Published on January 30th, 2018 by Bob Ciura
Roper Technologies, Inc. (ROP) increased its dividend by 18% on December 18th. In doing so, it has now raised its dividend payout for 25 years, and as a result has become one of the newest members of the Dividend Aristocrats.
The Dividend Aristocrats are a select group of 53 stocks in the S&P 500, with 25+ years of consecutive dividend increases.
In order to become a Dividend Aristocrat, a company needs a strong business model, durable competitive advantages, and the ability to withstand global recessions. Clearly, the Dividend Aristocrats are high-quality dividend growth stocks. Making the list is no small accomplishment for Roper.
Even more appealing is Roper’s high dividend growth rate. Even among the Dividend Aristocrats, dividend hikes of 10%+ are rare, which makes Roper’s 18% dividend increase even more impressive.
This article will discuss Roper’s business, growth potential, and valuation.
Roper designs and develops software, including both software-as-a-service and licensed technology, and engineered products and solutions. Roper has a diverse portfolio of products and services, which it provides to a multitude of sectors, including healthcare, transportation, food, energy, water, and education.
Roper focuses on four main business segments:
- RF Technology (40% of revenue)
- Medical & Scientific Imaging (31% of revenue)
- Industrial Technology (17% of revenue)
- Energy Systems & Controls (12% of revenue)
The core RF Technology business provides radio frequency identification—or RFID—communication technology, software, and information solutions. This is a booming technology, that has a variety of uses, including toll and traffic systems, security and access control, campus card systems, card readers, and more.
The Medical & Scientific Imaging segment offers products and software used in medical applications, and high-performance digital imaging. Industrial Technology includes water and fluid handling pumps, leak testing equipment, flow measurement and metering equipment, and water meter products. Lastly, the Energy Systems & Controls segment produces control systems, testing equipment, industrial valves and controls, and inspection and measurement products.
Roper is in the unique position of generating strong growth, across all of its businesses. For example, total revenue increased 22% over the first three quarters of 2017. All four operating segments posted revenue growth in that time, led by 57% revenue growth for the RF Technology segment.
Source: Earnings Presentation, page 11
RF Technology revenue soared 61% last quarter. Of course, a great deal of this growth was due to acquisitions, including the Workbook takeover. Still, organic growth increased 4%, and segment operating margin expanded by 280 basis points last quarter.
Naturally, such strong revenue growth has greatly benefited Roper’s bottom line. The company beat analyst expectations on earnings-per-share, in each of the first three quarters of 2017. In addition, operating cash flow rose 31% through the first three quarters, compared with the same period in the previous year.
Roper has generated excellent growth rates over the past several quarters, and its growth should continue moving forward. After reporting third-quarter earnings results, Roper also increased its guidance for the full year. It expects adjusted earnings-per-share of $9.27 to $9.30, up from previous expectations of $9.12 to $9.30.
The company expects 22% revenue growth for 2017, including 5% organic growth. Operating cash flow is expected to exceed $1.15 billion.
Acquisitions are a key component of Roper’s growth strategy. It spent $8.6 billion on acquisitions, from 2011 to 2016.
Source: Stifel Investor Conference, page 15
Such a high level of acquisitions can be a red flag, if the company paid too high a price for under-performing businesses. But in this case, Roper’s acquisitions clearly built value. Roper looks for other high-margin companies, with high levels of recurring revenue. The bulk of the spending was focused on RF application software, as well as medical software and services.
Competitive Advantages & Recession Performance
Over the past 15 years, Roper pursued an asset-light business model, with a specific focus on software and engineered products and services. The company adopted this strategy to expand margins, by reducing capital expenditure needs, while also generating recurring revenue. This resulted in much stronger cash conversion over time.
For example, Roper generated a total of $1.0 billion of free cash flow, in the five-year period spanning 2003 to 2007. It is on track to generate over $4 billion in cumulative free cash flow, from 2013 to 2017.
Today, Roper generates a 60%+ gross margin, and more than half of total revenue is recurring.
This provides Roper with a tremendous competitive advantages. Its high margins and operational efficiency provide it with lots of cash flow, that can be used to invest to stay ahead of the competition.
Roper is a cyclical business. It has the capacity for very strong growth when the economy is expanding, but it also struggles during recessions. Earnings-per-share during the Great Recession are shown below:
- 2007 earnings-per-share of $2.68
- 2008 earnings-per-share of $3.06 (15% increase)
- 2009 earnings-per-share of $2.58 (16% decline)
- 2010 earnings-per-share of $3.34 (29% increase)
As you can see, Roper is not a highly recession-resistant company. Earnings-per-share declined 16% in 2009. If the economy were to enter a recession in the years ahead, Roper could see earnings decline. While Roper’s earnings exhibited volatility, it still grew overall, from 2007 to 2010. As the U.S. recovered from the Great Recession, earnings continued to grow.
Valuation & Expected Returns
Roper is a high-quality company, with strong growth prospects, thanks to the high level of demand for its technology. It should not come as a surprise, that the stock holds a premium valuation. Roper trades for a price-to-earnings ratio of 30.3, which is above the S&P 500 Index average. It is also significantly above its own valuation over the past 10 years.
In the past decade, Roper held an average price-to-earnings ratio of 22.2. As a result, the stock is valued at a premium of approximately 27%, to its average price-to-earnings ratio in the past 10 years.
As you can see in the above chart, Roper’s valuation multiple really accelerated over the past few years. A significant contraction of the price-to-earnings ratio, toward its 10-year average valuation for example, would represent a significant loss for buyers at the current price. Potential overvaluation is a risk that investors could consider before buying the stock.
The company is still likely to generate returns moving forward, from earnings growth and dividends. ValueLine analysts expect the company to grow earnings-per-share by 20% in 2018, and by approximately 9% per year through 2022. The stock could still generate satisfactory returns, thanks to its high earnings growth outlook. Annualized earnings growth of 10%+ is easily achievable. A potential breakdown of future returns is as follows:
- 4%-6% organic revenue growth
- 2%-3% growth from acquisitions
- 1% margin expansion
- 1% share repurchases
- 0.6% dividend yield
In this scenario, total returns would reach approximately 9% to 12% per year. However, a contracting valuation multiple would reduce these returns. For example, if Roper stock were to return to a price-to-earnings ratio of 24 to 28, the stock would have a fair value estimate of $222 to $260, approximately 8% to 21% below the current share price.
Roper has a high-quality business model. Double-digit earnings growth is not an unreasonable assumption moving forward. The stock is a Dividend Aristocrat, and 10%+ annual dividend increases are also possible, thanks to the company’s high earnings growth rate.
However, with a price-to-earnings ratio of 30, and a dividend yield below 1%, Roper does not seem to be an attractive purchase for value and income investors.