Roper Technologies Inc (ROP) — Q3 2016 Earnings Call Transcript

Thank you, Audra, and thank you all for joining us this morning as we discuss the third quarter financial results for Roper Technologies. Joining me on the call this morning are Brian Jellison, Chairman, President and Chief Executive Officer; John Humphrey, Executive Vice President and Chief Financial Officer, and Paul Soni, our Vice President and Controller. Earlier this morning, we issued a press release announcing our financial results. The press release also includes replay information for today's call. We have prepared slides to accompany today's call which are available through the webcast or also available on our website. Now if you will please turn to slide two. We begin with our Safe Harbor statements. During the course of today's call, we will be making forward-looking statements which are subject to risks and uncertainties as described on this page and as further detailed in our SEC filings. You should listen to today's call in the context of that information. And now please turn to Slide 3. Today, we will be discussing our results for the quarter primarily on an adjusted non-GAAP basis. A full reconciliation between GAAP and adjusted measures is in our press release this morning and also included as a part of this presentation on our website. For the third quarter, the difference between our GAAP results and adjusted results consists of two items. First, a $2.2 million purchase accounting adjustment to acquire deferred revenue relating to software acquisitions. This represents revenue that those companies would have recognized, if not for our acquisition. Second, a $0.9 million debt extinguishment charge related to the replacement of our former credit facility with a new $2.5 billion facility that closed in the quarter. And now, if you will please turn to Slide 4, I'll turn the call over to Brian Jellison, Chairman, President and Chief Executive Officer. After his prepared remarks, we'll take questions from our telephone participants.

