Ingersoll Rand: Excellent Economics Well Reflected At Current Multiples (NYSE:IR)

Investment Summary

The industrials sector has potentially some of the least appealing price/value characteristics of all the S&P 500. When comparing the current market-cap-weighted value of the sector to its next 12 months’ projected earnings growth, it sits at the bottom of the pack, in contrast to the basic materials sector at the front. Whilst it might be easier to scour those at the left of the chart in Figure 1, arguably, the hurdle is quite low for those companies to the right.

Those companies in the industrials sector with 1) great financial performance [growth] with 2) excellent economic health [high returns on capital with economic profit] and 3) priced at mouth-watering valuations are all idiosyncratic diamonds in the financial rough.

Figure 1.

Ingersoll Rand (NYSE:IR) exhibits two out of the 3 characteristics listed above as I write today. The company’s recent gains in market value are well supported in the fundamental facts pattern, namely 1) high returns on incremental capital, 2) increasing free cash flow, 3) sales + earnings growth, and 4) redeploying its surplus funds back into the business at an advantage.

Issue is the market looks to have captured this performance and health well at 30.6x trailing earnings and >26x trailing EBIT. To move beyond these multiples could be a stretch; thus I am hold on IR on valuation grounds. Net-net, rate hold.

Background of IR

IR products include things like compressors, pumps, vacuum systems, and blowers, which it markets under its various brands [think names like Ingersoll Rand, Gardner Denver, Nash, and CompAir for instance].

It operates through two primary business segments: (1) Industrial technologies and services (“ITS”), and (2) precision and science technologies (“PST”). The ITS segment’s value-add is in industrial efficiency. It sells things like compressors, pumps, and blowers as mentioned earlier, which are critical to industrial processes.

Meanwhile, the PST business caters to more specialized markets such as biopharmaceuticals, medical devices, and space technology. This means it has exposure to commodity-like markets with low margins (in the ITS division) and highly specialized, differentiated markets with high margins (PST business).

In 2014, the company did $2.5 billion of sales on $321 million of operating earnings. By 2018, sales were $2.68 billion on $450 million of pre-tax income. Last year it clipped $6.9 billion in sales on operating earnings of $1.24 billion after major acquisitions and capital investments.

Analysis of recent developments

(1). Q1 FY 2024 earnings

In my view, the company’s Q1 FY’24 numbers illustrate critical insights to its short-term momentum.

For one, management has an optimistic outlook for the next earnings report. My views on this outlook are the following:

• Despite a 7% year-over-year decline in organic orders and a 100 basis points decline in revenue for Q1 FY 2024, the combination of 1) the company’s strong backlog, [which increased by ~200 basis points year over year], and 2) the book-to-bill ratio of 1.02x indicate its pipeline demand is robust [a book-to-bill >1 is preferred]. As such, my view is The Street should anticipate moderate sequential growth in revenue for Q2, driven by the execution of this backlog.
• A 290 basis points adj. operating margin decompression brought Q1 adj. EBITDA to ~$460 million (up 15% year-over-year growth on 27.5% margin). Given the company’s continued execution of its “i2V” (integrate to value) initiatives and strategic pricing actions, it isn’t unreasonable to expect further margin expansion in subsequent quarters, in my view. For instance, the ITS segment saw a 370 basis point margin increase and the PST’s operating margins loosened by ~50 basis points in Q1. The operating leverage was ~2.1x, which could persist. Management sees pre-tax margins hitting 30%. We – the investors – shall see too.
• Earnings were up by 20% to $0.78 per share and I want to highlight the incremental $1 billion share repurchase authorization that is set to commence in Q1 2025. This will not only 1) drive money flows to the stock [critical for momentum], but it will also 2) increase per-share earnings through the reduced share count, and 3) could potentially improve total shareholder returns.
• The company threw off ~$99 million in quarterly FCF. Management guides to CapEx at ~2% of revenue for the full year and the normalization of interest payments, and expects FCF to improve.

(2). Interpretation of results

Considering the current trajectory, analysts are likely to revise their estimates upward for IR, in my view.

For one, there have been 13 upside revisions to earnings in the last 3 months, against zero to the downside. The street now expects 10-11% bottom-line growth and earnings of $3.28 per share this year. Management’s guidance for total revenue growth of 4%–6% on adj. EBITDA of $1.94 –$2 billion gets it to $3.20–$3.30/share in FY 2024.

Investors should keep a close eye on several critical fundamental signals, in my best estimation:

1. Order book and backlog: I want to observe any significant changes in order intake or backlog levels to provide early indicators of future revenue trends.

2. Margin expansion: The thing I want to assess most on margins is operational efficiency and the impact of management’s cost-control measures.

3. Obviously, any share buybacks: Progress on the new $1 billion share repurchase program will be vital in my view to (i) see how bullish management is on its stock, and (ii) if it actually will commit to the purchases or not.

Keep an eye on these factors moving forward in my view.

Fundamental economics

IR has plenty going for it and has exhibited strong fundamental momentum over the past three years, potentially corroborating the lift in its share price over that time.

Firstly, working capital turnover has increased substantially alongside sales growth. As seen in Figure 2, management turned over working capital 2.1x in the 12 months to September 2021 but has increased substantially to 3x in the last 12 months.

This is a good sign as it indicates that, as more sales are booked on the income statement, the company is working through more receivables and payables alongside this. In other words, it isn’t just booking more sales growth without realizing the cash flow alongside this.

Figure 2.

This is verified by the fact that free cash flow has increased from $425 million in 2022 up to $1.37 billion in the last 12 months of business. Moreover, invested capital turnover has increased from 0.39x to 0.52x over this time – a 33% increase in capital efficiency.

Figure 3.

