Wednesday, October 31, 2012

Roper Industries, The Best Run Company in America?

All investors, in common with fisherman, have a tale to tell of ‘the one that got away’. Of course, I know you expected me to include Katy Perry in that list following her hit single of the name but bear in mind that she (in the video) took solace by making a wealthy man’s life a misery as a consequence. Maybe he was wealthy because he may not have made the mistake that I made in selling out early in my holding of Roper Industries (NYSE: ROP). Frankly, I think this is one of the best run companies in the US and here is why.

Hindsight Asset Management

Of course, backwards investing is one of the easiest things in the world to do and it’s easy to kid yourself by only looking at the winners. Incidentally, that’s what makes writing about stocks so useful. Once it is written down there is no room to delude yourself. That said I want to look back at the reasons why I thought Roper was a great company a couple of years ago and then sold at $68 and see if they apply now. Bear in mind the stock now trades at $104!

Roper is a diversified engineering company with the following characteristics

  • A focus on Investment in Machinery & Equipment in its cyclical businesses.  This sector was due an aggressive snapback in growth following the savage cutbacks it took in the recession.
  • Roper has a history of great cash flow generation. Its business tends to be asset light and so require relatively less capex.
  • Strong Ebitda margin growth and a strong track record of using cash to make earnings generative acquisitions.
  • It is a leader in a series of niche markets whereby it can better retain its competitive positioning.
  • Each of its business segments has good long term secular drivers and actually has some good defensive growth characteristics.

I want to develop the last point in particular. Here is a breakdown of 2011 sales.

Not only are revenues pretty evenly split but Ebitda is too. Ebitda margins across the segments range tightly from 29% (Energy) to 31% (Industrial) and Roper is a leading player in niche markets with these segments.

Roper Industries Industry Segments

Consider RF Technology. This is an area where technological advances and increased industry adoption (freight, road tolling, retail and utility performance measurement) are driving sales growth. Moving on to Roper’s Industrial operations, this segment largely services the utilities (and in particular water) with leak testing, flow measurement, automatic metering and performance monitoring equipment. Again, this is an attractive long term industry because the need to use technology to improve utilities performance will only increase in the future. Utility demand is growing and the days of cheap energy and water are gone.

The third largest segment is Medical and Scientific Imagery. Here again, Roper is positioned in strongly growing markets. Imaging for Radiation Oncology is a strong growth area. In addition, it supplies diagnostic and therapeutic products for one of the fastest growing sectors in medical devices, namely minimally invasive surgery (MIS).  Looking at Covidien’s (NYSE: COV) results over the last year shows very strong growth in MIS and whenever I speak to surgeons they mention this as their key growth area. There is a temptation to conclude that MIS' prospects are highly correlated with hospital admissions and elective surgical procedures but thanks to its cost reduction properties Covidien is generating strong secular growth. After the forthcoming stock split I would expect investors to re-rate Covidien as MIS will become more prominent in the medical device company. Of more concern would be scientific imagery which –despite its growth in applications- is still largely dictated by Government and academic budgeting.

The last segment is Energy Systems and Controls whose prospects are reliant upon large engineered projects in the energy industry and in particular in hazardous industries. These are the kinds of solutions that its customers can afford to take risks with and Roper has a history of performance. Moreover if we look at what the likes of industry bell weathers like Alcoa (NYSE: AA) are saying, energy spending is holding up well. In fact, Alcoa has been raising its estimates for Industrial Gas Turbine growth throughout the year. This is relevant because it's the strongest industry segment for Alcoa and the company has seen expectations downgraded elsewhere.

Look Ma No Financial Services and Not so Much China Either

Another reason to love Roper isn’t that it isn’t GE (NYSE: GE). In other words, this is an engineering company that does, err, engineering. It's not a metal basher with a financial services arm (in this case GE capital) generating a significant portion of its earnings.  I think this makes it a more representative stock of the Engineering renaissance in the US (led by cheaper gas) than GE. I also believe that GE may face some difficulties going forward. Aerospace is a cyclical industry and is somewhat reliant on emerging market growth. In addition, GE has been disappointing wth its defensive segments like healthcare.

In addition Roper is far less exposed to China’s growth moderation than a company like Eaton Corp (NYSE: ETN) or Caterpillar. Throw in Eaton’s reliance on cyclical industries like heavy trucking and Roper comes out on top again. Eaton has seen some downgrades recently with analysts citing weaker China hydraulics and NAFTA truck prospects. Eaton generates about 24% of its sales from emerging markets and most of it is in highly cyclical industries that are slowing.

But this isn’t just about end-market exposure. Roper is a very well run company internally.

This chart tells you a lot. Note how free cash flow has increased over the last five years and -crucially- how as a percentage of sales it has held up in a recession and in the subsequent growth period afterwards. This a sign that management and the business can see working capital reductions in tough years (leading to higher cash flows) but then they can be operationally geared to go for growth but not at the expense of margins.

A very well run company.

Where Next for Roper?

Unlike most in its sector, Roper has seen estimates rising this year and with mid teens growth forecast for the next couple of years the company is a strong GARP candidate. As ever, its cash generation is very impressive with trailing free cash flow of $578 million comprising 5.3% of its Enterprise Value. This looks reasonable and I think there is every reason that Roper can ‘do its earnings’ and generate mid teens returns for investors.

Perhaps my ‘one that got away’ is about to be get a make-up call?