When I last wrote on Ingersoll-Rand (IR) in February, I thought that this industrial conglomerate was the sort of perennial underachiever that could do well if and when management started delivering better results and the market really bought into the idea of reliable improvement. Although it's still early, it looks like Nelson Peltz's involvement with the company has improved sentiment, and it does look like management has credible plans for healing what has been a long record of underperformance.
Success At Last?
Ingersoll-Rand has been talking about restructuring since 2008, but didn't have a lot to show for it before this year. Now something certainly has to be taken in the context of a terrible U.S. construction market (which also hurt rival/comparable Johnson Controls (JCI)), but the relative outperformance of others like Stanley Black & Decker (SWK), Lennox (LII), or Dover (DOV) can't be ignored.
Maybe, though, these efforts are finally paying off. Management has pursued logical initiatives like more efficient sourcing and leaner manufacturing, and the company delivered a double-digit operating margin in the second quarter of 2012 - the first time in while that the company has done so on a reported basis. Even when factoring out charges, the company is showing real year-on-year improvement, and analysts seem more confident about their numbers now than they have in some time.
Peltz Has Brought More Attention, As Have Buybacks
When Nelson Peltz announced that in May that he'd taken a 7% stake in Ingersoll-Rand (via his Trian Fund Management), investors definitely took note. Peltz is well known for a focus on corporate restructurings and operational improvements as a means of improving performance - exactly what Ingersoll-Rand needs, then. What's more, in a somewhat unusual twist, Ingersoll-Rand management hasn't resisted his involvement - offering him a board seat which he initially declined before accepting in August of this year.
Management has also gotten more active with buybacks, with up to $800 million in potential activity in the second half of this year. Though I'm not uniformly positive on buybacks as a policy (particularly with those companies that still need operational improvement), it's hard to deny that this does improve institutional sentiment on the shares.
Still Much Work To Be Done
Ingersoll-Rand has had far and away the best year-to-date performance of major industrials. At the risk of sour grapes, I question whether this 50% year-to-date appreciation is wholly appropriate.
The company's residential HVAC business is still looking a little iffy, and the acquisition of Goodman by Daikin takes a potential buyer out of play. Likewise, climate is under some pressure due in large part to weakening commercial vehicle orders. The industrial business has also been looking a little better of late.
The key issue for Ingersoll-Rand is still the if/when/how much question of a construction recovery in the U.S. Almost 70% of the company's business is exposed to construction in some fashion, and it's pretty clear that a recovery would be a big help. A recovery in commercial building is still looking wobbly and iffy, as the Architecture Billings Index is just barely above 50 (though moving up), but residential may be slowly getting better.
On the industrial side, I think Ingersoll-Rand still has work to do. It's going to take quite a bit of investment to threaten Atlas Copco (OTCPK:ATLKY) in compressors, and its likely going to take time for the economy to improve enough to really help the golf cart business.
The Bottom Line
The strong action in these shares has brought some of the company's multiples back up into more normal ranges for industrial companies. Still, I can't help but wonder if analysts and investors have given a little too much benefit of the doubt to the company. Construction activity is still weak, after all, and though Ingersoll-Rand management's outlook for 2013 is relatively optimistic, that's not necessarily a widely-held view. On a more positive note, the company doesn't have all that much exposure to Europe and improving sales in emerging markets like China (even despite their economic challenges) can help offset that.
Giving the company more benefit of the doubt, I'm boosting my long-term free cash flow growth assumption to about 8% - a target that may look aggressive, but also incorporates an element of making up for lost time (and sales growth). Unfortunately, factoring in the debt still means that that sort of growth is worth about $50 - not the most compelling target relative to a current share price near $46. While I certainly feel better about Ingersoll-Rand now than back in February, I'd still be more inclined to buy an industrial like Atlas Copco or Lincoln Electric (LECO) today.