|Shares Out. (in M):||420||P/E||0||0|
|Market Cap (in $M):||11,800||P/FCF||0||0|
|Net Debt (in $M):||3,000||EBIT||0||0|
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The new Ingersoll Rand, “IR”, is a company that was recently formed pursuant to a Reverse Morris Trust transaction between Gardner Denver and Ingersoll Rand’s industrial businesses. The transaction was announced last spring and closed this March. The primary rationale behind the deal was to bring together the #2 and #3 global compression companies. Furthermore, it enabled Gardner Denver to dilute its exposure to its volatile upstream Oil & Gas business and enabled legacy IR to become a Climate Control pure play. Pursuant to the deal, new IR made a $1.9 billion dividend payment to the old IR. Old IR Shareholders got 51% economic interest while GDI shareholders will have 49% economic interest. Critically, management control will reside with Gardner Denver’s team.
While the short term will definitely be ugly, we believe the deal has the potential for substantial multi-year value creation potential. The upside will come from not only synergy execution but also an improvement in the underlying margin structure of an under-managed Ingersoll Rand Compression business. Over time, we also anticipate IR management will dispose of the non-core, lower margin, and more volatile parts of the portfolio. Looking out a few years, we anticipate the new IR will be a leading industrial business with high (29%+) EBITDA margins, minimal cap. ex (2% of sales), and deriving close to 50% of its Revenue from aftermarket. This profile will lead its multiple to increase in-line with best of class peers with similar business and financial profiles.
Gardner Denver was a poorly managed industrial company with decent products and a very robust energy business in the North American Shale when it was acquired in an LBO by KKR in 2013. In 2015, KKR brought in a new leader for GDI’s Industrial Division, Vicente Reynal. Mr. Reynal had previously been at Danaher for 15 years and worked directly under former CEO Larry Culp.
Reynal immediately sought to improve the economics of an industrial business he felt was under-earning in margins. The business is essentially highly engineered compressors, vacuums, and blowers for diverse manufacturing facilities across diverse end markets. The products are mission critical and low cost in relation to the value of the projects they support (and cost of downtime), while they also offer substantial higher margin after-market opportunities.
The improvements were striking and immediate. Reynal was made CEO of the entire company and its 3 segments – Industrial, Energy, and Medical. During this time, 40% of former Gardner Denver management was replaced by new leaders selected by Reynal. When KKR IPO’d the company in ‘17, employees were granted equity in the new company.
The company continued to make steady improvements in both the Industrial and Medical business. Yet from the time of the IPO (in 2017), all the variance in earnings (and stock price) was effectively tied to conditions in the upstream O&G market. Whether up or down, the net result was this essentially mitigated the internal improvements being made throughout the company. Conference calls were 80% on the upstream energy market with a minimal amount of analytical time spent on the Industrial and Medical businesses.
Yet as the company improved its internal execution in the Industrial Segment, it sought to make very small bolt-on deals in that space where they felt their ownership could add substantial value. These deals proved NPV+ and gave the company confidence that it could do something larger.
So Gardner Denver felt that it had substantially improved the Industrial and Medical businesses under Reynal’s stewardship but that the internal progress was being overshadowed by upstream E&P. In IR, they saw a complementary compression business that was globally #2 (to Atlas Copco’s #1 and GDI’s #3), making it a clear product fit. Beyond the obvious synergies, GDI management had been closely following IR’s Industrial Compresion business and developed a thesis that its business was similar to GDI Industrial pre-2015. That is, it felt that IR’s Core Industrial business was under-earning on margins.
So the IR deal did 3 things for GDI.
It enabled the company to capture a portion of the NPV of future synergies inherent in combining the #2 and #3 compression businesses globally.
It enabled the GDI management team to execute the margin expansion playbook they ran on GDI Industrial assets on under-earning IR Industrial Assets.
It considerably reduced the amount of direct exposure to upstream Oil % Gas, thereby enabling the company’s fate to be more directly aligned with their own execution capabilities.
The new company will have 4 segments. Industrial Technology & Services, Precision & Science Technology, Club Car, and Upstream Energy.
Industrial Technologies & Services
This is the most important of the company’s 4 segments. It will house the legacy GDI Industrial business and the IR Compression business. It will also retain the midstream and downstream business of GDI’s former Energy Segment as well as IR’s low margin Power Tools business (which we assume will be divested).
This segment is where the value creation will occur. The company has said that all $250 million of the anticipated cost synergies will flow through this segment.
On the organic margin uplift potential, GDI’s management team has said that they aim to bring their own Industrial margins up to 25% in the medium term. They have steadily increased margins from 17.2% in ’15 (when Vicente Reynal arrived) to 22.8% last year. In North America (30% of legacy GDI Industrial sales), Industrial EBITDA margins are already north of 25% while in Europe (49% of legacy GDI Industrial Sales) and APAC (16% of legacy GDI sales) are obviously below but have been on a clear upward trajectory. Importantly, GDI Industrial had aimed to take aftermarket sales from current 31.5% to 35% over time. This mix shift would also aid in margin expansion as aftermarket sales have roughly 500 basis points higher margins than OE sales.
The 400 basis point difference between Ingersoll Rand’s 18.7% EBITDA margins and GDI’s 22.8% EBITDA margin is surprising given IR’s greater % of sales from higher margin North America and, more importantly, its much higher aftermarket exposure (55% of revenues vs. 31% at GDI Industrial). The combination of higher North American sales mix and higher aftermarket sale mix would suggest that IR’s CTS margins should be higher than GDI’s.
