TIP808: Current Market Opportunities w/ Daniel Mahncke & Clay Finck

25:24So we're talking picking and packaging as well. And if you consider that Amazon employs over a million people in its warehouses globally, you can imagine how much they would save if they could automate most of that work. And it's not only about the money you would save, it's also about the efficiency gains, right? So robots don't need breaks and they can work 24-7. And they already store incoming inventory about 75 % faster and reduce order processing time by up to 25%. So to me, it always feels inevitable that at some point we will see more robots and less people working in their warehouses. Let's take a quick break and hear from today's sponsors.

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30:03Amazon, it's just been one of those companies that's continually redefined just the whole shopping experience. I remember back when I was in college, ordering online was something that just a lot of people didn't do. But then you go online, you figure it out, you hope that the package is going to show up to your place. And it tended to work most of the time. But then now, I'll order things on Amazon all the time and commonly have one-day delivery options. And I'm sure Amazon's going to figure out same-day delivery at some point as well. For the robotics piece, do you have any idea what that could mean in dollar terms for their economics?

30:40You mentioned a million people working in these warehouses globally. How do you think that's going to impact their financials? It's hard to put a precise number on it, but Amazon's cost to fulfill, ship, and deliver is supposed to be around$90 billion a year. Of course, all shipping and fulfillment costs and even a 10 % to 15 % reduction, which is likely to be very conservative, would add about$9 to$14 billion to the bottom line every single year. And that's something that I would expect to see very soon. And I actually wouldn't be surprised if the majority of those $90 billion in costs can be saved in, let's say, five years from now.

31:17And mind you, these are tens of billions of dollars in profits without selling any additional items. It's really just about the cost savings that you can now take advantage of. And just getting back to the scale economies shared model that you mentioned with Melly, if Amazon's fulfillment costs come down, there are basically two things that they could do. They either improve their margins or they drop prices further and basically reinforce the market position. And that's what Amazon has done for decades. And in reality, it's likely a mix of both that will happen. I do personally feel though that Amazon by now is so strong in the markets that it's operating in, that I feel like in the future, they will likely take more margin than they have done in the past.

31:56And I would assume that Melly has similar plans to automate their warehouses as well. Absolutely. Melly is deploying robots in its warehouses too. Generally, this will come to all big e-commerce retailers with the logistics footprint that Amazon and Mally have. So it should be a tailwind for the entire industry. But if you imagine that they start turning these segments into meaningfully profitable businesses, I think that will be a huge boost to profits. And Amazon is the company with the biggest revenue in the world. So most of that comes from the marketplace. And if they turn around those economics, I think the earnings power is beyond anything that we've seen with Amazon in the last 10 years.

32:34And margins have already inflected in 2025. So they have doubled their North America market, which is basically where you have the entire e-commerce operation from 5 % in 2021 to 11 % today. And I do believe that the true earnings power is still vastly underappreciated. Yeah. And tying back to jumping on these massive secular trends, I can't help but also mention Amazon's ads business alone. I'm personally a big fan of digital advertising. This is a market that has just been growing at an incredible clip and has a fantastic margin profile. And Amazon now has one of the largest ad platforms in the world with more than$70 billion in ad revenue.

33:20And as we all know, that's some of the highest margin revenue one can get. And it shouldn't be a surprise that ads are a growth driver for Melly as well. In your pitch, you also talked about their highly successful ad network, which is only about 2 % of gross merchandise value, while Amazon's is closer to 7%. So there's a lot of room for that to grow for Melly as well. And turning back to Meta once again, one thing that I love about Meta is that there's just so much internal demand for that compute. in so many ways to utilize AI, that it seems unlikely that these investments won't pay out, at least for the time being.

34:02You can arguably make an even stronger argument for Amazon on that front, since the ecosystem is even wider. As a matter of fact, just this week, Andy Jassy shared in an internal all-hands meeting that he expects AI will help fuel AWS to become a$600 billion business in 2036, which is double the previous estimate of how large they expected that business to become. So that would imply that he essentially expects AWS to grow at a 15 % kegger over the next decade. It's also worth highlighting that AWS growth has been accelerating as in the recent quarter, revenue grew 24 % year over year. We've already talked a bit about Amazon's investments and how they can utilize it via AWS.

34:50But what other ways do you see Amazon making use of AI? And I know that outside of this recording, you also said that you like Amazon right now because it feels like one of the few bets where the upside through AI is clearly more dominant than a possible downside. Yeah, maybe that's why I like Amazon so much, because it does feel like also talking to people in the industry and talking to people in our communities that AI makes things so uncertain. There are companies that we thought would be huge and structural winners for the next 10 or 20 years. And Constellation is actually one of those companies.

35:27And then AI came into the picture and you just don't really know how the company will look five or 10 years out. And to me, Amazon is one of those companies where I feel like I have a pretty clear picture or at least idea of how they could actually benefit from the entire AI investment cycle. So Amazon's AI strategy is basically stretching over the entire ecosystem, really. So what you think about first is probably AWS Bedrock and selling AI compute to enterprise customers. And what Bedrock does is that it basically gives customers access to hundreds of foundational models, including Amazon's own Nova models, but also Anthropics Cloud, where Amazon holds a substantial stake in.

36:04And now through a recently announced partnership, OpenAI's models as well. Amazon actually invested$50 billion in OpenAI as part of that deal. And i'm not a huge fan of that but to some extent i mean they're hatching their bets and considering how fast claude seemed to have outpaced jgpt who is saying that can't change quickly again i mean i'm humble enough fortunately to know that i don't even know one percent of what the decision makers at amazon know so i'm better off letting them make those decisions for me and what i like about this strategy is that amazon is not really competing in what to me seems like a very commoditized LLM playing field.

