Ingersoll-Rand Ploughs Ahead

The industrial conglomerate has developed strong new products, cut costs as prices of raw materials have climbed, and boosted margins

Diversified industrial concern Ingersoll-Rand (IR ; recent price, $68) is well-positioned to benefit from the continuing momentum in global capital spending, in the view of Standard & Poor's Equity Research Services. That's because the end markets the company serves tend to perform best in the late stages of an economic upturn. We also think Ingersoll-Rand will gain from its diverse product offerings and powerful cash-flow-generation ability.

Strength in IR's construction equipment, truck, and security and safety businesses, combined with new product offerings and international expansion, should drive 4% to 6% organic revenue growth over the next few years. This top-line growth will likely be supplemented by 4% to 6% annual gains from acquisitions of smaller businesses that complement existing activities. We believe that the outfit will be able to offset upward pressure on raw-material prices with additional surcharges to customers and productivity improvements.


  Finally, IR's solid balance sheet and strong free cash flow should provide management with a good deal of flexibility to achieve stated growth targets. In our opinion, the valuation multiples for the stock should expand as the market comes to view IR as a diversified industrial concern, rather than just a capital-intensive machinery manufacturer. The stock carries Standard & Poor's highest investment recommendation of 5 STARS, or buy.

IR is a global industrial conglomerate that manufactures a broad range of specialized equipment, including refrigerated truck trailers, mini-excavators used in construction activity, security products (such as doors and locks) used by the commercial and do-it-yourself markets, air and gas compressors, and golf and utility vehicles. IR generated total revenues of nearly $10 billion in 2003 and has well-diversified end markets, with no more than 30% of total revenue in any of its four business segments -- Climate Control, Industrial Solutions, Infrastructure, and Security and Safety.

New product innovation is a key to gaining share in existing segments and growing at above-average rates in newer markets. We believe that new offerings introduced in 2004 will add approximately $300 million to IR's sales by yearend. The Infrastructure business provides a good example of the company's success in such innovation. IR launched 17 new compact construction-equipment products under the Bobcat name in 2003, adding over $100 million to revenues, and introduced in 2004 another 15 new Bobcat offerings, contributing to the 24% growth in the brand's revenues in the second quarter of 2004.


  Also in the Infrastructure area, IR launched a completely redesigned golf car named Precedent in the first quarter of 2004. Precedent sales played a major role in Club Car's (IR's golf, utility, and recreational vehicles segment) 21% sales gain in the second quarter of 2004.

IR recently announced that it has entered into an agreement to sell its Dresser-Rand (oil-field equipment) business for cash proceeds of approximately $1.2 billion, effectively completing its transformation from a capital-intensive machinery manufacturer to a diversified industrial company. This sale, expected to be completed in the fourth quarter of this year, will cap a series of divestitures of several non-core, highly cyclical businesses that generated approximately $4 billion in combined revenue. We believe that management has done a good job of selling these assets for top dollar at opportune times of the business cycle.

We anticipate that approximately half of IR's expected revenue growth will occur in international markets. In 2003, North America accounted for 62% of total revenues, Europe 25%, Asia Pacific 10%, and South America 3%.


  The company seems very well-positioned to take advantage of China's current dynamic economic growth. In August, management announced that it had named a president for its China operations. Also in August, IR acquired the remaining 45% interest that it did not control in a commercial refrigeration-equipment manufacturing business based in Luoyang, China. IR now operates nine manufacturing facilities in China that produce a wide range of products, including air compressors, compact construction equipment, and climate-control technologies for trucks and buses.

Despite the recent upward pressure on raw-material costs, IR has been able to lower its cost of goods sold as a percentage of revenue in each of the last two years, and we expect that it will be able to again boost gross margins in 2004 and 2005. For the most part, materials cost pressure is being offset by added surcharges and improved productivity. In 2003, IR was able to trim over $100 million in costs for materials and services through several initiatives, including low-cost country sourcing, reverse auctions (where suppliers are forced to compete against one other), and better negotiations leveraging its buying power. We expect that the outfit will be able to reduce costs by more than $100 million again in 2004.

We think IR has significantly strengthened its balance sheet after taking on debt related to several large acquisitions. Its debt-to-capital ratio stood at 30% as of June, 2004, well below the 47.5% level of December, 2002. During that time, total debt has declined by 34% to $2.1 billion, from $3.2 billion. Management has stated that its debt-to-capital target range is 35% to 40%.


  In August, IR's board declared a 32% increase in the quarterly dividend rate and authorized the repurchase of up to 10 million common shares. We think this is a good use of cash resources and should still allow the business to maintain adequate capital to pursue future growth initiatives.

A combination of new product introductions, continued strong growth in the security and safety business, solid demand from construction equipment and truck markets, and expansion of IR's services businesses is expected to lead to revenue growth from continued operations of 7% to 8% in 2004 and 2005. For 2004, we estimate revenue growth of 10% in the Climate Control segment; 16% in Infrastructure; 11% in Security and Safety; and a 24% decline in the Industrial business, as a 24% drop in sales at Dresser-Rand (due to the elimination of certain businesses) more than offsets an 8% rise in Air and Productivity Solutions.

Combining the expected increased sales with benefits anticipated from restructuring actions implemented in 2001 and 2002, we see operating margins, which dropped to a 10-year low of 7.2% in 2001, continuing to rebound in 2004 and 2005. In 2004, we expect margins in the Climate Control segment to reach 11%, Industrial margins to expand to 10%, Infrastructure margins of 13%; and Security and Safety margins to total 17%. Interest expense should decline due to lower overall debt levels, although a rising interest rate environment could somewhat offset this benefit.

We expect operating earnings per share to grow about 40% in 2004, to $4.80, and another 15% in 2005, excluding one-time items.


  We project Standard & Poor's Core Earnings per share of $4.26 in 2004 and $5.07 in 2005. In 2004, our S&P Core EPS estimate includes estimated stock-based compensation expense of approximately $26 million (15 cents per share). In addition, we project costs of about $67.2 million (38 cents per share) in 2004 related to our estimate of the difference between the company's actual pension expenses and its use of pension accounting.

Our 12-month target price of $93 values shares of IR at 17 times our 2005 EPS estimate of $5.50, in line with its historical average multiple and the S&P 500. The shares currently trade at 13 times forward 12-month earnings -- a discount to its peer group's average p-e multiple of 16 times. IR also appears significantly undervalued based on our discounted cash-flow model.

Risks to our recommendation and target price include a slowdown in industrial capital spending, rising raw material costs, an inability to pass on surcharges to customers, and potential shortages of certain raw materials. In addition, any changes in the current tax laws related to IR's Bermuda-based tax status or any large, dilutive acquisitions could impact our outlook for the outfit.

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