Roper Technologies, Inc. (ROP) Earnings Call Transcript & Summary

Yes, good morning, everyone. I'm Brian Gesuale, senior analyst covering Industrial Technology space for Raymond James. Really delighted to have Roper Technologies here to talk about their story and evolution. The company's CEO and President, Neil Hunn; and soon to be CFO, Jason Conley, are here to take us through the story. Roper has long been in the business of generating free cash flow and guiding quantities. But more recently, after years of investment, has become more of a pure-play of software to really kind of getting into the tech and software serving much more than they had been previously. So with that, Neil is going to take us through some slides, then we're going to do a bunch of Q&A. So maybe why don't we kick it off and maybe just take us through the Roper story, who you are and a brief history of the company and then we'll do the q&a.

Yes, I appreciate that and certainly appreciate the opportunity being here. We're going to spend just a few minutes here and then get straight to your questions. So our heritage and our long history is we grew up as an industrial multi-industry compounding strategy. Over 20 years, that's evolved to be principally software compounding strategy. But what's remained consistent through that whole time as the portfolio has evolved is this simple statement, which is we focus on compounding cash flow. That's our focus by acquiring and growing niche market-leading technology businesses. It's just that simple. If you look at a very quick snapshot of the company at the top is the arc of our growth rates from 2019 to estimate for this year. As you can see, we're solidly sort of mid-singles to a touch higher in terms of organic, and it's hard to draw a line exactly through the total growth, but we'll call it mid-teens. So when you factor in the acquisition orientation margin profile, 40% enterprise EBITDA margins. On the bottom, it's we're 75% vertical software. There's 27 companies in the portfolio, 8 on the right, which are technology-abled product businesses, the balance and vertical software. While the end markets are very, very different. I mean we serve legal, education, health care, construction, transportation, government contracting, media entertainment, a lot. I mean going through quickly. And on the right-hand side, it's water and medical products. While the end market is very different, all the companies are very similar and that they're in small markets. They're leaders in their markets. They compete based on the intimacy they have with their customers. So this is not a scale play. The median Roper company is a couple of hundred million dollars in revenue. So they are small companies that are leaders in their small markets. They're blessed with tremendous business models that generate increasing amounts of cash flow as they grow. They're super asset light. So the characteristics of the businesses are very similar, while the end markets differ quite a bit. If you just look at a snapshot of the enterprise revenue, $5.4 billion this year. You can see, of the total enterprise, the recurring and reoccurring software is about 60% of the revenue base. And if you just look at the 75% of our company, that's software. About 80% of that revenue base is recurring or reoccurring. On the right-hand side, the very right-hand side, the nearly $3 billion of recurring revenue. You'll notice the $900 million of on-premise annual maintenance. Over the arc of the next 5 to 10 years, it's in flight today, but over to arc of the next 5 to 10 years, we're migrating that at our customers' pacing to the cloud. And that lift and shift comes at between a 2 and 2.5x uplift on revenue. So it's one of many sort of built-in growth drivers in the business. So the core, our center operation is very lean, right? So we have 70 or 75 people in our headquarter operation. And what we focus on at the headquarter operation is principally 2 things. How do we create an environment or an ecosystem so the businesses in the portfolio can continuously improve, and then how do we deploy the capital. And so in a very simple way, this is our business and value creation model. So as I mentioned, all of our businesses are market leaders. Every business is either #1 or #2 in the markets they serve. They're in very defensible end markets. So we talked about them before. So not only are we in defensible end markets that tend to be not cyclical. What we do for them is a critical component. And so we're -- they're either running their business on our software or they're doing a critical function with our software. And so we're in resilient end markets that generally aren't super tied to macro trends. What we do is mission-critical, so it's not discretionary. And then finally, our pricing model for the most part is subscription or fixed based and not transactional. So there's 3 levers of -- or layers of sort of stability that's built, baked into the model in terms of what we do and how we charge what we do. So as we -- that's the profile of the portfolio. So we focus intensely on how do these businesses get better over a long arc of time. For the last 4 years, that focus has been on how do we increase the organic growth rate of the organization. Our organic growth rate over the last 10 years for this portfolio is 6%, and we're arcing trying to get it to arc up to 7% or 8% systemically. We focus on this continuous improvement, super decentralized, but we have a model of how to create value. So you have to do -- companies have to do strategy well. They have to execute strategy and to run a very aggressive talent offense and fill the best team. And when you layer that with growth-based incentives, we tend to see this improvement we're talking about. And then finally, we take all the cash flow of all the businesses, and then we deploy it to the single next best use. And so we do that very essentially at the headquarter operation. If you sort of look at our leverage profile, which 3.5x financial leverage is our strategy, we have to do between $3 billion and $4 billion of capital deployment a year, which keeps the flywheel going. And when you put all that together, it's been a decent outcome for our shareholders over the long arc of time, about 4x that of the S&P, 18% or 19% compounded returns. So that's our algorithm, a growth algorithm that we believe is durable and sustainable. And with that, why don't we get to your questions.

