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

Excellent. Thank you, everyone, for joining. My name is Keith Weiss. I run the U.S. software research practice here at Morgan Stanley. And really pleased to have with us from Roper Technologies, both CEO and President, Neil Hunn; and CFO -- EVP and CFO, Jason Conley. So gentlemen, thank you for joining us. Before we get started, brief research disclosures. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com\researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative.

Excellent. So with that out of the way, again, thank you for joining us. Neil and Jason, I appreciate you guys joining us at the conference. I think Roper Technologies might be a new name to a lot of investors in the room. It's a company that started with George Roper selling gas stoves, and now you're 75% software. So can you give us a little bit of a background on sort of what Roper is all about, maybe a Roper [ 101 ], and then sort of tell us a little bit about the transition that you guys have gone through?

Sure, and thanks for having us. It's really a pleasure to be here, and thanks for taking the time to do the fireside chat. So I won't drag you through the long history of Roper, but I'll give you a snapshot of where we are today and then a little bit of the -- of how we got here. So today, we're 27 businesses, 75% of which are software, 100% of what we do is vertical in its nature. So we do -- we solve very specific problems for very specific people and very specific end markets. All 27 of the businesses are either #1 or #2 in their small but growing markets. Because what we do is literally mission-critical for all of our customers, so we're not discretionary tech spend, our customers need us to run their business. We're able to price based on value that we deliver. That yields great units and sort of enterprise economics. And because we compete on this notion of customer intimacy, we run a super highly decentralized model, which we can get into later to the extent it's interesting. But we do have a series of -- we have 4 operating executives that are like coaches that help the businesses get better and improve their organic growth outlook. So we don't just want our businesses to get bigger, we want them to get better. So we care how things are done. Being a permanent owner of these businesses, using that permanence as a competitive weapon is important for us to be able to build sustained levels, improved organic growth outlook. I think dissimilar from a lot of other software companies, we have a -- we take all the capital that's generated, very high free cash flow margins in our businesses and have run a very centralized capital deployment strategy. So we take all the capital in every given -- any given year right now, I have to deploy about $3 billion or $4 billion of capital. And we are able to find the very best idea. It could be adding the 28th or 29th company or it could be deploying it back in to some bolt-ons into our company. But it's us at the center that are making those decisions. When you put it all together today, we're about a $6 billion top line enterprise, 40% EBITDA margins, 30% free cash flow margins and have delivered sort of mid- to high teens shareholder compounding for 2 decades.

Awesome. Excellent. And maybe just to drill down to it, can you talk to us about some of those portfolio companies just to give us an idea of kind of what order makes up. And I don't -- maybe we could delve into some of the larger units. I think Deltek has been around for a while. You guys acquired that in 2022. What makes Deltek like a good example of a Roper portfolio company to all?

So Deltek was -- the time frame on that, we've acquired in 2016. Deltek is a perfect illustration of what a typical Roper business is. It happens to be our largest software business, but it is a software that's purpose-built for project-based businesses. So that's a -- so it's service ERP, but it's tuned at very specific verticals: U.S. federal government contractors, architects, engineers, marketing firm -- marketing services firms and where we're the clear leader across those verticals. If you're a government contractor of any scale, you're on a cost point. There is -- it's the features of how to do government-based cost-plus reimbursement are very bespoke. And if you're a government auditor and you know you're running on cost point, then they ask for very specific reports that demonstrate that. If you're running on competitive or customized software, then you're getting in and doing bespoke queries, for instance. So it is a perfect example of solving very specific problems in a niche industry. That business, like you'd expect in any vertical business, has very high gross retention sort of mid- to high 90s. It carries over into mid, maybe mid-plus net retention, and you get a point or 2 growth on top of that from that new. So it's a very good illustration.

Got it. And I guess that kind of leads into what you're talking about in terms of permanence. So something like a Deltek where the solution almost becomes a verb in their key verticals. You get a lot of assurance that, that is not going anywhere. That's going to be a de facto standard in that industry for a while?

It certainly helps the customers feel that -- because everything we bought heretofore has been bought from private equity, and there's usually multiple turns in private equity. That very much -- their short -- shorter ownership period informs their product investments in the product cycles. And so it's hard for a temporary owner to invest over a long arc of time across multiple time frames of product cycle, and we get to do that. So the permanence of ownership really resonates with the customers of our companies.

