Roper Technologies: Industrial Titan to Software Giant - [Business Breakdowns, EP. 108]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. and we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. This is Zach Fuss, an investor at Irenic Capital. And today, we're breaking down Roper Technologies. Roper is a fascinating case study in how an old industrial business can pivot into a new world focused on software and technology. Roper was founded in 1890 as a manufacturer of industrial equipment and home appliances. But today, it is one of the most profitable software businesses in the world. Much of the pivot and subsequent value creation can be credited to Brian Jellison, who took over in 2001.

1:25To Breakdown Roper, I'm joined by Joseph Shapochnik, Portfolio Manager of the TCW New America Premier Equities Fund. We discuss the business's roots, Jellison's acquisition strategy, and how Roper compares to other niche software acquirers like Constellation Software. Please enjoy this breakdown of Roper Technologies. Joseph, thank you for joining us to Breakdown Roper. It's a household name to many, but to the general market observer, they're somewhat unfamiliar with this massive company. So I think maybe just to kick things off, provide a basic overview of what the business is, what it does, how big it is.

2:07Zach, it's great to be with you. We're frequent listeners of Business Breakdowns, so it's a real honor. This business is a great example of the types of companies we've owned for a long period of time. Roper is a publicly traded US -based operator and acquirer of mission -critical niche vertical market software and technology businesses. Relatively big company, the company has an enterprise value of $52 billion. On a trailing 12 -month basis, Roper has generated $5 .6 billion in total revenues and $2 .25 billion in total EBITDA. Based on last year's EBITDA, it is the seventh largest software company in America, larger than Workday, CrowdStrike, or Snowflake.

2:53Vertical market software comprises about 75 % of total sales, while medical and water technology comprise the remainder of the portfolio. About 80 % of total sales are recurring, while the remainder are highly reoccurring and relatively acyclical. These businesses include the leading provider of ERP software for federal contractors, Dell Tech, and the leading provider of time and billing software for nearly all of the largest law firms in the country, Adderant. Roper utilizes a single measure to weigh all internal and external investments. They call it cash return on investment or CRI. I'm sure we'll dig into that in more detail shortly.

3:38top management is focused on redeploying the company's free cash flow to the acquisition of mission critical, high margin, highly recurring revenue businesses that generate consistently high CRI cash return on investment that is higher than the company's. I think it's also worth pointing out that these businesses typically grow at an organic growth rate of five to 10%. So not your typical high growth software businesses, more of the predictable, steady growth businesses that you might find in selected areas of software. Since the appointment of the company's former CEO, Brian Jellison, really the pioneer of the company's current business strategy in 2001 to the close of trading on April 11th of this year, Roper has compounded its per share equity value at nearly 16 % annualized relative to the S &P 500's 8 .5 % annualized return over that period of time.

4:37So Roper has been a 26 bagger since 2001. That's an exceptional summation of the business. And one of the most fascinating things to me about this particular business is how we got here from where we started. Maybe just give us an education on the business's history and the importance of Jealouson and pivoting the business away from its legacy roots. You make a great point. Roper was founded in the late 1800s and for its first 120 years was principally a manufacturer of industrial equipment, pumps, and home appliances. A new leadership team took control of the company in late 2001 and worked to shift the company's focus toward improving cash returns on investment by driving significant operational improvements and by acquiring high -quality, niche -focused, high -cash return businesses that generated recurring revenue.

5:38Over the next five years, so from 2001 to 2006, the company purchased progressively higher cash return on investment businesses that were principally at the time focused on niches in the industrial space and in the medical technology area. As a part of acquiring one of these industrial businesses, Roper received with that business a freight matching data analytics business called Dial -a -Truck, or DAT for short. DAT was and is the largest freight matching data network in the United States, which at the time of the acquisition in 2003 had over 18 ,000 customers. That was really an afterthought at the time of the 2003 industrial transaction.