We can take some from the audience too. I'll kick this off here. Maybe talk a little bit about the portfolio in terms of cyclicality. It doesn't seem to be a lot obviously, the macros are on those lines. Can you talk a little bit about that? And then maybe a little bit about your geographic exposure heavily North America sector [indiscernible].

Sure. So interesting, we've worked very hard to beat the cyclicality out of the portfolio. 40% of our 2018 revenue, we've divested over the last 3 or 4 years. The principal reason for the divestment is to remove or eliminate as much cyclicality as possible. So that's -- that is the strategy of the portfolio evolution. Byproducts of that, by the way, are the businesses we grow faster. We have more recurring revenue, and we're more asset light, right? So we have -- there's other increased quality attributes, but we're generally relatively intolerant or tolerant to the macroeconomics. As I said at the beginning in the prepared remarks, the end markets we serve, health care, construction, government contracting, education, insurance, big insurance exposure, just to give you some sense. So the end markets tend to be relatively resilient than what we do and how we charge for it. In terms of geographic, we're 85% U.S. indexed in terms of destination revenue, the balance being the larger, more developed economies, not a lot of emerging.

That's great. And maybe just a quick follow-up to that. With all the recurring revenue that you have, how do you think about your visibility in any given year as you start to think about the next 12 months?

Well, I mean, if you think about the ARR snowball or the growth algorithm of each of our business, software businesses, we're selling to enterprises for the most part. Only 2 businesses sort of target the SMB space. So I'll generalize for us that the vast majority of what we do is enterprise based. So we have high -- mid- to high 90s retention rates. We get a little bit of pricing. So you think the ARR snowball between attrition and price is basically even. And then we grow sort of 7 -- 6 -- between 2/3 and 3/4 of our growth algorithm is selling into our customer base, and the balance to adding net new customers. So you tend to have tremendous visibility as a result of the ARR snowball of our software companies in the low end, 60% of revenue will be on the very low end, 60% of revenue will be the recurring piece. The vast majority, it's 90 -- 80% to 90% and the balance is 80%.

Right. That's fantastic. One of the things that I think is really unique to the Roper story is -- as I've known it for years is your methodology for deploying capital and your cash return on investment. Would you maybe talk about the secret sauce there? Share a little bit of the inside baseball what you care to share? And also talk about how that's influenced your trading multiple over time and how you think it will influence it going forward?

Yes. So we've been long focused on our North Star of financial performances, this construct called cash return on investment. Without sort of getting too in the weeds of the analytics, think of it as a business quality indicator, which is what is your cash margins divided by how much cash intensity is required in the asset base, either working capital or fixed assets. And over this 20-year period of time, as we've evolved the portfolio from industrial software, we actually didn't start out with software as a destination. We started out with being more asset light as a destination and then determine that software was the best place and the best opportunity to do that. And so we're just relentless and ruthless and systematic and analytical about improving this cash flow orientation of the organization. So many times, we see software businesses or any business or of that matter that might have wonderful margins, but then we get underneath the hood in terms of the asset intensity of running their data centers or the asset intensity of -- or capitalizing a ton of software development, you actually realize that there's not a like cash that actually sort of yields from the business model. So CRI is a way to just see how much cash ultimately yields. Empirically, the highest valued companies have the highest CRI. So to your question about how it's impacted our trading multiple, if you disaggregate our 19% total shareholder return over 20 years, between 300 and 400 basis points of that is attributed to multiple expansion, which is directly linked to improved cash return on investment.

