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Edited Transcript of CSU.TO earnings conference call or presentation 27-Jul-17 12:00pm GMT

Thomson Reuters StreetEvents

Q2 2017 Constellation Software Inc Earnings Call

TORONTO Aug 13, 2017 (Thomson StreetEvents) -- Edited Transcript of Constellation Software Inc earnings conference call or presentation Thursday, July 27, 2017 at 12:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Bernard Anzarouth

Constellation Software Inc. - CIO

* Jamal Nizam Baksh

Constellation Software Inc. - CFO

* Mark Leonard

Constellation Software Inc. - Founder, Chairman and President

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Conference Call Participants

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* Paul Steep

Scotiabank Global Banking and Markets, Research Division - Analyst

* Paul Treiber

RBC Capital Markets, LLC, Research Division - Associate

* Ralph Garcea

Echelon Wealth Partners Inc., Research Division - Research Analyst

* Richard Tse

National Bank Financial, Inc., Research Division - MD and Technology Analyst

* Stephanie Doris Price

CIBC World Markets Inc., Research Division - Analyst

* Thanos Moschopoulos

BMO Capital Markets Equity Research - VP and Analyst

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Presentation

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Operator [1]

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Good morning, ladies and gentlemen. Welcome to Constellation Software Inc.'s Q2 Results Conference Call. I would now like to turn your meeting over to Mr. Mark Leonard, Mr. Jamal Baksh and Bernie Anzarouth. Please go ahead.

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Mark Leonard, Constellation Software Inc. - Founder, Chairman and President [2]

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Good morning. Thank you, Hugo. Welcome to the Q2 Conference Call and as you know, we go directly to questions. So, Hugo is going to give you instructions for how to tee up.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question is from Thanos Moschopoulos from BMO Capital Markets.

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Thanos Moschopoulos, BMO Capital Markets Equity Research - VP and Analyst [2]

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Mark you said on the last call that you doubled the size of your M&A team, relative to last year and that clearly seems to be paying off with respect to how much capital you've deployed this year. So, I think, that demonstrates, as you've previously said, that the constraints isn't the number of opportunities out there but rather your ability to find those opportunities. That being the case, why not triple or quadruple the size of your team? Is the constraint now, your ability to find and train qualified M&A people? Is it more a question about ensuring that you scale up team in a thoughtful manner rather than risk overinvesting? What are your thoughts on this topic?

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Mark Leonard, Constellation Software Inc. - Founder, Chairman and President [3]

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Well, since we got Bernie on the call today. Why not I let him sort of weigh in on the practicalities of scaling up.

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Bernard Anzarouth, Constellation Software Inc. - CIO [4]

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So, it's Bernie Anzarouth, this is my first time on a call, so please bear with me. So last time, we reported about 60 or so full-time M&A people that are on staff. And, I think, what you're going to find now, that we're providing the opportunity for BU managers and for portfolio managers to go out and deploy more capital. And what we've decided to do is to get them the resources that they need to go out and find more acquisition candidates. So the fact is that indeed, we are looking to add more M&A resources and, I think, we're probably about 10% more today than we were when we announced this, I don't know, last quarter, the quarter before. And I think where we will end up being is at least 20%, 25% higher by the end of the year, if not more. So yes, we are expanding our M&A force. And whether we get to double or triple, it’s tough to scale that quickly, to find qualified people to actually do that. As well, when you're adding that many companies to our fold, we do need the bandwidth as well. So we do have those trained up portfolio managers and BU managers to be able to take on those acquisitions and run them appropriately.

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Thanos Moschopoulos, BMO Capital Markets Equity Research - VP and Analyst [5]

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And so is the hiring focused, more in terms of the people trying to identify and source opportunities, the ones executing on closing the opportunities or both those areas?

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Bernard Anzarouth, Constellation Software Inc. - CIO [6]

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It's both those areas. So we do have a lot of business development managers that are going out and looking for the opportunities. And actually some of them have to stay in touch with those that we've contacted in the past and weren't ready to transact. So we need those folks to be out there as well as the people who can actually take it to a close, which is do the analysis, do the diligence, put the models together, and get it to close. So we do need a combination of the two for sure.

