I'll give credit where it's due - the involvement of Nelson Peltz and his Trian Fund Management, and the willingness of Ingersoll Rand's (NYSE:IR) management to embrace that involvement, has definitely delivered substantial near-term benefits to shareholders. These shares are up more than 40% over the past year as management has committed itself to a greater return of capital, improved operating efficiency, and the spin-off of its security business.
Things may even get better from here. There are actual signs of progress in margins, even though the company remains heavily exposed to end-markets (residential and commercial construction) that are not yet out of their trough. Even so, it looks like investors have already given management ample benefit of the doubt and fiddling with the balance sheet really doesn't seem likely to produce long-term value.
A Messy Q4 Does Include A Small Operational Beat
Ingersoll Rand's fourth quarter wasn't quite as strong as it first appears, but the company nevertheless logged an operating beat for the quarter. What's more, I think you can make the argument that the company beat in a way that matters.
Revenue fell about 1% as reported, with organic performance closer to flat compared with last year. The company's largest business, Climate Solutions, saw revenue fall about 1% on an organic basis, as weak results in Thermo King pulled down basically flat HVAC performance. Residential was also weak, as organic revenue fell about 5%. On the positive side, both Industrial Tech and Security saw organic growth of 4% and 7%, respectively.
IR's revenue results reflect a lot of what investors should have already known - namely, that key markets like commercial climate control, commercial vehicles and residential construction aren't all that strong. Margins offered some surprises, though. Gross margin improved about two points as reported, exceeding expectations by more than a point. Operating income rose 10% and the company logged not only a one-point improvement in operating margin, but yet another double-digit result (the third in a row).
Could IR Be A Performer Again?
There's plenty of quarter-to-quarter volatility in the HVAC and environmental control space, so quarter-to-quarter comparisons with Johnson Controls (NYSE:JCI), United Technologies (NYSE:UTX), Siemens (SI), and Lennox (NYSE:LII) aren't always the right way to look at these companies. Nevertheless, I think there's a case to be made that this business could be on the way up.
For starters, there are few companies as leveraged to an improvement in residential and commercial construction as Ingersoll Rand, with nearly 70% of revenue coming from those broad end markets. Given years of under-spending, not only is there an uptick in new construction to look forward to, but also substantial upgrades/refurbishments.
IR has been getting more active in building for that recovery. The company has been diligent about improving its portfolio and upgrading its offerings, and hitting the trade shows more aggressively to promote them. At the same time, the company has been working behind the scenes to take costs out of its manufacturing and distribution systems. It also can't hurt Ingersoll Rand's prospects that its rivals have other priorities - Johnson Controls needs to fix its auto business, United Technologies has been focused on its commercial aviation operations, and Siemens is still trying to find the right cost structure and mix of businesses for the future.
IR's recovery may not be limited to just its climate businesses. The industrial technologies unit did reasonably well this quarter against a very broad range of comparables like Danaher (NYSE:DHR), Illinois Tool Works (NYSE:ITW), Timken (NYSE:TKR) and SKF. I wouldn't go so far as to say that companies like Graco (NYSE:GGG) and Atlas Copco (OTCPK:ATLKY) now need to worry about IR aggressively regaining lost share, but it looks like Ingersoll Rand will no longer be easy pickings either.
Do Ingersoll Rand's Restructuring Efforts Really Make Sense?
Although I do think IR deserves credit for operational improvements and the way management has positioned the company to take advantage of the eventual recovery in commercial and residential construction, I don't have the same fondness for the company's restructuring efforts.
I don't really have a problem with management consolidating and spinning off its security operations. This is a $2 billion business and did well this quarter relative to the likes of Siemens and United Technologies, but I can see how management could designate this as the easiest non-core business to separate.
What I don't like is the decision to take on debt to accelerate capital return to shareholders. It's one thing for a company to recognize that it cannot reinvest surplus cash/cash flow at economically interesting returns, but it's quite another thing to borrow money and just funnel it back out to shareholders, even if rates are low.
Then again, there is another, much more cynical, way to look at this capital return. Ingersoll Rand's balance sheet was arguably under-leveraged, but management here has a pretty dismal M&A record - often over-paying and then integrating badly. So here's one way to look at this accelerated capital return policy - a fork or knife may be more useful than a spoon, but if the person you give it to is just going to jab it in their eye anyway, you may as well give them the spoon and limit the damage they can inflict on themselves.
Margins And Rebounding Markets Could Drive Growth
I continue to believe that investors should approach Ingersoll Rand with the assumption that management is inferior until and unless it proves otherwise. Even so, that doesn't mean that investors should ignore the growth possibilities here.
I expect IR's transportation refrigeration business to be consistently inconsistent, but I do believe that residential and commercial climate control demand is going to improve in the coming years - probably a little later than the Street expects, and with a longer, less dramatic cycle, but improving all the same. With that, I think Ingersoll Rand can look to long-term revenue growth of 4% to 5% - better than its trailing 10-year rate and better than other industrials like Parker-Hannifin (NYSE:PH) or Illinois Tool Works.
The margin side is where I think management can really earn its praise. I don't think the company will drive results up to Atlas Copco levels, but I think double-digit operating margins should be here to stay, with upside in the low-to-mid teens as better volumes drive better overhead leverage. If the company can manage that, free cash flow growth could hit the low double-digits.
The Bottom Line
Unfortunately for investors considering these shares today as a new investment, the Street pretty much expects all of what I just laid out to happen. A 10% to 11% free cash flow growth rate points to a fair value in the low $50s, and that's where we are today. If management can do better, substantially better, and lift the company's long-term free cash flow margin into the double-digits where other well-run industrials live, then the share price potential climbs into the high $60s.
I'm still a skeptic on this management, so I won't be buying shares on the idea of seeing that sort of free cash flow improvement. Given how well these shares have already responded to management's new direction(s), it's hard for me to see the argument for holding on today, as there seems to be more that could go wrong (a later, lesser construction recovery, disappointing margins, etc.) than go better than expected.
Disclosure: I 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.