That's great. Maybe if I just pull on the capital deployment thread a little bit more. You've just deployed close to $4 billion for frontline and a couple of tuck-ins. Talk about maybe your current leverage, how you think about dry powder and what your appetites are in the near term for capital deployment.

I want to let Jason talk about leverage and then I'll take the second part.

Yes, sure. So we think we're going to be in the [mid-2s] By the end of this year. As you mentioned, we just acquired Frontline for $3.7 billion gross. We had a tax benefit in that, but the headline was $3.7 billion. And then our divestiture proceeds from our industrial assets, we're going to net about $2.3 billion, maybe a little bit more than that. So we're looking at an undrawn revolver of about $3.5 billion at year-end, and we're obviously building some cash as well. So as Neil mentioned, we're comfortable being in the 3 to 3.5x leverage range. And so when you do that math, we could easily do $4 billion in 2023.

And that's sort of a run rate, as I mentioned, $3 billion to $4 billion is a run rate. We're sort of this balanced teeter-totter, if you will. We have this business that the enterprise of 27 companies that are wonderful, resilient, growing profitable cash-generating businesses, and then we have the systematic way to deploy that. So this concept of a balanced growth algorithm, 2/3 organic, 1/3-ish sort of M&A based is the resiliency that we look for.

Okay. Maybe just to pull one more and then I'll get to you, but maybe just to pull this thread one more nudge forward. When we think about your deals, you source, I think, exclusively from private equity. Rates obviously have moved up. How are multiples being impacted by higher rates and maybe an appetite for them to not be able to leverage quite as much as they would have in the past couple of years?

Yes, it's a very now question, right? And so you're right. Since I've been here 11 years, I think all but 1 or 2 have been from private equity and only a couple of very small founder-led deals and 1 very teeny, tiny public transaction that we did. So you're right, the preponderance of where we fish is in private equity. It's not exclusive, and it's not -- by the way, we're not set on that. We're constantly looking for value opportunity. There appears to be more conceptually in the public markets today than the private markets. But our experience, both at the company and my personal experience is it takes 6 to 12 months for private valuations to reset the public. We're very much in that window right now. There is no leverage loan market available to private equity. So there's just not a lot. We don't have a private equity bid. Private equity sellers aren't really selling at the market -- at the moment. So there's very -- there's activity, but it tends to be very bespoke and unique reasons for the activity right now because valuations haven't essentially reset to where they need to be in the -- given the current interest rate environment. The question will simply be, well, the private equity, I think, if you pull private equity, I think they would say we're going to wait out the interest rates. We think they're going to come down sooner than later, so we'll just wait. But if we sit in the sustained higher industry environment for a while, then asset prices will come down and then we'll get more active.

Fantastic. Question from the audience?

Yes. I wanted to maybe follow up on that growth. We had a [indiscernible] core partners. And they were really describing what you're saying, the private valuations haven't really come down yet. They're still '21. And the [Indiscernible] are in '22, '23. So if you do see that improvement where people are either going to run out of cash or need help or maybe they want to spin up another fund, do you stand with the $3 billion to $4 billion? Or do you see bigger opportunities? Do you go a little higher with leverage? How do you view that? Because it feels like it's coming your way.

Yes. So we'll react completely to what the market opportunity is. I would go back to when we just coming out of the pandemic. Was it the summertime, June or July, we did our largest transaction ever in Vertafore for $5.5 billion, and we went to nearly 5x leverage, 4.5x leverage. We view that as a terrific asset at a terrific price for very specific reasons that moment in time. And so yes, for the right thing, we'll absolutely sort of leverage up as we've done in the past. And we'll leverage back down because we want to sort of be over the long arc of time in this 3.5 range. But yes, we will -- we do believe the market is coming to us, so we'll just be patient over this period of time.