Got it. Got it. So can we dig into how Roper Technologies got to the point of 75% software? Was it all building up through acquisitions? Or was there dispositions on the other side of that? Maybe just give us an idea of how we got to where we are today?

So it's been 15, 20 years in the making. So we definitely started, as you alluded at the beginning, as an old line industrial products business. My predecessor came to the company in 2001 with a simple idea that value for both customers and shareholders was maximized by rotating the portfolio away from asset-intensive businesses that created their competitive moat with assets and dollars to businesses that were more knowledge-based or network-based where they create their moats based on customer intimacy and network effects and happen to be more asset efficient. And so over the arc of the last 15 years, as we've rolled up all the cash flow from all the businesses, the next thing we bought was a higher-growth, more asset-light, more software-oriented approach. We mixed in to 50-50 or so. And then starting in 2019, we made sort of a more radical shift to the portfolio, divested from in really '21 and -- '20 and '21 and '22, 40% of our 2018 revenues, which were the cyclical and more asset-intensive, more project-based part of our portfolio.

Got it. I wanted to dig into the use of M&A to kind of build out the company. And there's been a couple of examples within software as nearly Constellation Software offer has been one. Broadcom has probably been another one that has been very successful sort of building out companies. From the Roper's perspective, and I guess from your perspective, what's the key to doing M&A correctly that this becomes not a distraction and there's not inefficiencies that come along with it, but this is a competitive advantage in terms of doing M&A well and scaling and building out a company?

Why don't you go ahead?

Yes. No, I can start. I mean, I think as Neil mentioned, it starts with having that be centralized in a big part of our job. So we don't distract the businesses with M&A unless it makes a lot of sense for them. And so back to what Neil said, I mean, it allows us to allocate investment dollars to the best opportunity. So we don't see it as a distraction. We see it as part of our -- a big part of our job, I would say, and a big part of our growth story because that allows us to continue to buy vertical market software businesses that you couldn't otherwise own. We have a collection of those, and that we'll continue to grow that over time.

Yes. I mean, it's a core motion of our capability, right? So just what you'd want to see in the most well-run go-to-market engine, you'd want to see terrific funnel management, super analytical in how you narrow the funnel, know when to apply the level of resource at the right time. We see hundreds of deals a year. We engage on scores of them. And last year, we did 6. It's just a core well-honed motion of ours that's all focused on how do we just extend the cash flow compounding of the enterprise. We're not trying to build an empire, if you will. We're just super 100% focused on how do we compound cash flow to the best of our ability for our shareholders through both organic and inorganic.

We use -- just to add to that, we use investment-grade leverage to expand capacity and add to the returns for investors, which is a little bit, I would say, unusual in the compounding story. But it's quite common in industrial, and it's worked well for us.

Got it. It is unusual to see a software company actually knows how to use the balance sheet. Typically, software companies just run horribly inefficient balance sheets. Does the current interest rate environment sort of put a damper on sort of the ability to go out and run this M&A strategy? Do you have to go more into like a yielding mode rather than a sort of accruing mode, given where interest rates are?

Yes. I mean, I think over time, we've invested through all interest rate environments. And so we see that as we'll continue to do that. I think in the last 6 months, there's been a bid-ask spread, I think with rates being high, asset prices haven't come down. So we've been -- as we always are, we're just super patient and waiting for the sort of the market to come to us. But we still think it's important to continue to invest through cycle, some of our best deals have been in a rising interest rate environment where there is sort of fear in the market. So very active.

For us, it's all math. Our math says that it's better to invest through cycle and let the compounding begin than try to be market timers because even if you can assume you're a perfect market timer, the compounding still overwhelms it. And we know we're not a perfect market timer.

Got it. That makes a ton of sense. Can you talk to us a little bit about the vertical focus of software? Why is it important that these targets are more verticalized software versus like the really solid kind of horizontal software stories with good margins and the like?

Well, I'll say that going back 20 years, even in the -- in our industrial products, our heritage is vertical orientation and the benefits that accrue from that. When -- again, I said at the beginning, when you solve a very specific problem for a specific person, a specific end market, then this -- you compete on this intimacy, and then they want you to win, right? Our customers want us to solve their problems and help them win. So there's a fair amount of protection in these niche markets where you're the vertical solution leader. Like I said, we're either #1 or #2. So this intimacy is super important. As with all vertical, our software is hyper-tuned, and it just yields these great, very high gross retention stability metrics. And it goes to our view on risk, right? So we're at this dual-threaded growth strategy, which is partially organic and partially inorganic. It's all focused on compounding. And if there were like rules of compounding, the first one is you can't have nothing go backwards, right? So you're always trying to go forward. And so it views this vertical orientation and protection, we actively trade away like hyper growth for tremendous protection and take the stable moderate growth and then sort of put -- accelerate on that through the capital deployment. If our enterprise was like there are some winners and some losers and we -- some market was slowing and others -- it'd be -- the core would be less stable but then be able to put leverage on and run an M&A motion against it.

