No. of Recommendations: 9
To summarize it beyond the point of utility: for an investor, the main risk isn't that the clients will build their own tools. It's more that the barriers to competitive entry are lowered, so at the margin there will be more competitors. Ongoing spend to keep market share might hurt the long term economics of bond-like software products in non-growing niche markets, as they have traditionally relied on the fact that it just wasn't worth someone else's time (money) to build a new competitor in a small market.
It's very hard to say how much this going to be a problem for the economics of Constallation's past and future acquisitions. I can't see it killing them, but it has the ring of plausibility as a risk to consider. I can imagine this could cause their long their cash flow growth curve to flatten.
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I'm not saying it's a terrible pick at these levels, and in fact I do own some. Just always trying to look for flaws in any investment thesis.
Another thought to consider comes from my brother, with whom I was talking about Constellation yesterday. He figures that in the software niche that Constellation likes, customer acquisition cost is typically the equivalent of about 2-3 years of revenue, but then you have a very long tail of revenue with very low costs and customer churn that is low, typically <10%, so when Constellation acquires these companies, they cut software development costs to the bone and just milk it for the long tail. Now with new AI tools , a certain percentage of customers will use agents to get the job done without the software, and churn rates are increasing. They don't have to go up a lot for the economics of this business to really fall apart in a serious way. To take a simple example, if you have $100,000 in revenues from 10 customers paying you $10,000/year, and one of them has to be replaced for $25,000 (2 1/2 years of revenues), you make $75,000. But if you now have to replace 2 customers a year instead of one, then your net income drops from $75,000 to $50,000.
If this is true, Constellation's model was heavily based on low churn, and AI will increase that both because competitors find it easier to write software, but mostly because it only takes a small percentage of customers that can use AI agents to get the job done to put a big hole in profits.