The result of this trend has seen pre-tax return on invested capital nearly double, from 7.4% to 14.5% (trailing 12-month figures). We dub this here at Bernard “economic leverage on deployed,” signalling the increase in business returns resulting from either 1) an increase in operating margins, 2) an increase in turnover, or 3) both.

The result has been post-tax earnings increasing from $917 million to $1.28 billion over the testing period, on cyclical reinvestment patterns, allowing the company to throw off plenty of free cash float to its shareholders each period.

Figure 4.

The point to add here is that management has actually had a decent reinvestment runway to deploy capital at this advantage. As observed in Figure 5, the marginal return on invested capital (that is, the incremental growth of operating profit after tax produced by the previous period’s reinvestment) has sat at double digits in every period in a range from 13% to 41.9%. It was 12.2% in the 12 months to March 2024.

Management has had opportunities to deploy capital (including its recent acquisitions and growth initiatives discussed), and this has warranted ongoing growth of the intrinsic value of the company.

Figure 5.

Valuation scenarios

Consensus is calling for 5.6% growth rate in sales for 2024 and 18.6% growth in pre-tax earnings, creating 3.3x operating leverage if management hits these targets. It also eyes a 5%–6% revenue growth rate over the coming three years. This could get us to a 20.3% pre-tax margin for the ’24, a lift of 200 basis points from 2023.

Figure 6. Implied figures using consensus growth estimates

In that vein, the recent sales momentum may prove to be a tailwind for the valuation if it is not already reflected in the current market price. Shown below are the capital allocation decisions of management along with the financial performance of the company on a rolling 12-month basis since 2021. Sales growth is 3.4% per period, with incremental operating margins of 20.8% (most of this being realized in recent margin uplifts).

To produce a new dollar of revenues, management has had to invest $0.26 to intangible assets tied to acquisitions. This has been the majority of the investment drivers. It has also had to invest $0.06 to working capital (unsurprising given the efficiencies discussed earlier) and $0.06 per $1 of new sales to fixed assets.

Figure 7.

You will note this revenue growth rate is below consensus projections. Consequently, it has drastic consequences whether 1) management hits the projected 5 to 6% top-line growth or 2) maintains itself at this 3-4% range.

For context, investors have lifted the multiple paid capital invested in the business from 1.8x in 2021 to 3.0x at the time of writing.

To me, this is not surprising, as it exemplifies the increasing pre-tax returns the business has produced. At the same time, investors have also increased the multiple paid on post-tax earnings substantially, from 24.7x to 30.8x as I write.

Both are fairly exuberant multiples, so I am contracting them on my estimates going forward to be overly conservative and create a high watermark for this company to command a buy.

Figure 8.

Below there are two scenarios. The first, management continues at the 3.4% growth rate, no change in pre-tax margins or capital allocation rates.

On this basis, there is little to no implied change in the current stock price to FY 2026. In other words, the company is fairly valued as it stands under these assumptions.

Figure 9.

If we were to buy 1,000 shares of IR at markets today, the following is relevant under these assumptions:

• Cost of $94,500

• Earnings power of $3166.

• Return on market capital of 3.4% (note: this is analogous to earnings yield, where earnings are net operating profit after tax).

• Current P/E multiple of 29.8x

Under the above stipulations our earnings power to $3,516 or $3.52 in operating profit after tax per share, 11.1% cumulative growth, and 4% CAGR.

Figure 10.

Now, if management does produce the average 5% sales growth rate, there is a change on the implied valuation. But, investors would need to continue paying these substantially high multiples (which continue to price tremendously high expectations) to compound IR’s market value from here.

Keep in mind, this is presuming an above-average sales growth rate and 20% pre-tax margins. Hardly slouch numbers for this size.

Figure 11.

Under the same earnings power scenario as earlier, we obtain $3,916 of earning power, 23% cumulative growth or just over 7% CAGR. Neither are really attractive figures, especially when indexed against other more selective opportunities.

Figure 12.

Adding further weight to the negative view on valuation, my estimate is the margin of safety is only around 9 to 10% [it could trade at around 27x post tax earnings, only 9% tolerance to the downside].

Figure 13.

Upside and downside risks

Key upside risks to the thesis include 1) passing the 5% sales growth rate, 2 higher than average pre-tax margins [calling for >20%], and 3) continuation of multiple expansion beyond 3.0x EV/IC.

Meanwhile, on the downside, risks include 1) a further contraction in sales growth, 2) sharp contraction in post-tax earnings multiple below 25x, and 3) the broader set of macroeconomic risks (rates/inflation axis, geopolitical risks, commodity prices, and so forth), that cannot be ignored and could spill over into equity markets.

What could also change the thesis are two things-

1. Substantial earnings growth into the next 12 to 24 months with no change in earnings multiples (this would see us level off to more respectable valuations),

2. A sharp pullback to the $60s (given the strong fundamentals on offer at that price – 5-6% NOPAT yield).

In short

IR stock has trended on strong fundamentals over the past 12 months, justifying 1) higher market values, and 2) higher multiples relative to earnings and assets in the business.

It is not unreasonable to expect a period of outsized growth for the company going forward. The fundamentals support this – 1) 5 to 6% top-line growth estimates, 2) around 200 basis points in margin increase forecasted this year, 3) increasing pre-tax returns on capital, and 4) growing free cash flow as management works through working capital and reinvests surplus funds back into the business at an advantage.

The key downside risk in my opinion is valuation. The market looks to have well reflected these accelerating fundamentals at the current set of multiples. To trade higher than 30x post-tax earnings is quite the stretch in my opinion. More concerning, the risk-reward calculus appears skewed to the downside, with 1) my estimates of intrinsic valuation and 2) the margin of safety implying little on the return side. Net-net, rate hold.