36:42But I'm probably even more excited about how Amazon can utilize AI internally to improve its own business compared to the investments that they make into OpenAI or Cloud. That's exactly my thesis with Meta. They're already seeing these AI investments generate strong returns internally. And I can imagine some ways in which Amazon could also utilize AI in their own business. For example, they might provide more customized search results based on individual preferences or better ad targeting similar to meta. What are some other examples of this for Amazon? Yeah, some pretty exciting stuff you basically just mentioned where they could sell even more to customers because the recommendations are getting better.

37:23One thing that we also talked about already is robotics. I mean, the reason the next generation of robots can pick 65 % of Amazon's product catalog is because of advances in computer vision and AI. I mean, every robot arm in Amazon warehouses is essentially a huge AI system that has to identify a product or an object, figure out how to grasp it, and then place it. And that's a quote unquote, simple machine learning problem. But that is getting better with the more data you have. And there's pretty much no company that has more data on that than Amazon. And then you also have the customer facing side of the business, which is mostly about improving the algorithms and getting products to customers easier.

38:04one of those things they invested in is Rufus, which is their AI shopping assistant. They actually invested in this a while ago, but it keeps getting new upgrades. And instead of, for example, typing keywords into a search bar, you can now have a conversation with Rufus about what you're looking for, and it will basically guide you to the right product. You can also, and this is, in my opinion, a better feature, get information on the price history of a product and then set price alerts and automated buys. So for example, I want to buy something for my house, and I know I buy that every single month, then I can say, okay, well, at this price, let's say$20 for coffee or whatever, this is when I will always buy my coffee and I won't buy it if the price is increased.

38:45And you can also see where I traded in the last, let's say, four weeks. So this is a feature that I personally like. And I would say that generally all of this will feed even more data into Amazon's AI capabilities. So you could also imagine that in the ruthless conversation itself over time, you, for example, have promoted products. There are just so many options to monetize this further. Although Rufus itself is, I would say, still far from being perfect. And I think it makes a lot of the typical LLM mistakes that we see across the board. And I would probably personally not yet use it for my shopping on Amazon.

39:17I actually have a little bit of experience selling products in Amazon. And through that experience, it was clear to me just how dominant of a position Amazon is in. And I've read several of the books that are about their history and Jeff Bezos, as I'm sure you've read as well. And you just read how so many companies try and fight Amazon. And at the end of the day, they still end up listing their products on Amazon, even though Amazon's taking a 30 % cut and getting a massive slice of each transaction through their FBA fees, their fulfillment, and everything else that they provide. So the set of customers that they have is just insanely valuable and it's going to be extremely difficult for anybody to disrupt.

40:01But if there's anything I don't like about Amazon, it's probably the name that they chose for the AI shopping assistant. Surely they could have come up with something better, but maybe that's just me. Part of me feels like Amazon is following everyone else's lead and just putting a chatbot embedded into everything, even if most people don't necessarily need it. Admittedly, I've probably used it just a couple of times over the past six months or so, but I could imagine it being quite useful and asking me to tell me the difference between two of these products, help me generate gift ideas for my six-year-old nephew, or help me get everything I need to put together for my home gem.

40:40Just a few examples. Shifting gears here, as we are prepping for this conversation, I was happy to see that you wanted to discuss Constellation Software and their two spinoffs. I first covered Constellation back in February 2023, back on episode 531. And I think it's safe to say that that was one of my most popular episodes I've ever put together. As I was prepping for that episode, I read Mark Leonard's shareholder letters and essentially was compelled to purchase shares on the spot. The letters were just that good. And I was just chatting with a French Robert Sean here on the show, and he heard about Constellation on Christmas Eve, I believe it was 2013 at a Christmas party.

41:20And he was pretty upset when someone mentioned the company and he hadn't heard of it before. He wasn't familiar with it. And he had a very similar experience in reading, going home, reading the letters that night. Now, today, pretty much everyone knows about the company, given the stock's incredible run and recently somewhat dramatic fall. I guess getting information on Constellation in 2013 qualifies as probably being the best Christmas gift that you could have gotten. I actually think it's incredible. And it speaks for Mark Leonard and his skills also as an author that everybody feels the same way about his letters.

41:54I must admit, I only read them recently, maybe a couple of months ago from my research on Constellation. And I couldn't motivate myself before that to actually research Constellation or even read the letters of Mark Leonard when I was still trading at 40 times cash flow since I just knew I wouldn't actually buy the company. So I am thankful for the drawdown, although I probably shouldn't say that here on the show and speaking to you as a Constellation shareholder, a longer term Constellation shareholder. But I finally had an excuse to read the letters. And boy, Mark Leonard is really an outstanding guy.

42:25I felt the exact same way. I read them and I felt like he understands business so well. What he has built is exceptional anyway. So I really felt like I want to buy his shares immediately. Yeah. And anyone following Constellation knows that the share price is down due to AI taking down the stock prices of so many AI companies. And AI, it could come for Constellation's business in some ways. I know that most of our listeners will be aware of Constellation, but for those who aren't, Constellation owns more than a thousand small niche vertical market software companies, things like cemetery management software, court administration systems, or public transportation scheduling.