Thank you, Rob, and good morning, everyone. We'll begin with the Q3 enterprise results. We achieved record numbers across the board in the third quarter. Our orders reached an all-time high of $929 million, and if we had finalized the MTA order just a couple of days earlier, we would have recorded our first $1 billion order quarter. Revenue was strong, with net earnings also reaching a record EBITDA cash flow. Revenue increased by 7% to $947 million, which provided us with 2 points of organic growth despite challenges in the oil and gas sector. Foreign exchange impacted us by 1 point, while acquisitions and divestitures contributed positively with a net gain of 6%, as this was the last quarter without the full effects of the divestments. Growth came primarily from our medical, RF technologies, and software businesses, including Neptune. We had an exceptional quarter, which will be elaborated on shortly. The declines in oil and gas were in line with our expectations, anticipating a drop of around 20%, and that’s what we observed. Gross margins improved by 60 basis points to 61.3%, and EBITDA increased by 8% to $328 million. Our net earnings reached $169 million, yielding a DEPS of $1.65, surpassing our guidance. Free cash flow surged by 40%, marking an incredible quarter, with year-to-date free cash flow up by 11% and 40% for Q3 alone. We announced our acquisition of ConstructConnect today, which is set to close this week. This acquisition represents a significant addition to our business as it operates a SaaS network for the pre-construction industry, and we will provide further details later in this call. We experienced robust cash performance this quarter, achieving record results along with this acquisition announcement. If we look at the income statement, orders increased by 4%. Our book-to-bill ratio stood at 0.98, which is acceptable given the variability in activity. Had we been able to book the MTA order, our book-to-bill ratio would have reached 1.05, underscoring the strength of our core orders. There was nothing particularly unusual in the quarter, but the typical fourth-quarter delivery schedules were not as strong as anticipated. Revenue increased by 7% and gross profit rose by 8%. Our gross profit margin is up by 60 basis points. The operating income margin did decline slightly to 28.5% due to acquisitions and amortization but remains impressive. As you will see on the next slide, our EBITDA margin actually increased by 30 basis points, highlighting the strength of our cash-focused business model. Our net earnings rose by 4%, and the tax rate was aligned with our expectations. Comparing operating and EBITDA margins, while we have not historically led with these figures, our EBITDA margins have made notable gains from 32.5% in the third quarter of 2014 to 33.4% last year, and now to 33.7% this year. Operating cash margins have grown by 120 basis points over two years, and gross margins are also on the rise. Focusing on operating profit margins, where non-cash amortization can mislead, we are emphasizing the improvement in our EBITDA margins, which were up by 30 basis points. We continue to see strong cash flow performance without signs of slowing. We reported an operating cash flow of $317 million this quarter, with both operating and free cash flows up by 40%. Year-to-date operating cash flow now sits at $731 million, an 11% increase despite a challenging environment in our industrial and energy sectors. Our conversion rate has been remarkable, with a year-to-date conversion of operating cash flow at 146%. Our asset-light business model, which experts said couldn't improve further five years ago, continues to show significant progress. Inventories have decreased by 80 basis points, receivables are down by 150 basis points, and payables and accruals have increased by 160 basis points. Two years ago, we had 5.8% net working capital to revenue, and now we stand at 1.9%, reflecting a 67% reduction over two years. The quality of our recent asset-light acquisitions, alongside our commitment to improving our operations, has greatly enhanced our cash compounding and capital deployment capabilities. Looking at our financial position, we now have the largest balance sheet we've ever had, which opens up capital employment opportunities. We possess an undrawn revolver of $2.5 billion alongside $882 million in cash, totaling nearly $3.4 billion in available capital. Post-acquisition, our acquisition capacity remains around $2.8 billion. Since January 1, 2015, we have deployed capital amounting to $2.7 billion. The strength of our cash position and the flexibility provided by our new credit facility equips us for a promising acquisition pipeline. Our net debt to EBITDA ratio stands at just 1.7, and post-acquisition, remains around 2. This gives us considerable room to pursue transactions that will enhance shareholder value. Now, we will review the segment performance across our four categories as previously reported. Looking at Q3 performance in the energy segment, the EBITDA margin was 29%, with industrial tech at 32%. The margin performance in these challenging markets has been impressive, showcasing our ability to execute effectively. In 2003, combined revenues for these sectors totaled about $377 million while this year they are at $303 million, yet EBITDA margin slightly decreased from 32% to 31%, demonstrating our ability to sustain profitability amid declining revenue. Additionally, our future growth is increasingly anchored in RF, application software, medical software, and medical product businesses, accounting for nearly 75% of our total EBITDA. These divisions have shown strong growth, with EBITDA increasing from 39% to approximately 41% over two years. The controls and energy systems segment now represents under 10% of the company, with organic growth down by 13% as we anticipated. Although this segment is down, it has performed slightly better than in the second quarter and we expect similar trends in the fourth quarter. Profitability remains strong with operational margins at 25.4% and EBITDA margins at 29.2%. We foresee oil and gas remaining down by another 20% in this segment, similar to the previous quarter, with no significant growth expected this quarter. However, margins should improve. Energy segment operating profits started the year at 20.4%, climbed to 22.5% in Q2, and have reached 25.4% in Q3, with further increases expected in Q4. These segments still present a valuable opportunity for us, representing less than 10% of our total revenue. In terms of the industrial technology segment, this will be our last quarter discussing the divestiture of ABEL. Adjusting for this divestiture, the segment was flat, even with the upstream oil and gas component down 35%. This was largely offset by double-digit growth at Neptune, which continues to capture market share, and strong demand for the R900 automatic meter reading technology with numerous upgrades securing significant wins. Our $50 million R&D investment over the past three years in Neptune has positioned us for substantial advancements in the coming years. We have also seen improvement at Roper Pumps, and while we expect better results in Q4, some upstream-related businesses remain impacted. Overall, the segment is performing adequately, and we predict similar performance in terms of revenue and margins in Q4. Meanwhile, the RF technology and software segment is increasingly characterized by three components: RF products, tolling operations, and application software, now including ConstructConnect. This segment experienced a 20% revenue increase and a 26% rise in operating profit. The OP margin is at 31.7%, and the EBITDA margin rose to 38%, revealing strong organic growth of 7%, offset by a foreign exchange headwind. Demand in tolling and traffic projects in states like Florida, Texas, and Pennsylvania remains robust. Our recent relocation of the freight matching operation to a more suitable area in Portland has enhanced our capabilities. Additionally, we have seen significant growth in RF products largely due to demand in the senior living sector. The toll and traffic segment has received notable orders, and we strengthened our position with a $70 million MTA project focused on converting nine bridges and tunnels. The anticipated growth in toll and traffic is expected to continue into Q4 and 2017. The software segment shows strong overall performance, with mid-single digit organic growth across all areas, giving us positive momentum for 2017. Our acquisition of ConstructConnect for $632 million, which includes about $150 million in revenue and favorable EBITDA margins, reflects our strategic alignment within this space. On to ConstructConnect, we shared a detailed press release today. It's an extraordinary business with an impressive network showing substantial bid activity. The cloud-based technology allows users to stay informed on upcoming projects and contractor details, creating a highly interactive experience. Our collaboration with On Center will enhance the offerings and contribute to growth in the pre-construction industry. This business based in Cincinnati is set to contribute about $150 million in revenue next year and generate over $50 million in EBITDA, fitting seamlessly into our operational framework. ConstructConnect features a subscription model with high recurring revenue and minimal asset requirements, providing multiple pathways for future growth. This acquisition presents an excellent opportunity for us to continue shaping the pre-construction landscape. Moving to our medical and scientific imaging business, we recorded a 12% increase overall, with 8% attributable to acquisitions and 4% from organic growth. Despite some negative impact from foreign exchange, our medical businesses, which represent 85% of the segment, grew organically by 5%. Each of the separate business units in medical software and products saw growth throughout the year. Scientific imaging represented about 15% of the segment and experienced modest growth, with significant increases in the life sciences portion driven by cryo-EM market opportunities, while the physical sciences segment struggled. We anticipate ongoing mid-single digit growth in the medical segment, led by Alternate Site Solutions, while Scientific Imaging demand for new products remains strong. Many of these new products are expected for delivery in early 2017. Regarding our guidance update for Q4, we expect earnings between $1.77 and $1.89, which is a narrow range considering our financial strength and share count. Seasonal effects in the industrial and energy sectors may not benefit us this year, although we could adjust upward if normal seasonality occurs. The MTA project’s ramp-up will significantly influence our performance, as its completion by January 1 is critical. Customer preferences surrounding delivery continue to show some hesitancy in the industrial and energy markets. Our full year projections suggest a range of $648 million to $660 million, with most estimates clustering around $655 million to $660 million. Cash flow conversion remains impressive at around 140%, allowing us to manage headwinds while anticipately achieving 5% to 6% growth in revenue and EBITDA for the year. In summary, Q3 showcased record orders, revenue, net earnings, EBITDA, and cash flow. Medical software, tolling, and Neptune were standout performers, even as energy faced challenges. Our EBITDA reached 34.6% of revenue, and we achieved phenomenal free cash flow. The MTA all-electronic tolling project is set to kick off in Q4, but substantial work is expected to carry into 2017. We also made a strategic acquisition with ConstructConnect, which, along with our combined portfolio, supports our continued capital deployment strategy. With exceptional cash performance this year and a strengthened balance sheet, we are well-positioned for 2017. I’ll now take your questions.

