ROP - Roper Benefiting From A Nervous Street Looking For Safer Revenue And FCF Generation Stories

2023-10-31 10:08:05 ET

Summary

• Roper's Q3 results beat expectations, with revenue rising 16% and gross margin improving.
• Roper's exposure to markets that look weak for 2024 is relatively limited and the business supported by strong recurring software revenues and value offerings that customers won't readily abandon.
• Roper's mix of improving free cash flow, recurrent revenue, and lower cyclicality makes it appealing in a market worried about shorter-cycle markets.
• While I understand why Roper is outperforming, I can't really find valuation approaches that suggest it's mispriced or meaningfully undervalued.

It’s likely a stretch to call Roper ( ROP ) defensive given its high multiples, but in a market that is increasingly worried about the health of shorter-cycle markets, Roper’s mix of improving free cash flow, recurrent revenue, and lower cyclicality certainly has some appeal now. With that, these shares have comfortably outperformed the industrial sector since my last article , though not performing quite as well as pure software companies like Salesforce.com ( CRM ) or SAP ( SAP ).

I’m somewhat less concerned about Roper’s reliance on high-multiple deals with diminishing returns as I was before, and my sense from management communications (the investor day, presentations at sell-side conferences and so on) is that the company is more explicitly focused on organic growth and improved returns than before. I like that, and I also like the fact that apart from non-resi construction and trucking, the company doesn’t have outsized exposure to markets that concern me in 2024. That leaves a more basic and long-standing issue – valuation – and that is a harder one for me to resolve at this point.

A Beat-And-Raise Into A Nervous Market

I wouldn’t call Roper’s third quarter results and guidance for the Q4 a blockbuster result, but it was a beat-and-raise performance at a time when a lot of investors are worried about 2024 and looking for a binky to help them through this more volatile time in the market.

Revenue rose 16% as reported and 6% in organic terms, good for a very modest beat versus the Street. The Application Software and Network Software businesses both grew 5% on an organic basis, while Tech-Enabled Products grew 10% on strong results from both Neptune (metering) and Verathon (diagnostic medical devices).

Gross margin improved 40bp to 70.1%, helping support 18% improvement in adjusted EBITDA (with margin up 60bp to 41.7%). Adjusted operating income rose more than 16%, with margin flat at 29.1%, and segment profits rose more than 13%, with margin up 30bp to 32.5%.

Roper beat Street expectations by about $0.09/share at the operating profit level, with outperformance in all three segments offset by somewhat higher than expected corporate expenses. App Software profits rose 24% on an adjusted basis (margin down 10bp to 26.9%), while Network Software profits rose 11% (margin up 250bp to 45.2%) and Tech-Enabled Products profits rose 8% (margin down 60bp to 34.6%).

Management guidance wasn’t exactly groundbreaking, but guiding revenue to “more than” 7% organic growth was still an incremental positive, as was a 2.5% EPS guidance upgrade at the midpoint and healthy free cash flow generation.

A Better Mix For A Nervous Market?

Not all “compounders” have seen their multiples reinflate to the extent that Roper has – stocks like Ametek ( AME ), Danaher ( DHR ), Idex ( IEX ), and Nordson ( NDSN ) have underperformed since my last update on Roper – so I don’t think this is simply a case of investors coming back to a once-popular theme or category.

Instead, I think Roper is being rewarded for a business mix that better suits the uncertainty of the current period, and I’d note that while Fortive ( FTV ) has recently sold off, it had largely been tracking higher with Roper and at least some of what I am about to say about Roper could apply to Fortive as well.

Right off the bat, Roper doesn’t have outsized exposure to markets that look weak for 2024. Businesses like Aderant, CBORD, iTradeNetwork, and Strata/Syntellis have some general exposure to the economy, but nothing that stands out as especially vulnerable right now. Likewise, the company has meaningful exposure to medical markets through both software and hardware, and these markets are looking healthy at this point.

There are some businesses where Roper has exposure to weakening macro fundamentals. I’m thinking of businesses like DAT and Loadlink in trucking, Deltek in project management (architectural/engineering, especially), and ConstructConnect in non-resi construction.

There are asterisks though – I believe trucking will start improving again in 2024, and DAT and Loadlink are both benefiting from share growth and their position as important information clearinghouses such that users aren’t going to want to drop out just because business is soft.

With Deltek I would expect government contracting activity to improve in 2024 (offset by government shutdown risks), and I likewise wouldn’t expect customers to abandon ERP software and service automation just because of a weaker period. I’m more concerned with ConstructConnect, and I think new customers may look to delay signing on, but that’s a pause in the business trajectory, not a revocation of the longer term trend of adoption and digitalization of non-resi construction.

It's also worth noting again that Roper has been moving headlong toward a recurrent revenue model, and a little over 57% of Q3’23 revenue was classified by management as recurrent software revenue. New bookings will probably slow in 2024 on weaker overall economic activity, but given the nature of Roper’s software, including the cost savings offered by automating many previously manual tasks and the cost of switching to something else, I don’t really see Roper software as high on the list of items to be targeted for cost-cutting by customers.

The Outlook

This is admittedly subjective, but I also feel like management’s tone has been shifting. Listening to recent presentations to analysts and investors, I feel as though management is at least talking more about an increased focus on internal organic growth and improved returns, including improved free cash flow generation. One of the main bear arguments is that this is just an M&A growth story and when the music stops there (when the company can no longer find or afford growth-driving deals), the story falls apart. A subjective shift in tone doesn’t invalidate that, but improved organic growth, margins, and cash flow will certainly make for a stronger bull case.

Not too much has changed with my model since my last update. I’m still looking for long-term revenue growth in the neighborhood of 10%, with a roughly 50/50 split between organic growth and future M&A. Modeling future M&A is a virtual guarantee of being wrong about specific year-to-year performance, but ignoring M&A guarantees that longer-range revenue estimates will be much wider of the mark.

While free cash flow generation has been improving, I’m expecting a much slower rate of improvement in the coming years, though I think a low-to-mid-30%’s FCF margin is attainable, supporting low double-digit FCF growth.

Discounting those cash flows back doesn’t drive a particularly robust fair value, and I get a prospective long-term annualized return in the 7%’s – not terrible, and not out of line with quality industrials (to the extent that Roper is still an “industrial” in any meaningful sense), but no bargain. Likewise with EV/EBITDA, where the shares trade above what margins and returns (ROIC, ROCE, et al) can support. Looking at historical average forward multiples, Roper’s about in line with its long-term average (around 21.75x) and likewise on the higher end of what the Street has often paid for favored “compounders”.

The Bottom Line

I get why Roper would be more popular now, at least relative to more traditional industrials with more short-cycle exposure. Still, the valuation now looks pretty demanding and it will take further outperformance in organic growth, margins, and/or FCF to argue for an even higher multiple. This just isn’t a combination that works for me, and much as I like the idea of a high-margin business built around largely acyclical high-margin revenue, I don’t see this idea as significantly mispriced or undervalued.

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