43:06So the market's fears around AI is twofold. The main concern is that creating such software with the help of AI is now much easier, much cheaper, which is why competition will enter these verticals where Constellation is active. So that would mean that their current portfolio of over a thousand companies could be disrupted, at least partially, and that the pipeline for future acquisitions might be shrinking. So if AI tools flood the market, there won't be any high-mote VMS companies up for grabs anymore. So that is the simplified bear thesis. Talk about your take on this. I think there's a lot to say about this.

43:46Perhaps we should start by just quickly explaining the nature of VMS businesses once more. So VMS stands for vertical market software, and those are the types of niche businesses that you basically mentioned. So the reason why Mark Lennart, the founder and former CEO of Constellation, liked these businesses in the first place is that they are as close to everlasting as possible. In fact, this is why the market for 20 years was certain this is an undisruptible business that should trade at 40 times cashflow. So we're talking about industries here where the leading edge of tech is simply irrelevant.

44:19So the assumption of tech guys out there and also investors is that everyone would adopt new technology as soon as it is there. But everyone who has worked in the corporate world knows that's not the reality. We actually just talked about Kinsale a couple of weeks ago and you talked about the insurance industry and how just changing software at such a company takes a whole lot of time and is probably the more inefficient choice than just keeping your old software. If employees are used to a certain software system, it can be way more efficient to stick with what works, even though you might save a couple of bucks on implementing the new software or it can technically do more stuff than the old one.

44:55There's a rule of thumb that generally something has to be 10 times better than what you use right now to actually be willing to change it. And this is obviously not true for you and me. I mean, we can change the software that we use in an instant, but it is true for companies that handle critical data. I actually switched from ChatGPT to Cloud in a matter of a day. I felt like I was some kind of software engineer when I did that up until I figured out that pretty much the entire world changed to Cloud at exactly the same time. But that is just an example that there's basically no switching costs involved for me if I change from one LLM to the other.

45:30But imagine you're a company or you're a public institution, which is having decades worth of data and extensive knowledge in your current software. Well, at that point, you can't just change software overnight. A good example is court administration software. So court records have a legal chain of custody. And that means there must be a clear documented history of who created a record, who accessed it, who changed it, when and why. And if you switch software, you have to prove that nothing was altered during the migration process. The fact that timestamps and access logs remain intact, that permissions stayed correct, and that all records are still admissible in legal proceedings.

46:10And the amount of extra work required makes switching almost impossible in practice. And every AI tool involved would have to be tested and certified to handle that level of data sensitivity. So in this case, you would really only change the product if the alternative is actually 10 times better or significantly cheaper. Again, that's one of the common arguments, right? The idea is that AI now allows others to create new software solutions at a significantly lower cost. And the fact that AI now enables the creation of such software much more affordably means that it can then be sold much cheaper to the current client base of constellation.

46:50That's one of the main arguments, but I do think it's missing one important point as well. So the software itself can certainly be produced cheaper, but that is not really what clients are paying for. So over three quarters of constellations revenues actually come from maintenance. So customers pay for ongoing support with the systems, making sure that everything is running and updated. And that support team is where the main cost base for constellation lies. So you would need such a team, even if you created a software tool using AI. And except for the fact that it might be easier to build a leaner company structure if you start from scratch, which has always been true, not only since the age of AI, I don't see why Constellation shouldn't be able to reap the benefits from the fact that you now only need, let's say, two instead of five software engineers, thanks to AI.

47:38And then there's the cost structure piece where CSI software is rarely a big cost factor for their clients. So a number that I always see floating around is 0.1 % to 1 % of revenue, but it can be lower for companies with lower margin profiles. So to help put this into perspective, if a golf course is making$2 million per year in revenue, perhaps they're paying$10 ,000 on the software that handles tee time reservations, membership dues, member data, payments, and it provides solutions for managing tournaments. It's not entirely known how much it costs, and it depends on the company at hand. But given that Constellation has retention rates far above 90%, it seems that the value proposition matches the pricing pretty closely.

48:24One example I actually came across is that there's something like 30 golf courses in Indonesia, and almost all of them use the software within Constellation's ecosystem. So to me, this is a perfect example that if anyone knows the needs of the customers in that niche market, it's going to be Constellation. So they are best positioned to potentially utilize AI to improve their offerings and add even more value to customers. And as these software solutions only become more embedded into the company's workflows, this would naturally increase the switching costs over time as well. I also just think back to the argument of, is the manager of a golf course going to pull up Claude and just put together their own software solution to save$10 ,000?

49:15It just doesn't seem to be likely to me at all. If someone manages a golf course, they probably just like to golf and they like the camaraderie around golf and it provides them a good living. If they try and do that and the software fails, then they are out significantly more than the$10 ,000 they could have just paid Constellation. Another part of the Constellation story, I think back to the episode I did in 2023 and sort of my thesis back then, what really appealed to me was that these businesses are relatively resistant to poor economic conditions. So when the economy inevitably enters a recession, since these solutions are mission critical, the money just keeps coming in because they're relatively fixed payments and they're recurring in nature.

50:00And better yet, Constellation can actually come out thriving on the other side of a recession because they run into desperate buyers that need to exit their software companies, such as a struggling conglomerate who wants to carve out a niche part of their business to help them weather through a crisis. You just run into these sellers that need to sell and don't have to sell, which means Constellation can get some really attractive prices. I like the golf example because it often shows that you don't need just mission-critical industries in general. It's also enough to just be mission-critical to one company, even if there's a recession.

