Can Roper Technologies Maintain Its Acquisition Strategy?

Summary

• Roper Technologies has grown its business and expanded its margins over time. This has been driven by numerous strategic acquisitions.
• The balance sheet has become stretched, and the company's CROCI has declined. Due to the company's cash flow and pending divestitures, we maintain bullish outlook.
• The stock has appreciated 10% in January. This has placed shares just out of range of our target price. Roper Technologies is a fantastic company worthy of your watch list.

We recently evaluated Roper Technologies, Inc. (NYSE:ROP) as part of our dividend champion spotlight series. The company that provides niche technology solutions utilizes a growth strategy that strongly features acquisitions. This has helped the company grow at a rapid pace. However, this strategy has cost the business in some ways. The balance sheet has recently stretched, and Roper's cash rate of return on capital has declined. Now that Roper has wrapped up its fiscal year, we evaluate whether these trends are cause for concern, and whether the stock presents an opportunity to investors at the present time.

Roper has built somewhat of a growth engine that feeds itself over the past decade. Management has targeted (and acquired) asset light, cash flow rich assets that operate in synergistic niche markets. These assets boost the overall cash generation of Roper's business, which results in more cash being utilized to help fund the next acquisition.

Source: Roper Technologies, Inc.

Roper has not been afraid of going after "big game" either. Acquisitions over the past 10 years have been as large as the company's $2.8 billion deal for Deltek, or its $1.1 billion deal for PowerPlan.

This strategy has had a sizable impact on the business over the years. The impact of this strategy are two-fold. First (and most obvious), these acquisitions have helped Roper Technologies grow. Roper has selectively built up its presence in high growth niche markets such as RF technology related software, and software used for medical/scientific imaging. These two segments now represent approximately 70% of Roper's overall revenues. Over the past 10 years, revenue has grown at a CAGR of 8.16% and EPS at a CAGR of 13.36%. Free cash flow has roughly tripled over the past decade.

Source: Ycharts

The second and less obvious result of management's efforts have resulted in a company that is more "lean" from top to bottom. Roper Technologies has essentially become much less capital intensive. Over the past decade, management has drastically reduced its net working capital as a percentage of sales to a negative figure. This percentage is how many current assets are needed to generate sales/operate the business. A negative percentage such as what Roper now operates at, means that net working capital has actually become a source of cash. This extremely lean business model is a result of Roper's focus on software products and services rather than physical equipment and other products that consume higher amounts of resources to produce and distribute.

Source: Roper Technologies, Inc.

In addition to this reduction, margins have drastically expanded across the board at Roper Technologies. Gross and operating margin have both expanded, which has increased Roper's ability to convert revenue into free cash flow. Now converting more than $0.27 of each sales dollar into cash flow, Roper has become a "cash cow". This high profitability combined with strong revenue growth enables the business to generate large streams of cash that Roper can both distribute to shareholders and feed back into the business like coal into a steam engine.

Source: Ycharts

This strategy has had some negative impacts on the business as well. With two large acquisitions totaling $3.9 billion over the past two years, the balance sheet has seen debt jump up. Roper is currently carrying $363 million in cash against $5.21 billion in debt. The company's leverage ratio of 3X EBITDA exceeds our "warning sign" threshold of 2.5X.

Source: Ycharts

While we are typically concerned, we aren't worried about Roper's balance sheet. This is for a few reasons. First, the company has a long history of maintaining responsible leverage levels. We don't see a stretched balance sheet as "normal" for Roper. Second, the company generates large amounts of cash from its operations that can be used to pay down the debt fairly quickly. In the approximate 18-month period between the Deltek and PowerPlan deals, Roper was able to pay down a quarter of its total debt ($1.5 billion). Between EBITDA growth and the company's robust cash stream, we see future deleveraging efforts coming with similar rapid results.

Lastly, the company is in the process of divesting assets that will raise significant cash. Thermo Fisher Scientific (TMO) is currently in the process of buying Roper's Gatan brand for $925 million. The deal is currently being scrutinized, but there is currently no indication that it won't close. The company is also selling its Scientific Imaging business to Teledyne Technologies (TDY) for $225 million. This influx of funds totaling $1.15 billion will give Roper additional financial flexibility to pay down debt or fund acquisitions without further stressing the balance sheet.

The other negative impact that Roper's acquisition strategy has had on the business has been a steady erosion of the company's cash return on capital invested (CROCI). While a downtrend of this metric is often a red flag (this metric measures management effectiveness and business model viability), we make an exception for Roper in this scenario.

Source: Ycharts

Roper has had to pay premiums to acquire the assets that it has. These assets are high margin, high growth, and cannot be easily obtained at low valuations. Roper has no doubt had to "overpay", which has had a minor impact on the company's CROCI. The CROCI has downshifted from about 13% (meeting our benchmark of low-teens or higher) to 10% over the past five years. If the drop was to the low single digits, it would force us to reconsider our thesis. Its current trend is not drastic enough to outweigh the growth, expanding margins, and high cash flow generation that these acquisitions have brought to Roper.

So while there are some eye catching metrics on the surface (high leverage, declining CROCI), the long-term uptrends in growth, margin, and cash flow have compelled us to assign a very bullish grade on Roper's long-term potential. We believe that the company will continue to perform at a similar level in the years ahead.

Does that make shares a buy today? The stock is trading at just over $290 per share, towards the high end of its 52-week range. This is all thanks to the markets having their best January in roughly 30 years, pushing Roper up almost 10% in that time frame.

Source: Ycharts

Management recently closed the company's fiscal year 2018 and guided for earnings per share of $12.00-$12.40 for 2019.

Source: Roper Technologies, Inc.

This would place shares at 23.67X the upcoming year's earnings. Considering the stock's 10-year median earnings multiple of 24.22X, the stock is hovering around fair value. Considering strong growth and profit metrics, we usually welcome opportunities to "acquire wonderful companies at fair prices". Given the stock's recent run, however, we see a backwards step in the share price as likely - especially given continued drama in Washington, DC that could rile the markets. We have previously assigned a target price for accumulation at between $278-$289, and maintain that target as an excellent entry point.

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Author Disclaimer: Wealth Insights is an investor and investment author. His content is not geared to anyone's specific investment goals, time horizons, or risk tolerance. Content is for illustrative purposes only and is not intended to displace advice from a fee-based financial adviser. Accuracy of data is not guaranteed.

Analyst’s 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.