6:31And today is probably more valuable than the entire business that was purchased in 2003. And at the time, that comprised approximately 20 % of the total revenues of that business that was acquired. We believe that Roper gained its first exposure to the cash flow benefits or the attractiveness from a cashflow perspective of software businesses through its experience with owning and operating the dial -a -truck asset. In 2008, the company acquired its first software business and over the next 14 years purchased 15 software businesses, all from private equity for a total investment of $20 billion.

7:16These businesses include management software that managed independent property and casualty insurance agencies, human capital and business operation management software, which is used by over 10 ,000 educational institutions in the United States, and the leading provider, as we talked about, of time and billing software for 97 % of the largest law firms in the United States. The common thread is a focus on acquiring the leading provider in that particular niche area of a software market. The company had multiple growth drivers, that the revenues were recurring, that the business had negative working capital and high margins, and that they were acquiring a great team that had excellent prospects to compound free cash flow for a long period of time.

8:09It's become conventional wisdom in a lot of ways that software makes for fantastic businesses. High returns on incremental capital, high margins, high free cash flow conversion, negative working capital. And to the extent that you can redeploy that capital at high rates of return, you can really create a ton of value. I was curious if you know more about Brian Jellison's background, which in my studies suggests it was mostly industrially focused and how he came to really appreciate the financial power of these software businesses. Brian had worked at GE and was an executive vice president at Ingersoll Rand, nearly became CEO of Ingersoll Rand.

8:55But over time, he really grew dissolution with the bureaucracy, the constant meetings, the process reviews that were taking place at these big industrial companies. He was just fed up with how little time was spent on actually focusing on creating shareholder value. Jellison was wickedly smart, opinionated, unconventional, and hard charging. My suspicion is it really rubbed people the wrong way at these big companies. At the age of 55, Jellison got the call to become CEO of a small public company, which turned out to be Roper. And in November 2001, he jumped on the opportunity. For him, it was an opportunity to implement everything he had learned about leadership, building businesses, and creating value in an environment that was unfettered by what he viewed to be useless and cumbersome bureaucracy.

9:59He inherited, at the time, a relatively healthy industrial business that was focused on manufacturing pumps, control systems, and digital imaging equipment. And in 2001, total sales for the company were about a half billion dollars and EBITDA was $125 million. He immediately instituted a number of changes. First, like several of the executives that have been profiled in The Outsiders, Jellison adopted a single common financial measure that served to galvanize the company and create a common framework to assess investment opportunities, both internal and external. His measure, cash return on investment, or he called it CRI, is the ratio of cash earnings to gross investment, which includes the consideration of gross investment in property, plant, and equipment.

10:54He was of the belief that gross investment in property, plant, and equipment was a clear and certain call on future cash flows and was rarely accounted for by most management teams when they made an acquisition or they made a capital investment or a decision to invest in a new business or enter a new market. Jealouson understood that free cash flow multiples were directly related to the returns that a business generated. Improving the returns on a business would drive both a higher multiple on current cashflow and an acceleration in the rate at which free cashflow compounded in the future, a double benefit.

11:37CRI focused his businesses and managers on cashflow growth and disciplined investment. Jellison and his team were focused on improving the CRI of Roper's existing businesses by driving down working capital, managing CapEx carefully, and getting paid in advance as much as possible. He sought to ensure that acquired businesses carried significantly higher cash returns than the existing business so he would gain a natural tailwind through those acquisitions. The second significant change that he implemented was to the company's incentive structure. Instead of engaging in an annual negotiation with the company's dozen or so business heads at the time regarding bonuses and SG &A and budgets, etc., he detested that and talked about that all the time, talked about his dislike for annual negotiations with business heads about their business and budgets.

12:39He instituted a structure that paid out bonuses on a single metric, year -on -year improvement of the individual business units operating earnings or EBITDA. He felt this implemented the jockeying and gaming that invariably took place annually and focused the businesses on continuous improvement and profitable growth, or as he called it, variances. These changes resulted in remarkable simplicity and clarity. Roper had one measure for the quality of a business. Cash return on investment. One P &L for each business. Clear line of sight to the performance of each company that they owned. One metric for managers.