Got it. If I was to take a guess, I would say part of the vertical is also price protection. What I see in vertical software stories, they tend to solve a deeper problem for the end customer. They get more ingrained with that customer. More -- they're automating more of their business process, that's got to give you like -- what you talked about, not going backwards, that has to give you some elevated pricing power versus most?

Yes. I think it's -- we would agree with that, and our experience would say that, right? So as a general matter, price is going to offset every bit and then some of the attrition, right? So in [ AR snowball ], gross is going to be, whatever, 96. We're going to have 4 to 5 points of price, you're going to start at 100 or 101 and grow from there as opposed to being the whole and I think that's...

On enterprise?

On enterprise, for sure. Enterprise, most of what we sell to an enterprise. There are a couple of SMB, which would have different unit economics. But I think that just goes to the stability and the growth algorithm.

Got it. I want to shift gears a little bit and talk about macro and recent results obviously been very volatile spending back up through 2022. Can you talk to us a little bit about how Roper has performed over the past year? And what are you seeing in the spending environment today?

Yes. I would say moderately well. So this -- we grew 8% in '21, a little bit more than 9% last year organically, revenue. This year, we've guided to be 5% to 6% with an expectation for -- there to be a slowdown, especially in the second half. We hope we're wrong on that, but we try to be cautious. We tend to be buttressed with our customers because we're not -- we don't have a lot of volume-based pricing. And because they're mission-critical, we don't get a trade out when they slow down. So if there is any cyclicality a little bit on the end market than our pricing model, we do buttress that a little bit. But this portfolio through cycle, we believe, is sort of a 6% to 7% organic growth business and were a big part of what Jason and I have been trying to lead for the last 4 or 5 years in the business, how do we accelerate that, where we're solidly high single digits organic. And so that 6% to 7%, 5 years ago, it was 4%, right? So we've done a lot of work both internally and through the portfolio construct to have a more growthy resilient portfolio.

Got it. And can you dig into that a little bit? Like what were some of the key initiatives that took you from that 4% to 6% to 7%? And anything in particular that you guys are looking to, to help get from that 6% to 7% to 8% to 9%?

So, I think the -- this is a super important element of our structure, right? So we have our 27 business units, and their leaders are terrific operators, super intimate with their customers and are just very good operators. We've -- 5 years ago, we meaningfully increased our performance expectations. But then we also gave them sort of some coaching and center-led resources on 3 topics, principally to help them improve the organic growth outlook. And they're sort of like a motherhood and apple pie, but I'll walk through them briefly. First is, how do you do strategy? For us, it's just a series of choices, right? And so where to play and how to win and how do you decide to stop doing something to put more resources against the highest and best use, not a skill set that's widely built in smaller companies. It's built-in larger companies, but our portfolio is $100 million to $300 million companies, right? So teaching them how to make choice is important. We're showing them how to do it, and then they're the ones that are making the choice. Then the second thing is how do you actually execute strategy. This goes to our long-term ownership period. If you execute strategy and you build capability for repeatability and enduring nature, then the benefit accrues over a long arc of time. How many companies have you seen or we've all seen where they sort of do like a student body right against the strategic initiative, they get growth for a few years. And then when they take their eyes off and they do something else, then you regress here, and you're on this perpetual motion machine of not going anywhere. In our case, we want to build capability and then stack and stack and stack so you don't go backwards. And the third thing is team and talent. Everybody wants to use the workforce and team as a competitive advantage, but very few can and do because it's just hard. And so our coaches, our operating leaders teach our businesses how to do this. And we're going to give some examples in a couple of weeks at our first ever Investor Day how the organic growth rate and a handful of businesses that was low single digits to now low double digits. So it was mid, and now it's high. And so when you do these things well, there's -- it's demonstrable in terms of the uplift.

Got it. Got it. So 27 business units, there's coaching applied down to them to sort of adhere towards these key elements of sort of how to run these businesses efficiently and get to a better level of growth. How do you incentivize those 27 business units? How do you get everybody properly motivated towards [indiscernible] growth?

