Heating, ventilation and air conditioning (HVAC) company Ingersoll-Rand PLC (TT 0.04%) is a better stock to buy than process automation company Emerson Electric (EMR -0.34%), but that doesn't mean the latter isn't also compelling. Both stocks offer strong free cash flow generations, healthy dividend yields, and attractive valuations. Let's take a look at the two businesses, and see just why Ingersoll-Rand edges out its fellow electrical equipment company.
Image source: Getty Images.
Ingersoll-Rand's long-term growth prospects
Ingersoll-Rand arguably has better long-term growth prospects than Emerson Electric -- and they're probably less cyclical, too -- thanks largely to its climate segment, which includes well-known brands like Trane and American Standard air conditioning, alongside its Thermo King refrigerated transportation line.
The climate segment generated nearly 83% of Ingersoll-Rand's segment operating profit in the second quarter, compared to 17% from its industrial segment -- a loose collection of businesses including compressors, fluid handling equipment, and golf carts.
HVAC stocks offer investors a way to benefit from several global megatrends:
- Growth in the middle classes within emerging markets should lead to increased demand for modern heating and AC systems.
- The trend toward urbanization in emerging markets -- urban areas tend to be hotter than nearby rural zones -- should also boost demand.
- Global economic growth is shifting toward countries with hotter climates, such as India, Brazil, and China.
- Electricity demand from heavy AC use places significant stress on power grids, which will provide an incentive for localities to favor higher quality, more energy efficient solution providers such as Ingersoll-Rand.
All told, Ingersoll-Rand looks well set for the long-term.
What about Emerson Electric?
Fortunately for Emerson, it will also benefit from these trends. After all, the company's commercial and residential solutions segment includes some climate technologies businesses (HVAC controls and electronics), and those generated 39% of its segment profit in its fiscal third quarter, which it reported on last week. However, the company makes the bulk of its profit from its automation segment, and its oil and gas processing solutions.
Process automation in the energy sector helps companies more efficiently turn crude oil and raw gas into usable energy products. As such, Emerson Electric's business is vulnerable to energy price movements. Indeed, as you can see below the company's total underlying sales growth turned negative as oil prices declined from the middle of 2014, only to begin stabilizing in late 2016. Compare this with the relative stability of Ingersoll-Rand's organic sales growth.
Data source: Emerson Electric and Ingersoll-Rand presentations.
Ingersoll-Rand trades on a better valuation
All told, I would argue that Ingersoll-Rand should trade at a premium compared to Emerson Electric, based on the greater degree of certainty regarding its end-market demand growth. The one caveat would be if you have a bullish view on energy prices overall.
Given that, it's somewhat surprising to me that, based on common valuation metrics, Ingersoll-Rand stock is actually undervalued relative to Emerson Electric.
EMR EV to EBITDA (Forward) data by YCharts
Moreover, the improvements in free cash flow (FCF) generation margin by Ingersoll-Rand mean it trades at a better forward FCF yield as well.
Emerson Electric's management is expecting around $2.325 billion in FCF in 2018, compared to $1.375 billion forecast for Ingersoll-Rand. Based on their current market caps, this puts Emerson Electric on a forward FCF yield of around 5%, while Ingersoll-Rand trades at a forward FCF yield of 5.8%.
FCF yield matters because, theoretically at least, it's what a company has left to return to investors or use for earnings-enhancing acquisitions -- both companies pay out solid dividends, with Emerson Electric returning a forward dividend yield of 2.6% compared to 2.3% for Ingersoll-Rand. Moreover, both are expected to grow earnings in the low-teens percentages next year.
The bottom line
Frankly speaking, both stocks are attractive, but unless you have a strong (positive) view about the direction of energy prices and the process automation industry, Ingersoll-Rand is a better stock to buy on a risk/reward basis. Of course, there's nothing to stop you from buying both, and Emerson Electric would give your portfolio upside exposure to rising energy prices. However, if forced to choose, I would pick Ingersoll-Rand.
