A reinvented company with a large moat and reliable cash

In June 2022, Roper sold a 51 per cent stake in 16 legacy industrial firms to Clayton, Dubilier & Rice for an upfront payment of $2.6bn (£2bn). That headline figure obscured the deal multiple, which equated to an enterprise value of just over 10 times the businesses’ earnings before interest, tax, depreciation and amortisation (Ebitda). Investors seemed unconvinced that Roper had landed on the right side of the deal. In the fortnight that followed the deal’s announcement, its shares fell 17 per cent.

With equity markets then languishing at recent lows, the timing was never likely to be ideal. However, this decision was less about price than completing the reorientation of the business. Chief executive Neil Hunn described it as the “final step” in Roper’s divestiture strategy to reduce the cyclicality and asset intensity of the enterprise and said it would “expand Roper’s M&A firepower to more than $7bn”.

This war chest will be used on high-quality software businesses, with few assets, recurring revenues and strong cash flow. Since the disposal, vertical software makes up three-quarters of revenue (of which two-thirds is derived from application software, and one-third network software), with the remainder in the medical and water products division.

Moats around niche software

A key example of an application software business is Aderant, which Roper acquired for $675mn in 2015. It helps law firms with all aspects of running a firm, such as docketing, case management and billing. Aderant has more than 3,000 corporate customers, and a retention ratio above 95 per cent. In the legal world, that is a respectable number of customers, and the high retention rate speaks to the quality of the product.

Network software is a product that matches people or companies. In 2004, Roper acquired traffic management company Transcore. In 2014, Transcore spun out DAT (originally Dial-a-Truck), which then became the largest freight-matching software platform in North America. It connects brokers and carriers of freight and has more than three times the market share of its closest rival.

These software businesses exhibit two sought-after attributes. In the case of Aderant, the potential switching costs of shifting to a different platform and retraining to use it are significant and lead to sticky clients. DAT has also benefited from the network effects that have propped up Meta (US:META), Alphabet (US:GOOGL) and Amazon’s (US:AMZN) dominance of the consumer software market. Together, this helps explain why analysts at Morningstar consider Roper to be one of just 17 companies in the S&P 500 with a wide economic moat, and at least three sources of competitive advantage (the third, after switching costs and network effects, being scale efficiencies) – to find out more about Morningstar's economic moat ranking, see this week's Ideas Farm column.

Since the divestment, Roper has acquired Frontline Education and Syntellis Performance Solutions, software developers in the education and data analytics and business management markets, respectively. Both are cloud-based, cash-generative and were acquired using cash and Roper's rolling credit facility. In the case of Syntellis, a combination of capital-light assets and the company’s efficiency in converting sales into cash flow has resulted in a negative working capital position.

Compared with the industrials Roper used to buy, these high-quality companies are on the expensive side. Frontline Education and Syntellis cost 19 and 15 times forward Ebitda, respectively, leading to a depressed one-year return on invested capital (see table). This is, however, the nature of the beast: because high-quality businesses command high prices, the short-term hit is higher. 

Scale means cheaper capital

However, these non-cyclical, cash-generative businesses will increase Roper’s capacity to acquire more companies. First, because the existing portfolio generates ever more cash to reinvest. In turn, this should improve the terms on which banks will lend to Roper. In a worst-case scenario – should the portfolio’s cash flow fail to cover financing costs – Roper can always sell one of its many businesses. This flexibility and lower capital costs therefore give Roper a structural advantage over standalone software companies.

The strength of these software businesses can be seen in Roper's financial performance. In the second quarter, strong software recurring revenue meant organic sales growth hit 9 per cent, while a good handle on costs led to expansion in the operating margin across all three segments. Operating cash flow was also up 20 per cent, to $320mn. 

The cloud computing companies Google, Amazon and Microsoft have all observed their customers being more cautious on IT spend this year, so for Roper to be able to grow organic revenue while expanding margins is impressive. It also shows the importance of its software to its customers and portfolio companies’ capacity to raise prices across the board.

This is particularly beneficial when high interest rates have raised the price of money and increased the discount rate on future cash generation, thereby depressing high-value sectors such as software. Roper acquires its businesses from private equity usually after they have already stripped out many of the inefficiencies. As private markets digest this dual hit to financing and asset values, analysts believe there should be opportunities for Roper to pick up some good deals.

AI to drive growth

The sell-side is also optimistic about Roper’s position to benefit from generative artificial intelligence (AI), given its access to exclusive data in some of its market niches. Aderant, for example, has launched a generative AI product called MADDI, which automates time entry, cash receipt matching and docketing for its law firm customers. On a recent results call, management added that DAT had been using AI to reduce fraud in the freight industry.

Building AI products is expensive and requires rich datasets. But Roper’s ownership of multiple companies, each with access to unique data, means that it can both pool capital and transfer knowhow across businesses that in most industries operate alone.

To seize this opportunity fully, Roper might need to ramp up its research and development (R&D) spending. Last year, R&D came to $530mn, or 10 per cent of its revenue, and up from $485mn (or 8 per cent) the year before. The numbers are heading in the right direction, but these figures lag behind its competitors, with software companies usually aiming for the mid-teens per cent of revenue.

Such are the trade-offs when you switch to through-the-cycle businesses. This pivot has pushed up Roper's valuation to 27 times 2024 consensus earnings forecasts. That’s a premium to its five-year average of 22, but this should be considered in the context of its recent divestment away from cyclical industrials. Compared with its software group peers, Roper shares trade at around a 20 per cent discount, according to Jefferies – even though its size and diversification provide resilience and cheap capital that few other companies can match.

The companies Roper acquires are expensive, but double-digit organic revenue growth with a 21 per cent operating cash flow margin isn’t common. Niche business-to-business software isn’t always exciting, but it is reliably cash-generative, year in year out. That is worth paying up for.