By The Valuentum Team
Roper Technologies (NYSE:ROP) designs and develops license and SaaS software and engineered products and solutions. The firm generates ~70% of its EBITDA from its 'Medical' and 'RF Technology & Software' segments, and more than 50% of its total revenue is of the recurring variety. It has an impressive free cash flow conversion rate, as free cash flow has exceeded net income for nearly 20 consecutive years. Management expects this free cash flow generation to continue in 2016 with operating cash flow guidance of ~$1.0 billion, compared to ~$0.7 billion in 2015. The firm's focus on margins has been paying off as well, with gross margin growing to nearly 61% in 2015 from just over 54% in 2011.
There's not a lot of operating risk for a company with an asset light business model such as this one, but risks may arise from the firm's upstream oil and gas customers, which could pressure results as the prolonged downturn in the energy market continues. However, the firm's Medical and RF Technology segments have helped to offset the energy-related weakness.
Roper's strong free cash flow generating abilities allow it to continue to invest in the growth of its operations. In 2015 alone the firm spent $1.8 billion in acquisitions and totaled $4.8 billion in acquisitions between 2010 and 2015. Though we are vigilant of integration risk associated with such frequent acquisitions, Roper has a solid track record as it relates to integrating new businesses it has purchased. We're expecting an ongoing disciplined approach from Roper to acquire businesses that are leaders in their respective niche markets, including CliniSys in 2016, a leading provider of hospital laboratory software in Europe.
Roper Technologies' Investment Considerations
• Roper makes radio frequency products and services, industrial technology products, energy systems and medical/scientific imaging products. We're huge fans of its free cash flow conversion, which has been better than net income for nearly 20 consecutive years. This signals high-quality earnings. The company was founded in 1981 and is based in Sarasota, Florida.
• Roper's businesses that serve upstream oil and gas customers have come under pressure recently, and we're not sure when a sustainable recovery will come. The firm's Medical and RF Technology segments have helped to offset the energy-related weakness.
• We very much like Roper's focus on 'cash return on investment' (CRI). This metric approximates our return on invested capital metric, and on the basis of Roper's ValueCreation™ measure, it is executing well. CRI is a common metric used throughout the firm's business. At its core, the metric focuses on enterprise cash flow growth and disciplined asset investment.
• Roper is a tremendous generator of free cash flow, which has exceeded net income for nearly two consecutive decades and has been ~135% of net income over the past 13 years. Strong and sustainable margins and high incremental operating profit cause the firm to expect such tremendous cash generation to continue.
• Roper continues to put up solid order and backlog trends. Though the economic recovery has aided improvement, gross margins and EBITDA margins have jumped nearly 9 percentage points since 2009.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Roper Technologies' 3-year historical return on invested capital (without goodwill) is 35.1%, which is above the estimate of its cost of capital of 10.1%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Roper Technologies' Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is 3.2 (anything above 1 is considered strong).
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Roper Technologies' free cash flow margin has averaged about 23.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Roper Technologies, cash flow from operations increased about 16% from levels registered two years ago, while capital expenditures fell about 15% over the same time period.
In the first quarter of 2016, Roper Technologies reported ~$207 million in operating cash flow and capital expenditures of ~$9.5 million, resulting in free cash flow generation of ~$198 million. This represents a ~21% decrease from the same period in 2015.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
We think Roper Technologies is worth $133 per share with a fair value range of $106-$160. Shares are currently trading at ~$170, above the upper bound of our fair value range. This indicates that we feel there is more downside risk than upside potential associated with shares at the moment.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
Our expectations for revenue and earnings per share in 2016 and 2017 are in line with consensus estimates. We're projecting revenue growth of 8% in 2016 and ~5% in 2017 as weakness in the firm's upstream oil and gas customers is offset by strength in its Medical and RF Technology segments. We like what we've been seeing from the company in terms of order trends as of late. Its order backlog totaled $1.12 billion as of the end of the first quarter of 2016.
Our model reflects a compound annual revenue growth rate of 6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 6.2%. Our model reflects a 5-year projected average operating margin of 30.5%, which is above Roper Technologies' trailing 3- year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 3.8% for the next 15 years and 3% in perpetuity. For Roper Technologies, we use a 10.1% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $133 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Roper Technologies. We think the firm is attractive below $106 per share (the green line), but quite expensive above $160 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Roper Technologies' fair value at this point in time to be about $133 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Roper Technologies' expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $178 per share in Year 3 represents our existing fair value per share of $133 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.