OREANDA-NEWS. Fitch Ratings has assigned a first time 'BBB-' IDR to Constellation Software, Inc. (Constellation). The Rating Outlook is Stable. A complete list of rating actions follows at the end of this release. Fitch's rating actions affect Constellation's C$282.3 million debentures and $300 million undrawn revolver.

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 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.

Primary ratings 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 free cash flow, 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 comprises 63% of Constellation's total revenue (about 13% 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. 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 (69% 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 15.7% in 2014 (after dividends, 21.6% pre-dividends), which compares favorably to the rating category. Fitch expects Constellation to generate FCF of over $300 million per year (after dividends) beginning 2016. 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 about 0.56x as of Sept. 30, 2015. This figure is subject to increase based on management's remarks that it would consider issuing new debt to add dry powder for future acquisitions. 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.

Shifting Focus to Larger M&A

Constellation recently revised downward its hurdle rate for larger acquisitions. Fitch views this shift in strategy as a credit negative due to the higher multiples the company will likely have to pay in a more competitive bidding environment, which can increase leverage. Fitch's forecast assumes an increase in average purchase multiple (total revenue) from 0.8x - 0.9x historically to 1.5x, which should adequately capture this risk, in Fitch's view. Fitch believes Constellation's financial discipline and the likelihood that smaller deals will still comprise a meaningful portion of the transaction mix should temper the magnitude of an increase in purchase multiple.

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. Constellation's SaaS businesses have higher organic growth rates, but also higher attrition and lower profitability than its on premise ones. Fitch views the uncertain long-term net effect on Constellation'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 0.8x -0.9x historically) to account for increasing mix of larger transactions;
--$250 million of new proceeds from debentures issued under current program for dry powder;
--EBITDA margin declines 50 bps per year to reflect increases in incentive compensation;
--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 sustaining above 2.5x;
--Structural decline in mid-cycle organic revenue growth
--Weakened ring-fencing measures;
--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:

--An explicit conservative leverage target combined with successful financial and operational execution of rebalanced M&A strategy.

LIQUIDITY

Fitch believes Constellation has adequate liquidity based on the following:

Internal and External Sources - Fitch expects Constellation to generate FCF of over $300 million per year beginning 2016. The company has not historically maintained a meaningful cash balance ($85.6 million as of 30 September 2015), but has $286.2 million available on its $300 million revolver ($13.8 million LOCs and $0 drawn), and is currently negotiating an amendment that may increase this commitment. 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. Assuming an exit multiple equal to Constellation's purchase multiple, Fitch estimates Constellation's equity stake in TSS is worth about $95 million as of Sept. 30, 2015.

Maturity Profile - Constellation's debentures mature the earlier of 2040 or five years after an exercise of put rights by investors. The earliest possible maturity date for the debentures is currently in 2021 (exercise window is in March of each year). The company's existing revolver matures in 2016, but is currently undrawn and is expected to be re-negotiated in the near-term.

FULL LIST OF RATING ACTIONS

Constellation Software, Inc.
--Long-Term IDR 'BBB-'; Stable Outlook;
--Senior Secured Revolving Credit Facility 'BBB';
--Unsecured Subordinated Floating Rate Debentures 'BBB-'.