Description

In this fully valued market, I’m constantly searching for high-quality companies trading at reasonable prices. There simply aren’t many decent businesses selling for 10x-12x earnings today, and those that remain in the bargain bin often deserve their low multiple. It has become increasingly appealing to pay-up for a great business, even if that comes a price tag of 16x-18x earnings. These are companies with 5%+ sales growth, margin expansion, conservative balance sheets, shareholder oriented management teams, and business models that offer an extremely high probability of continuing this level of success. These are businesses like Watsco (WSO), Interactive Brokers (IBKR), Berkshire Hathaway (BRK.B), and Apple (AAPL), that all enjoy structural competitive advantages over their rivals that have expanded over time.

Roper Technologies (ROP) has similar structural advantages that have allowed the company to deliver a 19% annualized return to shareholders over the last 12 years. Much like Berkshire Hathaway, ROP specializes in allocating capital amongst a diverse array of high quality businesses and executing on a disciplined acquisition strategy. ROP’s 42 operating businesses share common traits of being high-margin, asset-light, free cash flow generating companies that have leading positions in niche markets. These businesses fit into four broad categories; Medical Solutions (34% of sales), RF Technology (29% of sales), Industrial Technology (21% of sales), and Energy Systems & Controls (16% of sales). ROP operates with an extremely decentralized model, allowing each business to operate independently. The operating teams within each business unit are incentivized to deliver long-term free cash flow growth. Excess capital is redeployed though acquisitions since most of the existing businesses require minimal cap-ex to grow. Since 2010, revenue per share has grown 9% annualized, while free cash flow per share has grown at a 16% clip. This accelerated bottom-line growth was driven by gross margin increasing from 53% to 59%, and EBITDA margin improving from 26% to 34%.

For a company that utilizes acquisitions as a core growth strategy, it is surprising to note that ROP doesn’t have an internal M&A team. Management relies exclusively on outside advisors with expertise in specialized fields. These advisors are not compensated based on the completion of deals, removing any incentive to settle for less attractive terms. Many of the newly acquired businesses have been starved for capital and see strong growth after a modest increase in cap-ex. In recent years, ROP has focused on acquisitions in the Medical Solutions division, where organic revenue growth has averaged over 7% for the last 6 quarters, and EBIT margins have expanded from 35.0% to 36.6%. Management has deployed ~$1B on acquisitions in the last 12 months, and expects to spend another $2B in the next 18 months.

ROP’s collection of high-margin, asset light businesses generate substantial free cash flow in excess of reported GAAP earnings. Since 2005, FCF has averaged 129% of net income due to non-cash amortization charges. Management has skillfully deployed this cash on acquisitions, further compounding the company’s overall growth. ROP utilizes modest leverage (gross debt 2x EBITDA) to enhance the company’s ability to take on larger deals. Over 10 years, this effective business model has compounded free cash flow per share at 14.5% and book value per share at 13.8%. Its not always easy for investors to get comfortable with a company that relies so heavily on acquisitions, but at ROP this strategy has been proven to deliver long-term compounded returns to shareholders.

Working capital management has been another strength of ROP that has improved FCF margins. In 2005, working capital as a percentage of net sales stood at 14.5%. Through diligent management of inventory, receivables, and payables, this figure has fallen to 5.0% in 2015. Over the past three years alone, this metric has fallen by 270bps.

