How to Invest in the Industrial Equipment Sector

If you have wondered how to play the anticipated resurgence in manufacturing in the U.S., the industrial equipment industry could be the place to look for stocks to buy. The logic behind this view is simple: If the economy is flourishing, manufacturing companies will look to expand capacity and spending on capital machinery will increase. At this stage general industrial equipment companies such as Siemens, ABB (NYSE: ABB  ) , Parker-Hannifin (NYSE: PH  ) , Honeywell International (NYSE: HON  ) , and Emerson Electric (NYSE: EMR  )  start to look attractive. Investors should also consider more niche market players such as vision machine company Cognex (NASDAQ: CGNX  ) or Roper Industries (NYSE: ROP  ) . It's time to look closer at the industry.

Source: Motley Fool Flickr Account.

What is the industrial equipment industry?

In essence, the industry represents any item of capital machinery that is sold to an industrial company in order to enable its manufacturing or processing activity. While this traditionally means hardware, investors should recognize that software and information technology are becoming an increasing part of the industry.


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Roper Industries Equity Research

Roper Industries  $ROP is one of the most interesting industrial stocks, not least because it appears to be more of philosophical concept than a typical industrial conglomerate. In essence, it's a collection of four disparate businesses that operate within their own highly profitable niche markets. The common philosophy behind each segment is that they are high-margin and highly cash generative companies operating with relatively asset-light business models. While this strategy has been working very well for Roper shareholders so far, is the stock a buy right now?

Roper reports full-year results
In order to quickly outline how Roper makes money here is a chart of its segmental operating profits in 2013.

Source: company presentations

Having disappointed in the previous quarter, Roper reported some better numbers in the fourth quarter resulting in adjusted revenue up 9% and net earnings up 11% for the full year. Moreover, there are six key reasons why Roper can do well in 2013.

Margins and cash flow, increasing software, and growing orders
First, Foolish investors should appreciate how well the management has increased margins and cash-flow generation. Roper's gross margin was around 58% for the full year, but note how it has increased over the last few years, particularly when compared to companies like Danaher   and Dover Corp $DOV .  The latter two are not perfect comparisons, but they do provide a good benchmark to judge whether Roper's gross margin performance is merely a function of the economy or not.

DHR Gross Profit Margin (Quarterly) data by YCharts

Clearly, Roper is outperforming its peers in terms of gross margin, so this isn't just about the economy.  Moreover, its free cash flow generation and conversion is outstanding. Roper generated $760 million in free cash flow last year, representing a conversion rate of 141% of its net earnings. Looking into 2014, management predicted that operating cash flow conversion would be 140% of earnings. Based on my calculations, and Roper's guidance for full-year EPS, its free cash flow will amount to around $8.35 in 2014. In other words, it's on a forward free cash flow yield of around 6%.

Second, one of the reasons that Roper is generating increased margins and cash flows is due to its increasing amount of software sales. On the conference call, CEO, Brian Jellison outlined that "If you look just like the SaaS businesses, pure software businesses, we get more than a fourth of the Company's EBITDA out of that." Moreover, he also argued that if application software was included, the figure would be closer to half.

Usually, software as a service, or SaaS, based businesses tend to generate recurring revenues over longer periods. Indeed, Jellison disclosed on the conference call that Roper has "a lot of recurring revenue in radio frequency and in medical" and the fact that deferred revenue jumped 12.6% to $209 million bears that out. This implies that Roper is increasing the amount of long-term value it gets out of its orders.

Third, Roper's order book looked good in the last quarter, its book-to-bill was 1.01 versus 0.95 in the fourth quarter last year.

Q4 2013	Order Book Growth
RF technology	11%
Industrial technology	3%
Medical and scientific technology	12%
Energy systems and controls	14%
Company	10% organic, 16% reported

Source: company presentations

Recovering businesses, underlying guidance is better, end markets improving
Fourth, the businesses that had difficulty in the previous quarters managed to recover well in the quarter. Imaging (medical and scientific technology) orders were surprisingly strong with a double-digit increase. Meanwhile, its nuclear inspection business, Zetec, was described on the conference call as being weak "as expected", but its orders "tell us that really the worst is behind us". These two nuggets of good news help to de-risk the stock somewhat.

Fifth, superficially Roper disappointed the market by issuing full-year EPS guidance of $6.05-$6.25 when the analyst consensus was $6.20. However, there is an extra tax charge of $0.20 in 2014, without this charge the guidance would have been a more impressive $6.25-$6.40.

And finally, prospects in some of its end markets are looking better. For example, its water pumps business, Neptune (industrial technology), will benefit from increased housing starts. According to Halliburton and Baker Hughes the U.S. oil and gas rig count will at least stabilize in 2014, and this could be a positive for elements of Roper's energy systems and controls segment.

Is Roper a good value?
On a P/E basis, Roper is not the cheapest stock in the sector.

