Jack Wx's  Instablog

In the summer of 2008, I started accumulating shares of Ingersoll-Rand (IR). At that time, American economy had shown plenty of uneasy signs, while I identified IR as one of the stocks with the potential to thrive through the possible upcoming downturn. I had three reasons to back up my beliefs, first, Warren Buffet's stake in the company, second, IR's move to acquire Trane, and third, its global footprint - the Asian market would provide immense growth opportunities.

Then the unfolding of the financial turmoil later the same year proved my timing was not right. IR was hit way harder than I had figured, primarily due to their exposure to the construction (both commercial and residential) market, and the increased debt level - as a result of Trane acquisition. However, I held onto my positions and haven't changed my long-term views on the company. Now we started seeing some positive signs of the economic trend, and I think it is a good time to revisit my thoughts on IR.

A Company in Transition

First of all, a simple description of IR's business from their 10K.

"Ingersoll-Rand Company Limited (IR-Limited), a Bermuda company, and its consolidated subsidiaries (we, our, the Company) is a diversified, global company that provides products, services and solutions to enhance the quality and comfort of air in homes and buildings, transport and protect food and perishables, secure homes and commercial properties, and increase industrial productivity and efficiency. Our business segments consist of Air Conditioning Systems and Services, Climate Control Technologies, Industrial Technologies and Security Technologies, each with strong brands and leading positions within their respective markets. We generate revenue and cash primarily through the design, manufacture, sale and service of a diverse portfolio of industrial and commercial products that include well recognized, premium brand names such as Club Car, Hussmann, Ingersoll-Rand, Schlage, Thermo King and
Trane."

Here are some key points from reading their 10K, 10Q and other financial presentations.

- On June 5, 2008, for $9.6 billion, IR completed the acquisition of Trane Inc, one of the top HVAC (heating, ventilation and air conditioning) companies, previously known as American Standard Companies Inc.

- On November 30, 2007, IR completed the sale of Bobcat, Utility Equipment and Attachments business units (collectively, Compact Equipment) to Doosan Infracore for cash proceeds of approximately $4.9 billion.

- On April 30, 2007, IR completed the sale of the Road Development business unit to AB Volvo for cash proceeds of approximately $1.3 billion.

- The international share of IR's revenue has been growing at fast pace, and the trend will continue. For example, for Climate Control, in 2001, 39% of the revenue is from outside North America, and in 2008, 47%. Overall in 2008, 34% of its revenue is from outside North America.

- IR's revenue is across multiple markets, including Parts & Service (25%), Commercial Construction (23%), Residential Construction (12%), International Construction (11%), Industrial/Process (9%), Supermarkets – Cases / Install (8%), Truck and Trailer (6%), Bus, Container & Other (3%), Golf & Utility Vehicles (3%). It seems to be very well balanced, not tying to any single market.

- The parts & service revenue, as mentioned above, is 25%, a very healthy number. It represents the recurring revenue, the very type that every company seeks with greatest effort. Its increase indicates the deepened independence of the customer upon the service/parts provider, which translates into guaranteed revenue. IR continues to put high priority on developing the capabilities to deliver recurring revenue.

- IR has been using Lean Six Sigma for years, and will continue to rely on it to achieve operational excellence, which reflects IR's clear and constant awareness of efficiency and cost.

So clearly, IR is a company in transition, from a traditional asset intensive American company, towards a light-weight, international company with good margin, steady stream of revenue and maximized immunity to American economic cycle. In other words, IR has been constantly recalibrating itself to remain as a GROWTH company.

Growth

1) Both high energy cost and environmental regulations will boost the demand for energy efficient solutions for HVAC and Climate Control technologies, which is the key to IR's growth in matured market.

The combination of HVAC and Climate Control accounts for 67% of IR's total revenue. Though IR is reasonably internationalized, North America still contributes more than 60% of the revenue in both segments, especially the residential HVAC, is very much like a typical American business.

Basically both businesses are tightly linked to the economic infrastructure. HVAC services the commercial market and residential market. The commercial market can be further divided into commercial (offices, retail, lodging, etc), institutional (health care, education, government, etc) and industrial (process manufacturing, life sciences, data centers, etc). The climate control mainly serves food transport and grocery stores.

In North America, these markets have been very mature. The population and the overall economy will continue to grow, the HVAC and Climate Market should follow, but I don't see the overall demand outpaces the overall economy. Here I believe the surging energy price and stricter environmental regulation will play a significant role in IR's future. They will force the customers to seek solutions with higher energy efficiency, or green enough to meet the legal standards. This is a process to consolidate the fragmented market, where the companies with superior technology, larger market share, better management and higher productivity win. Today's IR is well positioned to take advantage of this trend.

2) IR's international footprint creates itself golden opportunities to profit from the emerging markets.

