ROP - Good Better Roper - This Stock Is An Impressive Compounder

2023-07-23 04:39:42 ET

Summary

• Roper Technologies has transformed from an industrial company to a technology company, focusing on software and tech-based products, and has seen its share price rise by over 25% in the past year.
• The company has shown consistent growth in revenues, EBITDA, and free cash flow, and is a dividend aristocrat with a track record of 30 consecutive annual hikes despite a low yield of 0.6%.
• Roper's recent strong earnings report and positive outlook, coupled with its transformation into an asset-light business with substantial recurring revenues, make it an attractive prospect for the long term.

Introduction

It's more than a year ago since I covered Roper Technologies ( ROP ) . Back then, I covered the company's ability to generate tremendous shareholder value, despite yielding just 0.6% at the time - the current yield is still 0.6%.

The company, which used to be part of the industrial sector, is now a member of the technology sector, thanks to a wide variety of software and tech-based products and solutions to help its customers become more efficient.

After roughly 12 months, the company is now more than 25% higher, fueled by great earnings and its potential to generate consistent shareholder value.

In this article, I'll walk you through the company and explain what to make of the ROP ticker, which just broke through its prior all-time high with the support of strong earnings and great guidance.

So, let's get to it!

Compounding Returns With Roper

With a market cap of $53 billion and a focus on defensible niche markets, Roper operates market-leading businesses that design and develop vertical software and technology-enabled products.

Essentially, and according to the company , Roper pursues consistent and sustainable growth in revenue, earnings, and cash flow through continuous improvement in the operating performance of existing businesses and strategic acquisitions.

This is a big step to becoming a compounder, using the definition of C WorldWide Asset Management:

We firmly believe that the long-term trend in company earnings with high cash conversion determines the generation of returns, and that finding compounders is the holy grail of investing.

Over the past three years, the company has deployed capital for acquisitions, enhancing its portfolio with high-value software, services, and technology-enabled solutions.

This also includes major divestitures that helped turn the company from an industrial company into a technology company.

In November 2022, Roper completed the divestiture of a majority 51% equity stake in its industrial businesses, including Process Technologies and parts of Measurement & Analytical Solutions, to Clayton, Dubilier & Rice, LLC.

This divestiture resulted in Roper retaining a 49% minority equity interest in the new standalone parent company, Indicor, LLC.

Now, the company has a huge portion of recurring revenues, which is a key part of being a steady compounder.

Having said that, the company has three major segments - each responsible for a significant part of total revenue.

1. Application Software

This segment accounts for 49.1% of total net revenues and includes businesses like Aderant, CBORD/Horizon, Clinisys, Data Innovations, and others. These businesses offer software solutions for various professional services, K-12 education, government contractors, and insurance industry clients.

2. Network Software

This segment includes ConstructConnect, DAT, Foundry, iPipeline, iTradeNetwork, Loadlink, MHA, SHP, and SoftWriters. They provide cloud-based data, collaboration, estimating automation, and supply chain solutions for different industries.

3. Technology-Enabled Products

With 25.2% of total 2022 net revenues, this segment covers CIVCO Medical Solutions, FMI, Inovonics, IPA, Neptune, Northern Digital, rf IDEAS, and Verathon. They offer a range of products, including ultrasound accessories, wireless sensor networks, medical devices, and RFID card readers.

Here's an overview of these businesses, ranked from large to small:

Not only does the company have a business with exposure in fast-growing areas, but it also transformed its business into an asset-light business with a major portion of recurring revenues and a high cash conversion (as seen in the chart below).

These are the perfect conditions to become a wealth compounder.

Here's another definition of compounder stocks, this time from Morgan Stanley ( MS ):

We define compounders as companies with high-quality, franchise businesses, ideally with recurring revenues, built on dominant and durable intangible assets, which possess pricing power and low capital intensity . When evaluating these companies, we focus on franchise quality and durability, financial strength, industry position, and management quality.

The company ticks every box and has turned its business from 32% software exposure to 75% software exposure, allowing it to generate much higher organic growth and 500 basis points higher EBITDA margins compared to 2016.

Despite the fact that the company started transforming its business just recently, it has been a compounder for quite some time.

Since 2007, the company has:

• Grown its revenues by 8% per year,
• Grown its EBITDA by 11% per year,
• Compounded free cash flow at 12% per year, and
• Enjoyed 15% in capital gains growth per year.

Additionally, the company is a dividend aristocrat .

While its yield is just 0.6%, it has a payout ratio of just 8%, a five-year annual average dividend growth rate of 11%, and a track record of 30 consecutive annual hikes.

