Roper Is a High-Quality Cash Compounder Now Trading at a Discount
Roper Is a High-Quality Cash Compounder Now Trading at a Discount
Business Strategy and Outlook| by Joshua AguilarUpdated Feb 26, 2021
Roper is an acquirer of software companies with large amounts of deferred revenue. Large quantities of deferred revenue exist because many software businesses receive cash far in advance of when services are rendered. Roper uses this cash to invest in businesses at incrementally higher rates of return. Its targets have large bases of recurring revenue in oligopolistic, niche markets with small total addressable markets. That revenue base is protected by strong switching costs that frequently post customer retention rates greater than 95%. Roper’s businesses typically don’t own their own infrastructure, which further contributes to its asset-light business model. From 2003 through today, Roper’s net working capital as a percentage of sales dropped from 18% to under negative 8%.
Skeptics point out three criticisms: 1) Roper purchases businesses that have little strategic rationale with one another; 2) the company is starving its businesses for capital; and 3) the business model carries a lot of execution risk since the company will eventually run out of targets to purchase. We think all three of these criticisms miss the mark. First, we think Roper's purchases of unrelated businesses is an advantage. While competitors frequently purchase targets to either eliminate competition or buy distribution, Roper screens all opportunities based on how each business will add to long-term cash returns, a key reason we believe the stock has beat the returns of the S&P 500 by over 2 times since 2003.
Second, Roper’s businesses don’t require capital to continue growing. We estimate that maintenance capital expenditures are only about 1% of sales. Even so, free cash flow conversion consistently hovers over 100%. Finally, capital allocation has been integrally tied to Roper’s culture since the early 2000s. The firm also does not try to extract aggressive synergy targets from acquisitions, choosing instead to focus on opportunity cost. Private equity also provides Roper with a continuous revolving door of potential investment opportunities. In sum, we believe Roper is poised to continuously compound cash for many years to come and anticipate midteens EPS growth through the cycle.
Economic Moat| by Joshua AguilarUpdated Feb 26, 2021
We award Roper Technologies a wide economic moat. Even though we think Roper’s economic moat is more than just the sum of its parts, we still believe Roper’s individual constituents have strong and durable competitive advantages. In isolation, software businesses are not necessarily moatier than their non-software counterparts, in our view. By management’s own admission, there are public software companies that if purchased by Roper, would hypothetically be its worst return on capital businesses. In Roper’s case, however, not only are its subscription software businesses paid ahead of time on a recurring basis at about 60% of Roper’s consolidated business, most also rent their own infrastructure, which contributes to the asset-light nature of its business model. More importantly, Roper’s businesses tend to be in more oligopolistic, niche markets that have little risk of disruption given the small size of their total addressable markets and the importance of customer intimacy.
In 2019, the firm resegmented its entire operations for reporting purposes. In its application software segment, which we assign with a wide moat, we think the firm benefits primarily from switching costs. Application software refers to enterprise software intended for a specific application. In our view, switching costs are very strong in enterprise software due to several factors. These include a customer’s direct time and expense of implementing a new software platform. Other indirect costs include lost productivity as employees move up a learning curve on a new system as well as the distraction of employees involved where the change is occurring. Lastly, and perhaps most importantly, there is operational risk, including loss of data during any changeover, project execution, and potential business disruption. The more critical the function and the more touch points across an organization a software vendor has, the higher the switching costs are.
One specific example is Roper’s business Aderant, which sells end-to-end enterprise software for law firms. The software features a host of mission-critical solutions, including time capture, billing, docketing, finance, accounting, and business intelligence. It also boasts a retention ratio of greater than 95% with a customer base of over 3,000 of the world’s largest legal and professional services firms. Law firms particularly loathe change and switch providers at a glacial cadence given attorney concerns over both compliance and cybersecurity. Tracking billable hours, moreover, is the lifeblood of a law firm, and attorneys must meet stringent annual billing requirements amid both industry pricing and operating efficiency pressures. Missing a court date or client deadline, for example, could subject lawyers to professional sanctions, reputational harm, and malpractice claims from either fellow members of the bar or disgruntled clients. To a lesser extent, a business like Aderant also benefits from intangible assets, given its “domain expertise” or intimate knowledge of the “biglaw” attorney market. Aderant has addressed specific attorney-customer pain points, including document management and automating previously manual tasks such as invoicing and emailing client intake forms, which take away attorney staff time from higher ROI work.