50:33And you know, less people are golfing, even though you could make the argument that the people who do golf probably don't care that much about the recession. But anyway, the$10 ,000 that this business has to pay for the software, they will always have to pay it. If the business is still in business itself, then it has to pay for that software because otherwise the entire business would just not keep living on basically. And I got to say, another thing that is probably underappreciated is the factor of distribution. So let's say I have extensive knowledge in the gym sector. So I decided to build software for gyms.

51:04Now it does not only need to be 10 times better, which we have discussed. It does not only need to be cheaper with the same level of support and service, but I also need the distribution to actually reach out to gyms and make them want to adopt my product. And as investors who likely visited a business school, it's easy to sit at home and think about the efficiency of capitalism and be like, your product is better and cheaper than people will also use it. In reality, that's not the case. It's not always the best product that wins. I would first need to figure out how to even reach gym owners and then pitch them on the idea to switch to their entire software system.

51:37And I'm not sure how many gym owners will be open to that. After all, their business is already doing well. And if anything, it just introduces risk that they didn't have before. That's when switching costs generally come to play. I think everyone would agree that highly regulated industries might be difficult to disrupt, but there are switching costs in other industries that have low to no regulation. We just talked about the golf course, but the same is true for gyms. Gyms make a large portion of their profits for members who pay regularly, but rarely ever show up. And those members don't cancel proactively due to a mix of convenience and also the thinking that they just like to pay for a gym because technically they could go and of course they are fit people.

52:15But the moment you switch software and perhaps something goes wrong with the payment data, you have to ask customers to actually re-enter their credit card information. And that most of the time will be the trigger point where cancellation decisions actually happen. Suddenly you've lost a good chunk of your most profitable customer base. Let's take a quick break and hear from today's sponsors. Ever wanted to explore the world of online trading but haven't dared try? The futures market is more active now than ever before, and Plus500 Futures is the perfect place to start. Plus500 gives you access to a wide range of instruments, the S &P 500, NASDAQ, Bitcoin, gas, and much more.

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56:22Leading up to this discussion, I was taking a look at some of the most recent deals that have been announced. So they purchased a company called Compros. It's based in Missouri. The company was founded in 1987, and it had an employee count of roughly 20. Another company they purchased is called SK Trend, which also has 20 employees, but it's based in Budapest, Hungary. So Constellation clearly has this web of companies all over the world. There's a lot to nerd out on in terms of just digging into what some of these companies do that Constellation purchases. Recently though, they've been dipping their toes into public markets as they announced a new strategy called PEMS, Permanently Engaged Minority Shareholders.

57:07So instead of buying businesses outright, they target these larger public companies, take a stake in them, and try to get seats on the board and push through some operational changes to improve the business and improve its efficiencies. I'm curious to get your take on this, whether they're running out of these smaller deals, or they just need to find other ways to get capital deployed. Yeah, I think it's really much not about AI, which has also been a theory that people say, you know, now you have AI coming into the market, and they immediately don't find any good opportunities in the private market anymore.

57:40I don't think it's that. It's mostly just the law of large numbers. So Constellation has said previously that it's just difficult to go way beyond 100 acquisitions, which is currently what they average per year, without diluting the quality and still hitting the target returns of about 20 to 25%. So I do think it was a matter of time before we would see this strategic expansion. And if anything, I think AI pushed forward the timing. There's an argument to make that CSI should actually see more M &A activity right now because of the depressed valuations in the sector. However, prices in the private market move much slower than in the public market.

58:16So if you're the owner of a private software company whose business is not touched by AI at all, why would you accept a lower purchasing price for your companies simply because investors in the public market are spooked. So it's only natural for CSI to look for opportunities in the public market where, again, valuations are much lower due to these AI-related fears. And this naturally comes with some risks that you didn't have in the private market. I mean, as a value investor, we don't necessarily believe that markets are always rational and efficient, but the public markets are more rational and efficient than private months, just because there's a lot more liquidity that's pushing money to the stocks that do well and money away from the stocks that don't do well.

58:57So when you buy a company that is down in 90 % in the last five years, as it has been the case with the acquisition of Sabre, the company that Constellation just built a 10 % stake in, there is a good chance that there are real problems within the business. And also turning a business around as a minority shareholder is a much more difficult game than in the private market when they buy a business outright. Robert Leonard Yeah, it was interesting to see Sabre's stock price jump on the CSI announcement. To me, it makes a lot of sense if a business, there is a core product that is maybe a decent business for the next five years or so.

59:32I mean, Constellation, they aren't always looking out what business is still going to be around in 50 years. If a business is generating cash and it's likely going to be generating cash for the next five years and they believe that it's significantly undervalued, then it might make sense for them. What's also interesting is that for me as an investor, if I'm looking at Sabre, I might look at the balance sheet, for example, and say, this company has way too much debt. But Constellation might be able to make the numbers work for them much better if they're a strategic partner in helping them work through the debt issue.

1:00:03And I think you're right about private market valuations just being much slower to react. Constellation's chief investment officer, he actually shared that they haven't really seen valuations change at all in the private markets. And that competition to purchase those businesses is still very strong. So it's interesting to see these conflicting viewpoints where public markets are obviously very spooked, but in the private markets, demand for these businesses is still quite strong. One of the things I admire about Constellation 2 is just how adaptable they are in deploying capital in the best way possible, whether it's doing the smaller deals, going into public markets or venturing into new markets, or at least considering new markets, they will pursue what is in the best interest of their shareholders.

