Ingersoll-Rand's Upside Potential in 2014

It's not easy to find screamingly cheap shares in the industrial sector right now, as most of the big names seem to be pricing in a cyclical recovery. With that said, Ingersoll-Rand looks decently priced should its end markets pick up. The tricky bit is that its rivals in the climate technologies space, such as Lennox International and Johnson Controls Inc. , have both given results recently that confirmed positive underlying conditions, but not to the extent that many had hoped. The good news with Ingersoll-Rand is that its guidance looks a bit conservative, so any upside surprise is likely to be well received, and here is why.


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Lennox International, Ingersoll-Rand and Johnson Controls on the HVAC market

Heating, ventilation, and air conditioning, or HVAC, company Lennox International is always an interesting one to follow because its results give a good perspective on a market that is very important for so many other companies. For example, companies like Ingersoll-Rand and Johnson Controls  have significant HVAC operations. The sector as a whole is also a useful barometer for the condition of the North American construction markets.

Lennox International gives mixed results
The market took a dim view of Lennox's recent results and immediately marked its stock down a few percentage points. It's a slightly harsh verdict on the earnings report since revenue came in slightly better than analyst forecasts. Moreover, the company maintained its full-year forecast of 3%-7% revenue growth at constant currency, and adjusted EPS of $4.20-$4.40; the mid-point of this range implies nearly 19% growth from 2013.

 

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Lennox International Equity Research

While the pickup in the housing market has become a widely accepted investment theme, Foolish investors might favor taking a look at investing in the commercial construction market. One area of interest is the heating, ventilation, and air conditioning, or HVAC, market. The pick of the sector is Lennox International  $LII , with A.O. Smith $AOS also deserving of an honorable mention.

Lennox and A.O. Smith look set to grow earningsWhy is commercial construction considered next year's hot sector? The key argument is that the commercial sector tends to follow the residential sector, so stocks exposed to the former are likely to produce more upside in 2014.

You can think of the commercial construction sector as experiencing a rough five to six years where it grew lower than GDP growth, but is now set to grow faster than GDP, as the economy recovers. Indeed, it certainly seems that way if you look at consensus earnings-per-share growth forecasts for Lennox and A.O. Smith. Both companies are forecast to have high compound annual growth rates, or CAGRs, over the next four years.

Company	2013	2014	2015	2016	CAGR
A.O. Smith	34.9%	12.3%	12.7%	12.8%	17.8%
Lennox	35.8%	21.5%	16.6%	9.4%	20.5%

Source: Nasdaq.com

In the case of HVAC specialist Lennox, the market has clearly priced in a recovery due to its residential market exposure. However, it also has upside potential from a future recovery in commercial construction.

Lennox's management estimates that its 2013 revenue split will likely include residential HVAC contributing 49%, commercial HVAC 27%, and refrigeration 24%. Given the strengthening housing market, it's no surprise that 75% of the increase in overall segment profits came from the company's residential markets. Furthermore, Lennox generates around 85% of its business in North America, so it's very much a U.S. market play. Where it gets interesting is in the fact that Lennox's commercial operations tend to have a higher profit margin.

Source: company presentations

Essentially, if Lennox's commercial HVAC sales come in better than expected then there is an opportunity for a positive shift in the overall margin mix. Moreover, Lennox's management recently gave its 2014 forecast and outlined the key assumptions behind its 3%-7% revenue growth forecast. Management is estimating that North American residential units will be up "mid-single digits" from 10% in 2013. Meanwhile, its commercial units are forecast to rise in "low-single digits" from a paltry 2% in 2013. Frankly, Lennox's commercial forecast looks a little bit conservative, so you should see some additional upside.

Lennox's cash flow advantage
Lennox stands out for its cash flow generation. For example, A.O. Smith's management recently forecast $100 million in free cash flow, or FCF, for 2013, but this is not particularly impressive when compared to its enterprise value, (market cap plus debt minus cash) of around $4.6 billion.

In contrast, Lennox has converted 110% of net income into FCF over the last four years, and is forecasting 90% conversion in 2014. However, A.O. Smith has converted around 60% of adjusted net income into FCF over the last three years. 

For illustrative purposes, lets assume Lennox converts 100% of income into FCF and A.O Smith converts 60%. Using these rates and analysts' EPS forecasts we get an idea of future FCF per share. For the sake of simplicity, assume that enterprise value is equivalent to current values.

Source: Nasdaq.com, author's estimates.

Lennox looks to be fairly valued, but as discussed above, it offers upside potential if you are bullish on commercial construction. Meanwhile, A.O Smith doesn't look like as a good value, but it's likely to outperform if the sector picks up.

The bottom line
A.O. Smith and Lennox are not cheap stocks, but they both have good earnings leverage should the commercial construction market improve next year. Lennox is probably the choice pick, but don't be surprised if A.O. Smith starts increasing margins and cash-flow generation if its end markets pick up. HVAC is an indispensable part of a commercial construction project, and bulls on the sector should take a closer look at both stocks.