This is Andrew Krill on for Deane. I want to start off on ConstructConnect, this is the second meaningful deal you guys have done recently in Software-as-a-Service after Aderant. So I am just wondering if you could talk about market share within construction, and if there are any unique barriers to entry versus peers for the business.

Well, this is John Humphrey. So as far as barriers, I mean the barrier of course for a networks business is the strength and size of the network, and the ability for all of the different users to be able to transact business and grow their own businesses by utilizing the ConstructConnect network and software solutions. And I think it goes to the size of the network. When Brian talked about 800,000 users and 55 million invitations to bid every year encompassing almost 400,000 different commercial construction projects. I mean the size of the network and the combination that ConstructConnect has been able to put together between their different brands of iSqft, Bidclerk and Construct Data, and really turn that into a single integrated platform and that’s truly unique inside the industry. So from a competitive position. I think for most of those customers, the way that variable to grow their business and to bid on more projects and to win more, is through connection to the ConstructConnect network. And so that’s really the strength of that in the competitive position. There are a couple of competitors out there that also provide, particularly on the construction data side, but on the network and the integrated data, we really don’t think there is anyone of size there.

Okay. It is very helpful. And then just as a quick follow-up. Do you have any sense of potential accretion and then I guess kind of where you guys that EBITDA margin could eventually go versus the sort of 33% or so you are expecting next year.