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Thanos Moschopoulos, BMO Capital Markets Equity Research - VP and Analyst [7]

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Great, thanks. On a different topic, the organic growth for professional services revenue was down year-over-year, which we haven't seen in recent quarters. I realize there might not be a simple answer for that but is there anything specific you would call out?

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Jamal Nizam Baksh, Constellation Software Inc. - CFO [8]

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I mean the organic growth is only what, 1% decline, half of that percentage decline came from the transit group. And it's really timing, I mean, if you -- they're actually pretty large projects on the way in the transit group. And so I'd actually expect it to pick up in the next year or so. But yes, it's just timing of when we're recognizing revenue on some of these contracts.

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Thanos Moschopoulos, BMO Capital Markets Equity Research - VP and Analyst [9]

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Okay. And finally, there's obviously been some movement in the FX as of late, just to confirm if you look at current FX rates relative to FX rates in the past quarter or so. Should the recent FX movements be a very slightly positive contributor margins going forward? Am I taking that correctly there?

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Jamal Nizam Baksh, Constellation Software Inc. - CFO [10]

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Organic growth, possibly. Margins, it's always been a pretty immaterial amount. I mean, we also have a lot of Canadian expenses and as the Canadian dollars strengthens, that's going to go opposite to the margin impact. So I wouldn't have expect much to that margin percentage but if we are going to have, if not -- I'd expect less of an impact to organic growth, I mean, you're already seeing that. And there might be a small positive next quarter, I'm not sure.

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Operator [11]

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The next question is from Richard Tse from NBF.

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Richard Tse, National Bank Financial, Inc., Research Division - MD and Technology Analyst [12]

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Yes, thank you. Mark, I'm just wondering if you could provide us just a general broad update on the acquisition environment space since last quarter, any changes, any changes in trends et cetera?

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Mark Leonard, Constellation Software Inc. - Founder, Chairman and President [13]

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We try and monitor what's happening in vertical market software acquisitions generally. And I would say there may be a slight upward trend but nothing dramatic from what we've seen over the last few quarters.

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Richard Tse, National Bank Financial, Inc., Research Division - MD and Technology Analyst [14]

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Okay, and I guess, it seems that over the past maybe year or two, you've been spending a bit more time outside of North America, just wondering if you could sort of frame the global opportunities relative to North America. Obviously, it seems like there could be some outsized opportunities there but I'm not really that familiar with those markets, but if you can run through that, that would be terrific?

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Mark Leonard, Constellation Software Inc. - Founder, Chairman and President [15]

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We've done a number of acquisitions for instance in Germany. That was a place that we went to later because English wasn't as frequently found there. And we didn't have as many local staff to lean on to do acquisition. So it's a good example of a large market that we entered later. My sense there is that there are cultural differences that lots of entrepreneurs build their businesses and they tend to stay within the family. Perhaps more so than North America, where the idea of building a business and selling it is perhaps more the norm. And so I would say that in Germany, we are unlikely, to have on a per capita basis as many opportunities as we do for instance in America. And I think we're probably seeing something similar in Japan. It's very early days. There's two big sort of developed markets with relatively high labor cost, which are the kinds that we prefer. We don't tend to go looking extensively in low-weight rate countries. Because we find that vertical market software isn't as important and prevalent in those places.

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Richard Tse, National Bank Financial, Inc., Research Division - MD and Technology Analyst [16]

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Right. And I guess in those markets, would the deals be assessed more by, let's say, the corporate acquisition team as opposed the BUs or -- but I'll imagine you have a lot of BUs in some of these countries.

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Mark Leonard, Constellation Software Inc. - Founder, Chairman and President [17]

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I mean, Bernie, What's your sense of the BUs coverage of other geographies?

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Bernard Anzarouth, Constellation Software Inc. - CIO [18]

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Yes. Our offerings groups for example are such group recently made an acquisition in France and that was totally run and managed by the TSS group. So I think its whoever we have on the ground that's closest to the opportunity will be running with it, obviously, with support from head office of that operating group.