13:25Operating income growth on a year -over -year basis. One team responsible for M &A. top management led by the CEO at the head office in Sarasota, Florida. And one goal, free cashflow compounding at a high rate. So I think you do a great job capturing how he reoriented and drove his firm. From my understanding, he had some colorful interactions with shareholders, investors, the street. Are there any stories that you think particularly stand out as entertaining or informative? There are a lot of great Brian Jellison stories. I'll share a personal experience. I first met Brian at a very well -attended industrial conference in Chicago.

14:09He presented after many other industrial company CEOs had presented. And the incredible thing about the Jellison presentation was what he was focused on. He wasn't focused on talking about the macro environment. He wasn't focused on talking about the markets. He was really focused on talking about the performance of his company, the free cash flow that he was generating, the remarkable changes that they focus on cash return on investment were driving at his company, and the extent to which he was able to reduce the capital intensity and increase the cash flows of his company. And finally, his ability to pivot his business to become a more predictable, more recurring revenue business.

14:56These topics were not really discussed at the time by other companies or focused upon. These topics were really unheard of. So immediately, he distinguished himself and the company from others in the industry. And I'll never forget, he would cap off his presentation by reminding the entire audience that the EBITDA margins of his company were higher than the gross margins of all of the industrial companies that had presented that day at the conference. Just classic. A second story that I was told was Brian was marketing in New York with a well -known sell site analyst covering the industrial space.

15:39And in the meeting, one of the investors compared his performance and complimented him and said, the performance that you've generated is nearly as good as the performance Berkshire Hathaway and Warren Buffett has generated over that same period of time. Brian got angry. Brian got mad. He glared at that shareholder, and he grabbed a black marker and jumped up, got on a whiteboard, and proceeded to explain how the investor was completely wrong and how his record and Roper's record was far better than Berkshire Hathaway's record, far better than Warren Buffett's record, and proceeded to list all of the capital investments and acquisitions that had been done by Roper since Brian had become CEO and all of the decisions that Warren Buffett had made over that period of time and to explain in a quantitative way why that investor was wrong and why Brian and Roper had a better record than Warren Buffett.

16:48Another memorable part of Jellison and the way he ran the company was the way he ran a conference call and reported results. The presentations that you would see from Jellison on the quarter was focused on the metrics that he thought were most important. Of course, he would give an explanation on how the businesses had performed, but most importantly, he walked through how this translated to CRI and cash flow. And at the end of every conference call, of course, the company would provide investors with guidance. One of the funny things that he would say after he provided the cash flow guidance, he would say, for those of you that care about EPS, and then he would share the EPS guidance.

17:41That's the way he felt about EPS. For those of you that care about EPS, here's our EPS guidance. Jellison was not focused on EPS at all. And he thought that that was a measure that was not particularly important. He was completely focused on cash flow. And so in order to earn the right to interact with investors and sell -siders to that degree, you have to have a pretty purposeful and well -calibrated strategy for deploying capital. I'd be curious how he looked and assessed potential opportunities for acquisition. Jellison believed that there were three key dials, as he called them, that determined the productivity of a public company.

18:23The first dial is cash flow acceleration. Does the company accelerate the cash flow that it has generated by tapping into additional sources of capital and using those sources to accelerate the future cash flow of the company? The two sources of capital that he focused on were debt and equity. In the case of Roper, for every billion dollars of cash flow generated, the company invested a billion four in acquisitions or a 140 % acceleration. The second dial that he focused on is what is a company doing with the cash that they've generated and accelerated? The company can invest for the future, pay dividends, repurchase shares, or make acquisitions.

19:10In the case of Roper, 90 % of the cash flow that the company generated and accelerated was invested in acquiring new businesses. He felt acquiring new businesses built muscle. The third dial is the quality of the ideas that have been invested in. Are the acquired businesses superior to the existing enterprise as measured by cash return on investment? Is the existing enterprise's CRI improving because of these acquisitions? Roper improved its cash return on investment by over four times over a 10 -year period by employing this specific process. What would be what you would consider a good example that exemplifies that strategy and process?