Well, we still have a lot of work to do. I mean we are going to close on the transaction but it is worth thinking about it as probably somewhere in the $0.10 to $0.15 accretive for next year. We will be able to update you on that of course as we finalize the purchase accounting. And the margin profile here is also very good, right. We are talking about something that’s already in the mid-30% EBITDA margin. And so as it continues to grow, it will grow with high incremental margins. And so that’s how we see the margin progression over time as this network continues to get bigger.

I just want to add to the understanding that these acquisitions have a lot of non-cash amortization. So on a GAAP DEPS basis, people are looking at expensing that amortization and depressing what otherwise looks like earnings per share. The reality is, it will be very cash accretive. But on a GAAP DEPS basis it may only add $0.10 or $0.15. I think you get paid as a shareholder for monitoring what's happening to the quality of the cash earnings. The cash earnings of ConstructConnect will be great.

First, I want to congratulate you on a very strong cash generation quarter. My questions will obviously focus on DEPS. Regarding the medical cadence for the fourth quarter and energy, could you elaborate on your comments about what led to the downward adjustment in guidance for the fourth quarter?

I think two things in terms of the DEPS. It's just our view of that is that we are not going to get much in the way of seasonality. When we look to the orders that came in the third quarter, we get a lot of footprints and we call them booked and so they are booked with a quarter, shipped within the next quarter. And we didn’t see any uptick that would give us a reason to think we would have normalized Q4 seasonality, but we could be wrong about that, that would be upside that could happen to us. So, I think it's more than any one item and then we have been ready to go on a couple of projects that we expect and we are ready to go.

Energy is not particularly surprising but the medical cadence. Could you just expand upon that because I think your expectation was kind of high-single-digit growth as kind of an exit rate for fourth quarter?

Yes, Rob, I believe you are correct. This ties back to what Brian mentioned. When we examine the product orders, particularly for medical products, we anticipated a growth rate closer to 10%, but it's closer to 5%. This is compounded by the timing of imaging orders and deliveries. The life science instruments and components that Brian discussed are quite complex, unlike simply machining a pump. The process for converting orders to delivery can take 60 to 120 days, depending on yield and throughput, especially from certain suppliers. As we review the delivery schedules for imaging and medical products, we see a slight variance from our previous expectations. However, we still project this segment to exit at a mid-single-digit growth rate, which aligns with the trends we've observed over the past two and a half years.

Okay. So you see no underlying deterioration in the core organic growth rate of that segment?

No, we do not.

No, no.

Okay. And then in terms of the M&A pipeline, obviously you have transacted on a very interesting deal this quarter. But I mean what's the state of play in terms of how you look over the next, kind of 12 to 18 months in terms of capacities of these deals and the environment to get deals done. Because it has been, in the main, kind of a difficult environment to get deals done.

Yes. You know if you go back to January '15, in that 21-month period we have deployed $2.7 billion in capital. I mean in the next 21 month period or much sooner I would think that that kind of run rates are impossible. You know we have got hundreds of millions or billions of dollars of capital to be able to put to work and getting the new $2.5 billion revolver which is done, was a big deal because it's given us some flexibility around how much we can deploy at anyone point in time and that’s very helpful. So there are a number of small deals that we are engaged with at the moment and a couple of larger transactions which would be even bigger than ConstructConnect that we are involved with, we think are very attractive. So you never know, in terms of your word, cadence, how that will happen. But I would be very surprised if we didn’t deploy that capital in the next 12 months.

The final question is just around, you have heard this many times, but would you consider doing something akin to what some of your competitors have done, simply not competitors but public comps, in terms of perhaps just shifting to EPS excluding amortization.

Well, there's a lot of smiling in the room because that’s the proper way to measure us. I guess we are not interested in stepping on the SEC. Those people that are doing that, they can continue to do it for a longer period of time and if the SEC doesn’t say anything about it, that’s a smart thing to do because it's the proper way to measure the business. It's just not the way GAAP measures the earnings. So we had $50 million of amortization in the third quarter and what do we have, 101 million or 102 million of shares, you can do the math. I am apparently now allowed to say what that math generates. EBITA, earnings per share for the company will be and are spectacular.

Do you get the sense that given where rates are and when you are looking at deals, are you having to stretch a little bit more in terms of multiple because competitors who are looking at the same assets are able to do some funny math with rates being here in terms of returns?

