Ingersoll-Rand Outperforming As Management Hits Its Marks

By Stephen D. Simpson, CFA | July 22, 2013 AAA

Credit were credit is due – Ingersoll-Rand (NYSE:IR) has been in a seemingly never-ending state of restructuring since 2008, but management seems to be hitting its marks recently. Leaner manufacturing, smarter sourcing, a refreshed product line up and solid pricing all seem to be leading to the improved results that have been expected for some time now. Although these shares still don't look particularly cheap, Ingersoll-Rand is heavily leveraged to a recovery in residential housing and commercial construction and continued outperformance on margin targets could very well push the shares higher. Nothing To Apologize For This TimeIngersoll-Rand didn't report the strongest quarter among the industrial conglomerates, but it was hardly a quarter to regret. Revenue rose 3% on an organic basis, which was just slightly better than the sell-side expected. Growth was led by the Residential business (up about 7% organically), while the much larger Climate business improved about 5%. Industrial and Security were both weak, though, and down about 3% from last year. Ingersoll-Rand did pretty well on revenue (for the most part, at least), but did even better on margins. Gross margin improved more than a full point, and adjusted operating income rose 8%. That was not only good for a 140bp improvement in in operating margin, but also a roughly ten-cent beat versus estimates on the operating line. Every unit had double-digit margins, with only the Industrial category showing a year-on-year profit decline.SEE: Conglomerates: Risky Proposition? The HVAC Recovery – When, How Much, And For How Long?At long last, it looks like there are reasons to be positive on the residential and commercial HVAC and building controls markets that Ingersoll-Rand serves. Admittedly, the relevant comparables at Honeywell (NYSE:HON) and Johnson Controls (NYSE:JCI) haven't come roaring back to life yet, but it sounds like conditions are better at Ingersoll-Rand, with solid improvements in the residential business and some growth in the U.S. commercial market. With United Technologies (NYSE:UTX) reporting on Tuesday, we should have a more complete look on the market shortly, but it seems like new products are helping Ingersoll-Rand regain some share. I think bulls have a legitimate reason to be optimistic about HVAC equipment demand in the coming years. Several companies in HVAC distribution have commented that the past few years have seen significantly above-average levels of repair activity versus replacement, and that may be hinting at a sizable “shadow backlog” of business that will be above and beyond any demand tied to new construction. Spinning Security, But Work Remains ElsewhereInvestors have reacted quite positively to the news on the upcoming spin-out of Ingersoll-Rand's security business Allegion (to trade as “ALLE”). Allegion compares pretty favorably with Assa Abloy and Stanley Black & Decker (NYSE: SWK), and this transaction looks like it may be a “win win” for both parties.Even so, there's ample work for Ingersoll-Rand to do. I can't help but notice that the company's air compressor business continues to underperform Atlas Copco (Nasdaq: ATLKY), and while I don't think the company's golf car business lags Textron (NYSE:TXT) to the same extent, I still don't believe that the golf cart business is core to Ingersoll-Rand's future. Accordingly, I think management should be thinking about additional sales/spin-offs and focusing even more on those markets where they have a competitive edge.SEE: 4 Steps To Building A Profitable Portfolio The Bottom LineI won't pretend that I didn't miss just how strongly Wall Street would buy into Ingersoll-Rand's latest self-improvement story (and the presence of respected activist investors certainly hasn't hurt). With the shares up more than 50% over the past year, it's not surprising that they don't look like a major bargain today.  If Ingersoll-Rand can grow revenue at a long-term rate of 4% to 5% and drive 10% free cash flow growth with better margins, a fair value in the mid-$50s seems reasonable. While that's lower than today's price, it's worth noting a sizable amount of debt (more than $8/share) weighs down the valuation and Wall Street analysts often ignore debt in valuation. It's also worth noting that if Ingersoll-Rand can eventually get its free cash flow margins back up to the level of quality industrials (in the low teens), the fair value moves into the low $60s even with the debt. I'm not inclined to give management that much benefit of the doubt yet, but those investors who are bullish on Ingersoll-Rand's turnaround prospects still do have something to look forward to if this restructuring plan can produce more quarters like this one. 

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