Again, the yield is low, but ROP is an aristocrat with tremendous growth opportunities that should prevent younger investors from being discouraged by the yield.

So far, so good.

Now, let's dive into recent events, which include the just-released earnings and forward-looking comments. After all, we need more than historical data to assess the risk/reward later in this article.

Earnings & Outlook

In the second quarter, the company reported $1.53 billion in revenue, beating estimates by $30 million. Adjusted EPS came in at $4.12, which was $0.13 higher than expected.

Furthermore, organic growth was also strong at 9%, led by an impressive 8% growth in software recurring revenue and 19% growth in the tech-enabled product segment.

EBITDA increased by 20% to $617 million. Moreover, margins expanded across all three segments during the quarter.

Going a step further, in the Application Software segment, Roper Technologies reported revenues of $770 million, representing a 6% increase on an organic basis.

The EBITDA margins for the segment reached 43.7% in the quarter. Deltek, a company in this segment, showed strong performance in both government contracting and private-sector businesses.

Also, the momentum for Deltek's SaaS offerings remained high, and retention rates were historically strong.

Roper also announced the acquisition of Replicon, a market-leading timekeeping and workforce management SaaS solution for professional services firms.

This acquisition is expected to contribute over $70 million in revenue and $24 million in EBITDA next year.

The Network Software segment reported revenues of $358 million, representing a 5% increase on an organic basis, with strong EBITDA margins at 54.2%.

What's interesting is that Roper's US and Canadian freight matching businesses, DAT & Loadlink, showed growth despite challenges in the freight and logistics markets.

The spot market in which these businesses operate is expected to benefit from the volume of future freight shipments.

Also, the network software business that tech-enables the distribution channel for life insurance and annuities had significant ARR (annual recurring revenue) gains due to strong retention and customer expansion activity.

The Tech-Enabled Product segment hit it out of the park, as it reported revenues of $403 million. This translates to a 19% increase on an organic basis, with strong EBITDA margins at 36.4%.

To highlight a business in this segment, Neptune, Roper's water meter and technology product business, achieved record revenue performance, particularly in the residential and commercial ultrasonic or static meters.

Having said all of this, guidance wasn't half-bad either.

Thanks to the strong second-quarter performance, Roper raised its full-year 2023 guidance.

• Total revenue growth is now expected to be around 13%, up from the previous estimate of 12%.
• The organic revenue outlook was raised to 7%, up from the previous range of 6% to 7%.

Additionally, Roper remains optimistic about Generative AI, considering its potential for internal productivity and new product development.

The company also maintains a disciplined approach to capital deployment, with over $4 billion of available M&A firepower.

Balance Sheet & Valuation

Despite M&A activity, the net leverage ratio ended the quarter at 2.2x, with roughly $6.7 billion of debt and just under $1.5 billion of cash.

The company had a fully undrawn $3.5 billion revolver, giving them substantial acquisition capacity.

Roper enjoys a BBB+ credit rating.

Having said that, ROP is trading at 28x 2023E free cash flow, which is expected to drop to 25x using 2024E numbers. This translates to a 4.0% free cash flow yield, which suggests that the dividend is very safe and likely to enjoy continuous aggressive hikes.

Furthermore, the company is trading at 23.9x NTM EBITDA.

Given the company's potential, this valuation is fair.

Analysts seem to agree.

The current consensus price target is $518, which is 4% above the current price.

With all of this in mind, ROP is a great stock for my portfolio. Hence, I put it on my watchlist.

However, I did not yet buy it, as I like to buy stocks well-below their fair value.

Given the company's track record, I'm playing a dangerous game here. The company's fundamentals are great, and the trend is up. We could easily see a continuation of the uptrend.

However, I'm willing to take that risk. So far, I've done well using my strategy.

If it drops, I'm likely to be a buyer - either for my own portfolio or portfolios that I manage. A drop could be triggered by a further decline in economic growth.

My rating is bullish to reflect the company's qualities.

Takeaway

After analyzing Roper Technologies' performance and potential, I find it to be an exciting addition to my portfolio watchlist. With a focus on defensible niche markets and a transformation into an asset-light business with substantial recurring revenues, Roper has all the qualities of a wealth compounder.

The company's steady growth in revenues, EBITDA, and free cash flow over the years, coupled with its status as a dividend aristocrat, display its commitment to generating consistent shareholder value. Roper's recent strong earnings report and positive outlook further solidify its position as a promising investment.

Despite the current low dividend yield, Roper's tremendous growth opportunities and sound financials make it an attractive prospect for long-term investors. Although the stock is trading at a fair valuation, the company's potential for future growth warrants my bullish rating.

For further details see:

Good, Better, Roper - This Stock Is An Impressive Compounder