More than 30% of IR's total revenue comes from outside North America and its international appearance is very impressive. For all the four businesses, IR has manufacturing & distribution sites, sales consultant offices, and integration & service offices virtually across the entire world.

In the emerging markets, notably China and India, the bottleneck of their economic growth is the infrastructure. As a result, we see both countries put high priority, accordingly high investment into this area. For better understanding, let's paint a simplified picture here.

Combining the population of the two countries, the number we get is 2 billion. Now the 2 billion people need to live (residential development, which creates demand for IR's residential HVAC and security technologies), eat (cold chain and grocery store development, which creates demand for IR's Climate Control technology), work (commercial/institutio... development, which creates demand for IR's commercial HVAC and Industrial Technology products) and move around (transportation development, which creates demand for IR's Industrial Technology products). The key here is that the demand is driven by this gigantic population, and both countries are struggling to keep up with it. Therefore, IR is presented virtually unlimited growth space.

One extra point to note. Both countries have very limited farm land but are experiencing rapid urbanization, which actually creates an exceptional demand for the cold chain technologies. Currently the Climate Control contributes around 20% of IR's total revenue. I see high chance this business becomes a key driver of IR's growth in the next 5 to 10 years.

3) IR's leading market position will continue to generate revenue from parts & services

As mentioned above, currently more than 25% of IR's total revenue is from parts and services. This is a very healthy number.

In today's business world, especially the manufacturing section, we see more and more companies sacrificing the margin to win the customer's initial adoption of their solution. The logic is simple. Once the dependency of the customer on the solution provider is established, the parts & service revenue will eventually follow, which normally has higher margin, and recurring. IR's leading market position and technology advantage means they have stronger leverage to win the customer, in turn, the increased market share will consolidate such leverage and make IR even stronger. I am expecting the parts & service revenue continue to grow at a faster pace than the overall growth rate of the entire company.

Conclusion

IR operates in a traditional industry, where we won't see explosive growth, but a steady one. We see opportunities to be created by both the recovering American economy, and the unabated emerging markets. To certain extent, IR meets the definition as a 'boring' company as defined by Peter Lynch, which makes it an even better long-term stock. At the micro level, I liked the direction that the management is driving IR towards. Normally when we analyze a company, the most tricky part would be the evaluation of the management. Since IR is Warren Buffet's pick, things get easy - there is no need to question the capability of its management. While I'd like to point out that I was impressed from reading the IR related material. I see a management team with clear vision, sound mindset and a long term strategy that is constant, simple and well defined.

One more point to add. I believe IR has the option to combine its four businesses and acts as a solution package provider, which may be an important competitive edge that IR has been enjoying, and will continue to enjoy. In IR's presentation, it frequently used the grocery store to showcase its high performance solutions, where products from all its four businesses are employed and IR is very much like a one-stop service provider for the grocery operators/builders. For the customer, the benefit in cost, efficiency and maintenance to use service from this type of 'package provider' is apparent. And for IR, its four businesses should be able to continue to create opportunities for each other and bring in more and more organic growth opportunities.

Disclosure: Long IR.

Last week, both Visa (V) and MasterCard (MA) released their quarterly earning results. Here are some thoughts on their reports and the conference calls.

1) Economic Indicator

For a long time, consumer spending has been the driving force of American economy. Albeit the arguments that now finally comes the end of such an era, it is fair to say the consumer spending remains as the most accurate indicator of the economy. Many researchers publish reports, articles, statistics, etc. to track the economic activities, looking for all sorts of signs of the economic trend. But as a matter of facts, no indicators are more accurate than the financial results from Visa and MasterCard. Actually in my opinion, both companies themselves are the indicators.

There are two aspects of the consumer spending, the number of transactions and the total spending volume. I believe there are no entities capable of tracking these numbers as accurate as V and MA. The reasons? these numbers are their business and they simply occur on the information systems owned by the big two. On the other hand, Visa and MasterCard dominate the electronic payment market, which has been widely adopted across all industries. Listening to their conference call, you will hear them talk about virtually everything, the gas, the grocery stores, the fall of CircuitCity, the restaurants, the overseas travel, etc, somewhat their business represents the overall economic picture.

Then what does this mean for the investors in both companies? In my first article on my blog (read it here), I mentioned in the bear market, we pick companies capable of holding up well during the economic downturn, and benefiting the most from the economic upturn. At that time, I listed both MA and V as my favorites. Economic recovery means more consumer spending transactions and higher spending volume, which translate directly into the improved financial results from both companies. When observers read these numbers and conclude the economy is back to life, both companies have already harvested the fruits. From this perspective, we say both companies proceed the economic upturn, and not in a speculative manner, but in a concrete and logical manner. So if you believe the American economy will come back, these two stocks will be the ones definitely flying earlier and very probably, higher.

