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Morningstar | Roper Continues Its Incredible Record of Compounding Cash; We Raise Our Fair Value Estimate by 34%. See Updated Analyst Note from 22 Apr 2019

After taking a fresh look at Roper’s fundamentals, we raise our fair value estimate to $329 per share from $246 per share. Roper’s management team has done an exemplary job of compounding shareholder value, with a strategy focusing on buying moaty businesses at reasonable valuations. We see no evidence of diminution in its corporate culture after the passing of former CEO Brian Jellison (who was responsible for developing Roper’s acquisition framework), or a deceleration of any of the drivers that propelled its stock to double the returns of the S&P 500 for the period from 2003 until 2018.

The primary levers in our new fair value estimate include our revised moat rating, which we raised to wide from negative, a lengthened time period in our explicit forecast to 10 years from five years (which mirrors how we generally value enterprise software firms), and increased incremental margins assumptions as we think the firm will continually transition away from its legacy industrial portfolio in favor of software technology. We are, however, maintaining our Exemplary stewardship, stable trend, and medium uncertainty ratings.

Roper acquires software companies with large amounts of deferred revenue. Large quantities of deferred revenue exist because many software businesses receive cash far in advance of when services are rendered. Roper uses this cash to invest in businesses at incrementally higher rates of return. Even though we think Roper’s economic moat is more than just the sum of its parts, we still believe Roper’s individual constituents have strong and durable competitive advantages.

About 60% of Roper subsidiaries have recurring revenue bases in oligopolistic, niche markets with small total addressable markets. Roper’s subsidiaries’ revenue bases are protected by strong switching costs that frequently post customer retention rates of over 95%. Roper’s businesses frequently don’t own their own infrastructure, which further contributes to the asset-light nature of Roper’s business model. From 2003 to 2018, Roper’s net working capital as a percentage of sales dropped from 18% to negative 3%. As a result, Roper’s businesses don’t require additional capital to continue growing, and we estimate maintenance capital expenditure (inclusive of capitalized software) frequently numbers around 1% of sales.

Other moat sources we see include network effects. Network effects are present in businesses like TransCore, which offers the industry’s first interoperable RFID service that provides access to all public toll roads and bridges in North America. For example, more touchpoints benefits toll operators with the added ability to accurately collect and reliably process toll revenue. The more tolling solutions are added to the network, the more toll operators can monitor every aspect of its toll operations and use that data to make decisions in real time, including informing drivers of potential traffic bottlenecks or automobile accidents. From the customer standpoint, a more robust, nationally interoperable toll network eliminates the need for maintaining multiple transponders while also providing drivers with access to the lowest available toll rate.

Finally, we observe an intangible asset moat source in Roper’s Neptune business, which boasts a large installed base of smart meters sold to water utilities. Smart meters solve a specific customer pain point because it eliminates the utilities companies' need to force workers out of their vehicles and check their customers’ water meters, saving both time and expense (which to an extent, also indicates switching costs). Solving needs in this niche market gives Neptune the ability to exercise pricing power backed by long-term service agreements. The strength of this offering has allowed management to take profitable share gains.

In sum, we have confidence that the partnership between CEO Neil Hunn and CFO Robert Crisci will continue to faithfully apply Jellison’s framework and compound shareholder returns for many years to come.