When asked about this, the GDI management team was reluctant to criticize IR. While they have pointed to IR’s sub-scale exposure in Europe (where GDI has scale), they have also cited organizational and managerial structures that were similar to those that confronted them at GDI Industrial. In particular, IR is organized in a matrix structure with excessive managerial levels and less local accountability. Present day GDI, by contrast, is radically decentralized with limited layers and 45 headquarters staff.
In our model for Industrial Technologies & Services, I remove Power Tools (which I assume will be divested). I assume that 2020 is a tough year across the board with Revenues -15% to -20% across all 3 components (GDI Industrial, Ingersoll CTS, and GDI Midstream/Downstream) and Decrementals of around 35%. The 35% is derived from past comments that roughly 70% of cash costs are variable and that higher margin aftermarket revenues will not fall as rapidly as OE revenues. I also anticipate the company is able to hold the line on price given the mission critical nature of their service. I assume $25 million (0f the $250 million in synergies) flow through this year.
I then assume a gradual recovery with Segment revenues not reaching ’19 levels until ’23. My key assumptions are,
GDI Industrial is successful in getting to its original 25% target by ’23.
GDI Management is able to achieve a similar level of improvement on the acquired IR assets that they were with GDI Industrial assets with margins expanding roughly 400 bps from 18.7% to 23% by ’23.
Midstream and Downstream margins are flattish
$250 million in synergies is fully achieved by 2023
So in 2023, the Industrial Technologies & Services division EBITDA margins will increase from a PF 20% in ’19 to roughly 30% in FY ’23. The combination of 29% to 30% EBITDA margins with minimal cap. ex and a relatively high % of revenue (x>40%) coming from more predictable aftermarket should command a premium multiple.
Precision and Science Technologies
This division is a combination of GDI’s medical pumps segment and the legacy Industrial Pumps (focused largely on wastewater) of Ingersoll Rand. GDI’s Medical pumps business is high margins with minimal capital and has enjoyed a decent growth trajectory over the last few years. While the guidance had been for continued growth this year, I do anticipate some economic sensitivity around hospital capital budgets and thereby have results down this year before resuming an upward trend in subsequent years due to favorable secular trends. For the legacy IR pumps business, I also anticipate a fall-off this year with an eventual recovery by ‘22/23. For both parts, I do not assume much margin expansion. I also do not think there will be any synergies in this segment.
Electric Cars, Power Tools, Upstream Energy
These 3 are all in separate divisions. I expect that each will be divested. For my analysis, I assume that they are divested at low multiples of ’20 EBITDA. This implicitly assumes that the upstream business will fall to depressed levels this year and remains there. This is potentially a conservative assumption but it is pointless to assume anything other than the worst case scenario for North American upstream energy at this point. For these assets, I also assume no basis and so fully tax the proceeds. Again, this is a smart management team that might very well find tax free ways of unlocking value via spins, RMT, etc. If so, great but my aim is to simply give the company some minimal value for these non-core assets and focus on the potential in the core business.
PF IR Forward Walk
The above model incorporates my assumptions about segment performance as well as the after-tax proceeds from the sale of the non-core businesses. Additionally, I assume that there is roughly $90 million of corporate overhead, that the after-tax cost to achieve the $250 million in synergies is $320 million, and that cap. ex is roughly 2% of sales. For capital structure, I assume that it remains constant at 2.5x with any excess FCF going to buyback stock. In reality, I believe the company will likely pursue additional bolt-on M&A in the compression space but did not want to incorporate any NPV+ deal making in my scenario.
The 14x forward multiple is a function of the re-rating I would anticipate for a business generating EBITDA margins in the high 20% range with minimal cap. ex and a substantial aftermarket exposure relative to most industrial companies. The obvious one is Atlas Copco which trades at roughly 15.5X to 16X EBITDA and would be the most direct peer. Aside from that, companies in the US with EBITDA margins north of 25% and minimal cap.ex have typically commanded an EBITDA multiple well into the high teens (GGG, Idex). I have used 14x because one could plausibly argue that the Pumps business of IR is more cyclical with less aftermarket and should trade at 11x-12x. On the other hand, the GDI Medical is over 1/3 of Precision EBITDA and its comp set has multiples in the high teens to low 20s – reflecting the superior secular growth trends investors ascribe to that end market.
So 14x seems reasonable. It is a discount to Atlas Copco and the nosebleed multiples of several high margin, low cap. ex US Industrial companies while acknowledging the relatively attractive and improved margin structure that the company will possess.
On these assumptions, I get a $44 PT by the end of ’22. This generates a 19% IRR from the current price.
Risks are obvious. All their businesses will experience pressure in the near term. They are more leveraged than your typical industrial company as the 2.5x number originally contemplated will climb substantially given the expected sharp decline in EBITDA this year. There are no material covenants or near term maturities, but headline leverage will climb in the short term to the upper 3 range. Given the high margins and low capital intensity, I expect them to materially FCF positive in all scenarios. But I expect the stock to have substantial volatility.
For the longer term, the bigger risk is that the Reynal and team are unable to integrate the IR assets smoothly and unlock the value embedded above. If IR integration goes poorly, this will be an overly complicated, overleveraged and overvalued industrial. Equity will materially underperform its peers.
So I think the dispersion of potential outcomes is fairly wide. I think if they execute on the deal, the company will be re-rated as investors begin to price in the potential for more NPV+ M&A from what will be deemed one of the premier industrial management teams in the country.
The company reports next week but I do not expect much from guidance nor do I expect that they will change thier synergy targets, The thesis will really be proven/disproven over time as we get more evidence of the company's execution on deal synergies and underlying improvements in the acquired IR business.
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