1:00:52So the public company you mentioned is Sabre, ticker S-A-B-R. This is a software solution for the global travel industry. And what stood out to me about this deal was that it sounds like Mark Leonard, of all people, is leading the charge on it. So it does seem that his health has improved in recent months, and he's still doing what he loves at Constellation following the critical procedure that he had last year. Sabre's management team, they actually threatened what's referred to as a poison pill, which I had no idea what this was before they mentioned it. So they threatened a poison pill when CSI informed them about their stake.

1:01:28A poison pill, to put it simply, it's a way for the current management to maintain control by diluting shareholders' holdings, thereby reducing CSI stake and their influence. So obviously, this is a suboptimal outcome for every shareholder. Sabre's management, they didn't end up using the poison pill option, but it shows that these things just can get messy, especially since there might be selection bias. So the management teams of bad performing stocks might not be the most exceptional management teams out there. In the end, I personally don't see AI as a huge risk for Constellation more broadly.

1:02:05on the margins, of course, it could be impacted. I've gotten to know one of our community members pretty well who runs a VMS acquirer, used to work at Constellation. And he shared with the group that these verticals will always have the need for a professional vendor that is not the end customer to take all of the tools that are available, AI being one of those tools, and piecing together a solution that adds value in the best way possible for the customer. So to go back to my golf course example, could the course hire a software engineer to create a software that helps them book tee times? Of course.

1:02:43But first, there's so much that can go wrong in adopting a new solution. And second, even if there's some cost savings, that golf course can still be missing out on some additional features that the vendor could be offering them, which in the end will likely help the company make even more money. It's not like the end customer is getting screwed and price gouged. This is a low amount of their overall cost structure and critical to their operations. So instead, their size and the shift in how they approach M &A as they scale, it's going to be really interesting to see how it plays out. They are very strict on what returns they're targeting in all of these deals.

1:03:22So I'll be continuing to keep a close eye on how much capital they're able to deploy each year. I think largely for me, this is a sidecar type investment where I believe these are some of the best managers in the world, and they're not going to pursue opportunities that have even a fairly significant chance of not creating shareholder value. So I know that you spend also some time looking at the spinoffs as well, and other public companies that they've gotten involved with in Europe. I know you and I are pretty interested in one of those today, especially. But let's talk about Topicus and Lumine.

1:03:59So these were both spinoffs over the past few years. And I'm also excited about the spinoffs due to their incredible track records paired with, again, exceptional operators. And these are coming from a smaller starting base from which to compound from. So interestingly, it seems that the market puts a bit of a premium on Constellation's reputation and track record because it seems that The multiples of Constellation relative to the spinoffs is fairly similar. So I think for me, I think it's going to be much more difficult for Constellation to continue to grow at the rate that they have historically.

1:04:36Again, they're going to need to purchase 100, 150 plus companies per year to keep growing at double digits. While the spinoffs, for them to compound, look at Lumine, for example, they could do two to four deals a year and still compound at 20 % plus, which these also tend to be bigger deals than Constellations Bread and Butter. But still, two to four relative to 150 plus is a huge, huge difference. And Lumine, they only own around 34 companies relative to Constellations 1000 plus. So in theory, it'll be much easier for them to move the needle. Yeah, looking at all these companies, the spinoffs, but also the companies that the spinoffs buy has been really an incredibly interesting look into how the entire CSI machine actually works.

1:05:21And why also you have to pay premiums for those companies, because even though they don't have a proven track record to the same extent that Constellation has them, you see the exact same way of operating. So you have the same incentive systems. You have oftentimes people from either Topicus or CSI at the helm at these companies. So you kind of know what you're getting. And you know that this has worked so well in the past that as soon as they acquire a company, and it's a small base that company is starting from, it's incredibly attractive for investors to look at those companies. And especially today where the same trust that CSI and those companies have gotten in the last years is not there anymore due to AI.

1:05:56And you probably know all of these companies even better than I do since you've owned them for a while now. I looked at a lot of companies in that universe, including the ones you alluded to in Europe, which are mostly Polish companies. But I think I'll focus on Topikas and Luman here. We will have an episode coming out soon where we cover those other companies as well. Topikas and Luman differ in that Luma is focused on a specific vertical, but not bound to any geography, while Topicus is bound to a geography, but operates across many different verticals. So Topicus was spun off in 2021, and it sits on top of TSS, which stands for Total Specific Solutions, which is basically the actual operating unit that goes out and then acquires other VMS businesses for Topicus.

1:06:38So Mark Lehner, the founder and former CEO of Constellation, is sitting on the board of Topicus and Constellation owns about 30 % of the shares. The interesting thing about Topicus and TSS is that they operate in Europe and more specifically in the northern and western parts of Europe. And I talked a bit about the European VMS market in an episode I once did with Sean on Chapters Group, which is a German VMS acquirer. And generally speaking, it's just a lot more difficult to consolidate European companies because the cultures and most importantly, the languages are so different. Those are problems you don't face in the North American market where everyone speaks English.

1:07:16And Topicus is one of the few companies in the European market with enough scale to actually consolidate companies on this continent. And another huge tailwind is the succession problem, which is even more acute in Europe than it is in North America. There are tens of thousands of highly successful software companies that don't have a successor in place and will either be sold or just have to close down shop. And Topicus is undoubtedly the closest copy of Constellation among all spinoffs and subsidiaries, which obviously makes it pretty interesting. Yeah. Looking at Topicus's web of companies, it looks similarly complex to Constellation and the incentive system is practically identical too.

