A Few Short-Term Challenges Don't Cancel Ingersoll-Rand's Strong HVAC Results

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Summary

You can never be quite sure what investors will be willing to just "look past"; investors seem to have taken the suspension of 737 MAX production in stride as it concerns leading aerospace suppliers, and likewise investors seem to not be overreacting to a noisy quarter at Ingersoll-Rand (IR) that was impacted by some short-cycle industrial weakness and a steep downturn in the cyclical (but quite profitable) Thermo King business.

Given the significance of HVAC in global energy consumption (to say nothing of the number of people around the world who don't yet have it), Ingersoll-Rand is not only tied to a very strong underlying multiyear driver, but one that has an appealing ESG angle as well. This has led me to look past some of my valuation concerns, and I still like these shares, though I'd like them a lot more if I had the chance to buy below $120.

Not A Good-Looking Quarter…

This wasn't a good-looking quarter from Ingersoll-Rand, and I'm not suggesting it was actually a good quarter in disguise, but I don't think the negative drivers materially impact the long-term story.

Revenue rose 7% as reported and 5% on an organic basis, missing by less than 1% and nevertheless standing out as a good result so far in the industrial earnings cycle (though reports are coming fast and furious now, so may have missed some better ones). The Climate business posted a nearly 7% growth rate, about 6% of which was driven by volume, against a tough year-ago comp (up almost 9%), but this was about 1% lower than expected. The Industrial business, which will be combined with Gardner Denver (GDI) in an upcoming Reverse Morris Trust transaction, posted more than 2% organic contraction, beating expectations by about 1%.

Gross margin was definitely light, missing expectations due to decremental margins from the Thermo King business, but it was actually up 50bp year over year. Segment profit rose 9%, with 30bp of margin expansion, but came in about 3% short, driving a $0.05/share miss. Climate, where segment profit rose 4% (margin down 30bp) drove the miss, while Industrial's 27% segment growth was meaningfully better than expected. Operating profit rose 7%, with 10bp of margin expansion, and missed expectations by about $0.06/share.

For the full year, Ingersoll-Rand exceeded the average sell-side free cash flow estimate and just barely missed mine (about 1.5%).

… But Not So Bad Either

Part of the reason I'm not concerned about the shortfall in the fourth quarter is the extent to which it was driven by the highly cyclical Thermo King business. As truck orders are falling off a cliff, so too are orders for Thermo King's truck-mounted refrigeration units. Management indicated that the business saw a high single-digit revenue decline this quarter, and with the high profitability of the business, that produces meaningful decremental margins.

The core HVAC business remains quite strong, though, with sales likely up double-digits. Unfortunately management no longer provides detailed breakdowns of the businesses, but it is still possible to extrapolate from when they used to, producing a rough estimate of where the business is now. To that end, management did mention "high teens" growth for the North American commercial HVAC business.

So too with the orders. Climate orders declined 6% in organic terms, but would be up low-teens if you exclude Thermo King and a large one-time year-ago order in Commercial. By extrapolation, then, Thermo King orders have fallen off a cliff - perhaps down as much as 50% - and those decremental margins are likely to linger a bit.

In the Industrial business, it sounds like compression was weaker than Atlas Copco's (OTCPK:ATLKY) 2% organic growth, but it's hard to compare the orders since neither company went into specifics on the comparable businesses (Atlas orders were boosted by strong demand in large compressor categories where Ingersoll-Rand doesn't compete, and the smaller/mid-sized compressor business orders were described as "down").

The Outlook

I continue to like Ingersoll-Rand. I think the Gardner Denver will end up being a good one for shareholders, with the combined company being a more formidable rival to Atlas Copco. By the same token, though, Atlas has a very strong business here predicated on R&D-driven energy efficiency gains and new product development and a very strong sales network; getting bigger will help, but Atlas is no pushover.

Long term, I still really like Ingersoll-Rand's Climate business. Thermo King will always be cyclical, but I believe it more than earns its keep over the full cycle, and I think the commercial HVAC business (and to a lesser extent the residential HVAC business) is leveraged to powerful long-term trends in energy efficiency.

Valuation is still problematic, but not really any more so than for other quality industrials right now. I do believe Ingersoll-Rand can generate mid-single-digit long-term revenue growth (higher after the split), with attractive mid-teen operating margins. Discounted back, I believe IR's cash flows support a mid-to-high single-digit return on par with other quality industrials.

The Bottom Line

Given the strong long-term trends for Climate, I'd call Ingersoll-Rand a "first among equals", and it's still a stock I like despite the high valuation. This is about as close as I get to "ignore the valuation and just buy" in the large industrial space, and it would be much easier to love and recommend Ingersoll-Rand at a lower price. Perhaps an eventual market pullback will open such a window of opportunity.

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.