Roper Looks Strongly Positioned to Continue Compounding Cash as it Remakes Its Portfolio

Business Strategy & Outlook

Roper acquires 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 has dropped from 18% to negative 13%. Skeptics point out three criticisms: Roper purchases businesses that have little strategic rationale with one another; it is starving its businesses for capital; and the business model carries a lot of execution risk since the company will eventually run out of targets to purchase. All three of these criticisms miss the mark. First, purchasing 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 is the stock has beat the returns of the S&P 500 by about 2 times since 2003. Second, Roper’s businesses don’t require capital to continue growing. The maintenance capital expenditures are less than 1% of sales. Even so, free cash flow conversion consistently hovers well 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. Following portfolio changes, one can still believe Roper is poised to continuously compounded cash for many years, and it can anticipate mid teens EPS growth through the cycle.

Financial Strengths

Roper is in strong financial health, and it is adequately capitalized to meet its ongoing service obligations. As a result, one can derive a low risk of default in the model’s credit risk assessment, which is slightly better than the moderate risk the rating agencies assign to Roper’s bonds. One reason one is more confident is Roper’s free cash flow conversion, which historically hovers well over 100% of earnings (including 125% in 2020, on an adjusted basis). While the firm does take on leverage when acquiring a target, management has indicated it is absolutely committed to maintaining an investment-grade rating. At an investor conference in early 2019, CEO Neil Hunn indicated his belief that Roper could do a $3 billion-$3.5 billion deal and “easily be inside of investment-grade.” Since that time, Roper has spent over $6 billion in acquisitions and has still managed to maintain its investment-grade credit rating. As of the end of 2021, the firm’s net debt/adjusted EBITDA was about 3.4 times. While one normally doesn’t like EBITDA metrics when assessing a firm’s financial health, one can point out that Roper converts about 82% of its adjusted EBITDA into free cash flow. The firm’s interest coverage (EBIT/interest), moreover, stands at 8.5 times. Unlike other multi-industry conglomerates, the firm has no pension plan. Given that one doesn’t believe Roper requires any restricted cash to operate its businesses, one can add back 100% of Roper’s cash to the net debt calculation, which is also unusual in multi-industry coverage.

Bulls Say

Roper’s total returns have doubled the returns of the S&P 500 over the past 15 years.
Roper’s culture is greater than one person, and former CEO Jellison’s framework is safe in the hands of the current CEO and CFO.
The winning formula of using cash from a recurring revenue base to acquire cash-rich businesses at reasonable valuations shows no signs of slowing down, with expected future earnings growing at similar to historical rates as the firm ups its acquisition spending.

Company Description

Roper is a diversified technology company that operates through three segments: application software; network software and systems; and technology enabled products. The firm’s culture emphasizes acquiring asset-light, cash-generative businesses. Roper then reinvests this excess cash in businesses that yield incrementally higher rates of return. While the businesses are managed in a decentralized manner, Roper does not passively manage its portfolio. Instead, Roper manages its businesses through the Socratic method and empowers decision-makers through group executive coaching. Roper has now rotated a clear majority of its business from legacy industrial products into technology software in mature, niche markets with large quantities of deferred revenue.

(Source: Morningstar)

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