1:07:57One interesting nuance though is how the incentives differ slightly depending on what each part of the business is actually supposed to do. So Topicus is made up of two main arms. You have the original Topicus business, which has historically been more focused on growing its existing products organically. And TSS, the acquisition engine that goes out, buys more VMS companies, and each arm does have its own CEO and their bonuses reflect that difference. The TSS CEOs are measured on overall revenue growth, including acquisitions, because deploying capital into new deals really is their job. The topic as CEO, on the other hand, is only measured on organic revenue growth.

1:08:40So acquisitions don't count toward his bonus because his unit is expected to compound what it already owns, not grow through acquisitions. So it's a small but deliberate distinction that shows how detailed companies in the CSI universe are with these types of questions. And to me, that's what we talk about when we say the constellation is just operationally excellent. And that's something that you don't often see in most other companies that try to copy what Constellation does. And to me, Topicus is probably an option to invest in a somewhat younger and less mature CSI with the option to benefit from the European market tailwinds that I've just mentioned.

1:09:19But if you're worried about the law of large numbers with Constellation, I think there's an argument to make that Topicus will run into similar problems soon. I actually covered Topicus on the show shortly after that Constellation episode. back in 2023 because I just couldn't help myself. And as you mentioned, Topagus being based in Europe, that really attracted me. The thesis for me, at least, was that there's less private equity activity in Europe, which would give Topagus less competitive pressure in making acquisitions. And Europe is also a highly fragmented market, as you mentioned. There might be two different companies in a very small niche that do the exact same thing, but one may be based in the Netherlands and the other is in Hungary, which have different sets of laws and regulations in different languages.

1:10:06You just don't have that same dynamic when you're looking at Texas and Nebraska, for example. It's largely going to be the same. So Lumine was also quite an interesting company to look into. And since I like Constellation, Topicus, and Lumine for their own reasons, I actually decided to take an ownership stake in all three. Lumine is not bound by geography, but solely focuses on companies in the media and communications industry. Again, their track record of growth under David Nylan's leadership is just phenomenal. You look at what they did when they were under the CSI umbrella entirely, it's just unbelievable to look at what they've done to date.

1:10:48So the whole Constellation ecosystem is also interesting to me is that these guys just totally avoid the press and they just fly under the radar. They are just solely focused on creating shareholder value. I actually invited Nyland to join me here on the podcast. I wasn't able to get him on, which is probably best for me as a shareholder that he continues to focus on his business. And again, Lumine is not bound by geography. They focus on the media and communications industry. And it was a company that was started in 2014 and then spun off a constellation in 2023. And I really just couldn't believe the price dropped below 20 just last month, which would have been unthinkable just six months prior when the shares were above 50, and then they dropped below 20.

1:11:34It's quite amazing what markets can do in swinging in both directions. What's attractive about Lumine too is the type of companies they go for. So they focus on so-called carve-outs, so often parts of larger companies. And one of the advantages of carve-outs is that you don't have a lot of competition for those deals. And the parent company is also often happy to get rid of that part of the business. So the price that you have to pay is relatively low compared to other parts of M &A that you could do. And another advantage is that there's lots of potential for improvements at the acquired companies because they have been neglected for a long time, which means there's a lot of potential to increase margins just by getting rid of unprofitable contracts, repricing products, and also integrate Luma's best practices into those companies.

1:12:19The downside though is that it's quite difficult to predict reinvestment rates in any given year. I mean, in some years, Lumen acquires a handful of companies and in others, they only buy one or two companies. Covered, though, tend to be larger than the typical Topicus or CSI acquisition, which is where it doesn't need as much volume to move the needle for Lumen, which to some extent is shielding you from the problem of the law of large numbers, adding to that that Lumen is also just a significantly smaller company today. What's also interesting about these spinoffs is that to understand Topicus and Lumen, you clearly need to understand Constellation.

1:12:54To understand Constellation, you need to read the letters, get acquainted with this being a Canadian company that buys companies all over the world. So there's sort of multiple layers to this. And with Lumine, the carve-out dynamic is also the reason for the high volatility and their organic growth. So with Topicus and Constellation, it's just a slow and steady, low single-digit organic growth, consistent M &A engine. But But Lumine, you even see some quarters where organic growth is negative because they're doing a lot of work on these businesses and optimizing them upon making that acquisition and really take some time to see those positive organic numbers start to show up in the financials.

1:13:35Yes. One of those things where it's not enough just to look at the numbers, because if you do so, you have no idea what's going on and why it's so volatile. But when you just think about it, I mean, these companies that they acquire, they were apart from a parent company. And Luma basically has to rebuild all of it from scratch. I mean, that means you restructure processes. And again, you often cut some contracts, which of course, puts pressure on the top line in the short term. So as you just said, it's really about understanding the model and then also trusting the process. Because if you buy any of these companies, you have to trust the people at the helm and then sit in the bandwagon and hope they do what they've done in the last two or three decades.

1:14:11Yeah. One of my favorite lines from Mark Leonard was in the press release regarding the Lumine spinoff. He stated, I look forward to having CSI's long-term shareholders become long-term shareholders of Lumine Group. I hope my grandkids are still holding Lumine shares 50 years from now. And if you know Mark Leonard, you know that is quite a bold statement from him and certainly a stamp of approval for who David Nyland is and what he's doing in building Lumine. I know we're jumping a bit here, but I also quickly wanted to ask you about your opinion on SaaS in general. I know the intrinsic value portfolio has some SaaS companies such as Adobe.