Another example in the application software segment is Deltek, which Roper acquired in 2016. Deltek boasts a loyal and diverse customer base with a customer retention ratio of 97% that we consider best-in-class for enterprise software and indicative of strong switching costs. Deltek provides solutions in niche markets like government contracting as well as architecture and engineering firms. In government work, incumbency is also important, which we believe also indicates the presence of intangible assets. Other intangible assets in Deltek’s business model includes a well-versed knowledge of specific project management services. These services include a government contractor’s bill of materials, which have a different set of deal parameters given the professional service nature of the business (as opposed to sales of tangible products).
Pain points in government contracting work include timecards and expense reports, which have distinct compliance requirements subject to U.S. federal auditing regulation. Federal agencies have made increasingly stringent demands for transparency of contract charges obliging extensive audit trails. For example, vendors must use multiple billing calculations and the alphabet soup of invoice formats. Failing to comply and unsuccessful automation efforts from more generic software providers have led government contractors to incur extensive losses of time and money.
Winning business from U.S. federal agencies further requires government contractors to track past performance data and monitor client interactions, and business intelligence from Deltek’s software has yielded additional contract wins for government contracting vendors. IDC MarketScape has placed Deltek in the “Leaders” category after a thorough review of its offerings. According to IDC, Deltek’s Vision software is “heavily used by architecture and engineering, management consulting, IT consulting, and market research firms” and “few competitors can match Deltek’s expertise.” Switching costs are also evident in quantitative metrics from customers that have adopted Deltek’s Costpoint software, including revenue increases of 9% to 20%, profit increases of 10% to 25%, and days sales outstanding reductions of 10 to 12 days. As a result, 99 of the 100 largest U.S. federal prime contractors rely on Deltek software.
We also award Roper’s network software and systems segment with a wide moat, which we attribute primarily to a network effect. In Roper’s TransCore business, for example, its NationalPass offering provides the industry’s first interoperable RFID service that provides access to all public toll roads and bridges in North America. More touchpoints clearly benefit toll operators given the added ability to accurately collect and reliably process toll revenue. The more tolling solutions are added to the network, the more toll operators can monitor every aspect of its toll operations and use that data to make decisions in real time, such as informing drivers of potential traffic bottlenecks or automobile accidents.
Specifically, a single Vehicle Capture and Recognition System unit includes components and cameras with overlapping fields of view, which results in substantially improved system accuracy and revenue capture (that is, additional units help with capturing more license plates). In other applications, additional security solutions can expedite the identification of low-risk vehicles or provide other tracking solutions. From the customer standpoint, a more robust, nationally interoperable toll network eliminates the need of purchasing and maintaining multiple transponders, while also providing drivers with access to the lowest available toll rate. The technology is also available at far less expensive prices relative to alternatives and is readily available for purchase in vending machines throughout the State of Florida (which uses SunPass). Transcore’s transponders, moreover, use existing toll infrastructure, eliminating the need for costly modifications, which, to an extent, also evidences switching costs.
Other examples of network effects in this segment include Roper’s freight matching brokerage service in DAT Solutions. It’s the largest software-as-a-service subscription network for freight spot transactions in North America. A two-way network effect is evident in that brokers need trucks, while carriers need loads; the more loads and trucks posted on a network of load boards only increases the value of this service over time. If a truck drops off a load in Chicago and needs to return to New York, a user can log on to DAT’s system and find all available loads within a certain radius of where that user is located. Roper claims it’s not unusual for a specific load to be on its system in 10 seconds or less before it’s snatched up, given DAT’s ability to ascertain the best price for the most loads. DAT’s solutions, moreover, have boosted available capacity by 36%, while consolidation has allowed broker customers to access 400% more truckloads, according to DAT.
MHA, which is Roper’s alternate site group purchasing organization, or GPO, is the largest network of independent long-term care pharmacies in the United States (Roper claims 80% market share). The network’s bargaining power increases with a great collection of pharmacists, which its uses to collect reimbursement through the Medicare Part D program as well as lobby for their interests on Capitol Hill. According to a study co-authored by former Federal Trade Commission chairman Jon Leibowitz, providers (for example, hospitals) can realize savings of 10% to 18% using GPOs relative to the costs they would incur had they negotiated prices on their own. According to Roper, 100% of MHA’s revenue is also recurring, which we believe also indicates switching costs.
