One of the things I learned growing up in an apartment complex is that few brands are perceived by the eye more often than the brands on our door locks. My memories of Trick-or-Treating involve rows of Schlage locks and, of course, stuffing kitchen bags full of candy thanks to a high ROSE (Return-on-Sweat-Equity) ratio. So when I recently asked a Maintenance Supervisor where he buys door locks and found specimens of this mechanical technology going for up to $100 and beyond at Grainger, I figured there might be another big bag of candy in store.
Wall Street's talk of a "conglomerate discount" in the ~$40 price of Ingersoll-Rand (IR) after Nelson Peltz, an activist investor, disclosed a 7.1% stake, makes now a good time to take a fun look the company behind attractive lock brands like Schlage and Kryptonite. (Nelson Peltz' Trian Fund Management, L.P. disclosed a $900 million, 7.1% stake on May 8th, Ingersoll-Rand launched a new home page that advertises the breadth of its brand portfolio a month later.)
Since 2009, Ingersoll-Rand has been organized into four segments:
- Industrial Technologies (22% of sales) sells products like compressed air systems, tools (such as pneumatic hand tools), pumps, fluid handling systems, and material handling systems (i.e. architecture for keeping goods in a factory). This segment also includes Club Car products (mostly golf carts).
- Climate Solutions (56% of sales) is made up of cold-chain products and services sold under the Thermo King brand and commercial/industrial HVAC solutions sold under TRANE.
- Security Technologies (10% of sales) offers electronic and biometric access control systems and software, locks and locksets, door closers, exit devices, steel doors and frames - basically, everything that can go on a door - as well as time, attendance and personnel scheduling systems.
- Residential Technologies (12% of sales) overlaps with the previous segments, but offers mechanical and electric locks, HVAC, indoor air quality solutions, and remote home management exclusively for the residential market.
Recent operating margins by segment are as follows, with security delivering on hoped-for promise:
- Industrial Solutions: about 12% on sales of ~$2.9 billion
- Climate Solutions: about 8% on sales of ~$6 billion
- Security Solutions: about 20% on sales of ~$1.6 billion
- Residential Solutions: about 6% on sales of ~$2 billion
To make apples-to-apples comparisons between yearly income statements, extensive adjustments were made to control for acquisitions/divestitures:
- Operations discontinued in the last 10 years were treated as if they had never been part of the business, including removing gain/loss on sale for each divestiture as well as related asset impairment charges. Affected units: Integrated Systems and Services (2011), Hussman (2011), Energy Systems (2010), KOXKA (2010), Compact Equipment unit (2007), Road Development (2007), Dresser-Rand (2004), Drilling Solutions unit (2004), Engineering Solutions (2003), Waterjet (2003), and Laidlaw (2003).
- Removal or add-back of various small one-time "Other" charges, such as asbestos liability claims and an anti-dumping claim.
- 2008 acquiree TRANE treated as if it had always been a part of the business based on the financial statements of its former owner. Addition of past reported revenue and earnings from TRANE to income statements prior to 2008. (The large $9.6 billion acquisition was paid for with cash and stock.)
- Removal of a big 2008 after-tax $3.4 billion company-wide asset impairment charge.
The apples-to-apples model shows 9% revenue CAGR and 5% net earnings CAGR. Net margins deteriorated from about 11% in the 2002-2006 period to less than 6% in the five years following (largely because of Trane, which nets 5.3% and today makes up half of earnings, according to my calculations).
$12.2 billion market-capitalized Ingersoll-Rand is overvalued by a factor of two, if going by Benjamin Graham's industrial-strength formula:
Value = Current (Normal) Earnings X (8.5 plus twice the expected annual growth rate)
The final quantitative profile is that of a company yielding 7.25% (13.8 P/E) whose earnings and FCF can be expected to grow by 5% a year. It pays a 1.75% dividend.
Assets are $18.8 billion (of which $10.4 billion is total Intangibles). Liabilities are $11.7 billion and Shareholder's Equity is $7.1 billion.
Acquisitions/divestitures vis-a-vis book values:
- 60% of Hussman, a refrigeration unit, was sold for $438 million (originally $380 million) in 2011 - equivalent to $730 million for the business. It had been carried at about $1 billion and was written down $384 million pre-sale.
- The sunny environment of 2007 had brought in a $6.2 billion jackpot against $1.8 billion book - 3.4 P/B! - for the Compact Equipment and Road Development units (which together made up about a third of sales).
- The 2004 sales of assorted businesses that also made up about a third of then-sales were not carried far from transacted prices.
- On the acquisition side, the 2008 $3.4 billion company-wide asset impairment charge was mostly written against about a third of TRANE's intangible assets. The $9.6 billion (24 P/E) price on the TRANE deal was struck in 2007, right before asset values plummeted.
Earnings increasingly depend on the construction industry in America. The Security Solutions segment, the Residential Solutions segment, and a third to a half of the Climate Solutions segment all depend on construction. Together, construction-related sales make up about two-thirds of revenue and almost as much free cash flow.
Two parts of the company don't fit into that box. First, Thermo King (the "&R" in "Climate Solutions HVAC&R") is valuable because profits from cold-chain transport are less cyclical. (On the other hand, my hunch is that the Hussman refrigeration display case business was sold because its retailer-clients have nothing to do with the firm's other clients.)
Second, despite strong, reliable growth and good margins, Industrial Technologies (the mainstay Club Car, Ingersoll-Rand, and ARO brands along with factory-related services) don't make up more than about a fifth of earnings even though they are the identity of the company (from the website: "The Ingersoll-Sergeant Drill Company and the Rand Drill Company merged in 1905 to form Ingersoll-Rand").
Ingersoll-Rand does not describe itself using the words "construction provider" at all. A self-appraisal is critical and will become more so when building recovers, but this is scary: demand from the construction industry leads the macroeconomy and is cyclical, relatively unconcentrated, less profitable (save for security) and more service-related. Nevertheless, its growth is a direct consequence of management's choices and where the company ought to build moats.
The "Conglomerate Discount":
A Price-to-Book approach applies. When sold for the equivalent of $730 million last year, Hussman was written down by half of its Intangibles because Ingersoll-Rand overpaid for the stand-alone unit in 2000, paying a whopping $1.55 billion. TRANE was written down by about a third of its Intangibles because values plummeted after 2007 (even though the impairment to "Air Conditioning" was unacknowledged as Trane-specific).
Extending these patterns by deducting a third to a half of company-wide Intangibles (without double-counting Trane), the value of the company ranges from $15.3 billion on the conservative side (if the rest of the business has as little market-to-book value as Hussman had) to $16.5 billion on a more aggressive basis (assets originally carried richly, then marked down for rugged recessionary conditions). So there probably is a conglomerate discount of 25%-35%.
Can Mr. Peltz unlock this value? Despite an outsize presence in the food industry, I believe he may have bitten off more than he can chew. He may or may not be able to adjust shareholder's perceptions of their company, but, even if he can, managers won't approve a 20%/80% split (with 80% spun off), and I don't think any less drastic measures will do. Regarding downside, I believe Mr. Peltz' reasoning resembles that quoted in a Wall Street Journal article: "Food companies tend to have brands that produce significant cash flow, even when they are neglected or undermanaged or the economy is weak."
But despite strong franchises that have heretofore obscured the problem, most of Ingersoll-Rand will not produce significant cash flow if neglected or undermanaged and certainly not if the economy is weak. If construction dilly-dallies, latent asset value will be small relief.