1:14:52You've looked at companies like Salesforce. So talk about how AI plays into SaaS more broadly, because I think a lot of investors have come to the conclusion that VMS and CSI will be pretty resistant to the AI threat, at least in the near term. Who knows what happens, say, 10 years from now or more? So talk more about software more broadly and how AI could impact that industry. I should probably use that question as an opportunity to say that I'm not naive about the AI threat. Even for CSI, we've spent dozens of hours in our community talking about the AI threat. And many of our members understand the topic much better than I do, because they work in the space.

1:15:33And you just said that a lot of people kind of consider VMS to be more secure in terms of the AI threat. I think if we look at the market, that's not necessarily the case yet. I think to some extent, we're living in a bubble where we feel like people understand these companies pretty well. And I think there are good arguments to make that they will survive the AI threat. But I apologize for making it about Constellation again for a minute. But I do think that in Constellation's case, the more detailed risks I see, and to some extent, and they also apply to all of these SaaS companies, are that agents will take over the majority of workflows, and then the underlying software loses pricing power.

1:16:10And besides its data storage advantage, also switching costs. So Steph wouldn't be trained on the software to the same extent, because basically the agent does most of the navigating and actually operating the software. And that could be the case for constellations companies. But that's also something that you can think of for Salesforce. We've discussed this in detail in our community, but I think it will go beyond the scope of this episode just so much. There's obviously the opportunity for Constellation to build its own agents but in this case CSI's decentralization which is usually a huge advantage to how the company operates could actually become a major competitive disadvantage because technically horizontal agents like the ones from the big LLMs they are trained on more data points than any other model could ever be and Constellation subsidiaries operate in silos So they don't share databases, infrastructure, or even engineering talent.

1:17:01So each subsidiary's data is kind of locked within its own walled garden. And then a competitor building a vertical AI for, let's say, utilities, for example, can consolidate data across multiple utility clients to then better train models. That could lead to the fact that they simply have better models than Constellation can build by itself. It's also a larger investment if you can't amortize the cost of building an agent or specialized LLM across basically thousands of products. So ServiceNow, for example, one of the SaaS companies that has come under a lot of scrutiny in the last couple of weeks and months, they could technically build one AI workflow engine for the entire platform.

1:17:39And then if you think about what Constellation could do, well, they have a thousand plus businesses and each would have to build or integrate their own AI independently. And at a per subsidiary cost structure, that's maybe not even an economically viable choice. For the average 5 to 10 million EBITDA subsidiary that Constellation owns. And then arguably even larger problem though is the ability for companies to actually build their own software solutions from scratch. I actually just listened to Bill Gurley, who is a venture capitalist who I like to listen to from time to time. And he talked about Salesforce recently and how most companies only use a fraction of the whole product suite that Salesforce actually offers.

1:18:20And I analyzed, as you said, Salesforce a while ago. And while I believe it will be very hard for any other company to disrupt Salesforce, I think insourcing might actually be a problem. Because if you think about the customer base, Salesforce's customers are the biggest companies in the US. About 90 % of the Fortune 500 companies are customers of Salesforce. So those are the companies that certainly have the resources to insource this stuff and basically tailor it to their personal needs without paying for software that they never use. You know, we talked about the golf course for Constellation.

1:18:53If I'm the founder of that golf course, I will not spend my time vibe coding through Claude, my own software solution. But if I'm a huge Fortune 500 company, I can hire software engineers that through Claude might have the ability to now basically program their own system. And then I can also employ them to basically do all the maintenance that Salesforce would currently do. That said, and this is the tough thing about AI right now, the opinions of people who use Salesforce daily in their jobs compared to those who use AI daily just couldn't be more different. If you talk to people who use Salesforce, they always say, I don't like it, but it is impossible to remove it for our company.

1:19:30We just couldn't function anymore. And then you talk to people who use AI daily and they say, it's almost certain that this stuff can be insourced and it's probably happening rather sooner than later. I think ultimately, I believe the software companies that will survive are the ones with these massive ecosystems that basically combine dozens of critical software solutions or software that's actually hard to replace by AI. It just reminds me of your comment earlier that just because there's a better product out there might be cheaper doesn't mean people necessarily use it. So it'll be certainly interesting to continue to watch it play out.

1:20:07And as with Constellation, if you knew nothing about AI, you would think it was just business as usual if you were only looking at the financials of how much revenue is increasing, how much their acquisition spend has been in recent years. So yeah, it'll be interesting to watch continue to play out. I'd like to shift away from AI for the final segment of the show here and discuss one more company. A few weeks back, I put together an episode based on the principle of inversion. So instead of asking what company is well-positioned to succeed in this rapidly changing world of AI, I asked what company is almost certain not to fail.

1:20:45And that can be a tough question to answer given how fast technology is advancing and how many industries technology is getting its arms into. The company I covered in that episode was Lindy PLC. This is an industrial gases company. That episode number was 796 for those interested. And that sparked me to want to chat with you about Hermes, which as of the time of recording is down more than 40 % from its all-time high, and it's undergoing a sharp drawdown due to, I believe, the conflicts happening in the Middle East. At least that's the narrative. A couple of months ago, you covered Hermes on the Intrinsic Value podcast.

1:21:23It's a company I've dived into on the show as well. And it's one of the most fascinating businesses I've ever looked at. I don't think there's any other brand that embodies the luxury playbook better than Hermes. Because of that, you always had to pay up for the shares. When the company trades at 50, 60 times earnings, it's easy to sort of have it fall off your radar. But now the valuation, it might be getting to a little bit, slightly more interesting levels. Talking about falling off the radar, I actually didn't even notice the massive sell-off until a member of our community posted about it.