We also believe the firm’s measurement and analytical solutions segment merits a wide moat rating. This portfolio represents the less cyclical portion of Roper’s legacy portfolio (a large portion of the segment is exposed to healthcare), and we think this portfolio benefits mostly from switching costs, and to a lesser extent, intangible assets. A prime example is Roper’s smart meter company Neptune, which sells smart meters to water utilities throughout North America. While management has stated this business benefits from a “mini-network effect,” we think switching costs are the more applicable moat source here, along with some intangible assets. Intangible assets are evident in Neptune’s ability to solve a customer pain points by making all its network meters backwards compatible with non-network meters, which according to management, gives Roper some pricing power. This has allowed utility customers to migrate to network meters over a series of years and has allowed customers to not have to either abandon their historical investment or incur the expense of unnecessary downtime from a large, one-time migrations, which we believe evidences switching costs. Long-term contracts with price escalators also reinforce these switching costs, in our view.
Additionally, we assign Roper’s fourth and final segment, process technologies, a narrow moat due to both switching costs, and to a lesser extent, intangible assets. One thing that affects our confidence in this segment is the portfolio’s exposure to upstream oil and gas, which management states constitutes about one-quarter of segment revenue. The rest of the portfolio, moreover, is largely indexed to the rest of the energy markets and houses most of Roper’s cyclicality. Even so, management reports that these are mature businesses and strong long-term excess returns contributors to Roper’s consolidated business. Traditional industrials like three of Roper’s pump companies in this segment employ a razor/blade model by building a deep installed base of high-performing pumps (which we associate with intangible assets) and then enjoy large sources of high-margin, recurring revenue through the sale of parts and services (which we associate with switching costs). An example of switching costs in this segment includes ammonia valves sold for cold storage in cold chain and storage facilities, where leaks are devastating and these valves are used to regulate the precise control of temperature.
Because of its acquisition-heavy model, Roper uses nearly all its available free cash flow to purchase businesses, which keeps ROICs, including goodwill artificially low, despite the underlying improvement in the firm’s cash returns. In our view, if management were to hypothetically to turn off the acquisition spigot, we believe the firm’s reported ROICs would likely rise. Even so, including goodwill in our ROIC computation, the firm’s excess returns have safely exceeded our weighted average cost of capital for the historical length of our model, and we believe it is more likely than not that the company will continue clearing its WACC hurdle over the next 20 years.
Fair Value and Profit Drivers| by Joshua AguilarUpdated Feb 26, 2021
After rolling our model for full-year 2020 results and incorporating an additional year of earning power, we slightly raise our fair value estimate to $452 from $443. We value Roper at just over 30 times our 2021 adjusted EPS expectations, which we consider reasonable relative to the S&P's forward P/E multiple of just over 25 times given Roper's runway and still low, yet rising interest-rate environment. We still like the acquisition of Vertafore, as we think it exhibits strong switching costs given that it's a niche ERP system for the diffcult-to-navigate P&C insurance market. It's further along in SaaS migration than most of Roper's portfolio.
For Roper’s application software segment, industry reports point to increasing automation needs for key functions at the enterprise level. Application software, for example, is used to increase sales by retaining customers and netting new customers. The solutions identify users’ most valuable customers, create communications to obtain insights, increase engagement, and yield additional conversions, while also saving professional and staff support time for more ROI-increasing activities. Roper’s activities specifically focus on professional or specialized niches like the attorney market, government contracting, and engineering and construction firms, which present their own unique set of challenges and circumstance. Roper’s offerings specifically address these needs, which we believe creates a stickier offering and makes it harder for large players to displace them. Consequently, it also offers Roper greater than inflation pricing power, giving us confidence that this segment can grow its organic top-line CAGR at about 5% over the next 10 years.
In network software and systems, the firm’s other growth engine, the common thread in these businesses is using operational and financial data to yield insights across a network. These insights are then used in an organization's decision-making. We’re bullish on TransCore leveraging its equipment in highway infrastructure across the country, and we think the market clearly fails to appreciate the benefits that will flow through in 2021 once the NYC project continues when COVID is less of a factor. We also believe the segment can maintain its customer retention rates. As a result, we also model top-line organic growth at over 6% over the next 10 years, just above our application software projections.
Risk and Uncertainty| by Joshua AguilarUpdated Feb 26, 2021
We assign a medium uncertainty rating to Roper Technologies.
Like many diversified conglomerates in our coverage, Roper is exposed to a number of risks in the broad global economy. These risks include trade disputes and changes in exportation policies (Roper exports about 11% of sales based on 2018 and 2017 sales), cybersecurity risks, and software-product launch-failures in any of its verticals. Other risks include a downturn in the oil and gas market (specifically for its process technologies segment), as well as finding suitable high cash-return acquisition targets at reasonable valuations, which could lead to intangible and goodwill write-offs (goodwill constitutes 60% of Roper’s assets as stated on its 2020 balance sheet).
