The Risk-Reward Trade Off
From: Nicole Urken
Date: Thu, Oct 13, 2011 at 6:33 PM
Subject: Ingersoll-Rand Sum of the Parts
To: James Cramer
Looking at sum-of-the-parts valuation for IR based on the projected EBITDA figures for each of its segments, there is upside—BUT that is only if the company can hit the laid out 2013 targets. The case for Ingersoll as a speculative buy is only IF they are able to hit these projections. Considering their successive disappointments (and next Thurs 10/20 isn’t likely to be a blow out either), it could be dicey.
From: James Cramer
Date: Thu, Oct 13, 2011 at 10:26 PM
Subject: RE: Ingersoll-Rand Sum of the Parts
To: Nicole Urken
Given that the stock isn’t a buy based on what we’ve seen, let’s actually do a MOCK conference call—A script that would actually move the stock up. A fall on the sword approach. We call it “SCRIPT DOCTOR! !!
When you see a stock down big year-to-date, it can look like quite an interesting bottom fishing opportunity. That is, at first glance anyway. After all, Ingersoll-Rand caught our “Mad Money” eye for just that reason last week with the industrial conglomerate down 40 percent year-to-date. After taking a deeper dive into the numbers, we ultimately concluded in our segment on Friday that the risk-reward was not in our favor.
Why? Because the new management team, who took over in February 2010, had used up their “show me” grace period. Their successive missed quarters meant too much execution risk embedded in the potential upside.
Our exercise of looking at Ingersoll-Rand last Friday is a lesson on the important difference between theory and reality. Based on IR’s 2013 targets, the stock, theoretically, has substantial upside. If the company could even approach its 2013 margin target of 15 percent, it would mean a substantial jump from the 9 percent achieved in 2010—something that would benefit both the forward earnings and multiple for the stock. Not to mention that the company continues to have cost-cutting opportunities at Trane, its $10 billion acquisition from American Standard in 2007. And of course, given that 75 percent of the company’s revenues are commercial and residential heating, ventilation and air conditioning (HVAC)—a very late cycle business—there is upside once we get a turn in non-residential construction or a stabilization in the housing market.
As we noted last Friday, however, we needed to see a real acknowledgement of the dismal reality for the company based on its latest results and a re-setting of expectations—which we didn’t get.
On Thursday’s conference call, we heard nothing that we laid out last Friday… and because of that, Ingersoll-Rand remains a sell. Let’s take a closer look at what we said we needed to hear from management and, in contrast, what we did hear:
WHAT WE NEEDED: In our segment last week, we noted that we needed to hear CEO Mike Lamach take ownership of the recent disappointments and acknowledge them with humility. Then, he needed to lower the bar for (1) 2013 to the point where targets are believable and (2) for near-term quarters with conviction, vowing to take no prisoners if they miss again.
WHAT WE GOT: We didn’t hear any of that in Thursday’s announcement, which managed to just squeak past the lowered guidance from its September 30 pre-announcement. In fact, the company cut its near-term outlook yet again (moving 2011 EPS targets down) despite a slight 3Q beat and an active buyback. More importantly, the company made no changes to longer-term targets. In fact, in response to a direct question about guidance, Lamach said point blank that while the company is not seeing the recovery it anticipated in 2011, he refused to update the 2013 targets.
“What I am not going to do is issue any new framework,” Lamach said. “I think that what I would like to do is just sort of year-over-year tell you through guidance what we expect to do in terms of performance of the Company. I think that structurally and ultimately we will get to where we wanted to go.”
We needed a re-setting of the bar and guidance with credibility. We didn’t get either.
WHAT WE NEEDED: We noted that we would like to see some evidence of cutting costs at Trane, which is the big opportunity for the company to position themselves for when we get a turn in non-residential construction and some stabilization on the residential side.
WHAT WE GOT: Pricing and productivity improvement have not been enough to offset revenue declines. While operating margin this quarter was up 30bps, Lamach acknowledged on the conference call that, “the improvement was significantly below the margin improvements we have achieved in the past several quarters and look to achieve in the future.”
WHAT WE NEEDED: We need to hear disciplined on pricing and cutting costs here while expanding their product portfolio to offset the lack of new construction in the residential HVAC business.
WHAT WE GOT: Residential disappointed on both top-line and execution as pre-announced by IR, but there were no indications of near-term improvement.
WHAT WE NEEDED: We noted we needed to hear emphasis on expansion into international markets, where peers have a larger presence.
WHAT WE GOT: While IR did emphasize the international growth they are saying, they still lag peers in terms of their presence internationally—notably China, India and Brazil—and there have been no signs of a real acceleration.
Now, it’s true that management must contend with being levered to later-cycle business—while recent economic data points (including ISM) have been stronger, we are still waiting for a turn in non-residential construction and stabilization on the residential side. But, execution issues (including market share losses and inability to hit cost savings targets) means that the company is not as well positioned as peers once a turn comes. While the new management team isn’t at fault for overpaying for assets like Hussman (it paid $1.5bn in 2000 and just sold 60 percent off for $370mm) or for being late to the party on restructuring, they have now been in charge for 18 months and have used up their grace period. The stream of disappointments and lack of credibility in targets IS their responsibility now.
The bottom line: Just because IR is one of the cheapest industrials and a high beta name is not enough of a reason to buy it. The theoretical sum-of-the-parts analysis we did does not hold up because we cannot believe the targets, further weakened after Thursday’s dismal report and disappointing conference call.
If you are looking for a cheap industrial with operating leverage upside, look no further than Johnson Controls, which has a solid HVAC business in addition to its status as an auto-supplier. Even fellow-HVAC name Watsco, which also reported a disappointing quarter on Thursday, is better positioned than IR. Until IR improves its messaging, or can convince us it has the operating leverage to be well-situated for a macro turn, stay away.
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