So I think there's -- I'll directly answer your question, and I'll come back and talk to you about the profile of people that we try to hire, right? And so the incentive structure is maybe the most important sort of secret sauce in our culture. And it's simple, but very few others do it, is we pay solely based on growth, EBITDA growth. What every organization I've worked at prior to here, and I think 95% of organizations pay on some sort of plan or budget. And when you have an organization that's like ours, as multiple business units, if you do that, then we would provide our field teams and incentives delight us, and then we would have a filter not to believe anything they say. So in that culture, how can you have anything that resembles trust or I need help or how can we all jump on and start solving a problem. In our case, we pay everybody based on growth. And so the bad news whips around our organization at warp speed because there's a problem we all want to try to fix it. It's a super important element about how we -- about how our enterprise operates. Now the people we have -- we aspire to have leading our businesses have 4 traits, right, versus their competitors. I mean, right, what we're in is a competitive event, right? There's winners and losers, right? So you have to be uniquely competitive. You have to be a learner, right? None of us know it all, so you have to be able to adapt to the situation and continually learn. We want people to be what we call strategic operators. So how do you think long term and bring that to today. And maybe the most unique and important for us is we want people that are authentically geeked up about building a business, not growing, not making it bigger only, but how do you make the building elements of the business? How do you do a small tedious things on a repeated basis to make it authentically a well-run machine? And so when you have that persona of a person with a growth-oriented incentive, then we see great things accrue to us and to them.

Got it. And to be clear, it's -- your incentive on the EBITDA growth in your individual...

In your individual business. That's right.

Okay. Got it. Can I play devil's advocate on that a little bit? Like is there a risk of, let's call it, the Elliott risk, if you will, meaning like Elliott the activist stuff, like you have a manager that is kind of gutting the potential future growth opportunity, top line growth opportunity to get to better EBITDA over time. That could last for a couple of years if you really kind of try to squeeze the rock, but you're left with a hole, if you will. You're left with a hollow company. How do you ensure that is not penny-wise [indiscernible] sort of more short term in nature?

There is in theory, that risk, but in practice, it's well managed and doesn't exist for a couple of reasons. First, when I say we're decentralized, we're authentically decentralized. There are 27 Presidents, CFOs, ERP systems, and there's no hiding from the numbers. There's no matrix. There's no allocations to EBITDA. So every month, every quarter, P&L, balance sheet, there's nowhere to hide. You can see it in the numbers. Like you can't. It can't be hidden. Perhaps more so is our group executives. I mean, they have -- the operating leaders, they have 6 to 8 companies each. They're intimate with these companies, right? And so then we have a whole strategic planning and annual operating planning review process that we go through with the group executives. There's too many checks and balances to see that and really no incentive, right? I mean, when you have the mindset of the person that we're hiring, they're here, they build their career in a business here, right? You don't make money, you will become wealthy at Roper as an operator from running a $40 million P&L to a $200 million to $800 million. If you can grow your $100 million P&L over a long arc of time, you will create wealth for that person and their family. And so there's no incentive to do that either.

Okay. So everyone is aligned to sort of the longer-term annuity that you build out the compounding ethos that...

That's right. And there's -- I mean, as Neil mentioned, we look for builders. And if you're a transactor, if you've been in private equity, we see that and they see it. And they -- it's usually just not a good cultural fit, and so they'll opt out of that. The other part I would just highlight is that there is a portion of the equity that's tied to Roper, right? So it's not all just the company. So there's sort of a tie in back there.

Got it. That makes sense. And then they do really well for 5 years, they get to move down to Sarasota? Got it. So one of the other kind of really impressive points is consistently operating with EBIT margins above 40%. Incentives is definitely one part of that. But it's -- having covered software for a long time, does the growth and profitability tend to sort of coming on. How do you ensure that sort of everybody aligns to sustaining that? And do you ever worry about missing growth opportunities by being so focused on that EBITDA margin side?

Do you want to start with that one?

Yes, I would say that we just focus on growth. We just happen to acquire businesses that have a great sort of structural margin. They're usually leaders in their market, high net retention, high gross margins. And so they have plenty of room to invest between gross and EBITDA, very low CapEx, right? So we get good free cash flow margins from that. But I mean, I'd say if anything, we don't see opportunities missed. If anything, we encourage some investment even in COVID for a couple of our businesses. We underwrote some additional R&D so that they could exit faster coming out of COVID. So we are mindful. We have conversations about that. So a president will present that opportunity, and we'll have those conversations. But I would say, by and large, they have enough to reinvest in their P&L without sort of sacrificing growth.

