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AGB 2022.9 - Roper Technologies (ROP)
Reinvesting Cash Flow into Software Assets
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“What Roper is in a sentence is we compound cash flow. That's our focus. How do we compound the cash flow for our shareholders over a long arc of time? By buying great businesses and then making them even better.” - Chief Executive Offer, Neil Hunn, at the Jefferies Conference in June 2022.
Roper is a serial acquirer of businesses that fit a very specific set of characteristics. While most serial acquirers try to stick to one or two industries, Roper rather acquires businesses across industries that meet three criteria. First, the business has to meet Roper’s CRI (Cash Return on Investment) threshold, which is a measurement of cash flow return.
CRI = (Net Income + Depreciation & Amortization – Maintenance Capex) / (Net Working Capital + Net PP&E + Accumulated Depreciation)
Second, Roper determines whether the management team can thrive under the company’s ownership. This is a judgement call from Roper’s management. They’ve stated that they want to work with builders that have a growth mindset. Third, the market that the business participates in has to be niche with sufficient barriers to entry and the business has to be the clear market leader or part of an oligopoly. If Roper doesn’t have the expertise to analyze the industry, the company brings in outside consultants to help.
Roper sources acquisition targets almost exclusively from private equity sponsors. The company states that it likes to approach PE firms during the 3rd year into their ownership tenure because it’s after the PE firm has done work to clean up the business and it’s before the time for a traditional exit like an IPO. But from an outsider’s perspective, it’s difficult to find evidence of how consistently this happens and whether this gives Roper an advantage during the buying process.
Roper also states that the company competes against other PE firms for these businesses 90% of the time. And because Roper acquires established market leaders that participate in defensible niches, it’s difficult to underwrite much margin improvement and/or expanding growth rates after acquisition, something that some PE firms like to incorporate into their underwriting process. So, for these types of businesses, Roper competes well and has a higher chance of winning deals.
Once a business has been acquired, Roper allows the business to run almost autonomously, with very little decision making done from headquarters. In fact, the enterprise is run in a decentralized fashion with very little overlap of backend systems and resources among the business units. There is no central ERP system or cloud partner that needs to be integrated. Each business is run by an independent management team and they make the strategic and resource allocation choices for their respective businesses.
Roper does influence its business units by assigning coaches that work with executives to help guide strategy and execution when necessary. But ultimately decision making is done by the business leaders. Executive compensation is based on year over year growth metrics, so management is incented to grow rather than just exceed expectations/budgets.
Over the past decade, Roper has acquired almost 60 businesses, and most of them were platform deals vs. bolt-on. Because many of these acquisitions were software businesses, software now makes up the majority of the company. Roper likes the recurring nature of software businesses as well as the negative working capital requirements. Net working capital as a % of revenue has declined from 6% in 2014 to -9% in 2021. In June 2022, the company announced the divestiture of 16 cyclical businesses to PE firm, CD&R (discussed further in the last section). After this event, net working capital should be -18% of revenues.
After the pending divestiture, the business units will be grouped into two segments, Vertical Software and Medical & Water Products. Vertical Software will be the majority of the company at 75% of revenues, while Medical & Water Products will contribute 25%. Within Vertical Software, it can be further broken down to Application Software and Network Software, which were the prior segments. Here are examples of each:
Aderant – Provider of software for law firms. Aderant’s software helps law firms with calendaring/docketing, knowledge and case management, billing, etc. Aderant services over 3k law firms around the world with an annual retention ratio greater than 95%.
DAT – Largest platform for freight matching in North America. DAT’s platform connects brokers and carriers to facilitate truckload matches. The company commands 3x-4x more market share than its largest competitor.
While the businesses themselves are run in a decentralized fashion, the deployment of capital is very centralized. Headquarters makes decisions on where all excess capital is deployed, and that is usually in the form of new platform acquisitions.
Roper believes that the company has a cost of capital advantage due to its main funding source being excess cash generated by the business units and cheap debt (at least for the past decade). The company has been successful at deploying almost all of the internal cash flow generated by its business units.
