Constellation stock undervalued as market underestimates cash flow, says UBS

On Thursday, UBS initiated coverage on Constellation Software (ETR:SOWGn) (CSU:CN) (OTC: CNSWF) stock with a Buy rating and set a price target of Cdn$5,150.00.

The firm highlighted Constellation's status as a high-quality capital allocator within the vertical market software (VMS) sector and its impressive track record since its initial public offering in 2006.

UBS emphasized the company's moated business model, which supports pricing power and access to data for decision-making, solidifying its position as a preferred acquirer.

The analyst noted that the VMS sector is characterized by high barriers to entry and the potential for margin and cash flow expansion. The industry is also seen as benefiting from long-term structural demand due to the mission-critical nature of its software.

The integration of Constellation's offerings into client workflows is believed to reduce the risk of disintermediation, supporting the case for a modest premium over its three-year average valuation.

UBS anticipates a positive future for Constellation Software, forecasting a free cash flow (FCF) compound annual growth rate (CAGR) of over 18% for the next five years. The market's current discounting of FY26 FCF at U$2.6 billion, compared to UBS's estimate of U$3.1 billion, suggests potential for a re-rating as the market may be underestimating the company's free cash flow generation capabilities.

The firm has modeled diluted International Financial Reporting Standards (IFRS) earnings per share (EPS) for FY25 and FY26 at $49.98 and $62.00, respectively. These projections are slightly above the consensus estimates of $49.57 and $61.02 for the same periods. UBS's coverage initiation and positive outlook reflect a strong belief in Constellation Software's continued growth and profitability.

In other recent news, Constellation Software's third-quarter financial results for 2024 showed a slight shortfall in revenue but exceeded expectations in terms of EBITDA, as reported by BMO Capital Markets.

The firm noted that despite a year with relatively flat merger and acquisition activity, Constellation Software consistently achieved robust year-over-year EBITDA growth.

BMO Capital Markets has updated its outlook on Constellation Software, increasing the price target to Cdn$4,900 from the previous Cdn$4,800, maintaining an Outperform rating on the stock. This adjustment follows improvements in the company's fully consolidated estimates, notably from its affiliates, Topicus and Lumine.

Lumine was singled out for significant margin improvement, largely due to effective cost optimization strategies at its recently acquired businesses, Motive and Axyom.

Despite a quiet quarter for mergers and acquisitions, BMO Capital anticipates Constellation Software's EBITDA for Q3 2024 will exceed consensus expectations. These are among the recent developments for Constellation Software.

InvestingPro Insights

InvestingPro data and tips provide additional context to UBS's bullish stance on Constellation Software. The company's market cap of $68.32 billion USD underscores its significant presence in the software industry. Constellation's revenue growth of 22.11% over the last twelve months aligns with UBS's positive outlook on the company's future performance.

InvestingPro Tips highlight that Constellation Software has maintained dividend payments for 18 consecutive years, indicating financial stability. This consistency supports UBS's view of the company as a high-quality capital allocator. Additionally, the tip noting that Constellation is trading near its 52-week high corroborates UBS's optimistic price target.

The company's P/E ratio of 115.6 and P/E ratio (Adjusted) of 107.4 for the last twelve months suggest that investors are willing to pay a premium for Constellation's shares, aligning with UBS's assessment of the company's moated business model and potential for growth. This high valuation is further supported by the InvestingPro Tip indicating that Constellation is trading at high earnings and revenue valuation multiples.

For investors seeking a more comprehensive analysis, InvestingPro offers 13 additional tips that could provide deeper insights into Constellation Software's financial health and market position.

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