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Operator [19]

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The next question is from Paul Steep from Scotia Capital.

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Paul Steep, Scotiabank Global Banking and Markets, Research Division - Analyst [20]

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Great. Mark or Bernie, could you maybe just talk a little bit about the evolution in the M&A process and the structure to better scale the organization? Like I noticed that Bernie, congratulations, has a new title may be over the last six months?

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Mark Leonard, Constellation Software Inc. - Founder, Chairman and President [21]

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We were just joking about that.

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Paul Steep, Scotiabank Global Banking and Markets, Research Division - Analyst [22]

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But I guess the bigger question -- the understanding was, all roads led to Bernie, in the old model. How's that changed to help scale and also make sure that the process is still intact?

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Bernard Anzarouth, Constellation Software Inc. - CIO [23]

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Yes, so we joke about me being the bottleneck in the whole process. And so the easy way to remove that was to give me a new title and not have my hand in the process anymore. That's not entirely true, so we did increase the threshold by which the operating groups were able to make acquisitions on their own. So having said that, we're -- we decentralized the M&A function significantly, recently. So what we've done is, we've allowed more people in the BUs to deploy more capital, without necessarily getting headquarter's approval. So it'll allow us to make more acquisitions and deploy more capital. Now we don't really know -- or we won't really know for about a year or two if the capital that we're deploying today is going to generate reasonable rates of return. So it's kind of early still to declare the experiment a success. We might have some setbacks, we might have a couple of investments that go sideway or even down, but we have to give the BU managers and the portfolio managers, who are deploying the capital, some time to learn and mature. And so we won't really know if the experiment is a success for another four or five years. The one thing is that we will be deploying far more capital. But still under the guidance of the operating group managers in a team that has been there since day one. So all of that experience that we've built over the years is not lost on the new acquisitions. And the new people coming in, they will be overseeing these people as well. So I have full confidence in our ability to deploy more capital.

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Paul Steep, Scotiabank Global Banking and Markets, Research Division - Analyst [24]

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So is there a new process for you to -- I find it hard to believe you're entirely going to go hands-off. I know you said, you just upped the threshold, is there going to be some form of like a spot audit? I guess, what's different about now having a CIO role? Is it now -- your goal is now to control overall capital rates, which before you and Jamal and the board and the team would have been doing?

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Bernard Anzarouth, Constellation Software Inc. - CIO [25]

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So I still get -- you're absolutely right, Paul. I still get to see everything. And William, who used to work for Mark, is working for me now. So we've got expanded capacity. And we do still look at everything. And we still have our hands in all of it and we do give our candid feedback to all of the folks that are out there, generating leads and working on acquisition prospects. So we do give them our unbiased opinions. Yes, that is true.

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Paul Steep, Scotiabank Global Banking and Markets, Research Division - Analyst [26]

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Okay. And then I guess maybe Mark, secondly, on the large deal environment, have there been any thoughts or changes in how you'd approach those in terms of helping differentiate CSU, we've talked about in the past that those situations tended to be more challenging. Has there been any progress or thoughts around, how you'd better maybe approach stock market?

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Mark Leonard, Constellation Software Inc. - Founder, Chairman and President [27]

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We were talking about one of the brokers, yesterday, who seems to use us as the group they come to, when they've got a busted process, one where they've gone out advertised the company, published the information, shipped a hundred copies of the investment memorandum or whatever they call it. And people have gone into diligence and then discovered that a bunch of it was hooey. And the enthusiasm for the prospect has dropped away. And in many of those instances, there's still something of substance there. And we are willing to do the work to understand what that substance is, and are often comfortable doing more diligence and providing a price. So that fallback position of someone who's willing to transact in messy situations is a position, I think, we can carve out in the brains of the brokers who are trying to get transactions done that may not be glossy and perfect. In addition to that, obviously, when we have a strategic advantage because we're already in the particular vertical and there are obvious synergies, we may be a buyer of preference. And when there are not crisp numbers, when you can't -- when they are doing carve outs of large corporate transactions, again, we're willing to build our models from the ground up to work from individual salaries and offices and maintenance contracts and sort of construct our own financial picture. So I'd say, those are some instances where we can perhaps play where others would not.

