Ingersoll-Rand Better Valued, But Not Better

| About: Ingersoll-Rand plc (IR)

Summary

Ingersoll-Rand is heavily exposed to building markets, and non-resi/resi construction in Europe and North America look to be among the few growth areas for 2016.

Underperformance in Industrial is a lingering problem and IR will be sorely pressed to close the performance gap with Atlas Copco, while Club Car is too small to really help.

Further operating margin improvements, a lower tax bill, and more efficient working capital management can support a 10% long-term FCF growth rate and $55-plus fair value.

It has been a while since I've liked Ingersoll-Rand (NYSE:IR), as I believe the shares have been buoyed by quite a bit of faith around the Street in the company's restructuring efforts. This skepticism has kept me on the sidelines, and with the shares down around 20% from the time of my last article, I can't say as though I've missed out on much.

The startling weakness in global equity markets since the start of the year and in industrial stocks, really, since the middle of 2015 has created some bargains provided that 2016 isn't the start of another deep or prolonged recession. I still have a lot of quality-based issues with Ingersoll-Rand - the company is a strong player in HVAC, but I don't believe the company is doing much to shrink the gap with Atlas Copco (OTCPK:ATLKY) in industrial and there's still a lot of work to be done on margins. At this price, though, I don't think so much benefit of the doubt is baked into the price and patient investors could see some upside from here.

Construction Figures Prominently In The Positive Column

Construction, and particularly non-residential construction, is shaping up as one of the better-looking markets for both North America and Western Europe in 2016. That plays to Ingersoll-Rand's strengths, as the company generates about 60% of its revenue from construction and renovation spending on HVAC systems in both the commercial and residential segments.

The recent numbers show some of the strength. Climate revenue was up 8% in the third quarter on an organic basis, with residential growing by low teens and commercial by mid-single digits, after 6% growth in the second and first quarters of 2015. I don't think Climate is going to be a torrid grower in 2016, but I think low-to-mid single-digit growth will be a pretty good result relative to other industrial markets and I expect the construction-related part of the business will do better than that.

Based on a relative/comparative growth rate, Ingersoll-Rand seems to be gaining share in Europe, which I consider a meaningful positive given that Europe has generally been the company's weakest geography. Ingersoll-Rand has been consistently reporting better sales growth than Daikin and Lennox (NYSE:LII) in Europe since 2013 and has generally been outclassing United Technologies (NYSE:UTX) as well since 2014. The situation is not quite as positive in the U.S., where the company has generally enjoyed about 30-40% share in the commercial HVAC market. On the commercial side, Lennox looks like it has been gaining some share and UTX showed a solid uptick earlier this year, while Lennox has also been gaining some share in the residential market.

Will Transport Hit The Wall In 2016?

One of the risk factors that Ingersoll-Rand will face in 2016 is potential weakness in the transportation part of its HVAC business. ThermoKing contributes about 20% of the company's Climate revenue, and more than half of that comes from refrigerated trailers and trucks.

The problem is that truck orders were running strong for a while but have clearly turned. Class 8 truck orders fell 36% yoy in December after dropping 59% yoy in November and 45% in October. Trailer orders have also started to decline significantly (down 45% in December) and the fear is that reefer trailer orders will soon follow. What's more, investors have clearly started worrying about the health of the trucking sector, and many marginal players will have to cut back on capex in 2016 if their tonnage starts to fall off.

It's not all doom and gloom for Ingersoll-Rand, though. First, North American trailers represent about 25% of the ThermoKing business, so it's not "game over" for growth in Climate even if this business declines by double-digits in 2016. Second, both ACT and FTR (industry research sources in the trucking space) report pretty healthy backlogs in the reefer trailer space - although that backlog will get chewed through quickly if December's order declines continue. Third, the average age of the U.S. reefer trailer fleet is supposedly around 5.5 years against an estimated useful life of 7 years - if there is a drop in orders here, I don't think it will last long as operators will have to refresh old units (although the risk of fleet contraction is something to consider).

What's more, Ingersoll-Rand has a sizable European business with ThermoKing (where it enjoys 60%-plus share in trailers) and growth opportunities in areas like auxiliary power units and containers, with the latter being driven by growth in global trade of foodstuffs like chicken and produce.

Industrial Technology Needs Work

I don't really have any problems with Ingersoll-Rand's Climate operations. Lennox has stepped up its game (including areas like Variable Refrigerant Flow systems), but I believe IR can continue to gain share in Europe and Asia and more or less hold serve in North America. I don't have the same level of confidence in the company's Industrial Technologies business.

The core of this business (around 60% of segment sales, or 15% of total sales) is the company's air compressor business. IR is a distant runner-up to Atlas Copco and hasn't really offered a serious challenge to its Swedish rival in some time. Being #2 in a large business isn't the worst thing in the world, but IR's sub-15% operating margin isn't impressive when you look at Atlas Copco's 20%-plus margins (though to be fair, this isn't a straight apples-to-apples comparison).

Atlas Copco has succeeded with its asset-light, service-oriented model and a relentless drive to take costs out of the business and IR is not going to win back share on price. Given the critical importance of energy efficiency in air compressors (energy represents as much as 75% of lifetime ownership costs), product innovation could be one way for IR to win back business, but it just doesn't seem to be clicking for IR.

The Club Car business is a different story. Growth has been better here (up high single-digits in the third quarter, versus compressors declining by mid-single digits), and this remains a pretty good business from a margin and ROIC perspective. Unfortunately, Club Car really is an outlier - IR's air compressor and tool businesses are nothing special, but I'm not sure that there are extensive growth opportunities for the Club Car business.

Some Opportunity Even With Modest Expectations

Ingersoll-Rand has done some good things over the last few years; the company's gross margin is back above 30% and operating margin is back in the double-digits. A recent settlement of a long-standing tax issue will take a bite out of reported 2015 free cash flow, but it should open the door to the company more aggressively managing its tax exposures and finally getting some benefit from its Irish domicile - IR pays quite a bit more in taxes than Eaton (NYSE:ETN) or Tyco (NYSE:TYC), which is why I believe there's more work that can be done here. IR also successfully disposed of its remaining 37% stake in the Hussman refrigeration business, and got a decent price from Panasonic ($400 million) in the process.

But what of the outlook? I think IR will be able to post low single-digit growth in 2016 on the back of strong construction markets, but weakness in transportation refrigeration and "general industrial" (the air compressor business) are threats to watch. Longer term, I still believe this is a company with 3% to 4% topline growth prospects. I still believe that the company can leverage improving operating margin, lower taxes, and better working capital efficiency to drive FCF margins into the double-digits. A 10% FCF margin is not terribly impressive among the high-quality industrials, but it's quite a bit better than IR's historical performance and good enough to support double-digit annualized FCF growth and a fair value in the mid-to-high $50s. A mid-teens ROE would likewise support a fair value in the range of the high $50s to low $60s on a price/book basis.

The Bottom Line

I do believe that Ingersoll-Rand is well-positioned to take advantage of growth in non-residential and residential construction in both North America and Europe in 2016 and 2017. I likewise believe there's enough growth there to offset some weakness in transportation refrigeration from weaker reefer trailers and a manufacturing recession-led weak patch for the air compressor and tool businesses.

I don't yet have much conviction about the quality of this business, though. I think Ingersoll-Rand is a stock that you can buy because it's cheap, but I'd rather buy a company that is cheap and good, and I think investors have that option in Atlas Copco (as well as some of the other industrials I've written about recently). So although I think Ingersoll-Rand is priced to offer upside over the next two years or so, it's not good enough or cheap enough to be a favored pick.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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