constellation's total revenue in 2016 (about 25% of Maintenance and other recurring revenue is from SaaS businesses). Maintenance revenue is highly stable and tends to be more resilient than license fees and professional services during downturns. End Market Diversification Constellation's industry agnostic acquisition approach has resulted in exposure to over 70 niche end markets in the public and private sectors. Constellation's performance is consequently not tied to a narrow set of industry dynamics as is the case with most Vertical Specific Software (VSS) providers, which tend to specialize in one or two industry verticals. The company's largest exposure is to the broader public sector (67% of total revenue), which includes a fragmented government customer base that has proven resilient during economic downturns. Constellation's diversified exposure creates a natural hedge against revenue volatility - the company's largest organic revenue decline was 3% in 2009, a time when many VSS providers saw double digit declines. Strong FCF Profile Constellation's FCF margin was 18.1% in 2016 (after dividends, 22.6% pre-dividends), which compares favourably to the rating category. Fitch expects Constellation to generate FCF of over $300 million per year (after dividends) over the forecast period. Strong FCF generation has enabled Constellation to fund a large portion of its M&A organically, and obviated the need for meaningful leverage. Standalone Financing Model In 2013, Constellation acquired TSS for $342 million, its largest acquisition to date. The company fully funded the transaction with a bridge loan at Constellation, which was fully repaid by the end of the following year. Fitch views the strong legal, operational and strategic ring-fencing measures in place around TSS as a repeatable model that the company will leverage for future larger, riskier transactions, and a key offset to some of the risks involved with increasing focus on larger transactions. Standalone financing, however, may not always be available (e.g. unprofitable targets, market conditions) or preferable (e.g. strategic benefits from systems integration), which would cause Constellation to finance certain larger acquisitions at the parent company. Fitch would view acquisitions of larger distressed companies (declining revenue or unprofitable without immediately identifiable cost synergies) financed permanently at the parent level negatively due to the execution risk involved in improving those trends. Low Leverage with a Flexible Policy Constellation's unadjusted debt/operating EBITDA ratio was 0.4x as of Dec. 31, 2016. Fitch's forecast assumes mid-cycle leverage at Constellation will remain below 2.0x, which compares favorably to the rating category. Fitch's expectation of leverage sustaining above 2.5x for longer than 12-18 months would likely exert negative pressure on the rating. Constellation's lack of a formal leverage policy adds uncertainty around how much leverage the company would assume if returns were compelling enough and standalone financing were unavailable or not preferable, in Fitch's view. Opportunistic M&A Constellation's business model requires a continuation of opportunistic M&A's of software companies that provide mission-critical products and services to vertical markets in order to maintain its continuing growth. In recent years, acquired companies have varied in size from an average of $5 million-$8 million to larger ones of over $100 million. Fitch believes the company remains discipline in its evaluation of acquisition targets based on IRR without imposing target on number or size of acquisitions. Despite the numerous acquisitions, Fitch sees limited integration risks as Constellation's strategy is to run the acquired entities independently; this strategy effectively limits integration risks that generally arise from M&A's and systemic risks given the independence of operating entities. This also results in limited synergies to be realized from M&A activities. Uncertain Financial Impact from SaaS Investments Fitch believes concerns around security, compliance and customization provide a tangible demand for on premise vertical software, but that capital constrained customers will continue to push forward adoption of hosted vertical applications at a measured pace. SaaS now comprises 25% of Constellation's total revenue; Fitch views that the transition to SaaS should not result in disruption in revenue generation as SaaS revenues should mostly replace existing on-premise maintenance revenues. Nevertheless, given the limited contribution from SaaS, the uncertain long-term net effect on the company's margins and FCF of an increasing SaaS revenue mix as a rating constraint. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: --Organic revenue growth of 3% per year; --Acquisitions of $400 million per year financed permanently at Constellation; --Average acquisition revenue multiple of 1.50x (versus 0.8-0.9x historically); --EBITDA margin maintained at 25% as company maintains discipline in its IRR-based measures of its businesses; --Dividends remain constant at $85 million per year. RATING SENSITIVITIES Future developments that may, individually or collectively, lead to a negative rating action include: --Fitch's expectation of leverage (unadjusted debt/operating EBITDA) sustaining above 2.5x; --Decline in mid-cycle organic revenue growth to a flat or negative figure; --Contribution of recurring revenues declines below 60% of total revenues; Fitch views this as a measure of the quality of revenues; --Fitch's view that existing ring-fencing measures at TSS have weakened; --Larger acquisitions of distressed companies financed permanently at the parent level. Future developments that may, individually or collectively, lead to a positive rating action include: --Management's introduction of an explicit conservative leverage target; --Fitch's expectation that acquisitions will be fully funded with organic cash flow. LIQUIDITY Fitch believes Constellation has a strong liquidity profile based on the following: Internal and External Sources - Fitch expects the company to maintain FCF generation of over $300 million per year. The company has not historically maintained a meaningful cash balance ($349 million as of Dec. 31, 2016), but has $470 million available on its $485 million revolver ($15 million LOCs and $0 drawn). Fitch does not believe financial covenants within the revolver will restrict near term capital deployment. Contingent Liquidity from TSS - Although TSS's existing debt agreements restrict it from upstreaming meaningful proceeds to Constellation absent a waiver from its bank lenders, Constellation's two thirds equity ownership in TSS provides a source of contingent liquidity equal to the residual proceeds to shareholders following a monetization event. Maturity Profile - The company's debentures mature in 2040, or five years after an exercise of put rights by investors. The earliest possible maturity date for the debentures is currently in 2023 (exercise window is in March of each year). The company's existing revolver matures in 2020. FULL LIST OF RATING ACTIONS Fitch has taken the following ratings actions: Constellation Software, Inc. --Long-Term IDR upgraded to 'BBB' from 'BBB-'; --Senior secured revolving credit facility upgraded to 'BBB+' from 'BBB'; --Unsecured subordinated floating rate debentures affirmed at 'BBB-'. Contact: Primary Analyst Alen Lin Senior Director +1-312-368-5471 Fitch Ratings, Inc. 70 West Madison St. Chicago, IL 60602 Secondary Analyst David Peterson Senior Director +1-312-368-3177 Committee Chairperson Jason Pompeii Senior Director +1-312-368-3210 Media Relations: Alyssa Castelli, New York, Tel: +1 (212) 908 0540, Email: alyssa.castelli@fitchratings.com. 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