I will say right from the beginning that I haven't been a fan of Ingersoll-Rand (NYSE:IR) for some time now. While the involvement of activist investors and a commitment to launch debt-funded share buybacks has helped the stock significantly since October of 2011, the next leg of improvement is going to have to come from better execution. This is where I'm not sure the company can deliver, and where I fear investors have given too much of a benefit of the doubt to management. That said, investors who have more faith in management could look to improving construction markets as a driver for the next move in the stock.

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Looking Back At A So-So Start To The Year
Even though Ingersoll-Rand's performance has been lackluster for some time, investors largely gave the company a pass on first quarter results – chalking them up to the same general industrial malaise that has caught up others like Danaher (NYSE:DHR), General Electric (NYSE:GE), Honeywell (NYSE:HON), and United Technologies (NYSE:UTX). Revenue fell 1% on an organic basis this quarter, with Climate, Industrial, and Security all down by low single-digit percentages and Residential up 6% on an organic basis.

I think margin performance is critically important to the Ingersoll-Rand thesis, and the progress here was decent. Gross margin improved by a point and operating income increased 9% on a 70bp improvement in operating margin. That said, the company is still running a very heterogeneous business, with margins in Industrial and Security in the teens and margins in Climate and Residential in the single-digits.

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HVAC Isn't Back … But Is It Getting Better?
About two-thirds of Ingersoll-Rand's business is tied to commercial and residential construction, largely through its HVAC businesses. Unfortunately, this is still an industry waiting for recovery and it doesn't look like that's coming in 2013.

Residential has been getting a little better for Daikin, United Technologies, Ingersoll-Rand, and Lennox (NYSE:LII), but largely on delayed replacement business. What's more, a lot of the growth has been in lower-priced, lower-function products. Given that these installations last for upwards of 10 years, there are certainly some opportunities evaporating because of the more difficult economy and the absence of a strong recovery in housing (it's harder to argue for upgrading to a better HVAC unit when housing prices are still depressed).

The commercial market is likewise still pretty challenging. In particular, Ingersoll-Rand continues to see weakness in its core institutional business, and this is a market that isn't likely to improve until the jobs numbers and property tax receipts get better. In other words, I wouldn't be surprised to see United Technologies, Lennox, and Johnson Controls (NYSE:JCI) rebound sooner in commercial than Ingersoll-Rand.

Can Management Outdo The Tides?
There's certainly an argument to be made that Ingersoll-Rand is cyclically depressed, as both commercial and residential construction fell out of bed when the housing bubble collapsed. As activity improves, then, Ingersoll-Rand should go along for the ride and reap better revenue, better efficiencies, and better margins. History suggests some legitimacy to that idea, as operating margins and returns on invested capital were both in the teens prior to the bubble.

It's not as though there aren't some reasons for optimism. Ingersoll-Rand's Security business stacks up well relative to Tyco (NYSE:TYC) and United Technologies, and though management is looking to divest this business, it still shows that management can run a solid business. While the case is not so compelling in the Industrial segment (where IR trails rivals like Atlas Copco and really needs to do something with the Club Car business), I am willing to acknowledge that there is evidence to suggest management could do good things with the business as a whole if/when construction turns around.

The Bottom Line
Ingersoll-Rand's stock has certainly done well over the last 18 months. I do worry, though, that a lot of the enthusiasm generated by activist investor involvement, the big buyback announcement, and still more restructuring (Ingersoll-Rand has been in seemingly perpetual restructuring for five years) could abate once investors realize that management is relatively constrained in what it can do by the still-sluggish construction market.

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I'm looking for long-term revenue growth of 4% and roughly double that for free cash flow, as I do believe management will be able to improve margins and free cash flow conversion due to the restructurings and eventual market recoveries. That growth is only worth about $50 to $52 per share, though, so clearly bulls need to bank on better growth. All other things equal, each 1% of long-term revenue growth is worth about $4 per share in fair value, so it would seem to take an assumption of at least 6% long-term revenue growth (double the expected growth in GDP) to argue for buying Ingersoll-Rand today.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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