Why is it a good business?
After the recently announced divestiture of most of the company’s cyclical businesses, Roper is mainly a software business at 75% of revenues. For its Application Software businesses like Aderant, Deltek, Vertafore, etc., the company benefits from switching costs, similar to other software companies. As these businesses grow, the customer’s switching costs increase due to the knowledge base formed around the use of the application and in many instances the customer’s data that’s generated after many years of using the software. For the company’s Network Software businesses like ConstructConnect, DAT, Foundry, etc., there are varying degrees of network effects as well.
Given that Roper is a conglomerate with businesses that address many different markets, there should be some advantages from owning two companies within similar industries, or at least ones that target similar customers. While the company’s headquarters doesn’t direct any of its business units to do anything specifically, there are instances where they will suggest that selling to each other’s customers could result in higher win rates. Roper has mentioned that Deltek and ConstructConnect have much higher win rates with each other’s customers since the reputations of these businesses are high within their respective customer bases.
Also, because Roper’s business units are market leaders in defensible niches, organic growth rates are less variable and more predictable. The company has averaged organic growth of 4.2% over the past decade and only posted slight negative growth in 2015 and 2016. Even during the Covid related lockdown period in 2020, Roper continued to give annual guidance.
On the capital allocation/acquisition side (Roper management and headquarters) there are some small benefits to scale. There is a benefit to having more reps when it comes M&A transactions, and Roper has narrowed down where the company most effectively competes against other PE buyers for deals. Because of the company’s size and tenured history of competing for deals, Roper has good relationships with most PE sponsors who are looking to sell companies that the company would have an interest in. Some of these PE firms include Hellman & Friedman, Vista Equity Partners, Francisco Partners and Thoma Bravo.
Roper also benefits from having relationships with many management teams prior to making an acquisition. Because Roper has a good reputation for buying and growing their acquisition targets over the long-term, the company can build relationships early. The company has stated that every deal that’s been completed since 2016, which includes Deltek, ConstructConnect, iPipeline, PowerPlan, Foundry, Vertafore and others, Roper had preexisting relationships with the management teams of those businesses.
Returns on incremental capital?
Over the past 10 years, Roper has spent 2% of its capital on capex, 12% on R&D and the remainder on acquisitions. The company has also made a few divestitures over the years when there were opportunities to improve the average quality of the subsidiaries, amounting to 6% of capital. Because the company has tilted more towards acquiring asset light business over the past decade, capex spend is relatively small. Of the cumulative capex spent, ~60% of the capex was for growth purposes while the remaining ~40% was on maintenance.
R&D spend as a percentage of revenues has historically been below that of other software companies, and because of that some were concerned that Roper’s subsidiaries were not reinvesting enough in R&D. But as management has pointed out in recent years and as the recent divestiture reveals, the R&D spend for the software business are inline with peers in the mid-teens percentage of revenues.
Acquisitions have been the main growth engine for the company as the management team believes it’s the best use of capital. Over the past 15 years, 90% of the capital spent has been on platform deals, or new businesses. The remaining 10% have been on bolt-on acquisitions. The company believes that acquiring a competitor to shore up market share for a business unit isn’t the best use of capital. Instead management believes that the business should be able to gain or maintain market share on its own. Bolt-on acquisitions are usually to add a complementary product offering.
Here are the meaningful deals with the relevant deal metrics over the past 5 years:
Deltek, an application software provider for project based businesses, was acquired in 2016 for $2.8B. Deltek’s customer base is government agencies (60% of revenues), architecture & engineering firms (25%) and professional services firms (15%). At the time of the deal, Deltek was expected to generate $535M of revenue and $200M+ of EBITDA, implying a multiple of 14x EBITDA.
PowerPlan, an application software provider for asset centric companies that helps improve operational efficiency, tax strategies and mitigates compliance risk, was acquired in 2018 for $1.1B. PowerPlan has a 98% customer retention rate. At the time of the deal, PowerPlan was expected to generate $150M of revenue and $60M of cash flow, implying a multiple of 18x cash flow and likely 15x EBITDA.