2) Visa's Advantage Over MasterCard

In my previous discussion about MA (read it here), we mentioned that the Visa's dominant market position gives it the competitive edge over MA. Since MA can't produce anything with real or perceived difference from Visa's products, the competition pattern somewhat mimics that between Intel and AMD. Now based on the recent reports, it seems the Visa's dominance in the debit market gives it another layer of advantage over MA.

When we look back, the logic seems to be really simple. We are experiencing the credit crisis. Consumers cut back in credit card usage, and resort more to debit cards. This simply is a big positive for Visa. Visa saw the growth in debit card revenue offset the negative results from credit cards, but MA doesn't have such a luxury. In addition,talking about the future growth in the international market, especially in the developing countries, we all know that the credit system is a lot more complex and sophisticated than the debit system. It requires a series of setups, establishments, regulations, etc, which normally take long time to mature. But the debit card system, basically only requires the card holders have cash in their bank accounts. Therefore, the debit card's growth usually proceed the credit card. On one hand, compared to MA, Visa's dominance in the debit card market will position it better to take advantage of these growth opportunities. On the other hand, not everything is so negative for MA. Visa's advantage is mostly in the developed countries, while in the emerging markets, the opportunities presented to both are equal.

One noteworthy interesting point. In MA's 2008 10K, they quoted the recent bank consolidations as one potential risk, but in Visa's earning conference, they confirm that they expect to be the beneficiary of such consolidations. This certainly reflects Visa's dominant position, but also servers as a sign of Visa's long-term, established, strong relationships with big banks, which is intangible, but might very well be another advantage over MA.

3) International Growth

Both companies posted strong growth in the international market. Their strong performance outside the US helped offset the weak US market, guaranteeing their stock will recover at a faster pace than the US economy. Actually the global diversification is another rule I proposed to apply to pick stocks during the recession.

4) Energy Play

Both companies noted the dropping gas price negatively affected their results.

Actually MA and Visa are all good candidates for energy play.

Many believe the future era will be featured by high energy price, in that case, both companies will be benefited from this trend. After more than 100 years, the human world has been built to be relying on energy. There is no short term solutions to change this fact. High gas price may reduce several trips to Florida, but the enormous basic need will still be there, and grow, when you count in the developing countries from Asia. Both companies benefited from the short time energy bubble we witnessed in 2007 and early 2008, and I won't be surprised to see the similar situation reappear in the near future.

5) The Unabated Trends: Go Plastic and More Transactions

I continue to hold and increased my holdings in MA and Visa during the economic downturn. The underlying theory is based on two beliefs. First, the worldwide worldwide secular shift from cash and checks to electronic forms of payment will be inevitable and fast. And second, when people scale back their spending, it may, on the other hand, boost the total number of transactions. The report from both companies confirmed such views.

6) Final Conclusions

- Both companies delivered very solid performance, and Visa is even more impressive.
- I won't say MA is cheaper than Visa. I am holding onto my old opinion, Visa deserves a higher multiplier owing to its advantage over MA.
- Both stocks are not cheap. But I think the overall market may continue to push them higher.

Disclosure: Long both MA and V

It is well known that Warren Buffet is bullish on the railroad industry. But among the top four American railroad companies, Burlington Santa Fe (BNI), Union Pacific (UNP), CSX (CSX) and Norfolk Southern (NSC), he has clear preferences. BNI is no doubt on the top, UP comes as the second, and NSC and CSX are much less favored. Through this article, I will try to provide my understanding of his logic behind his preferences. I will attempt to answer three questions, 1) why does he pick the railroad industry? 2) Why are CSX and NSC less favored? And 3) why is BNI more favored than UP?

To Question 1: Railroad has to be the future of American freight transportation

When we talk about moving freight around without incurring hefty cost, normally there are two options, the trucks and the locomotives. In the old times, thanks to the low energy cost, the advanced highway infrastructure and their point-to-point flexibility, the trucks dominated the shipping market. But now the picture is changing. I believe in the long run, the railroad will become the backbone of American freight transportation network, while the truck companies will be confined to short distance shipping, operating between railroad stations and the customer locations as a support to the national railroad network.

The above statement is based on the following facts and beliefs.

First, railroad is simply a more efficient way to move freight. According to BNI, one intermodal train removes more than 280 long-haul trucks from the nation’s highways.
Second, based on the type of freight (industrial material, agriculture product, coal, etc) , the rail is 2-8 times more fuel efficient than trucks.
Third, Rail is more environment friendly. It emits only 2.6% of the total U.S. green house gas emissions, while trucks, 21%.
Fourth, the progress of information technology helped the railroad companies build more sophisticated train control systems, resulting in increased accuracy, efficiency and flexibility, continuously narrowing the advantage of trucks over railroad.
Fifth, I believe the coming era will be featured by high energy price, which will continue to consolidate rail's cost advantage over the trucks.
Sixth, intensified environment concerns will drive stringent regulations, which will drive up the operation cost for both rail and trucks, but the impact will be a lot more punishing for trucks than for rail, thus the cost advantage of the latter will be further consolidated.
Seventh, under the recession, the cost awareness of the customers makes rail an even more attractive alternative to trucks. This will help rail companies gain market share against trucks, better position themselves to take advantage of opportunities created by the upturn economy, thus further build its dominance over trucks.

