Anyone who believes the winter weather caused unnatural weakness in U.S. construction, and that activity will subsequently rebound, will be interested in Ingersoll-Rand (NYSE:IR). Along with Johnson Controls (NYSE:JCI), which has a large building efficiency segment, Ingersoll-Rand has possibly given conservative guidance because of the weather. Is this enough of an argument to make the stock a buy? And what does it mean for Johnson Controls?
Ingersoll-Rand's earnings drivers
The key to answering this question is to appreciate how the company makes its money. Following the spin-off of its commercial and residential security businesses, called Allegion (NYSE:ALLE), Ingersoll-Rand's focus is on climate control and industrial solutions, with around 67% of segmental income coming from the former. Overall revenue growth is forecast to come in at 3%-4% for 2014, with the split between segments as follows:
|Segment||2013 Operating Income||Forecast Growth for 2014|
Clearly, its climate segment, which primarily sells heating, ventilation, and air conditioning, or HVAC, is growing faster than its industrial segment.
Focusing on the industrial segment for a moment, Fools should not necessarily read this as a bad sign for the industrial market. Investors in the sector will have noted that the current recovery has been marked by some notable divergence in prospects within the sector. For example, aerospace and autos are currently doing well, while mining, shipbuilding, defense, and heavy industries are not. Therefore, it is somewhat misleading just to look at the headline Institute for Supply Management, or ISM, data.
Indeed, on the earnings conference call, management acknowledged there were "slight differences" in its end markets versus the ISM coverage. For example, Ingersoll-Rand's tool business isn't focused on the car industry. It's worth contrasting Ingersoll-Rand's industrial segment with Johnson Controls, which receives the majority of its revenue from the automobile industry.
Ingersoll-Rand's climate segment and construction markets
The idea that strength in residential construction will lead to a recovery in commercial and industrial construction (as infrastructure is built around new communities) is an interesting theme for 2014, at least it is with this author. However, just as with the industrial segments results, the outlook is mixed. Quoting from the fourth-quarter-earnings conference call:
For 2014, the Commercial and Industrial put-in-place forecast was to be up for 13%. Those markets were up 8% in 2013. With Commercial and Industrial, the strongest verticals are expected to be office and bank buildings, warehouses and garages.
Unfortunately, Ingersoll-Rand expects its institutional markets to be down 1% in 2014, following on from an 8% decline in 2013. This is a bit of an issue, because institutional construction tends to be more HVAC-intensive. However, there are indications that the market is bottoming. All told, the North American, non-residential, put-in-place market is expected to increase by 6%.
Put-in-place simply refers to the value of work completed and under construction during the period minus the value at the start of the period. This is an important definition to understand, because much of HVAC demand tends to be relatively late cycle in a construction project. In fact, Ingersoll-Rand forecasts an 11% increase in overall construction starts, likely to translate into increased demand for HVAC "impacting later 2014 or even 2015, depending on the type of building, equipment and services that are involved."
As for the specific strength in warehousing, Fools may want to consider what NCI Building Systems (NYSE:NCS) said recently about its end markets. In other words, Ingersoll-Rand's outlook confirms the strength that NCI sees in warehousing and storage.
What does it mean for Ingersoll-Rand and Johnson Controls?
Essentially, both are attractive stocks, but there are some subtle differences.
Ingersoll-Rand's industrial end market exposure is likely to make it tough going in 2014, while its climate segment has good prospects in 2014 and onwards thanks to a recovering construction market. Meanwhile, Johnson Controls is likely to enjoy an ongoing strong automobile market in 2014. The difference is that Ingersoll-Rand is more about future prospects, while Johnson Controls is delivering right now.
Turning to valuation, Ingersoll-Rand's forecast of $900 million in free cash flow for 2014, puts it on a forward free cash flow to enterprise value (market cap plus debt) yield of 5.2%, while Johnson Controls' forecast of $1.6 billion in free cash flow makes its equivalent yield 4.2%. Moreover, analysts have both stocks growing EPS in the low-40% region over the next two years. Arguably, Ingersoll-Rand is a better value, but it requires more belief in a recovering construction market.