Well, I wish it were funny math, but it isn't funny math. The difference is, we don't like to go above like four times debt to EBITDA, and those guys are willing to take on times at eight times EBITDA. So, they don't deploy much more equity in a transaction than we do; we just don't want to have seven or eight times debt to EBITDA. We are going to remain investment grade and to do that you want to be around four times debt to EBITDA and coming back to 3 or 3.5 or something. So you know we are very disciplined about wanting to and guaranteeing ourselves to maintain investment grade status. The prices that people are paying for things are really bifurcated. Oddly enough, the industrial assets are trading at really more than they're worth in a normalized interest environment in the M&A world, because they don't have a lot of EBITDA even though they all require a lot of capital spending to maintain that EBITDA. So those multiples are interestingly high. Then the asset light business trades at a premium to that but the arbitrage for us on the asset light businesses is more favorable than those people that are buying the more capital-intensive businesses. So something like ConstructConnect, it will be a long-term compounder of investment for us which is great, as opposed to the guys that are buying the capital-intensive businesses thinking that it looks like I'm paying a lot but there is the nature of their cyclical activity and when there is this higher number, this will happen. We will leave that field to everybody else. It is not where we're going.

Thank you. I just wanted to touch on Neptune as well. I mean the results this quarter, obviously very, very strong. There's this story out there, that has been out there for a while, fair or not, about a lack of investment. You talk about $50 million of R&D. Can you just talk about your positioning there on the highest technology type products, like on the AMI development and how you're capitalizing on your installed base? I mean the numbers speak for themselves but this has kind of been out there for a while and I guess, maybe give you guys a chance to address that.

Yes. I think $50 million was what we have done in R&D, not M&A. In the last three years, we have put $50 million of work there. We are also opening a new software development center for Neptune that will really help us and a lot of things we're doing. So we're not going to provide a lot of information about what we're doing but I can just suggest you that we have the best reading technology that’s available and has the highest integrity results. We have an enormous installed base and maybe people forget that the way our R900 product works, we can upgrade that, the AMI status. And there is a lot of ways to collect the technology but if you have got the right core unit that can use multiple ways of gathering the data, you will be a little bit ahead of the game. So we are able to do upgrades for people in the AMI arena that they always, if they ever migrated to it, they do that and we have won a lot of those. Over $30 million of that just in the third quarter. You saw other things. Mobile activity, you see Verizon picking us as the person that they are working with development on mobile technology. So there's a lot of different things going on and we are not going to provide more information than we have around that, but Neptune will have record performance in 2016. So if anybody thought it didn't have some kind of long-term reason for performing well, explain to me why they are growing so much.

Fair enough. John, in the last quarter, you mentioned that some smaller hospitals were taking longer to adopt Sunquest, which made sense given their size compared to your focus on larger hospitals. Can you provide an update on how that progressed through the third quarter? Has it stabilized, and is the customer base you are targeting continuing to show consistent capture rates?

Yes. It has been consistent. And you are absolutely right, in fact Brian talked about the order intake, right. So remember that fully two-thirds, if not more, of Sunquest revenue is recurring revenue in terms of maintenance on installed software that's already been out there. And so when we look at the order intake, it's a much smaller piece of their total revenue but when they look at their order intake, which is about the new Lab 8.0, it's about the new blood bank solution, it's the new outreach solution. So the nurses can start the testing process right at the bedside and be able to start that data flow and workflow to the lab right from the bedside. So all of those upgrades are driving that order intake to be a record level for the third quarter. It is true that on the lower end, the smaller hospitals and integrated solutions can make economic sense for them, but the competitive environment and the solution that Sunquest delivers is, it continues to be very good and our competitive position continues to be very strong, particularly in those larger hospitals.

I am wondering if you could expand a little bit on Sunquest. You talked about record orders. Maybe just the richness of this product upgrade cycle that we have seen and maybe give us a little bit of a preface as to what we might expect in 2017.