19:58In 2003, approximately two years after becoming CEO, Jellison acquired Neptune, a leading provider of water meters and meter reading technology to the U .S. residential market for approximately $475 million. This represented about a third of the company's market cap and was a deal that Jellison had a very hard time getting past the company's board of directors. It was just so big and came just a couple of years after he became CEO. It was a really big bet. Neptune operated in a niche business, had a strong market position with about 35 % of the U .S. water meter market, and had 27 million installed units at the time.

20:48The business operated with substantial recurring revenue. About two -thirds of total water meter sales were for replacing existing meters, which of course is very attractive from Jellison's perspective. Neptune provided a unique technology that enabled automated meter reading, which would serve to accelerate the business's growth for a long period of time. Automated meter reading, or AMR, had penetrated just 10 % of residential meters at the time. The financials of the business were extremely attractive. Gross margins were in the mid -40s. EBITDA margins were 29 % versus Roper's 21%. percent. CapEx was a paltry two and a half percent, far lower than the company's CapEx.

21:35And because meters were billed to order, the company carried very little inventory. So very little cash was tied up in inventory. This was a highly cash generative, high CRI business. Roper paid approximately eight times EBITDA and continues to own this high return business that has continued to grow at a high single -digit organic growth rate for the last 20 years. A year after acquiring his first acquisition, Roper acquired Transcor, a transportation products and services company, for approximately $600 million, or about a third of the company's market cap, the second very sizable acquisition that Jellison engaged in in a relatively short period of time.

22:24Transcor was a leading provider of automated tolling services, equipment, and RFID tags for municipalities, and the owner -operator of the largest freight matching data network in the United States. Our belief is that the company had one significant competitor in the tolling space in the United States, and with 18 ,000 customers at the time, really didn't face significant competition in the freight matching network software business. So you can see the niche orientation of this company and you can see why this business really had significant tailwinds. The management team believed that the business would benefit from the growth of tolling in the United States, a secular shift to RFID readers and tags, and in the wake of 9 -11, an increased interest in asset tracking and security.

23:20Greater than 50 % of the company's sales were tied to long -term contracts with municipalities associated with designing, building, and operating tolling systems and subscriptions to the freight matching network. From a financial perspective, the business showed similar profitability to Roper from a gross margin and EBITDA perspective, but far superior cash returns on investment. The two transactions that the company engaged in collectively represented a billion one of invested capital, similar to the company's market cap when Jellison took over the company in 2001 and dramatically reduced its dependence on the classic cyclical industrial markets and set it on a path of building a highly recurring, economically resilient, and free cash flow compounding machine.

24:10A year after closing Transcore and four years into the transformation, EBITDA and free cash flow had risen by two and a half times and Roper's stock had beaten the market return by about four times. Over the next three years, the company deployed capital to the acquisition of medical products companies and its first real software acquisition, which is Seaboard. Seaboard is a software -enabled access controls business that serves the housing market, food service market, college campuses, and hospital campuses as well. The company had extremely high customer emission rates, in excess of 95%. Working capital and banks were far lower than that, far lower than Roper had been accustomed to, and EBITDA margins were far higher than the company average.

25:02Seaboard was one of the highest CRI businesses Roper had acquired and likely opened management's eyes to the attractiveness of software businesses. You've cited through this conversation a handful of examples that looking back have been successful, but as the company gets bigger, the ability to redeploy the capital that it produces at high rates, I presume would become increasingly difficult. How are they able to identify opportunities in a world today where it's just a lot more competitive and they're a lot bigger. There's no doubt that's true. The first advantage they have is that they can be extraordinarily selective.

25:41They have no pressure to engage in a transaction. There's no clock on them. Additionally, Roper can be industry agnostic. The focus is really to find the highest quality businesses with the highest cash returns they can find. Second, the Roper team is focused on a relatively narrow segment of the software market, which isn't for all acquirers. For a business to qualify and to interest them, the company must have a high cash return on investment, grow revenues in a relatively tight range. They focus predominantly on businesses that grow mid to high single digits or low double digits on a consistent basis, on an organic basis.

