Ingersoll-Rand (IR): Positioned for Excellence

In the summer of 2008, I started accumulating shares of Ingersoll-Rand (IR). At that time, American economy had shown plenty of uneasy signs, while I identified IR as one of the stocks with the potential to thrive through the possible upcoming downturn. I had three reasons to back up my beliefs, first, Warren Buffet's stake in the company, second, IR's move to acquire Trane, and third, its global footprint - the Asian market would provide immense growth opportunities.

Then the unfolding of the financial turmoil later the same year proved my timing was not right. IR was hit way harder than I had figured, primarily due to their exposure to the construction (both commercial and residential) market, and the increased debt level - as a result of Trane acquisition. However, I held onto my positions and haven't changed my long-term views on the company. Now we started seeing some positive signs of the economic trend, and I think it is a good time to revisit my thoughts on IR.

A Company in Transition

First of all, a simple description of IR's business from their 10K.

"Ingersoll-Rand Company Limited (IR-Limited), a Bermuda company, and its consolidated subsidiaries (we, our, the Company) is a diversified, global company that provides products, services and solutions to enhance the quality and comfort of air in homes and buildings, transport and protect food and perishables, secure homes and commercial properties, and increase industrial productivity and efficiency. Our business segments consist of Air Conditioning Systems and Services, Climate Control Technologies, Industrial Technologies and Security Technologies, each with strong brands and leading positions within their respective markets. We generate revenue and cash primarily through the design, manufacture, sale and service of a diverse portfolio of industrial and commercial products that include well recognized, premium brand names such as Club Car, Hussmann, Ingersoll-Rand, Schlage, Thermo King and
Trane."

Here are some key points from reading their 10K, 10Q and other financial presentations.

- On June 5, 2008, for $9.6 billion, IR completed the acquisition of Trane Inc, one of the top HVAC (heating, ventilation and air conditioning) companies, previously known as American Standard Companies Inc.

- On November 30, 2007, IR completed the sale of Bobcat, Utility Equipment and Attachments business units (collectively, Compact Equipment) to Doosan Infracore for cash proceeds of approximately $4.9 billion.

- On April 30, 2007, IR completed the sale of the Road Development business unit to AB Volvo for cash proceeds of approximately $1.3 billion.

- The international share of IR's revenue has been growing at fast pace, and the trend will continue. For example, for Climate Control, in 2001, 39% of the revenue is from outside North America, and in 2008, 47%. Overall in 2008, 34% of its revenue is from outside North America.

- IR's revenue is across multiple markets, including Parts & Service (25%), Commercial Construction (23%), Residential Construction (12%), International Construction (11%), Industrial/Process (9%), Supermarkets – Cases / Install (8%), Truck and Trailer (6%), Bus, Container & Other (3%), Golf & Utility Vehicles (3%). It seems to be very well balanced, not tying to any single market.

- The parts & service revenue, as mentioned above, is 25%, a very healthy number. It represents the recurring revenue, the very type that every company seeks with greatest effort. Its increase indicates the deepened independence of the customer upon the service/parts provider, which translates into guaranteed revenue. IR continues to put high priority on developing the capabilities to deliver recurring revenue.

- IR has been using Lean Six Sigma for years, and will continue to rely on it to achieve operational excellence, which reflects IR's clear and constant awareness of efficiency and cost.

So clearly, IR is a company in transition, from a traditional asset intensive American company, towards a light-weight, international company with good margin, steady stream of revenue and maximized immunity to American economic cycle. In other words, IR has been constantly recalibrating itself to remain as a GROWTH company.

Growth

1) Both high energy cost and environmental regulations will boost the demand for energy efficient solutions for HVAC and Climate Control technologies, which is the key to IR's growth in matured market.

The combination of HVAC and Climate Control accounts for 67% of IR's total revenue. Though IR is reasonably internationalized, North America still contributes more than 60% of the revenue in both segments, especially the residential HVAC, is very much like a typical American business.

