With Core Growth Slowing, Roper’s Valuation Case Is Harder To Make (NYSE:ROP)

Roper (NYSE:ROP) management has been very upfront over the years about their desire to continue to transform the businesses toward higher-margin recurring revenue with lower capital intensity and a focus on niche businesses with higher barriers to entry. That has largely meant “software … and lots of it”, and Roper hasn’t been shy about paying high multiples to build the portfolio and decided to dispose of a majority stake in most of its legacy industrial businesses in 2022.

I was lukewarm on Roper back in August of 2021, largely on valuation/market expectations, and the shares have derated since then, leading to about 10% relative underperformance to other industrials. Over that time, many “compounders” have seen multiple compression, with the group moving from average forward EBITDA multiples in the 20x-22x range to the mid-to-high teens.

At this point, I still have issues with Roper’s valuation. Mid-single-digit growth for 2023 looks soft next to what I’m expecting from other industrial software companies, and Roper has been leveraging up without much evidence of sustained improvement in growth or margins, which leads me to worry that they’re stuck in a situation where they’ll be paying more (valuation multiples) and getting incrementally less (in terms of growth/margin improvement). Given that I can’t really find the shares cheap, even by the elevated valuation standards of software companies, this remains a “pass” for me now.

Largely In-Line Fourth Quarter Results

I didn’t see all that much in the fourth quarter results that blew me away (nor seriously disappointed me). Revenue was basically in line, though core segment-level profits were weaker than I’d expected, and the beat versus the Street was largely in the below-the-line items.

Revenue rose 14%, or 7% in organic terms, which was just in line with expectations. For the segments, organic revenue growth was 7% at Application Software, 9% at Network Software, and 5% at Tech-Enabled Products.

Gross margin was basically stable with the year-ago period (down 10bp) and up slightly on a sequential basis (30bp) to 70%, with App Software at 68.9% (down 40bp yoy), Network Software at 84.9% (up 50bp), and Tech-Enabled Products at 57.2% (down 10bp).

Adjusted EBITDA rose 17%, with margin up 110bp to 41.4%, while operating income rose 16% (margin up 60bp to 28.8%), and segment profits rose 16% (margin up 50bp to 32.3%). The latter was a modest (2%) miss versus expectations. App Software profits rose 25% (margin up 70bp to 27.4%), Network Software profits rose 11% (margin up 100bp to 42.4%), and Tech-Enabled Products rose about 8% (margin up 120bp to 32.7%).

Guidance Doesn’t Seem All That Impressive

Roper management guided for 5% to 6% organic growth in 2023, with only Tech-Enabled Products expected to grow faster (at a high-single-digit rate). This marks a greater deceleration than other software companies are showing, including industrial software companies where the overall growth target still looks to be in the range of 10% for 2023.

I believe at least some of this can be tied to the end markets that Roper serves. I expect non-residential construction and overall large-scale project activity to slow, impacting businesses like ConstructConnect and Deltek, and I believe the strong results that Roper saw from its freight businesses in 2022 (DAT and Loadlink) will not repeat in 2023 given a much slower freight market. I also see somewhat mixed trends in a lot of the medical markets Roper’s portfolio serves – while procedure counts are recovering, staffing issues remain significant. I likewise don’t think Neptune is likely to repeat the strong 2022 results it produced; I believe this is still a net share-gainer over time, but the pace of growth will likely slow in 2023.

How Differentiated Is The Model, Really?

Roper enjoyed an exceptional run through around mid-2021, with the market rewarding the company’s growth-by-M&A plan and pivot towards software with exceptional share price outperformance and almost equally-exceptional forward multiples (at least for a company that was still, theoretically, an “industrial”).

Since then, sentiment has cooled, and not just for Roper but for many of those previously richly-valued compounders. I’m not pretending to speak for investors on the whole, but I think the market has come to realize that in many cases the differentiation that these companies were offering in terms of core growth, margin leverage, and free cash flow generation, was either not quite as good as promised, or not good enough to support the robust valuations. Since then, many of these companies (Fortive (FTV), Hexagon (OTCPK:HXGBY), IMI plc (OTCPK:IMIAF), Rockwell (ROK), and Roper) have underperformed the broader industrial space and seen multiple derating.

Specific to Roper, I’m concerned that the company is having to pay more and more for deals (including over 19x EBITDA for the revenue Frontline Education deal) that don’t meaningfully improve the forward growth or margin outlook all that much. At the same time, the company is taking on debt to fund these deals. I don’t have a problem using leverage to grow, but I think using leverage to pay high multiples without clear needle-moving improvements in the fundamentals is riskier.

The Outlook

Barring significant acceleration in the business, I don’t see a good reason to expect core organic growth to exceed 4% to 5% over the long term – not that that’s a bad growth rate for a “typical” company, mind you. I also continue to model in some level of M&A; I’m sure I’ll be wrong about the year-to-year impact but with a company like Roper where M&A is core to the growth story, I’d rather make the trade of precision for overall accuracy. To that end, I think Roper is likely to generate high-single-digit revenue growth, including future M&A.

Core EBITDA margins (adjusted for the divestitures) haven’t really improved much over the last few years, and I expect a slow grind toward 41%-42%. Likewise, while Roper’s free cash flow margins are quite high, I expect a slow rate of improvement from the low-to-mid-30%s and low-double-digit long-term FCF growth.

With low-double-digit FCF growth would be quite good for most companies, it’s not enough to drive an especially attractive fair value on a discounted cash flow basis. I don’t think Roper is dramatically overvalued, but I’d expect a total annualized long-term return in the 7% to 8% range. Multiples-based approaches are less accommodating; even if I treat Roper like a full-fledged software company, the shares trade ahead of what the anticipated revenue growth and EBITDA margin would typically support for a forward EV/revenue multiple.

The Bottom Line

I think Roper has built a solid and diverse collection of software businesses that generate substantial recurring revenue and free cash flow and enjoy decent or better barriers to entry. My concern, though, is how much runway is left – I think finding deals that can meaningfully boost the growth/margin outlook will get harder and harder, and I’m concerned that the company will have to rely more on leverage and “deals for growth’s sake” to significantly accelerate growth from here. I may be completely wrong about that, but given that concern, I want a wider margin to my FCF-based fair value than what the shares offer today ($400 or less would start getting interesting again).

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