I think it's early to talk about 2017. We actually have a review coming up with Sunquest in about a month. So we will be talking about not only 2017 but importantly 2018 and 2019, and the plans that they have around the investments there. So one is what I was kind of just mentioning in terms of the continued on the upgrade side around Lab 8.0 and the new blood bank solution. But also wouldn’t ignore the investments that we have made around genetic testing and the workflows associated with that. So you really have the blood side which is the core lab, high volume testing environment that every hospital has to have. And I think of the other side, which is the anatomic technology and the emerging genetic workflows around genetic testing. That’s where we have made important investments with the acquisition of GeneInsight and continued R&D around to be able to make that workflow as efficient and as quick with getting information back to the doctor as timely as happens today on the blood side. And so for all those reasons, I think the Sunquest and our entire platform of hospital software solutions, which of course includes Data Innovations and CliniSys, and GeneInsight and a variety of other things, all of those businesses really deliver those software solutions to hospitals. I think their future looks very bright as a result of the investments that we continue to make there.

Yes. You can really see that when you look at that net working capital chart where you are down 5.8, people think you could never get lower and now we are 1.9. Certainly a lot of that as you get deferred revenue and you get paid in advance for work you do and most of the things that we look at these days have those qualities. So I thought, we get to zero ultimately negative at some point but I don’t see us going up. The amount of small niche businesses that work in kind of oligopolies where customer service is critical and then those that have the ability to have kind of a network effect, there are most of those things out there than you might imagine. Because when you are focused on product businesses, you don’t necessarily see some of these kind of things. But all of the people that are involved in transactions and banking businesses and then private equity businesses, kind of meddle what we favor, what we look like. And so the funnel what we have of incoming opportunity is really amazing. And just incumbent on us to sort through that funnel, find the best management teams. So that’s the end market opportunities that are in favorably competitive environments. And believe me, there is more high quality things available that our balance sheet could tolerate. Fortunately, we have got a big enough balance sheet to capture some of them.

Brian, could you just talk for a minute or two about the New York MTA contract. I think you had mentioned there sites should be performed in the fourth quarter, kind of accelerated. Given the size of that contract, are we talking about maybe $20 million to $25 million of revenue in the fourth quarter and then the balance of the sites, the other six sites, does that all fall into the first half of '17?

No, I believe the commitment in the contract is clearly outlined regarding what has been agreed upon for release. It is expected to be completed by November 2017, as we have been informed. There is also the ramp aspect to consider, as we have been collaborating on engineering work to ensure that the overhead kiosk and related components being constructed are satisfactory. The rollout will begin gradually. I estimate that we might achieve around $10 million in revenue during the fourth quarter, with the total being approximately $72 million across the entire period. Ultimately, the installation and release of the technology will depend on their desired pace.

Okay. Understood. And just then just a last question, I have, just around MHA. There is a lot of noise around drug pricing, both generic as well as branded. And then also I noticed in the Slide that you had, that there was a suggestion that the alternative site solutions business would kind of be a leader here in the fourth quarter. Can you just kind of pull all that together? Has the noise around drug pricing impacted just the revenue stream in the pasture there at MHA, and then also is this alternative site solutions business being kind of the fourth quarter leader? Is there timing there or is there contract renewals or what would drive that in the fourth quarter?

Yes. Sure. So in terms of its contribution on the growth side, it was up in the 3% or 4% in the third quarter and we expect that to be modestly better in the fourth quarter. From a drug pricing standpoint, I mean you are right, that is something that we look at. A lot of the headlines that you see around drug pricing are really targeted for our being sold to the senior population. Remember MHA is around alternate site healthcare and the largest portion of their revenue is coming from skilled nursing homes, long-term care facilities. It's not really the headline prices around EpiPen or whatever else that you might read in the Wall Street Journal. It's really for kind of the longer chronic illnesses that are being sold through the MHA contracting vehicles. So, we do look at drug pricing. It's been lower than what we would have seen in years past but still positive in 2016. We're not counting on an awful lot of drug pricing lift as we think about the future for MHA. They continue to expand in their solutions in non-drug supply chains, including food and other things around long-term care facilities and other nursing homes. So they continue to expand that. And then they also expand their software solutions around data analytics. You have seen us make a couple of acquisitions that also serve the alternate site healthcare which are not GPO but are really around software solutions that allow those members and customers to run their businesses more efficiently. That's where we look for growth. We don't really count on underlying drug price increases as something that is going to drive our performance, although it does have an impact on our revenue.

Audra, we will have to follow up with Alex, I think. Well, thank you very much for joining us and we look forward to speaking to you again in about three months.