ATLKY - Ingersoll Rand Executing Well And Better Days Are Still Ahead

Summary

• Ingersoll Rand has steadily exceeded expectations this year, with third quarter results about 5% better than expected at the revenue and EBITDA lines, and strong volume and margin performance.
• I do believe capex spending could slow next year, but Ingersoll Rand is well-placed to benefit from years of catch-up spending as well as increased attention to energy- and resource-efficiency.
• The shares aren't the biggest bargain in the industrial sector, but paying a fair price for a well-run company with above-average revenue growth/margin expansion potential can still work out well.

A year ago I was neutral on Ingersoll Rand ( IR ) shares, as I liked the multiyear growth story underpinned by the company’s exposure to capital spending and certain ESG touch points like energy and resource efficiency, not to mention the M&A optionality, but didn’t love the valuation. The shares have sold off about 5% or so since then, keeping pace with the broader industrial space and outperforming Atlas Copco ( OTCPK:ATLKY ).

I’m still not exactly thrilled about the valuation, and I don’t feel that my underlying expectations (high single-digit revenue growth and meaningful margin/FCF margin expansion) are conservative. Still, at a time when short-cycle names are rolling over, I think Ingersoll Rand is in better shape than most over the next five years (and beyond). While I’m tempted to hold out in the hope of a better price on a market sell-off, I don’t think there’s anything wrong with owning a good company (and one likely to outgrow its markets and peers) trading at a reasonable price.

Strong Trends Across The Business In The Third Quarter

Ingersoll Rand may not have smashed analyst expectations in the third quarter, but the numbers themselves were good and at a time when many companies have shifted from beat-and-raise to miss-and-lower, Ingersoll Rand management is still seeing evidence of healthy trends in the business.

Revenue rose 18% in organic terms to $1.52B, beating by about 5%. That growth was balanced between price and volume, and while the 9% price movement is more or less average with other industrials (and a few companies like Allegion ( ALLE ), Honeywell ( HON ), and Trane ( TT ) did even better), the 9% volume growth is one of the best results I’ve seen so far.

Ingersoll Rand has incurred less trouble from cost inflation than many peers, and gross margin fell 80bp yoy to 38% this quarter. Comparisons to pre-pandemic levels aren’t so helpful because of the significant restructuring of the company, but the company did start 2021 with a 38.2% gross margin, so again, there hasn’t been as much damage here as with other companies.

Adjusted EBITDA rose 20% to $376M, beating by 5%, with margin up 110bp to 24.8%. Operating income rose 29% to $197M (margin up 150bp to 13%), but the company and analysts emphasize adjusted EBITDA over operating income (for better or worse).

IR's Industrial Technologies and Services (or ITS) segment posted 19% revenue growth (to $1.2B) this quarter. That beat expectations by 5% and surpassed the results posted by Atlas Copco in its Compressor, Industrial, and Power segments. Compressor sales were up “low 20%’s” versus 13% for Atlas’s Compressor Technique, while Vacuum/Blowers rose at a mid-teens rate. Tools and Lifting saw “high double-digit” growth, which compares well to the 14% Industrial Technique growth at Atlas. Segment EBITDA rose 15% to $314M, with margin up 70bp to 26.2%.

The Precision and Science Technologies (or PST) business saw 15% growth, beating expectations by 4%. There is some comparability here to Atlas’s Power Technique business (revenue up 20%), as well as IDEX ’s ( IEX ) FMT (up 17%) and HST (up 13%) segments, and I’d say that Ingersoll Rand held its own. Adjusted EBITDA rose 22%, with margin down 60bp to 29.1%.

Not Much Of A Slowdown Yet

While many industrials are seeing weakening orders and some compression in their backlogs, demand remains healthy for Ingersoll Rand at this point.

Orders rose 14% yoy in organic terms (and 4% qoq), with a book-to-bill of 1.09x. That’s a slowdown from recent quarters (1.11x in Q2’22, 1.22x in Q1’22, 1.06x in Q4’21), but not a dramatic one.

ITS orders rose 16% (with a book-to-bill of 1.13x), with compressors up “high double-digits” versus 21% order growth at Atlas Copco. PST orders were up 3% as reported and 8% adjusted for orders related to COVID-19, and I believe the book-to-bill was positive on that adjusted basis (it was 0.95x as reported).

Management reiterated revenue growth guidance, but slightly boosted EBITDA guidance for the fourth quarter, and given a trend of reasonable but conservative guidance, another revenue beat is not out of the question.

I do believe that we’re going to see a meaningful short-cycle slowdown next year, but I don’t believe it’s going to be a uniform slowdown. I think there will be a more noticeable slowdown in components and consumables as demand slows, backlogs are delivered, and inventories rebuilt. Those trends may only apply to around a third of Ingersoll Rand’s business, though, and markets like food/beverage, life sciences, oil/gas, infrastructure, water, and renewables are likely to hold up better.

I do see some risk of a slowdown in capital spending, as companies take a generally more conservative approach in an environment of higher rates and weaker end-user demand, but I think it will be a brief slowdown. Industrial companies had been underinvesting in capex for years leading into the pandemic, but have since learned some lessons about running with no surplus capacity and using extended supply chains.

On top of that, Ingersoll Rand has some arguably under-appreciated ESG leverage. Compressors are a major source of electricity use within a manufacturing facility (I’ve seen estimates of one-third), and Ingersoll Rand has been developing new products that are significantly more efficient. Likewise with other products that reduce water usage.

The Outlook

Management has shown that they’re serious about their growth by M&A plan, and between ongoing M&A and growth in core businesses like compressors, vacuums/blowers, and specialty pumps, I believe management’s low double-digit growth target through 2025 is credible. I don’t think the company is likely to pursue particularly large deals, but there should be opportunities to add distribution, manufacturing, and technical capabilities in its ITS segment and expand into adjacent products/markets in the PST business.

I like how management has restructured the business around more attractive core growth opportunities in both its industrial and non-industrial markets, particularly with respect to “high-grading” some of its pump/fluid transfer businesses. I’m looking for growth in industrial production capacity as well as retrofitting/replacement for greater efficiency, and ongoing growth in non-cyclical markets like life sciences, water, and food/beverage, and that supports a healthy mid-single-digit organic growth rate, augmented by ongoing M&A.

I’m looking for high single-digit long-term revenue growth, with underlying organic growth in the 4% to 5% range. I don’t normally like modelling in M&A, but Ingersoll Rand has been explicit that this is part of the growth/capital allocation strategy. Management has also been executing on margin-improvement efforts, and I think further actions, including adding more IIoT functionality, can help drive more margin expansion. I think 27%-plus adjusted EBITDA margin is possible in 2025, and I’m looking for gradual expansion of FCF margins toward 20%, driving mid-teens FCF growth.

The Bottom Line

Between discounted cash flow and a margin/return-driven EV/EBITDA approach, I find Ingersoll Rand more reasonably priced than clearly cheap. I see a long-term annualized potential return around 8% and near-term upside of around 10%, and there are certainly cheaper industrials out there. As I said in the beginning, though, investors can still do well holding the shares of good companies that are "fairly-valued”, as these companies have a way of outperforming expectations over time (certainly true for names like Atlas, Eaton ( ETN ), and Honeywell).

Why am I not saying “Buy”? It’s hard to give Ingersoll Rand that rating when other high-quality industrials are even cheaper, but this is a name that is still high up on my list today and would definitely be a priority if the shares were to weaken.

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