ROP P/E Ratio (TTM) data by YCharts

Moreover, on a forward P/E ratio of around 22 times earnings, it's hard to argue that it is anything more than fair value at the moment. On the other hand, Roper is a high quality company and for the reasons articulated above, it has upside earnings potential in 2014. Foolish investors may want to keep an eye out for any buying opportunity should it dip from here.

Time to Buy Roper Industries

Industrial conglomerate Roper Industries (NYSE: ROP  ) serves end markets as diverse as toll roads, water handling systems,oil & gas drilling, and medical imaging. But Roper underperformed the market this year, rising less than 10%, and also recently cut its full-year guidance. Despite those setbacks, however, its management has successfully continued its long tradition of integrating acquisitions, while squeezing every last penny of profit from its ongoing businesses. Let's review five key reasons why the stock's current slump could actually be a buying opportunity.

Roper Industries lowers guidance
The company started the year expecting 13% to 17% in EPS growth, and 8% to 10% in revenue growth. But analysts have now downgraded their full-year expectations to 13.1% and 8.5% respectively. Essentially, Roper was forced to guide the market lower due to a combination of weaker-than-expected performance at its nuclear business, Zetec, and some weakness in oil & gas drilling activity in the US. The market didn't like these developments, but in the long run, Foolish investors just might.

Five reasons to buy Roper Industries
First, Roper's order book and backlog is in excellent shape. Orders grew 18% in the quarter, and with a backlog of more than $1 billion, there should be plenty of growth to come next year.

Second, the weakness at Zetec is due to some unexpected nuclear plants being shut down, and a corresponding lack of orders for its testing equipment. Roper's management expects these issues to continue into the fourth quarter, this part of the company could easily bounce back in 2014.

As for the weakness in US oil & gas drilling, the best way to gauge industry conditions would be to look at the oil services company Baker Hughes' (NYSE: BHI  ) North American rig count data. This metric is the most widely followed indicator of North American drilling activity. In other words, if Baker Hughes is reporting strength, then Roper could expect to see some future improvement, too.

Source: Baker Hughes presentations

The count seems to be stabilizing, and Baker Hughes believes it will only decline 2.5% in the next quarter. However, companies can still generate growth if they innovate, and Baker Hughes actually saw record revenues for its North American drilling services thanks to "innovative products and services".  In a similar vein, Roper has a new drilling product called DuraTorque, which is "doing very well" according to Roper's CEO, Brian Jellison. DuraTorque has good chances to succeed, because it's aimed at an area of the market (larger-sized directional drilling) that thus far hasn't lived up to Roper executives' expectations.

Third, Roper's most profitable segments are outperforming the rest of the company. Here is a breakout of its operating profits for the third quarter.

Source:company presentations

In the third quarter, energy operating profit declined 4% and its industrial technology profit was flat. On the other hand, RF technology saw profit rising 15% while its medical and scientific unit recorded a 64% increase in operating profits. The latter was helped by contributions from Sunquest, which makes medical information software. Nevertheless, organic revenue growth remained at 3%. As for its RF technology segment, Roper forecasts double-digit organic growth in the fourth quarter.

Fourth, a lot of Roper's other end markets are seeing strong growth. Medical imaging solutions and RF technology (particularly for toll roads) are forecast to have "solid growth" in 2014, according to Roper's management.

Moreover, if housing starts continue to climb, then Roper's metering and water handling solutions (industrial technology segment) should see some upside in 2014.

One of its peers, Watts Water Technologies (NYSE: WTS  ) , recently gave an outlook which I would only describe as being cautiously optimistic. Watts generates 60% of its sales from residential & commercial flow control products, so just like Roper's water handling systems, it relies on construction activity for its growth.

The increase in new US housing starts in 2013 has been a strong support to Watts' residential business, but housing starts have stalled to around 900,000 (annualized rate) due to interest rate increases in the US. Watts is predicting that starts will return to 950,000 by year end , and that "the anecdotal evidence we're seeing suggest that the nonresidential construction market is likely to turn sometime next year." If Watts is right, then Roper could see some, upside too .

And finally, Roper's management has managed to improve its operational performance, despite having to reduce guidance. For example, its cash flow conversion has gotten even better, enabling the company to keep its full-year operating cash flow guidance at $800 million. In addition, the Sunquest acquisition that Roper made in 2012 has bedded in well. Given Roper's acquisition history and current cash flow generation, you can expect more deals to come in 2014.

Where next for Roper Industries?
Roper's valuation doesn't look cheap in relation to some of its peers.

ROP P/E Ratio (TTM) data by YCharts

However, analysts have 12% earnings growth forecast for 2014. In other words, if it ends 2014 on "fair value," then the stock price will be up 12%, and there may be upside to these estimates.

Looking forward, Roper will want to see a snap-back in nuclear activity in 2014, some stabilization in US oil & gas drilling, and a pickup in US construction activity. All three look like decent assumptions. Roper expects the nuclear plants to be reopened, the Baker Hughes data is suggesting conditions are bottoming, and housing construction continues to grow.

There's a strong argument that Roper's current dip makes the stock attractive. At least, I hope so -- because I bought some.