The stock prices of United Technologies (RTX 0.31%), United Parcel Service (UPS 1.15%), and Ingersoll-Rand (TT 1.27%) all fell recently after they reported their third-quarter results, and although each has recovered somewhat, they remain below their 2017 highs. It's therefore worth taking a look at all three to see if those declines provide a good value entry for investors.
United Technologies: A stock for the patient
There wasn't a lot wrong with United Technologies's Q3 results, but the reality is that the key drivers of the stock's performance are of a strategic, long-term nature.
The investment case for buying United Technologies rests on the idea that it trades at a significant discount to its peers, yet it's in a phase where it's earnings growth is being held back by the moves it's making to generate long-term earnings and cash flow. Arguably, the stock should actually trade at a premium during this phase, but markets rarely do what they are expected to do. The chart below shows forward enterprise value (market cap plus net debt) to EBITDA -- a commonly used valuation metric.
Skimming through that latest earnings report, one can see that United Technologies made progress on most of its objectives:
- Pratt & Whitney is on track to hit its production target of 350 to 400 of its geared turbofan (GTF) engines in 2017; two technical issues are being dealt with in line with management's previous commentary.
- Otis is expanding unit sales in China, even if pricing remains negative.
- UTC Aerospace systems is achieving good aftermarket sales growth, even though original equipment sales have been falling in the last two quarters, while the Rockwell Collins acquisition -- to be completed in Q3 2018 -- remains on track.
The idea is that establishing GTFs on aircraft -- they're the sole engine being used on Bombardier's CSeries, and they're also an option on the Airbus A320Neo -- and selling more Otis elevators in China will generate long-term service and aftermarket revenue for the company. Meanwhile, adding Rockwell Collins' (COL) avionics and flight controls to United Technologies' mechanically actuated aircraft systems will create a company better positioned to negotiate with Boeing and Airbus.
Ultimately, United Technologies remains on track with its long-term objectives, so any weakness in the stock price should be seen as a buying opportunity for long-term bulls.
United Parcel Service has a margin problem
FedEx Corporation (FDX -0.12%) and UPS have similar issues to deal with overy the next few years. Both need to convince the market that the capital spending requirements demanded by rising e-commerce delivery volumes won't impinge on free-cash-flow generation.
Both have felt margin pressure due to those increasing e-commerce deliveries, and in Q3, UPS's core domestic package segment came under further margin pressure. Management has made it clear that it's not running the business with a focus on near-term margin, but rather on long-term growth -- commentary that likely generated concern in some quarters.
However, it's not all bad news. UPS's stock dipped after it delivered its Q3 results, but has somewhat recovered thanks to a broader bounce in the transportation sector. In addition, there are signs that UPS' and FedEx's pricing actions are leading to volume and yield growth in e-commerce.
All told, it's far from clear whether UPS or FedEx will be able to expand margin in the manner that many investors are hoping for, and it makes sense to wait until both companies are demonstrably on the path to expanding e-commerce delivery margin before buying in--dip or no dip.
Ingersoll-Rand's margin stumbles
The situation with the air conditioning and industrial products company's stock is rather more prosaic, and I think its recent dip in price is a buying opportunity.
The investment case for buying Ingersoll-Rand stock rests on the following points:
- Long-term growth and margin expansion within its core heating, ventilation and air-conditioning (climate segment) operations (brands include Trane and American Standard).
- Cyclical recovery in its industrial segment (industrial compressors, power tools, materials handling and, rather bizarrely, golf carts).
- Valuation attractive to its peers.
The industrial segment is performing well in 2017; according to CFO Susan Carter on the Q3 earnings call, it "is actually performing a bit better than our guidance with strong organic bookings growth of 5% overall" in the third-quarter.
However, the prime reason why the stock fell post-earnings was probably the reduction in overall adjusted operating margin from 14.5% to 14.1%. The guilty party was its climate segment, which generates 83% of segment operating income. Its adjusted operating margin declined year over year to 16.5% from 16.8%, and CEO Mike Lamach basically admitted he wasn't happy with margin performance overall, saying, "[O]ne area that we're not satisfied with and we expect to improve on in 2018 is our operating leverage." By operating leverage, he simply means the company's ability to convert increased revenue into operating income through margin expansion.
But here's the thing. In fact, here are the four things:
- The margin compression in climate segment was largely due to booming sales in China (20% order growth year to date) and the Middle East, which currently come with lower margins, but offer the prospect of long-term service sales.
- The increased China sales are still earnings accretive, and there was no change to management's 2017 guidance for adjusted continuing EPS of $4.50.
- Lamach claimed "we're focused on accelerating productivity initiatives to drive higher leverage in 2018 and beyond," and some of the cost pressures (also a factor in compressing margin) should moderate next year.
- Margin pressure from increased China sales should moderate as the company starts to anniversary increased sales from this year.
All told, the margin pressure is coming from a good reason--increased sales in emerging markets--and Ingersoll-Rand remains on an attractive valuation. Management expects $1.2 billion in free cash flow in 2017, putting the stock on a free cash flow to market cap yield of nearly 5.5%. That's attractive for a company expected to grow earnings by 13.5% next year, and I think Ingersoll-Rand stock is worth picking up now.