Foundry, a software provider that specializes in complex visualization solutions (special effects), was acquired in 2019 for $540M. At the time of the deal, Foundry was expected to generate $75M of revenue and $25 of cash flow, implying a multiple of 22x cash flow and likely 17x EBITDA.
iPipeline, a cloud based software provider of workflow, marketing and sales automation for the life insurance industry, was acquired in 2019 for $1.6B. At the time of the deal, iPipeline was expected to generate $200M of revenue and $70M of cash flow, implying a multiple of 23x cash flow and likely 19x EBITDA.
Vertafore, a cloud based software provider that focuses on improving and automating processes for the P&C industry, was acquired in 2020 for $5.4B. Vertafore has over 20k independent agencies and 1k insurance carriers as customers and touches over $140B in premiums per year. At the time of the deal, Vertafore was expected to generate $590M of revenue and $290M of EBITDA, implying a multiple of 18x EBITDA.
EPSi, Welis and IFS were acquired as bolt-ons in 2020 for $467M. EPSi integrated with Strata, while Welis and IFS integrated with iPipeline. Combined, these companies were expected to generate $75M of revenue and $30M of EBITDA, implying a multiple of 15.5x EBITDA.
Roper has also made a few divestitures in recent years in addition to the recent divestiture of its cyclical businesses. The company sold Gatan and the Scientific Imaging businesses in 2019 for $925M and $225M, respectively. Roper sold these businesses to diversify away from cyclical and asset intensive businesses. Gatan was sold for 18x EBITDA. The company also sold Transcore, Zetec and CIVCO Radiotherapy in 2021 for $3.2B at a 20x EBITDA multiple.
The high multiples on recent acquisitions (though to be fair, most were software companies) would imply that the returns on capital based on the first year alone wouldn’t be impressive. EBITDA multiples in the range of 14x-19x would imply a pre-tax return of 5%-7%. Those level of returns would imply that Roper would have the lowest returns on capital for a company we’ve analyzed so far.
But you have to account for growth and improving cash flow positions of the acquired businesses. From Roper’s perspective, the asset quality of the recent acquisitions is much higher than the ones from a decade ago. And the company states that using its CRI methodology, the recent valuations are higher but not much higher than they were 5-7 years ago. As an added bonus, since the passing of the Tax Cuts and Jobs Act, the returns have also improved on a cash flow basis.
We estimate that Roper generated returns on incremental capital between 8%-13% over the past 5 years. The incremental capital returns imply that Roper’s strategy of acquiring market leaders in defensible niches has worked, allowing the company to grow intrinsic value by double digits percentages annually.
Because Roper’s businesses exhibit low-to-mid single digit organic growth, already have high margins and are asset light businesses, heavy capex isn’t required for growth. R&D is a larger area for reinvestment, but because most of the business are already market leaders in their respective niche markets, heavy R&D is also not required for growth. So, the main avenue for reinvestment is through acquisitions.
In our previous write-up of Broadcom, we tried to come up with a list of potential acquisition targets. That was only possible because Broadcom typically acquires public companies with certain financial characteristics within two specific industries, semiconductors and enterprise software. (We’d like to point out that VMware was on the list of potential targets). For Roper, this is much harder because the company is primarily acquiring private businesses from PE sponsors and the acquisition targets are not necessarily confined to certain industries.
Roper has completed between 5 to 10 acquisitions annually over the past decade, spending between $200M to $6B per year. The years after a large acquisition is made (Deltek in 2016 and Vertafore in 2020), the company tends to pare back its spending and rather focus on bringing debt levels down to maintain an investment grade rating (usually between 2x-3x net debt/EBITDA).
Going back to 2016, the company outlined the amount of capital that Roper is looking to spend on acquisitions. This number went from $1B in 2016 to $1.5B annually in 2017. Then it was $5B of capital spend for the next 3 years and then $6B for the next four years. In 2018, the company boosted its target spend level to $7B over the following 4 years, partially due to the benefit from tax savings. Starting in 2019, the $7B capital spend target was changed to an evergreen number.