26:28Businesses that produce very high EBITDA margins north of 40%. Businesses that have high cash flow margins and dominate a specific niche that has growth opportunities and relatively low levels of competition. It really takes a lot for an asset to meet the company's unique criteria, which isn't the criteria that most people are focused on. Third, for businesses that are looking for a permanent home, there aren't that many companies that can write a $5 or $10 billion check and execute diligence as quickly as Roper can. I think fourth, quality software businesses should perform better under Roper's ownership than most others.

27:17so the multiples that Roper can pay in some cases perhaps can be more than others can justify. Roper really provides these businesses with a permanent home and the ability to make long -term investments. Roper's governance system provides these teams with appropriate incentives to grow and invest for the long term. The teams of the acquired businesses are not forced to optimize for a private equity sale, which will take place in three or four years or two years in some cases, the company's customers and prospective customers can rest assured that the company will be able to act in the customer's long -term interests.

27:58So from that perspective, Roper has a number of advantages for other acquirers, which gives it the opportunity to selectively make great acquisitions in an environment that I think you correctly articulated certainly is more competitive than it was 10 or 15 years ago. And then I guess the natural question after that is, once they do acquire these companies, what is it about the ownership structure and the way that they manage them that kind of enables them to grow and expand margin? The company operates a very decentralized business model. As we talked about, the company has 27 individual businesses and 27 presidents.

28:40Roper has a group of group executives that stay close to these business presidents and ensure that the company's common standards are applied across all of the companies, including cybersecurity, talent management, and bringing in outside resources as they're needed to assist these presidents. The company has strategic reviews every three years to review the company's growth plans for the next five years. They check in on the company's growth plans on an annual basis, and the business has quarterly reviews which are focused on organic growth, EBITDA leverage, and cash flow and cash return on investment.

29:24Our view is that these reviews have become more formalized and more rigorous under the company's relatively new CEO, not that new anymore, Neil Hunt, who's implemented, I think, a significant amount of rigor to those reviews. Business unit bonuses, as we've discussed, are tied to year -on -year growth of EBITDA. When the business you buy is capital light, you can focus that business on the growth of EBITDA because EBITDA turns out to be a relatively good proxy for cash. And so I guess what I'm really trying to get at here is vertical market software businesses and software conglomerates are becoming more commonplace.

30:11If I compare this business to something like Constellation Software, which we've covered in past conversations, what are the key differences there? Constellation has been an unbelievable business run by an incredible management team and an incredible CEO. What a record. There are a lot of ways to get to heaven, and Roper certainly has a different approach relative to Constellation. I think the first key difference is that Roper is focused on larger scale M &A. So transactions in the $2 billion, $4 billion, $5 billion range is very much where they're focused. Constellation acquires many, many small companies and on occasion, a large company.

31:00Constellation acquires businesses very frequently. Roper does it every year or so. So the frequency is different. The size of deal is different. The strategies are different for M &A. As you think about it, Constellation has decentralized M &A across the world. They have folks in Spain and Japan and Sao Paulo executing M &A transactions. Roper does all of the M &A out of the head office in Sarasota, Florida. M &A is run by Neil Hunt, the CEO of the company, and a relatively small team. So differences in the way deals are executed. Roper predominantly focuses on acquiring businesses from private equity.

31:43I don't know that the company has done a deal that has not been from private equity in the last several years. Constellation acquires deals from many, many different types of sellers, including public companies that are selling businesses. So the sourcing is different. Roper focuses on assets that are in the United States. Constellation is more global in its acquisition strategy. Roper is focused on only investing or acquiring high quality businesses and willing to pay a fair price for those assets. Roper is very risk averse in terms of business risk. CSI is more willing to take on a business that isn't growing or perhaps is even producing negative growth if the company believes the returns justify taking that action and if they believe they can infuse it with best practices that could potentially improve the trajectory of those businesses.