Basically both businesses are tightly linked to the economic infrastructure. HVAC services the commercial market and residential market. The commercial market can be further divided into commercial (offices, retail, lodging, etc), institutional (health care, education, government, etc) and industrial (process manufacturing, life sciences, data centers, etc). The climate control mainly serves food transport and grocery stores.

In North America, these markets have been very mature. The population and the overall economy will continue to grow, the HVAC and Climate Market should follow, but I don't see the overall demand outpaces the overall economy. Here I believe the surging energy price and stricter environmental regulation will play a significant role in IR's future. They will force the customers to seek solutions with higher energy efficiency, or green enough to meet the legal standards. This is a process to consolidate the fragmented market, where the companies with superior technology, larger market share, better management and higher productivity win. Today's IR is well positioned to take advantage of this trend.

2) IR's international footprint creates itself golden opportunities to profit from the emerging markets.

More than 30% of IR's total revenue comes from outside North America and its international appearance is very impressive. For all the four businesses, IR has manufacturing & distribution sites, sales consultant offices, and integration & service offices virtually across the entire world.

In the emerging markets, notably China and India, the bottleneck of their economic growth is the infrastructure. As a result, we see both countries put high priority, accordingly high investment into this area. For better understanding, let's paint a simplified picture here.

Combining the population of the two countries, the number we get is 2 billion. Now the 2 billion people need to live (residential development, which creates demand for IR's residential HVAC and security technologies), eat (cold chain and grocery store development, which creates demand for IR's Climate Control technology), work (commercial/institutional/industrial development, which creates demand for IR's commercial HVAC and Industrial Technology products) and move around (transportation development, which creates demand for IR's Industrial Technology products). The key here is that the demand is driven by this gigantic population, and both countries are struggling to keep up with it. Therefore, IR is presented virtually unlimited growth space.

One extra point to note. Both countries have very limited farm land but are experiencing rapid urbanization, which actually creates an exceptional demand for the cold chain technologies. Currently the Climate Control contributes around 20% of IR's total revenue. I see high chance this business becomes a key driver of IR's growth in the next 5 to 10 years.

3) IR's leading market position will continue to generate revenue from parts & services

As mentioned above, currently more than 25% of IR's total revenue is from parts and services. This is a very healthy number.

In today's business world, especially the manufacturing section, we see more and more companies sacrificing the margin to win the customer's initial adoption of their solution. The logic is simple. Once the dependency of the customer on the solution provider is established, the parts & service revenue will eventually follow, which normally has higher margin, and recurring. IR's leading market position and technology advantage means they have stronger leverage to win the customer, in turn, the increased market share will consolidate such leverage and make IR even stronger. I am expecting the parts & service revenue continue to grow at a faster pace than the overall growth rate of the entire company.

Conclusion

IR operates in a traditional industry, where we won't see explosive growth, but a steady one. We see opportunities to be created by both the recovering American economy, and the unabated emerging markets. To certain extent, IR meets the definition as a 'boring' company as defined by Peter Lynch, which makes it an even better long-term stock. At the micro level, I liked the direction that the management is driving IR towards. Normally when we analyze a company, the most tricky part would be the evaluation of the management. Since IR is Warren Buffet's pick, things get easy - there is no need to question the capability of its management. While I'd like to point out that I was impressed from reading the IR related material. I see a management team with clear vision, sound mindset and a long term strategy that is constant, simple and well defined.

One more point to add. I believe IR has the option to combine its four businesses and acts as a solution package provider, which may be an important competitive edge that IR has been enjoying, and will continue to enjoy. In IR's presentation, it frequently used the grocery store to showcase its high performance solutions, where products from all its four businesses are employed and IR is very much like a one-stop service provider for the grocery operators/builders. For the customer, the benefit in cost, efficiency and maintenance to use service from this type of 'package provider' is apparent. And for IR, its four businesses should be able to continue to create opportunities for each other and bring in more and more organic growth opportunities.