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Paul Steep, Scotiabank Global Banking and Markets, Research Division - Analyst [28]

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Great. One just quick clarification as well, I noticed you are out of the public equity market it would seem at the moment. Is that just a factor of opportunity set and valuation versus any other change that you might have had or change of heart you might've had?

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Mark Leonard, Constellation Software Inc. - Founder, Chairman and President [29]

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Yes, that's exactly the right conclusion, Paul. It's -- everything's expensive, and things of size, where we can put some dollars at play, all seem to be trading high. I think one of the data points I saw was that the average vertical market software company, with more than a $50 million market cap is trading at 3.8x revenues and those tend to be fairly hefty valuations.

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Operator [30]

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Next question is from Paul Treiber from RBC Capital Markets.

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Paul Treiber, RBC Capital Markets, LLC, Research Division - Associate [31]

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Just want to follow up on one of Paul's questions. Just in light of the more decentralization of the M&A function. How do you utilize, or what processes have you put in place to utilize the data and experience of the company in that structure? And one thing that struck me it was at the AGM you mentioned that you have the insight to push back on M&A assumptions given that you know, in light of your history, if the assumptions are in like in the 99th percentile or 50th percentile.

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Bernard Anzarouth, Constellation Software Inc. - CIO [32]

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Yes, so we use base rates as you mentioned, to compare any new prospects that we're looking at in terms of valuations and what the forecast -- expected forecast would be for these prospects. And we compare it to our 330 odd acquisitions that we've made so far. We don't track all of them specifically, a few of the acquisitions have been tightly integrated to other operations. So we -- it's very hard to see the results of that one -- of the individuals that were tightly integrated. But we still track, for the most part, all of the businesses that we've acquired, since the beginning of time. And we do get to see how they've evolved over the years and we look at key metrics, core profitability, growth, different aspects of the operations and we do get to compare these new prospects that are brought in, or at least the expected forecast to what we've seen in the past, and whether or not the forecasts are a little overblown or if they fit into what we have done in the past. So all of that experience that we've built over the years, is being used in assessing new prospects for sure. That was all -- did I get all of your questions?

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Paul Treiber, RBC Capital Markets, LLC, Research Division - Associate [33]

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Yes, I mean, I imagine, there are actually some new processes set up though, if there is indeed more decentralization and the headquarters isn't as involved?

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Bernard Anzarouth, Constellation Software Inc. - CIO [34]

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Yes, so if you think back 10, 15 years ago when everything was run or headed by headquarters, that same process is headed up by the operating groups. So they have their M&A folks, they have the guys that have been with us since '96, '97, who have been working on all of these acquisitions since we started. So all of that experience has just been brought one level down from headquarters to the operating group. So those processes are still in place, there's a lighter touch from headquarters if you want to put it that way. But we do get all of the information, we do still get to see everything that's going on. So that oversight is still there.

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Mark Leonard, Constellation Software Inc. - Founder, Chairman and President [35]

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We regularly compile the information, Paul, and disseminate it to the group general managers and the M&A heads. And then once a year we have an M&A conference We had a 100 and something people at it last fall, and we'll do the same again this fall.

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Paul Treiber, RBC Capital Markets, LLC, Research Division - Associate [36]

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Okay, great. Another question on M&A, just wanted your thoughts on the strategy to push down capital allocations to the business unit managers. From what you've seen -- and I know this is early days, but do you think capital allocation is a natural talent that someone has or doesn't has, or do you think it's something that can be taught and they can gain overtime?

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Bernard Anzarouth, Constellation Software Inc. - CIO [37]

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I think if the folks are enumerate enough to run a business and to understand the ins and outs of an operation, they can understand how a new operation could run. Now maybe they have the bias of believing that they could run anything if their own operations is running really quite smoothly. But I think that over time we're able to teach them and they could learn. It's not -- I mean it's a bit of an art and it's a bit of a science, but given the metrics that we give them, it's hard to not get it really quickly. Again as Mark said, we have our M&A session every year. We talk to our M&A guys pretty regularly, weekly. And the general managers get the feedback from me on a regular basis as well and we get together every quarter. So that feedback loop is always there and I think the information is disseminated well enough that our guys can pick it up.