You talked about increasing your organic growth rate [Indiscernible] 6% to about 7% to 8%, but at the same time, you get this metric of kind of cash flow returns.

Yes.

And so usually, that takes investment. Can you talk a little bit about how kind of return on that investment? And is it like pricing that drives the growth rate? Or is it kind of more sustainable new product folks understand that?

Really appreciate the opportunity to talk about this. It's a passion of mine and ours, and we've been working at it for my whole time here, but enterprise-wide for the last 4 years. So it's -- first, I really appreciate the intersection of the cash return question and growth because we are not focused on growth at all costs. That is not our story. The reason we want to increase our growth rate is that we increase the amount of cash that comes out of the bottom of the bucket so we can increase the compounding for our shareholders, right? So it's all about what yields down. So this is CRI accretive, cash return investment accretive organic growth is what the focus is. For each company, it's literally company by company about what the best way to do it. The focus is absolutely on systemic improvement, not trying to sort of how do we arc up to -- from a company from 6% to 10% for a year or 2 and then come back down. That is not -- we'd rather not do that candidly. We want to focus on the systemic improvement. Good, and it's every growth lever you can think of. It's product, it's go-to-market, it's pricing. But if you had to -- we've just finished our annual operating planning reviews for the companies over the last 2 or 3 weeks. And if I had to sort of just synthesize, the general orientation is probably 2/3 or 3/4 product led, right? How do we innovate and build new products into adjacent markets? And the...

It could be add-ons and things like that?

It could be add-ons, very much so adjacencies. And I can give you a couple of examples, probably our longest tenured examples actually a medical product company called Verathon. It doesn't really matter what they do. But in terms of the products, it's an ultrasound for bladder volume measurement and a laryngoscope for intubations. 10 years ago, they're a 2% to 3% organic growth business that had major launched a new product every 3 or 4 years. Today, they're high singles, low double-digit, consistent grower that launches between 4 and 6 new products a year. And so that's very much been a product-led strategy at or in our legal software business for the last 5 or 6 years. It's been all about land grabbing. So it's been a sales-driven strategy. But now that the large law firms have settled on their system of record in terms of their financial performance, their financial operations, now it's about how do you develop sort of bolt-on products. So Aderant going forward is going to be very much an organic product development story, and each company is bespokely different.

Great. Let's maybe talk about -- dig into one of the portfolio companies. I think Frontline is a good place to start, a big deal for you guys. Education software space, that means a lot of different people and a lot of different things that the folks in the audience. Maybe take us through what made that asset appealing to you, kind of take us through the process and how we can expect it to operate under the Roper umbrella going forward.

Yes, delighted to do it. And as I go through it, I would invite you and encourage you to think as much or more about the process versus how the process influenced the Frontline itself, you can do both. But the reason we liked it is we just went through our process, and it checked all the boxes. So the first question -- actually before I get into that, our orientation around acquisitions is we're fundamentally business pickers. We're trying to find the very best businesses we can find in markets that are stable and resilient. So we're not market pickers. We're not trying to sort of predict a market trend or a market shift and then position an asset in front of that shift. We think that's highly risky. You could win. You could lose. We're much more about stable, secure, predictable, observable, right? And so that's the orientation we go into every sort of target with. So that is the business in a market, in a niche market and a leader. So in this case, this is K-12 U.S. education. There's -- what Frontline does is simplistically everything that a school district needs to do that's not in the classroom. So think the administrative part, teacher management, apps and team management, teacher recruiting, teacher training, teacher onboarding, asset management, school ERP, special education administration, think of those types of products. And they're the clear leader in the administrative part of K-12. They're in 10,000 of the 13,000 or 14,000 school districts. They have 30 products they sell on average, each customer consumes 3. The second thing then are the competitive forces observable and stable. In this case, they very much are. At the top level, you're like this is not going to be a growth industry because a number of school districts is flat and a number of students is projected to be flat. But when you look inside of that, the tech enablement is what's going to be the decade-plus loan growth driver. The vast majority of what frontline sells is they're automating a manual process or no process or excel. And there's a tremendous long arc of tech enablement that will occur in this space. So you have these durable, predictable long-term growth drivers that could lead into management team. So as a management team, fundamentally excited to build the business because there's not going to be another transaction. So we're evaluating that. Does it have a growth profile and a cash flow and a business model that yields a bunch of cash flow at the end? In this case, it's probably our second or very best working capital as a percentage of revenue company. So they're just blessed with this wonderful business model. And there's other criteria, but you go through the list, and it's just check, check, check.

