Ingersoll-Rand (IR) is a diversified industrial with three operating segments: Industrial Technologies, Security, and Climate Control. The company has been making deals of late to transform itself into a less cyclical company, selling off its Bobcat division of heavy machinery and purchasing leading HVAC manufacturer Trane (TT) - positioning the combined company-to-be as a leader in climate control in both residential and commercial building.

I think Ingersoll-Rand is intriguing as an investment for a number of reasons:
-The Trane acquisition gives the combined company a number of synergies it could realize over a multi-year period. Management estimates this is about $300 million, but that seems conservative in comparing operating expenses as a percentage of sales for both companies - if Trane was to shed 300 basis points in SG&A to make it comparable to Ingersoll-Rand, that alone would amount to $200 million in cost savings. This ignores any purchasing scale power or overhead reductions which can be realized, which combined could conceivably amount to more than $300 million in savings there.

- Ingersoll-Rand is traditionally thought of as a cyclical heavy equipment company, and this has translated to a lack of enthusiasm for shares of late as residential and commercial construction concerns weigh on the earnings outlook. The new Ingersoll-Rand, however, is primarily a climate control company (two-thirds of revenues, pro forma) - an industry which is much less cyclical. It seems fair, then, to argue that the company deserves a higher multiple to normal earnings relative to a heavy cyclical like Caterpillar (CAT) or a Deere (DE). CAT, however, trades at a 50% EV/EBITDA premium to IR, with DE (15.2x) at nearly twice IR’s multiple (7.25x). While this could be easily explained if Trane was highly dilutive to earnings, that simply isn’t the case.

-Continuing on the cyclical or non-cyclical theme, one obvious point of concern is that Trane’s exposure to the commercial construction market could make growth targets very difficult to achieve. This is reasonable at face value, but with more than one-third of revenues from service contracts this steady source of revenue should help offset some end-market weakness if commercial construction cools from its rapid-growth clip of the past few years. Further, contrasting the commercial market exposure (forecast - strong but weakening) from Trane with Ingersoll’s traditional residential market exposure (forecast - weak but slowly improving) shows how the diverse revenue mix should help offset some of the natural cyclicality in the company’s end markets.

-As for how Ingersoll-Rand fits into the economic cycle, low interest rates should favor such “industrial-lites,” making IR something of a play on an economic recovery. At the same time, the connection between Ingersoll and the broader economy could be clouded by post-Trane acquisition items, so I feel Ingersoll is much more a play on simple execution in their climate control segment than anything else. There are better ways to get sector exposure - I think Weyerhaeuser (WY) fits that bill better.

-A reasonable case for earnings estimates in 2010 looks to be slightly above $5/share, with upside scenarios saying that EPS in excess of $6 is possible if some combination of the following occur: synergies in excess of those targeted by management, lack of a significant falloff in commercial construction, or a stronger-than-expected showing from new residential homebuilding.

-If Ingersoll-Rand was to be given similar multiples to United Technologies (UTX), which seems to be the pro forma company’s closest comparable, IR would be trading around $65/share (13x earnings on a conservative $5 in 2010 EPS), or about 45% higher than the most recent close.

All of this amounts to a simple thesis that the Ingersoll-Trane combination is going to be a powerhouse in climate control - a very good market to be in domestically (for reasons of recurring revenues) and abroad (where the climate control market is underpenetrated). Shares have been seeing sharp rallies of late, so I’d look to pick up shares on a pullback into the low $40s.

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