Other issues more unique to Roper’s acquisition model include misidentifying poor management at a target company, or a diminution of its own unique culture, which emphasizes decentralization with accountability. We think the biggest risk to Roper would be abandoning Jellison’s framework, but it’s not one we see happening in the foreseeable future. A more likely risk, in our view, is that the team of Hunn and Crisci would potentially misread a deal’s economic prospects or fail to appreciate certain competitive threats in a target’s markets. While Roper has never taken an impairment charge from an acquisition, we think it’s inevitable it may one day have to, even if it’s multiple years into the future as it grows in market capitalization. In some ways, size itself may one day become an issue, but we see this as more of a hurdle beyond the next 15 years.
Stewardship| by Joshua AguilarUpdated Feb 26, 2021
We award Roper’s management team an Exemplary stewardship rating conducted with our prior methodology. We will be transitioning our assessment rubric for Roper and the rest of our stock coverage to the capital allocation methodology by the end of September 2021. That said, we expect our rating will remain unchanged given our high regard for Roper's management team and its culture.
Roper’s acquisition model is the brainchild of the late and universally well-regarded manager, Brian Jellison. Under his stewardship, the firm grew its market capitalization from $1.5 billion to more than $30 billion, and from 2003 to 2018, Roper compounded total annual shareholders returns at 19%--over 2 times the 9% annualized returns of the S&P 500, in that time period. We suspect Jellison first honed his capital allocation skills at Columbia Business School (which has produced a laundry list of well-known investors given its historical association with Benjamin Graham), while also learning the ins-and-outs of industrial operations with stints at stalwarts like General Electric and Ingersoll-Rand.
Roper’s business model, however, is greater than one person. Its model works, in our view, because Roper has successfully institutionalized its culture. We see no evidence of its culture watering down. We think keys to Roper’s business model’s success include its decentralized business model, its focus on long-term shareholder value by acquiring businesses with durable competitive advantage at reasonable multiples, and its preference for niche business that compete on customer intimacy as opposed to scale. We like Roper’s emphasis on decentralization and a bottom-up approach because it empowers Roper’s managers to make the best possible decisions for each of their individual businesses.
That said, decentralized ownership doesn’t mean passive ownership. Roper finds highly driven talent and makes its team accountable for its decisions by drilling them through the Socratic method (which is common in professional training like lawyers or doctors). One key differentiator we really like is that Roper doesn’t move its people from business to business (in contrast to a firm like General Electric), which in our view, allows its talent to focus on one specific area of excellence over multiple years. Finally, Roper doesn’t manage through budgets, but based on its teams’ performances. While Morningstar prefers evaluating acquisitive firms through the lens of ROIC including goodwill, Roper manages its businesses based on its team’s ability to grow cash return on investment, which is highly correlated to long-term stock market returns (with an R-squared of over 95%).
Current CEO Neil Hunn and CFO Robert Crisci have already made for a great partnership, in our view. We've had the opportunity to speak with them at the Electrical Products Group Conference and were impressed that they’ve been involved with sourcing mergers and acquisitions for quite some time. Unlike its counterparts, Roper eschews large M&A teams. Aside from Hunn and Crisci, few other individuals are involved in evaluating Roper’s deal flow for possible acquisition (one example would be the firm’s general counsel). Hunn and Crisci are involved in the entire life cycle of a potential deal, from meetings with management, to due diligence, to a deal’s closing. Hunn developed his operating chops for a decade at MedAssets, an Atlanta-based SaaS firm, while Crisci previously headed Roper's IR team.
One area of difference between Hunn and Jellison we expect centers on Hunn’s operating pedigree in Roper’s medical and application software businesses. We believe Hunn will be more process-oriented relative to Jellison as to how strategy is developed at the individual business level. Additionally, while the company pays a dividend that increases every year (at a 23% payout ratio to 2020 GAAP EPS or an expected 20% payout ratio to our 2021 GAAP EPS estimate), the dividend clearly takes a backseat to the firm’s M&A strategy. Even so, we expect the firm’s payout ratio to remain in the 20s as percentage of GAAP EPS during our explicit forecast. Overall, however, we are confident in the pair’s ability to carry on Jellison’s framework and perhaps find ways to incrementally improve it, during our 10-year explicit forecast and beyond. The acquisition of Vertafore, in our view, signals management's willingness to spend more on M&A in any given year than the market appreciates after deleveraging in 2021.