To Question 2: For BNI and UNP, the geographic layout of their railway network gives them insurmountable competitive advantage over NSC and CSX

The competitive advantage of BNI and UNP is of a unique type. It has nothing to do with branding, technology superiority or management excellence, but originates from the simple fact that BNI and UNP happen to be the ones that operate the railroad network in Midewest and West America. To be more specific, the advantage lies in the following aspects:

1) Intermodal. For all four companies, intermodal is a significant portion of their revenue. CSX and NSC operate in East America. They connect with ships from the Atlantic ocean, transport shipments originating from or destined for Europe and Latin America. Whereas BNI and UNP connects to the Pacific ports, eventually with Asia and Australia. Now the picture is clear. Across the Pacific ocean, BNI and UNP has China. On one hand, China is the world factory, manufacturing virtually everything required in American daily life, on the other hand, an emerging economic giant, thirsty for all sorts of goods produced from the American land, especially energy and agriculture products. This type of import and export is projected to grow strong for the coming dozens of years, thus offering BNI and UNP vast growth potential.

2) Agriculture. In the past several year, externally, Asian countries need to import grain from the US to feed their people, and internally, America needs corn to make ethanol. The soaring demand for these types of goods created the agricultural boom. The recession slowed things down, but will it change the domestic and international demand pattern of American agricultural products? My answer is No. Again BNI and UNP happen to own the railroads that run through the enormous American farmlands, and there is no means that is more cost effective than trains to move grain, corn or beans. The farmlands now give BNI and UNP another growth opportunity that their two brothers in the east can only dream of.

3) Geography and industrialization. In East America, the territory controlled by CSX and NSC, we see higher industrialization, dense population, numerous big cities, a slew of ports along the Atlantic Ocean, in other words, a well developed environment for all means of transportation to prosper, including trucks, ships and rail. Therefore, for CSX and NSC, in addition to competing with each other, they have to compete with other shipping means, which normally are already mature and well managed. While in the west, Rocky mountain and the desert somewhat confined the industrialization to the strip along the Pacific ocean. It is the vast plain running deep into the heart of the continent. Here we see small population, sparse cities, tiny towns and infinite farmland. It is never preferred means to move the common goods, such as coal or grain, around with trucks, because the volume would be small, the cost would be high, and normally you have to move long distances. In summary, this is an environment where only the rail can manage to survive and prosper. For BNI and UNP, except competing with each other in certain regions, they don't face any other serious challenges.

To Question 3: The black gold gives BNI the edge over UNP

In West America lies one of the largest coal reserve in the world - Power River Basin (PRB). Once it was estimated to have 200 billion short tons. The newly published study revised the number in a shocking manner, claiming 190 billion tons of reserve, about 95% of the original assessment, as economically unrecoverable. So there is only 10 billion tons left, let's accept it for now. In 2008, around 40% of American coal production came from this area, around 450 million tons, and most of them were used for power generation. With 10 billion as the reserve, it is safe to say the supply is guaranteed for at least 10 years.

And for the next 10 year, I believe the amount of coal that the railroad ships out of this area will grow year after year.

First, the growing demand of power generation requires greater coal output.

Second, currently the fuel types for power generation include petroleum, renewables, nuclear, natural gas and coal. For renewables, there is still a long way to go before they become reliable and significant sources for power generation. For nuclear, there is always the key concern about safety. For petroleum and natural gas, they are turning too expensive, and there is no chance for the trend to reverse considering the worldwide demand will only go intensified. So coal somewhat becomes the only option. I see power generations will rely more and more on coal, which adds further demand for the output from this area.

Third, coal from this area has extremely low sulfur content. Thus, many coal-fired power plants in the U.S. buy PRB coal to blend with other coal with higher sulfur content to meet the environmental regulations. We foresee the environmental regulation will become stricter, which may become another contributor to the higher demand of PRB coal.

Now comes the last and the key question. Who has the privilege to move the PRB coal? Checking the railroad network map, you will find BNI almost has exclusive coverage in the area. In 2008, 22% of BNI's revenue was from coal, and now it seems this big chunk of revenue is not only guaranteed, but also guaranteed to grow. Therefore, right here, lies the ultimate advantage of BNI over UNP.

Disclosure: Long BNI, No Positions in UNP, NSC and CSX