Really helpful. And anything else from the audience?

Yes. Maybe can you just go back on that cyclicality because we've heard from a lot of software company [Indiscernible] sales factors, extending. Really interested if, in fact, could you [indiscernible]. And then you come frontline [Indiscernible]. And I guess they're not competing quite in the same space, but just for them [indiscernible] teacher shortage due to delaying adoption of their products because there's [indiscernible]. So I guess [indiscernible] cyclicality in parts of the business you wouldn't have expected in a normal time. [indiscernible] some cyclicality.

Let's talk about cyclicality. And then if I forget on the frontline, remind me, we'll come back and talk about that. I don't want to ignore that question. So we're paying super close attention to any early warning indicators we can find around slowdown. For instance, we have a business that sells basically tax software to investor-owned utilities. In the -- at the end of the second quarter last year, we saw some very large projects in the sales queue push. And we're like, interesting. What are we expected to see it here, turns out all those closed in the third quarter. So that was like just a novel thing to that business. We saw in our government contracting business at the enterprise level, the very, very large at the end of the third quarter slowdown. That's because there wasn't very much M&A activity in the gov con space. There's not only a lot of M&A activity at enterprise level, and they've slowed down. We think that's actually through the budget and the election, but we don't exactly know. We have a business in freight match. So we're like ubiquitously, we organize -- our technology organizes the spot freight markets in North America. As you'd expect, there's a massive run up in COVID, and then the carrier base is contracting a little bit at this moment. The business still grows, but the number of carriers is contracting. So there's early indicators, but we've just gone through the AOP process, and we're certainly not going to give you our thoughts on our guidance for next year, but our companies were markedly bullish. I think we, at the corporate level, sort of be a little more bearish because maybe the macro is a little bit better. But in terms of their smaller industries and what they do, they were feeling pretty good. Anything you want to add to that?

No, I think that's great.

Go ahead.

You got to do frontline.

Yes. And then frontline, I'll say this concept of teacher shortage is something that frontline leans into because they help solve the teacher shortage problem around credentialing and training and recruiting and absentee management. I think the stat is 29 million absentee management the teachers -- subset teachers placed in the last 12 months. So they're very active in that. And if you look at the -- there's 3 parts of the macro parts of the portfolio, the HCM piece is the piece that's been growing a little bit faster than the other couple -- other pieces over the last 12 months.

Eddie?

Yes. No, [indiscernible] department obviously over the long haul [indiscernible] same date for constellation [indiscernible] in the exact rate? You must [indiscernible]

Yes, comparisons to Constellation and Mark, I think superficially is what I would say, right? And so I think the commonality is that we're both software acquisition oriented strategies, but that's about where it ends. We are -- and by the way, Mark and the team have done a tremendous job. When we look at the performance, and we're in awe just like you sort of highlighted. So their strategy certainly worked. Ours is different, right? We're generally a little bit larger -- I mean, a meaningfully larger software businesses. We're generally buying -- we're very much leaning into organic growth, where Constellation is less so.

Leverage.

Financial leverage, right, versus not. But their strategy has worked. Ours has been okay. It's just 2 different ways.

Maybe if we talk about the longer-term model here. You talked about accelerating organic growth. I would say even from 6% moving up is great, but the overall portfolio a couple of years ago was more like 4.5, about...

3 or 4.

Yes. So can you maybe talk about what your targets are for organic growth? You kind of hinted at that, maybe give us a little bit of a time line. Talk about the overall margin expansion on an annual basis and maybe how that converts to free cash flow as you think about free cash flow conversion.

