As much as investors and analysts talk about growth, you'd think that would be the be-all end-all of stock selection. The data tells a different story, though, particularly in the industrial sector. When it comes to industrials, at least the diversified conglomerates, it would seem that margin leverage, improving ROICs, and active capital deployment are what really drive shares over the long term. To that end, Roper (NYSE:ROP) still looks like an interesting stock to watch.
Another Unimpressive Growth Story
The theme for the first quarter of 2013 has been disappointing and dreary industrial earnings reports, and Roper certainly fits that theme. While reported revenue rose 4%, organic revenue was down 3% on an identical decline in volume. That puts Roper behind other conglomerates like ABB (NYSE:ABB) and Danaher (NYSE:DHR), ahead of GE (NYSE:GE) and Illinois Tool Works (NYSE:ITW), and in basically the same boat as companies like Dover (NYSE:DOV) and Honeywell (NYSE:HON).
If there was a growth “leader” for Roper, it was in the company's RF business which grew 2% this quarter. Energy was down 2%, industrial technology was down 7%, and medical was down a surprising 8% on an organic basis (up 25% reported, due to M&A). Generally speaking, Roper was bedeviled by weak demand for medical cameras and instrumentation in energy and industrial technology, as well as the loss of a water meter contract last year.
Margin performance was more encouraging. Gross margin improved nicely, up more than two points from the year-ago period on an adjusted basis. Operating income, too, posted a double-digit gain (up 11%), with operating margin up a point and a half. While the operating margin was a little better than most analysts expected, the revenue shortfall led to an operating miss and the company's reported beat versus consensus was due to items like tax rate.
Often On The Hunt, But The Quarry Is Getting Pricey
Like Danaher (as well as Illinois Tool Works and GE), Roper has been an active and avid deal-maker for a long time now. The company has a solid record of integrating its purchases, generating a good internal return on the purchase price, and then managing those business well over the long haul.
Even so, I'm a little concerned about recent trends. Roper paid $1 billion (cash) for Managed Health Care Associates – a provider of technology and services for alternate-site healthcare providers (which basically means any place that isn't a hospital or doctors office). In most respects, this is a very typical Roper deal – it offers technology-based solutions that drive down costs for users and has a strong recurring revenue base.
Roper paid about 10x EBITDA for this deal. Although that's not out of line at all for healthcare technology deals, it does mean that the company has recently spent close to $2.4 billion in recent months for about $240 million of EBITDA. While the implied multiple is below the company's multiple, it does narrow the expected internal rates of return and put more pressure on the company's lean operating and integration skills.
It does sound as though the company will be taking a breather – management commented that it sees its deal capacity as about $400 million to $500 million for the remainder of the year.
Restoring Organic Growth Could Take Some Time
If I have a big concern with Roper, it's that investors may not be patient if and when the company sees an ongoing sluggish growth environment. I'm not a big believer in the second-half rebound story, and I think that could pressure companies like Roper where the expectations typically call for ongoing growth and margin expansion.
I think Roper's experience in medical and scientific instrumentation, combined with what we've heard/seen from others like Danaher, GE, Thermo Fisher (NYSE:TMO), and Waters (NYSE:WAT) argues for a challenging 2013. Likewise, I do believe instrument demand in industrial tech and energy could disappoint as companies continue to be very cautious with their capex and spend largely only for replacement/maintenance and not growth.
The Bottom Line
There are more than a few similarities between Roper and Danaher. Danaher is much larger and Roper sports a much larger operating margin, but they've both highly diversified conglomerates that make M&A a key part of their growth plans. They both have high free cash flow margins relative to the industrial sector (Roper's in the high teens, Danaher in the mid-teens), they both have a solid record of ROIC improvement (but not as high of returns as you might expect), and both carry premium multiples due in large part to expectations of ongoing margin improvement and cash flow growth.
Both also look similarly valued relative to their expected cash flow streams. I do believe that Roper can be a growth leader in the industrial space, growing revenue and free cash flow in the high single-digits, and that works out to a fair value around $125 today. While I think there are cheaper stories to be found, Roper is the sort of stock that tends to do quite well over time, and I wouldn't expect a big discount unless the economy/stock market really pulls back sharply.
At the time of writing, Stephen Simpson owned shares of ABB in his portfolio.