Monday, February 4, 2013

Roper Industries Equity Analysis and Research

Another good set of results at Roper Industries (NYSE: ROP), and the company continues to execute superbly within a strong set of end markets. I think there is some upside from its key growth drivers in 2013, and Roper will need it because the stock is approaching full value. With that said, this is a very well run company, and for those willing to take a long term view it’s worth looking at very closely.

Roper Delivers Again

Roper’s business model is to invest in market leading positions within niche industries, a strategy that has paid off over the last 10 years. I’ve previously discussed it in an article linked here. Margins have expanded rapidly, and its asset light business model means it generates substantive amounts of cash flow from which it can make carefully selected acquisitions in order to generate growth.
All of this sounds wonderful, but any company following this path has to do two things. First it needs to make sure it is investing in the right niches, and second it needs to make sure its growth plans don’t come at the expense of operational performance. I would argue that Roper is doing both of these things very well.

Roper’s Industries Earnings Analysis

I’ll start with the second concern.

End of year backlog rose 15% to $953 million, and Roper is forecasting EBITDA margins to grow again this year. Investors need to be aware, however, that Q1 will probably be the weakest growth quarter of the year in terms of EPS (11-12%) because of some tougher comparisons and the impact of a loss of a customer in the industrial business. No matter, the full year guidance was for 13-17% EPS growth and 8-10% on the top line with mid teens growth in operating cash flow.

The company is able to grow cash flow and earnings more than revenues thanks to margin expansion and good cash flow conversion.

So while sales are expanding, its free cash flow conversion is growing at a stronger rate. Roper does a very good job of converting earnings into cash flow thanks to its asset light model, meaning that capital expenditure requirements tend to be quite light.

All of which leads to some impressive movements in cash flow:

So the answer to the first concern has to be that, despite acquisitions and a difficult macro-environment, Roper is managing its businesses well.

Roper Industries Growth Drivers

Having demonstrated its exceptional performance over the years, it’s time to look at its business segments and end drivers. Frankly the numbers above suggest that the company has been favorably investing in the right market niches, but is there more upside in 2013?

First here are the segments by operating profit split for 2012:

There is nice sense of diversification here and I think 2013 is looking good.

Firstly, in Medical Imaging the Sunquest acquisition has been successfully integrated, and when I look at companies like Varian Medical Systems (NYSE: VAR) or Elekta, the market for radiation oncology is expanding quite nicely. Indeed, Varian has plenty of upside potential through the growth of new products in radiosurgery and expansion of therapy into indications like lung cancer. Moreover, Roper has also worked with the likes of Accuray, a company that has been downgrading prospects recently, but ultimately Roper will benefit from increased volumes, and this is what Accuray is aiming to achieve.

I also like its exposure to Minimally Invasive Surgery (MIS), in which Covidien (NYSE: COV) is the leading player. Covidien raised guidance recently, and much of this was due to strong MIS performance. MIS remains under-penetrated in US hospitals, and expansion opportunities are very strong in emerging markets. Everyone worries about austerity measures, but MIS delivers cost savings via better patient outcomes and shorter hospital stays.

Revenues were flat in RF Technology for the year, but operating margins increased by 250 basis points leading to operating profit growth of 10%. With increasing software revenues Roper’s management believe it can expand margins and revenues again in 2013.

The Industrial Technology segment saw revenues rise 8% and operating profit up 15% for the year. With fracking and oil shale gas activity showing no signs of slowing, its fluid handling operations should do well. Indeed, if the US is about to see a renaissance in manufacturing spurred by cheaper energy then increased industrial production will then feed back into increased demand for energy. Furthermore if new housing starts are going to improve then demand for Roper’s metering and water handling solutions surely will too. It is a similar story in the Energy Systems and Controls segment where global LNG projects are creating demand for compressors.

Roper Industries Equity Analysis

LNG, oil shale, fracking, new house builds, MIS, radiation oncology etc. The list of favorable end market drivers is impressive, and provided the economy does okay in 2013, I think Roper is well positioned.

The problem is that the market seems aware of that fact and has priced the stock accordingly. On a forward PE of nearly 21x earnings, it is hardly cheap.  It is a high quality stock, but it is still exposed to some cyclical growth factors, and that means macro risk. I think it is fairly valued right now; I closed out my position when it hit my price target earlier in the year. Nevertheless I’m monitoring this with a view to buying back in with a $125 price target.

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