Description

CERTAIN STATEMENTS CONTAINED HEREIN REFLECT THE OPINION OF THE AUTHOR AS OF THE DATE WRITTEN. NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT.  YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. Please see additional Important Disclaimers at the end of this analysis.

Investment Overview:

• Roper Technologies (“ROP” or the “Company”) is a unique collection of ~45 high quality businesses, run by an owner-operator mentality management team that has a proven track record of creating value through M&A[1]. ROP has consistently acquired market leaders in niche verticals with strong returns on tangible capital, taking a Berkshire-like “forever owner” approach, and then utilized that free cash flow (FCF) generated from its portfolio companies to purchase additional high quality businesses – this is the flywheel that has turned ROP into a compounding machine that’s been one of the best performing stocks over the last 17 years, appreciating ~1500% vs 300% for the S&P 500 from 2003 through 2019. 

• ROP calls Cash Return on Investment (CRI), which essentially represents returns on tangible capital, its “north star” [2] to both acquiring and operating businesses, and describes this guiding framework as its version of “money-ball investing.” ROP has increased its CRI from sub 100% back in 2003 to 400%+ as of 12/31/19, as over that time it’s used its cash flow to consistently acquire additional high quality businesses, and that journey has led to ROP primarily acquiring software businesses in the last decade plus. The software businesses ROP aims to acquire embodies its key criteria for new acquisitions – market leaders in niche verticals, high margins and recurring revenues combined with a capital light model, all leading to strong returns on tangible capital or CRI. In 2019, ~62% of EBITDA was generated from such software assets; though the remaining 38% of EBITDA generated from more product centric businesses in medical, industrial and energy end-markets are still excellent assets with highly desirable economics (per 2019 10K). 

 [1] See Exhibit A on next page for how ROP defines ‘high quality’ businesses.

^[2] Quote by CEO Neil Hunn at 5/21/2019 Investor conference.

• Exhibit A: The Exhibits below outline ROP’s business model & general framework for compounding capital.

* Source of exhibits above – ROP 2/19/2020 Investor Presentation 

• Below is what I believe is an excellent overview from CEO Neil Hunn walking through the ROP business model (from 2/19/2020 Barclays investor conference)

“So Roper is a bit different than most of the companies here. Our strategy for 2 decades now has been singularly focused on how to compound our cash flow, and as a result, the TSR at the highest possible rate that's sort of risk managed and sustainable. And the way that we do that is we operate a portfolio today of 45 different businesses. The end markets are wildly different. Water meters and tolling to half our portfolio now is software, about half products, half software. But the 45 business models are highly similar. All the businesses are in niche markets. We love the niche markets because they protect us from the sort of disruptive competition. These TAMs that all the businesses in are very small. Some TAMs are $100 million. Maybe the largest TAMs are $1 billion, $1.5 billion. So they're very small served markets.

  All the businesses tend to be the leader in what they do. And so in these markets, we tend to compete on what we term as customer intimacy. So being very close to what our customers do. Most of our products or software that they buy is core to what it is our customers do. And so they give us feedback all the time about how to continue to evolve and develop the products and serve the markets.

Then all 45 businesses also tend to have a higher -- a relatively high degree of recurring or reoccurring revenue. And then perhaps the most -- the hallmark staple characteristic of these businesses is they don't require capital to grow. For almost 2 decades, CapEx in this business has been about 1% of revenue. So these are wonderfully asset-light businesses. In fact, our working capital as a percent of revenue now is negative 4%, 5% and our fixed assets in total are somewhere in the 7% or 8% of revenue. So it's a very, very asset-light model.

  
Now the asset selection is just a part of the story, right? We have a very unique operating structure that allows these businesses to thrive. And so we have 45. We operate this very decentralized approach, which we think is a necessity with these types of assets, right? And so we have 45 of everything: 45 executive teams, ERPs, development centers, locations, whatever, 45 of everything. And the reason that we bear the cost of that infrastructure is these businesses have to act extremely nimbly in these small served markets because the competitors are small competitors, family run or private equity owned, for the most part, or small divisions of larger companies. So they're acting nimbly, so we have to act equally, if not more, nimbly. So this org structure enables that, right? There's no better example of that in the real world as how our energy business has reacted here last year. In the fourth quarter, margins -- or full year, the margins were up in the face of headwinds. And so those businesses were able to shed the costs very quickly. Do it and then tell us they did versus ask for permission or ask if they should do it.

 
But there's a difference in the way that we operate. We have this org structure, and -- but -- and just because we're decentralized, we're far from passive owners. So we have a group executive layer. Each group executive, of which there are 5, have a portfolio of 7 to 10 companies each, and their job is to be a thought partner/coach about how to evolve our businesses to be great, really great in the way they actually develop strategy, the way they execute strategy and the way they run a talent offense. And over a long arc of time, we expect to see our businesses improve their cash returns and improve their organic growth rates and improve their margins, which has largely been the case.

 
And then finally, and perhaps the most important part of our org structure, is the way we pay people. We pay the entire organization based on growth. Most companies here, I would suspect, pay people and their teams based on some sort of budget, plan performance. And for us, it's super important culturally because if you pay people based on a plan or budget, you provided your operating teams an incentive to lie to you, and you have a filter not to believe anything they say. So I would submit you can't have a culture of trust or, for that matter, accountability. So all the tough stuff, the problems get elevated in our organization because we're there all to try to solve because those are the barriers to growth typically.

 
And so these businesses and this org structure generate about $1.5 billion of free cash flow. And because they're so asset light, they have no way to deploy it back in their business. And so the third hallmark of our enterprise and our strategy is a very centralized approach to deploying the capital. It's -- we have a very small staff in Sarasota, about 55 or 60 people. The vast majority of that is sort of the administrative overhead of being a public company. And then there's a couple of handfuls of executives, and it's our responsibility to deploy the capital. So we don't outsource this to our operating companies. We don't outsource it to an M&A team. We are the ones doing the capital deployment and it's very process ridden. Does it meet our cash returns? Yes or no? Does it meet our organic growth thresholds? Yes or no? Do we like the management team? Are they builders? And then is it a type of business we like? And those are the characteristics I started with. When you put all that together, we have a -- that strategy, which has been in place for nearly 2 decades, has yielded in the neighborhood of 19% or 20% TSR compounded for 2 decades. And so we -- as we play that forward in our models, basically the same returns are modeled for us. And so a lot of our focus is how do we sustain that strategy and the execution against that strategy.”

[3] Note: “TAMS” is Target Available Markets. “TSR” is Total Shareholder Return.

• It’s also important to point out that this management team eats their own cooking, highlighted by this quote from Neil Hunn at a 2/19/2020 Barclays investor conference “Rob (CFO) and I are very overweight. I mean it's -- we're all in like 95% of our net worth.”

HISTORY

• Brian Jellison joined Roper as CEO in 2001, coming from Ingersoll Rand, and he is the one that implemented and executed the Roper business model discussed until his death in Nov 2018. The exhibits below highlight the improvement in margins, asset intensity and thus returns over the last 15 years, which is about when Jellison started doing his first transformational deals under the new ROP playbook. Under my basic definition of returns on net assets (EBIT/(net working capital + PPE), where net working capital is simply receivables + inventories – payables), ROP’s pre-tax returns have increased from ~50% in 2004 to 200%+ at the end of 2019, and when including deferred revenues in working capital as ROP does in its CRI definition, returns are ~400+% (at 12/31/19).  

* Source of exhibit above – ROP 2019 Annual Report