Frontline Technologies Group, LLC (ROP) Earnings Call Transcript & Summary

Good morning. The Roper Technologies Conference Call will now begin. Today's call is being recorded. [Operator Instructions] At this time, I'd like to turn the conference call over to Zack Moxcey, Vice President of Investor Relations. Please go ahead.

Good morning, and thank you all for joining us as we discuss our acquisition of Frontline Education. Joining me on the call this morning are Neil Hunn, President and Chief Executive Officer; Rob Crisci, Executive Vice President and Chief Financial Officer; Jason Conley, Vice President and Chief Accounting Officer; and Shannon O'Callaghan, Vice President of Finance. Earlier this morning, we issued a press release announcing our definitive agreement to acquire Frontline. The press release also includes replay information for today's call. We have prepared a short presentation to accompany today's call, which is available through the webcast and is also available on our website. Now if you'll please turn to Slide 2. We begin with our safe harbor statement. During the course of today's call, we will make forward-looking statements, which are subject to risks and uncertainties as described on this page, in our press release and in our SEC filings. You should listen to today's call in the context of that information. And now if you please turn to Slide 3, I will turn the call over to Neil. After his prepared remarks, we will take questions from our telephone participants. Neil?

Thanks, Zack, and good morning, everyone. Thanks for joining us on short notice. This morning, we're excited to share with you the details of our most recent acquisition, Frontline Education. Briefly, Frontline is a leading provider of SaaS software solutions targeted to the U.S. K-12 education market. We're buying the business for $3.725 billion from Thoma Bravo. As part of the transaction, we received an approximate $350 million net present value tax benefit which yields a net purchase price of $3.375 billion or about 19x their 2023 EBITDA. Frontline is an exceptional business. The business is characterized by having high single-digit organic growth with north of 90% of the revenues being recurring in nature. This business has a great net working capital profile at negative 40% as a percentage of revenue. Given this net working capital profile and the 15-year tax benefit, Frontline will have unlevered free cash flow equal to roughly that of EBITDA, really exciting growth and cash conversion characteristics here. Importantly, Frontline has built a very capable Bolt-On Acquisition capability, a capability we expect to invest behind going forward. For calendar 2023, we expect this business to have revenue in the $370 million range and EBITDA around $175 million, yielding EBITDA margins north of 47%. We'll finance this transaction with a combination of cash on hand and the use of our revolving credit facility, the magnitude of which will depend on the timing of the closing of our industrial divestiture to CD&R. Pro forma for The frontline and industrial transactions, our net leverage will be around 2.5x. We expect the deal to close in the fourth quarter and be reported in our Application Software segment. Not surprisingly, Frontline meets all our acquisition criteria. To name a few, Frontline is a leader in the resilient K-12 education software market. This market like so many others, is one that is undergoing significant digital transformation. Frontline serves an important role of helping school systems operate more efficiently. We very much like the fact that Frontline has multiple durable growth drivers. They have very high gross retention rates in the mid-90% range and net retention rates in the 107 to 108 ZIP code. We love the stickiness of their solutions and the durable, diversified growth drivers. They have north of 90% recurring revenue, significantly negative net working capital, which yields very strong cash conversion and a dedicated, seasoned and passionate leadership team and employee base that comes to work every day excited to help improve the country's education system and develop the next generation of learners. So this is just another perfect fit relative to our capital deployment and corporate strategy. Let's turn to the next page, Page 4, and outline what frontline does. Next slide, please. Frontline is a leading provider of mission-critical K-12 administrative software. Their comprehensive K-12 Administrative Software is highly trusted and widely used that delivers real impact to school districts across the United States. Frontline has a national footprint with 10,000 K-12 districts, serves millions of educators and has a product portfolio comprised of 30 products. The company's products are bundled into 3 categories: Human Capital Management, or HCM, Business Operations Management and Student Management. As we look at our HCM offerings, which represents about half of their ARR, Frontline has a comprehensive state-by-state compliance set of offerings that helps districts recruit, hire, train and develop staff as well as the leading tool that helps with absence or substitute teacher management. For instance, last year, Frontline's tech offerings helped place about 29 million substitutes. Relative to business operations, Frontline offers purpose-built ERP for state and school district needs including capabilities to manage the increasingly complex landscape of district assets. This product category is about 20% of the company's ARR. Next is Frontline Student Management segment, about 30% of ARR. The company offers special program management solutions and student information systems. Finally, the company has invested in and is launching a powerful suite of data and analytical solutions with more to come on this in the future. The secular trend that cuts across all the Frontline offers is that K-12 districts are in the early stages of automating the workflows and processes. As we wrap up and turn your questions, Frontline is purpose-built for the K-12 education market, a market that is highly regulated on a state-by-state basis. Frontline has a national footprint of customers and the national distribution capability. They have high single-digit organic growth profile that is underpinned with fantastic retention rates, 90%-plus recurring revenues and long-term secular demand. And finally, they have a tremendous working capital and cash conversion profile. We're delighted to welcome Frontline to the Roper family, where we will be their permanent home going forward. Now let's turn to your questions.

[Operator Instructions] Our first question today comes from Deane Dray from RBC Capital Markets.

It isn't often that you get an acquisition that does overlap, at least in end markets, with an existing business. We've seen it with Sunquest. But here, there is potentially some overlap with Seaboard, which has a bit more exposure to the college market. But just are there overlaps with Seaboard? Are there any synergies, any scale there?

