The New Ingersoll Rand Debuts Under Challenging Circumstances

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Summary

While the combination of the former Ingersoll Rand’s non-HVAC businesses and Gardner Denver into the new Ingersoll Rand (IR) makes plenty of sense on a long-term basis, this is a tough time for this new company to make its debut. A host of short-cycle manufacturing end-markets are under significant pressure now, not to mention commodity markets like mining/metals and oil/gas, and acyclical businesses like medical/life sciences aren’t big enough to pick up the slack.

Ingersoll Rand should see its short-cycle business pick up around year-end, leading the way into a solid recovery in 2021 and beyond. Upstream oil/gas is going to be weaker for longer, I believe, but it’s now a smaller part of the overall business. On top of that are meaningful synergy and cost reduction opportunities. The “but” at the end of the road is valuation. While I do see a path to adjusted operating margins in the mid-teens and similar levels of FCF margin, the share price seems to already reflect that and I’m concerned the company could execute quite well objectively but still underwhelm from a relative price performance perspective.

Tough Times As Most Markets Ratchet Down

Expectations weren’t all that high for Ingersoll Rand in its debut quarter, but the company still came up short on both the revenue and EBITDA lines (missing by about 6% and 7%, respectively). While many industrial companies management to beat relative to lowered expectations going into the quarterly reports, the challenges of modeling the first quarter of the combined companies arguably earns the company a pass for this first quarter.

That said, the 14% pro-forma revenue decline was still significantly worse than the roughly 4% average revenue decline for the larger industrial group, particularly given that Atlas Copco (OTCPK:ATLKY) reported a 4% drop in its compressor business and a 14% drop in its industrial tools business. EBITDA declined 24% on a pro-forma basis, with segment EBITDA down 23% and margin declines in three of the four businesses.

Industrial Technologies and Services saw a 17% decline in revenue, and this is the more comparable segment to those two aforementioned segments of Atlas. Management also pointed to the 23% decline in its Power Tools and Lifting sub-segment, which doesn’t compare well to the roughly 13% revenue decline at material handling comp Columbus McKinnon (CMCO). Segment EBITDA declined 25%, with margin down 150bp.

Precision & Science Tech saw a 9% revenue decline, with better performance in medical pumps helping to offset some of the declines in other markets. Relative to peers/comps like IDEX (IEX) and ITT (ITT), this too was not a particularly strong performance. Segment EBITDA declined 6%, with margin up 120bp.

Specialty Vehicle Technologies saw 7% revenue growth and this was easily the standout performer this quarter. Segment-level profits did decline 1%, though, with margin down about 80bp.

Last was the High Pressure Solutions business, which saw 29% revenue contraction amidst significant capex cutbacks among oil and gas companies. Profits declined 43%, with margin down 620bp, but still comparatively strong at 24.6%.

Short-Cycle Markets Should Rebound, But Oil & Gas Is More Problematic

The good news for Ingersoll Rand is that it’s more than halfway through a typical short-cycle downturn (six to eight quarters). Granted, the outbreak of Covid-19 makes this a decidedly atypical cyclical downturn, but I nevertheless believe that Ingersoll Rand will see signs of normalization (if not rebound) in the fourth quarter and into/through 2021 in most of its short-cycle markets.

It’s worth remembering that the company’s short-cycle exposure is quite diverse. The auto/truck end-market is the biggest at around 5% of sales, but around half of the business is made up of a diverse set of manufacturing end-markets. With that, industrial production numbers would be the most relevant macro-economic indicators to follow.

Ingersoll Rand’s oil and gas exposure is a different matter. Including some petrochemical end-markets, these markets make up about 20% of the company’s sales (mostly in the High-Pressure Solutions business), though about half of that is in upstream oil/gas. Ingersoll Rand’s exposure consists of product lines like frac pumps, drilling pumps, and fluid ends (used with fracking and drilling), making the company acutely leveraged to U.S. drilling activity. While oil prices have recently recovered to a point where some drilling makes sense, overall activity levels have plunged, with drilling rig counts down almost 70% and active frac fleets down more than 80% year-over year as of late April (and down about 70% relative to the average for the first quarter). Some analysts believe the frac spread count could fall another 50% or so from that late April level, putting even more pressure on an already-pressured business.

I believe the upstream oil/gas sector could be looking at a multiyear recovery process, as it will take time for the survivors to repair their balance sheets and resume capital spending. The good news for Ingersoll Rand is that this can be a profitable business even with well below average activity levels. Although I think this business is likely to go into the red in Q2, and could stay there for a few quarters, I think margins can return to the mid-teens even as the multiyear recovery plays out.

Better Together

It will take time, but I believe this newly-merged business can generate some meaningful long-term operational synergies. Management has already identified $350 million in cost savings opportunities (up from an initial target of $250M) across functions like procurement/supply chain, manufacturing, and back office functions.

Longer term, I see opportunities for the company to leverage a larger base in compressors to compete more effectively with Atlas Copco and drive better aftermarket service capture. I don’t believe Ingersoll Rand will be in a position to take share from Atlas for a while, but it should be able to stem the losses, and I expect the company to be able to leverage its enhanced scale for more effective product development -- developing more energy-efficient compressor designs is critical, as energy costs are more than half of lifetime compressor ownership costs.

I also see some longer-term opportunities for portfolio transformation. I’d expect management would like to eventually find a buyer for the low-margin vehicle business, but there are opportunities to add scale in pumps (especially specialty pumps in areas like medical/life sciences) and in tools.

The Outlook

I believe Ingersoll Rand can produce core revenue growth in the mid-single-digits over the long term, with adjusted operating margins and FCF margins in the mid-teens. A stronger recovery in oil/gas would offer some upside, as would better market share performance in compressors and better success in capturing aftermarket parts and service opportunities.

Unfortunately, the FCF I expect from Ingersoll Rand isn’t enough to drive an attractive fair value, nor is the company’s near-term margin/ROIC/ROA outlook. While I’ve seen several sell-siders value Ingersoll Rand with a forward EBITDA multiple of 14x or thereabouts, the reality is that the company’s margin trajectory doesn’t support that sort of premium – that’s usually reserved for companies with high-teens operating margins.

The Bottom Line

At the right price, this would be an interesting industrial name to consider, particularly with short-cycle markets likely to turn more positive around the turn of the year. I don’t think this is the right price, though, and I’m content to watch and wait for a better opportunity, even while acknowledging meaningful revenue and cost synergy opportunities in the coming years.

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.