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Mark Leonard, Constellation Software Inc. - Founder, Chairman and President [38]

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Remember, there's a lot of data points too from which they can learn. I don't know how many models William and Bernie see a week but they're providing feedback on these models on a very regular basis to a large group of people. And every time you get feedback you're honing your skill and learning against the hard stone of these experts.

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Bernard Anzarouth, Constellation Software Inc. - CIO [39]

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And we're not shy about giving the feedback so.

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Paul Treiber, RBC Capital Markets, LLC, Research Division - Associate [40]

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Okay. One last one from me. Margins continue to improve, as you get larger and I know you mentioned in the past that there is no economies of scale -- or I guess economy of scale in the business, but the data seems to suggest otherwise. Could you just bridge between those two comments?

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Jamal Nizam Baksh, Constellation Software Inc. - CFO [41]

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I mean if the margin improvement Q2 '16 versus '17 there was what, a 1% margin improvement. I mean, if you look at the key expense buckets like staff cost, which is our key expense, I mean that as a percentage of revenue didn't change quarter-over-quarter. You've got some improvement in third-party license maintenance and PS, and then you've got some improvement in hardware. So again, timing of that and that's not our core business but you've got some margin improvement there. And again, I wouldn't say that's because of economies of scale, it's just got to be with margins on third party products. And then there is benefit like if you look at our other expense lines, where you've got things that aren't necessarily tied to revenue that were stable. So you've got a little bit from improvement there. But it's minor little things and not a part of our core business that is improving. Right, so -- if I saw staff cost as a percentage, coming down, then I would say fine that's economies of scale. But that's staying pretty steady.

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Paul Treiber, RBC Capital Markets, LLC, Research Division - Associate [42]

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I think my comment was more just along if you look at over a number of years, 5, 10 years or so, the data would suggest that as you've scaled, the margins have improved significantly. And I was wondering if there's an underlying driver of that.

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Jamal Nizam Baksh, Constellation Software Inc. - CFO [43]

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I mean, yes over years, I would say that the impact of acquisitions, like historically, has always been a negative impact on acquisitions -- on CSI at the beginning, as we turn businesses around. As we become larger and acquisitions as a percentage of our total are less, then you're going to have less of that negative. And then the other thing we had in the last couple of years, is you had -- you had a TSS that was acquired in '13 that was being improved. And then you had a couple of hundred million dollars in healthcare business that actually had margins way in excess of the CSI average even though from a topline perspective, they were negative organic growth. So if you had a positive from acquisitions, plus acquisitions improving and -- I think, that actually is what was leading to the improvement as opposed to synergies or economies of scale.

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Mark Leonard, Constellation Software Inc. - Founder, Chairman and President [44]

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I think it was really good explanation and worth reading the transcript over a couple of times.

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Operator [45]

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(Operator Instructions) The next question is from Stephanie Price from CIBC.

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Stephanie Doris Price, CIBC World Markets Inc., Research Division - Analyst [46]

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Given the move to a more decentralized M&A model, can you talk about the oversight process post acquisition and whether that's changed at all?

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Bernard Anzarouth, Constellation Software Inc. - CIO [47]

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Sure. So post acquisition, the portfolio manager, BU manager is right in their overseeing the integration of his business and that's still being run by the operating group. And what we have instituted is the post acquisition review about 12 months after the acquisition to see if everything has gone according to plan. Now it used to be managed -- those parts, used to be managed by headquarters. Now for the most part they are being run by the operating group general managers directly, with CSI in attendance, so headquarters in attendance. That would be either myself or William. And we are continuing to do that on a regular basis. And what we do, is we try to take the lessons learned from those acquisitions and whatever happens during that transition period of the first year, and try to disseminate that -- those learnings to the rest of the M&A folks on a pretty regular basis.