Very minimal. It's really the Horizon part, the K-12 part of Seaboard, where there's potentially a little bit of cross-selling opportunity for us. It's something that we very lightly explored to the diligence process, something that both Seaboard and Frontline are excited to explore. But -- as you know, in the Roper way, that will only happen if they're in their own self-interest for their company's benefit, they agree to do. It will be nothing that's forced from the center. But there is potentially to push the -- or if you will, the sell-through, the Horizon capability through the large national footprint of Frontline.

That's helpful. And then just as the follow-up, since the K-12 is a very highly regulated environment, as you said, are there any like certifications state -- at a state level, regulations that Frontline has to meet? And then for Rob, just anything about that tax benefit and the tax horizon for that would be helpful.

Sure. I'll take the state regulatory one and obviously, Rob, on the tax benefit. So it's one of the characteristics we like is the fact that the company told us -- they told us once in the diligence process, they told us 100 times that states are like countries. So education in this country is regulated state by state. It is something that the software portfolio that Frontline has deals with the complexity of that regulation that's ever changing. It's also an enormous barrier to entry for the more horizontal players or that would sort of prevent them from coming into the K-12 education space.

Yes. On the tax benefit, so it is over 15 years. It's about $35 million a year on average for the first 10 years. And then it's less sort of for the last 5 and really the first 5 years maybe a touch higher than that. So maybe in the $35 million to $40 million range for the first 5 years.

Our next question comes from Christopher Glynn from Oppenheimer.

Congrats.

Thank you very much.

On the free cash flow conversion of EBITDA, I don't recall any other deals kind of hovering in the 100% range. I'm curious, just to firm that's the long-term profile and what's particularly different from the other deals you've done that maybe 80% to 90% free cash conversion in terms of their flows and how that works?

Yes. So yes, it is over the long term. So there's 2 good guys here, if you will, right? One is the tax benefit I just mentioned also the answer with Deane, that $35 million to $40 million a year. The second one is because of the very negative net working capital that Neil mentioned, you get as the business is growing high single digits, you sort of get an extra $15 million to $20 million a year in cash from that sort of change in deferred revenue line where you're getting the cash in advance. And so that helps sort of drive the faster cash flow compounding, if you will.

Great. And then just curious on the competition, the relative leadership with this position? Is it an absolute pole position or kind of more of the -- out by a nose?

Well, there's many categories of education software. I mean, there's the categories that Frontline has, but there's other categories that are in the classroom, the content, the classroom software in terms of -- so there's a wide array of types of software that are sold. It's a very -- as a general matter, it's a very fragmented ecosystem, but less than half the market is vended. So as we go to the -- that did the tech enablement of the entire K-12 system, there is a long runway of tech enablement to occur. As it relates to the areas that Frontline plays in the administrative fees there, and they're the leader in that part.

Our next question comes from Julian Mitchell from Barclays.

Congratulations. Maybe just my first question would be around what's been the sort of recent historical organic sales rate? Is it consistent with the high single-digit projection? I might to help us understand the underpinnings of that growth. Do you have a sense for how automated the K-12 market is today? And how much sort of penetration uptake there is left? And then also kind of help us understand a little bit more clearly what are Frontline's competitive advantages? It's sort of hard for the outside to have a sense of that?

Okay. I'll try to tick through each of those, if I -- if we miss one, certainly come back or hit us after call. So yes, the short answer to the first question is their historic organic growth rate over the last 5 or so years has been equal to that of what we're projecting going forward, sort of in the high single-digit space, maybe a touch higher. In terms of the growth algorithm, we talked about in the prepared remarks that there are many growth drivers that have durability. That's where we spent -- as we do with most of our acquisitions of the vast preponderance of our diligence effort is on not just -- what the growth drivers are, but the durability of each. As I talked about in the prepared remarks, they have mid-90% gross retention, 107, 108 net, if they're going to grow high single digits to see that roughly 80% of their new bookings, if you will, come from cross-selling to their customer base, which has been a decided part of their strategy over the last 4, 5 years, as the number of apps per customer have gone from just around 2 to just about 3 today, again, against a cohort of 30 products that they sell. In terms of the market, it's -- depending on if -- there's a lot of different cuts of the size of the market, roughly plus or minus $6 billion is the opportunity. Less than half of that is vended today. The company reports that 85% of their deals are "not competitive." So they're not in RFP situations and they're just sort of chewing up the tech enablement for their customers.

That's helpful. And then just a more brief follow-up question. The EBITDA margins are in the high 40s today. Maybe help us understand kind of where have they moved from under Thoma Bravo ownership? And where do you think the sort of long-term margin rate should settle out?

Yes. Those have been pretty steady EBITDA margins over the past several years. I mean the business invests a lot. I mean R&D is mid-teens as a percent of revenue. So I mean, it's a -- those are very stable margins for a high single-digit organic growth business in this segment. So our goal under ownership, as always, will be to see what we can do to accelerate that growth and continue to have strong margin performance.

Our next question comes from Joe Giordano from Cowen.

You talked about growth into this. Like what has COVID done for the business in terms of changes? Has it kind of raised awareness for this type of technology? Has it changed anything strategically that Frontline has had to do?