Roper (ROP) is an underappreciated long-term value creator, one which I have provided coverage on exactly a year ago as the company was making an acquisition of a software company, as an example of its continued transformation.
Given that great track record, I like to keep a close eye on M&A developments as the company has quite a unique business model which actually makes great sense if you think about it. Roper aims to hold leading positions in niche segments across a portfolio of software and engineered products and solutions. Typically, these operations are light in terms of capital requirements, as local management teams are given quite some freedom to thrive.
The distinctive strategy and solid execution of its intentions made that Roper has been a dream stock for long-term holders. The company has grown sales by a factor of 15 times in a period of roughly 15 years through a combination of organic growth and deal-making, with more than $10 billion spent on acquisitions over the recent decade, notably in software and related markets.
When I looked at the software deal of iPipeline in August 2019, the company had of course only reported its 2018 results as the company has grown to a $5.2 billion revenue base driven by solid growth. The company reported very steep GAAP earnings of $944 million, or $9.05 per share, as adjusted earnings came in as high as $11.81 per share, all while leverage ratios were manageable at 2.5 times. With the company guiding for adjusted earnings to improve to roughly $13.00 per share for 2019, I was left concluding that at $355, valuations were sky-high at around 27 times.
The reason why I checked on the company was the $1.6 billion acquisition of iPipeline in order to provide SaaS applications for life insurance and the annuity industry. With sales of around $200 million, an 8 times sales multiple did not look necessarily cheap, yet was actually in line with Roper’s own valuation, as margins are similar and organic sales growth came in at double digits.
Nonetheless, with shares trading around 27 times earnings and net debt of $6.5 billion following the iPipeline deal, I was a bit cautious as leverage ratios jumped to 3.2 times. This came down a bit as the company sold Gatan in a $925 million deal to Ametek (AME) that fall, yet I found the valuations a bit too high. That said, quality prevails over time, as this was just a $1 stock in the early 1990s. Being impressed with the quality of the business and management and hence I would be ”happy” to pay a 22 times multiple, corresponding to $300.
Working with a 22 times multiple, I am certainly not buying shares at the moment. This targeted entry multiple and some growth would make me happy to start initiating at around $300 based on the conditions last year. Unfortunately shares never traded below the $330 mark for the rest of 2019 and even hit a high near the $400 mark in February, when they of course did sell-off alongside the market amidst the Covid-19 outbreak, to hit a low of $240. During that move lower, I bought a tiny position around $270, yet small, as I was getting filled on other orders left and right.
Roper delivered on its promise during 2019 as the company reported adjusted earnings of $13.05 per share, yet that is quite a clean number, not distorted heavily by huge stock-based compensation expenses, for instance. With net debt down to $4.6 billion by year-end and EBITDA approaching the $2.0 billion mark, leverage ratios of 2.3 times were very reasonable as well. When these results were released late January, the company was comfortable to outline a guidance for 2020 calling for 6-7% organic sales growth and saw adjusted earnings per share at around $13.30-$13.60.
The company cut this guidance (of course) alongside the first quarter earnings report, seeing earnings at $11.60-$12.60 per share. While down substantially, the cut in the guidance was less pronounced than the underlying share price movement, and all of this happened when many companies were pulling guidance altogether. In fact, the company hiked the midpoint of the earnings guidance to $11.90-$12.40 per share when the second quarter results were released in July. Net debt has been reduced further towards $4.0 billion, with EBITDA still trending at near $2.0 billion a year.
These results show some real stabilization and in fact, Roper’s management feels comfortable enough to announce and pursue a mega-deal. The company has reached a $5.35 billion deal to acquire Vertafore, a cloud-based software provider for management, compliance, workflow and other solutions which help to automate the property and casualty insurance lifecycle. With $590 million in sales, the deal does not come cheap at 9.1 times sales, yet the business is very profitable with EBITDA margins of essentially 50% based on EBITDA contribution of $290 million, for an 18.5 times multiple.
To put this into perspective: Roper has 105 million shares outstanding which by now have risen to fresh all-time highs as the business has proven to be extremely resilient, with second quarter sales down just slightly, and revenues for the first half of 2020 actually up slightly. Shares now trade at fresh all-time highs at $450 per share, for a $47 billion equity valuation, or $51 billion enterprise valuation. With sales trending at $5.2 billion a year, Roper is actually trading at roughly 10 times sales, and around 25 times or even higher EBITDA multiples.
In that sense, the company is making a bargain. Net debt will jump from $4.0 billion to $9.3 billion overnight, yet with EBITDA pegged around $2.3 billion, I am a little surprised that the company is leveraging up to 4.0 times as the Covid-19 uncertainty is not a thing of the past, yet the company has proven to be very resilient in these conditions. It seems very safe to say that Vertafore could generate $275 million in EBIT, as this is a capital-light business. Assuming 4% interest on $5.35 billion in net debt, incremental borrowing costs of $214 million still yield about $60 million in pre-tax earnings contribution, or about $0.40 per share after taxes. Of course, this number grows once the earnings contribution grows, and interest costs will come down.
This observation and normal earnings power of close to $14 per share makes that in a Covid-19 free world earnings might approach the $15 per share mark going forward. This shows that multiples have only expanded further to 30 times earnings in such a rosy scenario, and thus higher earnings multiples at this moment, all while leverage will increase quite a bit as well.
Right here and now, with shares up two-thirds since I acquired a small stake in March, I find it very easy to take some profits although I continue to appreciate the quality of the company and its shares. The truth of the matter is that valuations simply seem too rich to create a decent risk-reward profile here.
If you like to see more ideas, please subscribe to the premium service “Value in Corporate Events” here and try the free trial. In this service, we cover major earnings events, M&A, IPOs and other significant corporate events with actionable ideas. Furthermore, we provide coverage of situations and names on request!
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.