1:21:56And I guess the problem right now is that there are so many other high quality stocks selling off. It's kind of difficult to make a decision regarding where to add. But I do believe that MS is one of the best opportunities in the market right now for a relatively smooth, let's say 10 % annual return for the years to come. If I compare MS to LVMH, for example, I would always prefer MS. Technically, LVMH is a more diversified company. And one could argue that's an advantage. But I think in my mind, there are only a handful of high-end luxury brands and lvmh just doesn't own that many of them they own a lot of brands that basically target the aspirational luxury market but those markets are much more bound to macro economics and they carry a lot more brand risk due to you know possible overexposure of the brand and ms is really targeting the the top one percent you could probably argue it's the top 0.1 percent of the population and that's the fastest growing segment of luxury buyers growing at a cake of almost 10 % per year compared to only 1 % for the aspirational buyers.

1:23:01And it's barely dependent on macroeconomics. It's almost impossible to replace a brand in this segment. I think the biggest risk is that a brand of a master's caliber is kind of losing its exclusivity by trying to sell more volume and then invite these aspirational buyers into the ecosystem. Yeah, but that seems pretty unlikely in the case of Hermes. The company's family run, It's been family run since it was founded all the way back in 1837. It's on their sixth generation of family members running the business. And to this day, every heir of Hermes has to begin his or her career as an apprentice in production.

1:23:42They have to spend a decade there also before they can even get to an executive position. So this shows just how much pride the family takes in what they do and how much they value what the Hermes brand stands for. So there's zero risk that as a shareholder, you would wake up one day and hear that Hermes has moved their production to Asia to save on costs or anything like that. And as long as you avoid these drastic mistakes, which I have no doubt that the Hermes family will be good stewards of the brand, it's hard to replace a brand with just that much prestige in history as Hermes. There's a saying, it reminds me of a Buffett talking about Coca-Cola.

1:24:23If you had a billion dollars or$10 billion and tried to create the brand that Coca's created, you just couldn't do it. It's the same thing with Hermes. So the management truly views the shares in this company as a generational asset, and it's looked down upon to try and optimize the next quarter's EPS figures. So given that the luxury players are betting on strong growth in China in years ahead. China has really put a drag on the luxury market overall in recent years. And I was surprised to see that even the Chinese government is cracking down on citizens who flaunt their luxury goods on social media with the thinking that it's just not good for young people to flaunt things like leather handbags.

1:25:07So yeah, the Chinese government is trying to discourage the purchase of these high-end luxury goods. But similar to the macro conditions, I would expect this to be just a temporary headwind for the luxury players. I think it's one of those news that you read and you kind of get scared over it, but I don't think it's long-term too. I would also say that this is probably yet another news that feels like it could come for LVMH rather than MS because the top 0.1 % of luxury buyers, they tend to be more understated about the luxury consumption and not necessarily posted on social media. So I wouldn't expect MS to take a huge hit because of these measures, a very long-term risk that I could potentially see for MS in China, if you want to look for one, is a movement which is basically toward more Chinese luxury brands.

1:25:57So there's a general trend that we've seen in China and especially with Chinese consumers in recent years. However, once again, I feel like MS is somewhat shielded from this because the top 0.1%, and to be honest, it's probably even okay to say the top 0.01 % that shop at MS are more likely to be global citizens anyway. So the trend of choosing Chinese brands likely won't be that strong among this customer base. Generally, though, I just want to point out again that you still have to pay 40 times cash flow for MS. So it's not a bargain at all. And Sean and I looked at Ferrari a while ago when it was still trading at similar multiples.

1:26:35That's a company that is applying a similar playbook in the auto industry. And nobody would have thought that we would see a cash flow multiple of just 25 times anytime soon. And yet, if you look at the chart and the valuation, we're there now. So that doesn't mean that a mess isn't a good buy here. But looking just at the relative valuation can be dangerous for companies that have traded at these massive premiums for such a long time. I certainly tend to agree with you. If you're paying 40 times earnings for any company, you need to have a very long time horizon. And you have to be fairly certain just that earnings are going to continue to grow because the market is implying double-digit earnings growth for at least the next decade and that nothing will negatively impact the business over that time period.

1:27:22The other thing is that if shares of Hermes are down significantly, odds are that shares in other companies are down as well, which leads to many value investors just never managing to get a position in. It is an interesting opportunity though, So given that the stock is down, but I don't think anything fundamentally has really changed with the business from a long-term perspective. And that's the key point is that long-term perspective while the market is looking ahead at what's happening over the next one to two years. But Daniel was actually kind enough to put together a valuation model for Hermes that our listeners can check out.

1:27:57The model, it shouldn't be used as what the intrinsic value necessarily is, but the listeners can pull up the model, plug in their own assumptions, and come up with their own valuation assessment. So I'll be sure to get that model linked in the show notes for those interested in checking it out. With that, I think we can close out the episode there, Daniel. Thank you, as always, for joining me here for this wonderful conversation today. And I look forward to continuing to follow along in your journey here on the show. Well, it was an honor for me to be part of your last episode on TIP, Clay. And I think the great thing is that here on TIP, I can really say that we are all friends.

1:28:32So I'm very sure that we will still keep very close contact. And yeah, with that, thanks for everything you've done for TIP and all the best for your new journey. And to all of our listeners today, thanks for tuning in and I will see you soon.

1:29:16Thank you.

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