So target is a 4-letter word inside of Roper, right? Because we're very -- our incentive system is the more you grow, the more you get paid, right? So we don't have budgets. We don't pay based on plans and we don't set targets because then, you don't know the level of authenticity of what you're getting back. It's we can get -- I can get in -- spend 10 minutes on the cultural ramifications of that, but I'll spare you. That said, we have meaningfully increased the performance expectation across the board for our businesses, keeping in mind that we want to be CRI-accretive organic growth. When we look at the opportunity, so it's not a target, we believe there's a very clear opportunity to be in the 8% to 9% range. I don't think we'll fully achieve the 9%. I think that's like near perfection across 27 companies, but is there a 7.5% or 8%? I believe there is, but let's talk in 2 or 3 years and see our level of execution against that. That's not guidance. It's an aspiration for sure. But when we can do that, if we can take it from 6 to 8, that's 200 basis points, obviously, of cash flow growth, margins will increase a little bit, but we're not actually asking the businesses right now to improve their operating leverage or trying to take that incremental operating leverage and put it to the product road map or into the go-to-market strategy to drive increased growth rate, but there'll naturally be some, right? So if we're at 8%, maybe we're growing 9% or 10% cash flow with a little bit of margins. I mean, we're at 40%, so let's not get carried away. And that's what we're driving towards.

Fantastic. Maybe just...

I think there's one over here.

I was just going to ask, how is the price [indiscernible] talk through systematic improvement, you didn't mention price.

Well, in the ARR snowball concept, I did a little bit, right? So price in the software businesses is a systemic annual part of the growth algorithm. As a general matter, it's not set this way, but just the way it works out, it's going to offset attrition. So think 4 to -- 3 to 5 points of price every year this year. Coming year, it might be 1 point higher if I had -- if we had to sort of just think conceptually what we heard a couple over the last couple of weeks. But no, it's sustainable. And it goes to really the value that we deliver, the intimacy that we have. I mean, very rarely do we hear the customers bulking. I'll give you an example, Vertafore. It's -- it was a large acquisition we did coming out of COVID. It's software that the property and casualty agencies run. It's their agency management system. We're sub-1% of the total cost of an agency's P&L cost structure. And so they're relatively insensitive, if they get a 4 or 6 or 7 or whatever the percentage increase is. And that's -- that would be sort of indicative of where we sit in the cost bar, right? We're important, but smaller dollars.

There has been much discussion [indiscernible] any managers coming in and saying, [indiscernible] inflation, right, [indiscernible] this year.

Not to take advantage of a situation with the way that our -- we ask the company to think about this, and this is the way they did think about it. They looked at what their incremental cost of labor is going to be, and they are trying to capture all the incremental cost of labor in the year-end price. And so that was the objective. And then maybe the margin on top of that, right? So maybe to get a little bit more. But if you have a company that is Vertafore routinely, you'll get 5 points of price, maybe they're getting 6, right? It's that kind of pricing.

And with some businesses, they don't renew every year. It could be a multiyear, so you don't get -- you don't capture all that in 1 year.

Right.

Anything else from the audience? We're just about out of time. Neil, maybe just one last kind of drop the mic moment for you. No follow-up from me or the audience. Maybe just what message do you want to leave people with today as they think about Roper going forward?

Appreciate that opportunity. Hey, we've got slugged through a portfolio redesigns from 2018 to get the portfolio and the company to where it is, right? So 75% software, 25% technology-enabled products, this very predictable, consistent mid-teens cash flow compounding algorithm that has the opportunity to even better based on our asset [Indiscernible] getting better, CRI improving and inflecting the organic growth rate another point or 2. And we're just excited to sort of introduce, if you will, or bring to the software world, the technology world, what's lived in industrial forever, which is this compounding mindset. This dual threaded organic growth and acquisition strategy, it's a combination of 2 that makes us special. And we're just excited to tell that story.

Great. Neil, Jason, thanks so much. Thank you, everyone, for joining us in the last day of the morning. Appreciate it.

Thank you, guys.