Medical Solutions

Making up roughly 34% of total sales, and 42% of EBITDA, Medical Solutions consists of 17 businesses in the medical software and scientific imaging markets. These vary from Sunquest, providing diagnostic and lab systems to hospitals, to SoftWriters, a software provider targeting pharmacies in long-term care and other assisted living facilities. In the Imaging space, Lumenera, Photometrics, Princeton Imaging and others design and service specialized cameras and imaging software for use in scientific and medical applications. ROP offers limited detail on the individual operating performance of each business, making it a challenge to get a solid grasp on the performance of each entity. For some investors this makes an investment in ROP a non-starter, but this disclosure is no different than Berkshire Hathaway, where we may get an occasional anecdote on how Clayton Homes, or Brooks Shoes, has fared, but there’s little detail given on financial metrics. At Roper, organic growth in Medical and Scientific Imaging has been in the mid-single digits. This segment has seen the majority of ROP’s $4.2B in acquisition spending since 2014. The remainder of 2015 provides some tough comps for organic growth after 2014 saw a big push from the Medicare Meaningful Use Requirement. I expect low single digit organic growth through year-end, with a return to the 6%-9% range in 2016. Operating margins have expanded from 23% in 2010, to 35% in 2014.

RF Technology

RF Tech contributes about 29% of sales, and 28% of EBITDA. These seven businesses span electronic toll collection and traffic management, security and access control, commercial food service software suites, freight matching services, and fresh food delivery logistics. Like the Medical Solutions segment, these businesses are deeply integrated into their customers’ daily operations, with high-margin, recurring revenue streams and limited cap-ex requirements. Mid-single digit organic growth in recent quarters should continue through the remainder of 2016, driven by new bookings in traffic and toll collection, and freight matching. Operating margins have expanded from 20% in 2010, to 28% in 2014.

Industrial Technology

Industrial generates 21% of sales, and 17% of EBITDA. The business mix includes water pumps, material analysis, automatic meter reading services, and leak testing products. Roper hasn’t contributed significant capital to the Industrial businesses in recent years, yet they continue to contribute meaningful cash flow. Recent results have been hit by upstream oil and gas exposure through the fluid and water pump business and lumpy revenue from Neptune meter reading projects. The back half of 2015 should see mid single digit revenue declines driven by weak demand from customers oil and gas market. Operating margins have expanded from 26% in 2010, to 30% in 2014.

Energy Systems and Controls

Energy contributes 16% of sales and 13% of EBITDA. These businesses provide control systems, testing, measurement, sensors, valves, and controls for customers in the energy industry.  Sales were down 12% in Q2’15 on mixed results. Sales directly into the oil and gas industry were off 20%, with sales to other customers remaining flat. Despite a 12% top-line drop, operating margins only fell 100bps, highlighting ROP’s asset light framework. Management hasn’t done any acquisitions in the Energy segment for over 10 years, and has no appetite to go bottom fishing in the current market. Sales have grown at an 8% CAGR since 2010, but will be off significantly in 2015. Operating margins have grown from 23% in 2010 to 26% in the most recent quarter.

Valuation

ROP trades at 16.9x 2016 FCF of $9.86 per share. This includes an estimated $1B of acquisitions, contributing $0.38 of FCF growth. Management has clearly expressed an interest in spending $1.5B - $2.0B on deals over the next 12-18 months. Given the company’s outstanding acquisition track record, this looks like a highly probable driver of earnings growth in 2016. Based on P/FCF, ROP trades at a modest premium to its peer group. Compared to companies like GE, HON, and DHR, Roper deserves to trade at a far higher multiple. ROP has a better business mix, room for organic growth and margin expansion, leading share in most of their niche markets, and a strong probability of executing on more deal-driven growth in the future. This management team didn’t deliver 19% shareholder returns by getting lucky on 1 or 2 big deals. They have successfully executed dozens of deals and improved their process along the way. Working capital intensity has declined, margins have improved, and recurring revenue has grown. Even without multiple expansion, ROP has a reasonable path toward 12% - 15% earnings growth. There’s no surprise catalyst, impending buyback, or spin-off driving this investment thesis. It is simply a company with a long track record of above average growth, with a strong probability of continuing that growth, selling at a very reasonable free cash flow multiple.

Catalyst

There’s no surprise catalyst, impending buyback, or spin-off driving this investment thesis. It is simply a company with a long track record of above average growth, with a strong probability of continuing that growth, selling at a very reasonable free cash flow multiple.