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Stephanie Doris Price, CIBC World Markets Inc., Research Division - Analyst [48]

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Great. And then in terms of organic growth, you press released 2 contract wins over the quarter. Can you talk a bit about, where you're seeing organic growth and the outlook for it going forward?

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Bernard Anzarouth, Constellation Software Inc. - CIO [49]

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I mean, the group's forecasting a strong second half, but our ability to forecast organic growth has been terrible. So I wouldn't place a lot of stead in that.

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Operator [50]

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The next question is from Ralph Garcea from Echelon Wealth Partners, please go ahead.

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Ralph Garcea, Echelon Wealth Partners Inc., Research Division - Research Analyst [51]

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Couple of quick questions, can you just remind us on the thresholds, what the old ones were versus the new ones for the BU, M&A strategy? And does it differ graphically, I guess, between North America, Europe and I guess what the Japanese JV is doing?

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Mark Leonard, Constellation Software Inc. - Founder, Chairman and President [52]

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Sorry, I didn't catch that last question Ralph?

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Ralph Garcea, Echelon Wealth Partners Inc., Research Division - Research Analyst [53]

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Do the thresholds differ geographically?

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Mark Leonard, Constellation Software Inc. - Founder, Chairman and President [54]

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Okay. So with the Japanese JV, we're just learning, and so we're intimately involved in anything that we are looking at there, no matter how big or small. With the other operating groups, we have the same thresholds for all of them.

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Ralph Garcea, Echelon Wealth Partners Inc., Research Division - Research Analyst [55]

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What's the new one verses the old one again, on size?

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Bernard Anzarouth, Constellation Software Inc. - CIO [56]

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$20 million is the threshold at which they have to come to CSI for approval and board approval as well. Prior it was $10 million for the board.

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Ralph Garcea, Echelon Wealth Partners Inc., Research Division - Research Analyst [57]

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Okay. And then I mean how do you compensate these guys? Is there a success fee or do you wait the 12 months to see if they deliver an EBITDA number? I mean how are these guys incentivized, I guess to...

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Mark Leonard, Constellation Software Inc. - Founder, Chairman and President [58]

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So the idea is to invest capital and get good rates of return. So and I'm hoping that the vast majority of them are compensated the way that we are, which is the return on our capital, and for the growth of the business. So we're not like an investment bank. We don't pay people to put money out the door or to transact.

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Ralph Garcea, Echelon Wealth Partners Inc., Research Division - Research Analyst [59]

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Okay. And then, I guess, lastly, you've done 28 deals in the first half. You've got this increased bandwidth now, I mean, should we look at modeling sort of 50 to 60 deals through the second half? Or how does the pipeline look in -- can you give a range, I guess, of deals for the second half?

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Bernard Anzarouth, Constellation Software Inc. - CIO [60]

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I can't give a range. It so difficult to tell. All I know is that everyone is extremely busy looking at a lot of potential acquisitions and it's impossible to predict whether or not those acquisitions will close.

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Mark Leonard, Constellation Software Inc. - Founder, Chairman and President [61]

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Just to give you some color on that impossibility of prediction. We have a sort of funnel of acquisition prospects and we can add that up, we've figured out how to use that function in Excel. And we do so periodically and I went back and looked at those totals that we had over time, and the amount of acquisitions we actually closed during those periods, and I found the correlation between our funnel and the actual acquisitions closed was zero. And not just zero it was so close to zero that I'm thinking of commercializing our sales funnel as a random number generator.

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Ralph Garcea, Echelon Wealth Partners Inc., Research Division - Research Analyst [62]

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Okay. That's fair.

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Operator [63]

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Thank you very much. So we have no further questions. I would now like to turn the meeting back to you Mr. Leonard. Thank you.

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Mark Leonard, Constellation Software Inc. - Founder, Chairman and President [64]

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Thank you, Hugo. Thank you to all for attending the Q2 conference call. Look forward to chatting with you in a quarter's time. Bye-bye now.

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Operator [65]

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Thank you. The conference has now ended. Please disconnect your lines at this time, and we thank you very much for your participation.