ROP - Roper Technologies: Promising Growth Potential Amidst Challenging Market Conditions

2023-05-06 08:19:17 ET

Summary

• Roper's focus on asset-light businesses in the software sector provides a buffer against supply-chain challenges and inflation concerns.
• The company has a disciplined history of mergers and acquisitions, strategically expanding its portfolio and capitalizing on growth opportunities.
• Despite a challenging market environment, Roper consistently delivers strong financial results, achieving impressive double-digit cash earnings growth.
• I keep a buy rating on the stock and keep an end-of-year price target of $499.

Thesis

I remain bullish on Roper Technologies, Inc. (ROP), given the company's consistent software focus, disciplined history of mergers and acquisitions, and the cessation of the divestment program. Despite the challenging market environment, ROP continues to consistently deliver strong financial results and achieve impressive double-digit cash earnings growth while skillfully transitioning its portfolio towards asset-light businesses with higher ROIC. The company's emphasis on asset-light businesses in the software sector serves as a mitigating factor against concerns surrounding ongoing supply-chain challenges and increased inflation. I keep a buy rating on the stock and keep an end-of-year price target of $499 on the stock based on an assumed forward PE multiple of 28x applied to the FY2025 EPS estimate of $17.84.

Post Q1 Outlook

Roper's first-quarter results exceeded market expectations . The company performed well in terms of revenue, primarily driven by its hardware businesses at Technology Enabled Products ((TEP)). I believe the positive sequential improvement in recurring software revenue is a good sign, and management's comments regarding high single-digit (HSD) growth in organic software bookings further support this, indicating that the momentum from the fourth quarter carried over into the new year, and demand remains strong.

Roper's Shift to Software Mitigates Industrial-Outlook Concerns

Demand should remain positive in many end markets for US industrials in 2023, yet economic clouds are building. I believe energy markets may stay favorable as capital spending expands, even with some pullback in oil prices. Construction markets are mixed, with industries exposed to US federal-spending programs such as equipment rental and construction equipment outperforming. Residential trends are very soft, and nonresidential construction growth might temper, affecting HVAC, building controls and some areas of electrical components.

In my view, Roper's asset-light, software-focused businesses help blunt worries over persistent supply-chain constraints and heightened inflation. As the company capitalizes on its diversified portfolio of digital offerings, which should continue to expand through M&A, it could outperform its peers. Roper's planned divestment of its product businesses will limit cyclical exposure.

Roper Strategy Won't Change as a 'Tech' Company

I don't expect Roper's strategy to shift much with its current portfolio of 75% software and 25% medical and water products. The decentralized business model will remain intact. The company should continue to seek assets with an attractive cash return on investment ((CRI)), high recurring revenue and low asset intensity. Product deals aren't ruled out, but in the past decade, well-defined criteria have favoured software -- consuming over 95% of M&A funds -- which I expect to continue. Though at the corporate level, Roper doesn't strategically seek to build platforms, individual businesses do bolt-on deals to strengthen market position and fuel growth. The management would like to allocate more capital to bolt-on acquisitions, which offer high returns owing to synergies.

ROP Substantially Improves Businesses That it Buys

There is a common investor perception that ROP buys businesses and does not improve them because it does not extract large 'cost' synergies, unlike many MI companies tend to do with hardware deals; however, there are several examples to illustrate how this is definitely not the case. Deltek provides a good example of the growth algorithm at ROP - growing recurring revenue HSD organically on a consistent basis, vs MSD growth at the time of acquisition in 2016, alongside a ~500bps increase in EBITDA margins. Market share gains appear consistent - Aderant has not lost a single customer to its largest competitor in recent years, and its share has risen from 31% to 48% in 7 years. At Vertafore (ROP's largest acquisition in 2020), R&D has moved from $90 million in 2020 to $104 million in 2022, with more technology and new capabilities, and there have been several bolt-on deals since it was brought into ROP.

Financial Outlook

Following a multiyear portfolio-optimization effort, I believe Roper is poised for higher organic growth and returns, low cyclicality and increased cash-flow generation. The sale of the remaining industrial units in 2022 positioned the company to achieve 9% organic growth vs. 3% in 2019 and an EBITDA margin of 40% from 36%. Compound annual sales growth in 2019-22 of the software-led Roper was 14% vs 5% when it owned the industrial units. The volatility of annual organic growth narrows substantially with the new sales mix heavily weighted to software (75% of sales).

I believe Roper's strong cash-flow conversion, averaging 115% in the past three years, is sustainable. Negative net working capital, as a percentage of sales, improved to minus 17%, with more to come as higher deferred software revenue helps fund an active M&A strategy.

Valuation

I believe Roper should be compared to a technology peer group, with software comprising 75% of sales and expected to go higher. The sale of remaining industrial units makes it difficult to compare the company to industrial peers. A predilection for software is the result of a long-standing strategy: compound cash flow, raise the stability and durability of cash flow and reduce asset intensity. Constellation Software Inc. (CNSWF) has a similar roll-up strategy yet typically buys numerous, very small businesses. Constellation's shift toward seeking larger deals shouldn't limit Roper's M&A opportunities, given an ever-expanding pipeline of niche software assets.

The stock trades around its average 30% historical premium on P/E, and I think a cleaner portfolio and visible growth better support the premium here, especially if the earnings environment gets choppy for others. I keep a buy rating on the stock and keep an end-of-year price target of $499 on the stock based on an assumed forward PE multiple of 28x applied to the FY2025 EPS estimate of $17.84.

Final Thoughts

ROP has continued to outperform the market and posted strong financial results amidst a challenging macro environment. The transition towards a software-led business has been fruitful for Roper, with a compound annual sales growth rate of 14% from 2019 to 2022. The company's shift to a software-heavy sales mix, constituting 75% of total sales, has significantly reduced the volatility of annual organic growth. Moreover, I believe the company's emphasis on asset-light businesses in the software sector serves as a mitigating factor against concerns surrounding ongoing supply-chain challenges and increased inflation. I keep a buy rating on the stock and keep an end-of-year price target of $499 on the stock based on an assumed forward PE multiple of 28x applied to the FY2025 EPS estimate of $17.84.

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