It’s important to point out that Roper has benefited from utilizing cheap debt to acquire these high quality software assets over the past decade. This has helped increase the incremental returns of the acquisitions much higher than the EBITDA multiples of the acquisitions would imply.
And because the company is mainly buying profitable, asset light, negative working capital businesses, with each subsequent acquisition, Roper is able to take on a higher debt level while maintaining the debt/EBITDA ratios at an investment grade rating. And when the company extends its debt level above that to fund a large acquisition, Roper can quickly pay down debt through cash generation or any future divestitures of its lower quality businesses.
With a reinvestment rate between 95%-125% and a return on incremental capital between 8%-13%, we estimate that Roper has increased its intrinsic value between 10%-12% over the past 5 years. The reinvestment rate for the company is high because almost all of the excess capital that’s generated is redeployed into acquisitions after paying a small dividend. Roper does not do buybacks because the company estimates that acquisitions will almost always have a higher return on capital vs. buybacks.
If you think about it, Roper’s management has only been able to exhibit above market returns over the years because of its high reinvestment rate. Quality assets like software for the most part will always be “expensive”, but management recognized that with a bit of organic growth and use of leverage, the intrinsic value growth of the company could be sufficiently be above market. If Roper were conservative with its acquisitions, either by (1) holding out to only acquire these businesses at lower multiples or (2) only acquiring smaller businesses, thereby using less debt, the intrinsic value growth would have likely lagged behind the broader markets.
What else is important?
Recent divestiture of its cyclical businesses
After many months of speculation on a sale of the company’s cyclical businesses, Roper divested Alpha, Dynisco, Hansen, Hardy, Logitech Materials, Struers, Technolog, Uson, AMOT, CCC, Cornell, Flow Technology, Metrix, PAC, Roper Pump and Viatran in June of 2022 to CD&R.
A new entity was created and debt of $1.95B was issued, of which Roper received $1.75B in a one-time dividend. CD&R received a 51% equity ownership of the new entity in exchange for $826M, implying an equity valuation of $1.6B and an enterprise value of $3.37B. The businesses collectively generated $320M in EBITDA, which implies a trailing multiple of only 10.5x.
Roper received $2.6B in pre-tax proceeds and retains 49% of the entity, which is valued at $794M. The company expects to divest the remainder of the ownership interest in the future.
The transaction brings many issues to the forefront, which may have contributed to Roper’s recent underperformance:
Some market participants believe that the implied valuation multiple of the cyclical businesses are too low at 10.5x EBITDA, especially when Roper will likely reinvest the capital in higher multiple software businesses in the 14x-19x EBITDA range. This is also much lower than Roper’s recent divestiture of Gatan (another cyclical business) for 18x EBITDA.
Another issue is that the transaction wasn’t as tax efficient has some shareholders would have liked. It’s difficult to know what the cost basis is for many of these businesses, but considering that most of these businesses have grown organically over many years, it’s likely that the partial sale will result in a capital gains tax bill.
And lastly, Roper is now again challenged to put that capital to work in a timely manner so that compounding can continue. And with debt costs increasing this year, it may be more challenging to find acquisition targets that meet Roper’s CRI threshold.
Even though it’s the core growth engine for the company, optionality for Roper also comes from acquisitions. The company has a track record of continuing to organically grow many of its businesses after acquisition.
Sometimes there are also hidden assets within an acquisition, which can increase returns materially higher. As an example, Roper acquired Transcore for $600M in 2004. Transcore provides smart city solutions for transportation departments around the world.
Roper divested this business to Singapore Technologies Engineering Ltd in 2021 for $2.68B. At the time, Transcore was expected to generate $135M in EBITDA, which implies an exit multiple of 19.9x. During the 17+ years that Roper owned Transcore, the business generated $1.5B in FCF. This with the high exit multiple would result in very high returns for this deal.
However, the returns of the acquisition get even better since both DAT and LoadLink came with the original Transcore deal. These business are leading software businesses that Roper still owns today.
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