I have a couple more questions, but I want to see if there's any questions from the audience before I go on, at the back?

Really quick. If you could talk a little bit about [indiscernible] how are you guys [indiscernible] things that might look [indiscernible] just a little bit about which things you think about [indiscernible]?

Sure. Repeat the question. So just -- so folks can hear. So how do we qualify what end markets we'll invest in and then ultimately, which businesses, is that fair? So first, I would say unequivocally, we're business pickers, right? So our entire diligence mechanism is tuned towards finding great businesses. And then obviously, as part of that, you have to understand the end market. What we're not is trying to find a fast-flowing market and then find a good enough asset in that market. There's lots of folks who do that. That's not what we do. So we start with the sort of industry forces that we want to understand. Is the industry stable? Are the competitive forces observable and stable? Is the value that customers attribute, again, observable and our diligence, like, why do you buy and who do you buy it from, are there shifting and changing? So we look for a lot of stability. Also, many of our businesses were one that we're the leader in a 2-horse race or there is a duopoly or there might be -- we might be the leader in a -- very consolidated sort of competitive moat segment by way of example. Then there's the industry, the company criteria. Is it the leader? Does it have -- is it #1 or #2? Does it compete on intimacy? Does it have high recurring revenue? Does it have high gross to net? Does this AR snowball with pricing and attrition, all that favorable and we diligence each one of those. And if those things -- and if there's no existential risks. And so we've seen many things over a decade in the automotive sector, a lot of software and data businesses, we can't find a way to deploy capital there because with autonomy, electrification, there's going to be winners and losers. And those feel to us like big existential threats and that -- so we're not going to do that. So we go park our capital on a more safe, stable end markets. It doesn't mean there's not macro trends that are driving, right? There's a tremendous amount of digitization of workflows like life insurance and property and casualty, agency management, spot trucking are wildly manual processes today, so we sort of have the secular tailwinds of digitization, that is the case in a lot of end markets. There's a ton of cloud migration to SaaS. Those are happening. Those are just normal sort of tailwinds and don't care about existential risks. But what we say internally, if there's a 0 in the [ Monte Carlo ], we're out, right? It's too much risk.

Could you expand a little further on how you think about capital allocation back into your existing businesses versus into new investments?

Sure. So from a capital allocation, so our businesses don't -- as you'd expect, they don't require capital per se to grow, right? So there's not like CapEx that we have to worry about in the capital allocation. In terms of our M&A capacity, the best deal -- about 10% of our capital deployed historically has been back into the portfolio. They are the best deals we've done from a return perspective. We'd love for there to be more of that and plan for that going forward. But it's all in pursuit of increased organic growth rates in the businesses. Again, the incentive is growth. And so our operators would consider and be excited about a bolt-on if that bolt-on once integrated was going to improve the organic growth outlook of the enterprise -- of their business. And so we'd love for that to be doubled, if not higher because they're great for our businesses and great for the enterprise. Maybe you want to add to that?

No. That's great.

Maybe time to sneak one last one.

[indiscernible].

So it's -- we have a very -- so we have a very small M&A team like 2, and then it's in the job description of the executives. So every bit of 1/3 of Jason and my time has been on capital deployment. We use our Board as an investment committee essentially. So we don't just show them the deals that we're recommending, but some of the deals that were on the fence on or even deals that we were recommending against, so they get a sense of calibration. So it's a combination of the executive team, the M&A team and our Board.

Got it. We're at the end of the time, but maybe just like one last closing thought. You guys are doing your first ever Analyst Day. You're here at the Morgan Stanley conference. Is there a reason for sort of more of an investor outreach at this point in time?

Yes. I mean, we've been -- we made the decision in our boardroom in fall of 2018 to do this portfolio work. We're busy doing that. COVID happened. It slowed down. It's hard to divest things in middle of COVID. And so it's hard for us to be very aggressive with our investor communication. We're in the midst of the portfolio change. The last transaction closed just before Thanksgiving this past year. And so we feel like what we've been accruing to for a few years is here, and that's what our spending [indiscernible].

Sounds great. Well, thank you so much for coming in and sharing the story.

Terrific. Thank you so much. Really appreciate it.