Gardner Denver: 1 + 1 Might Be 3

Gardner Denver will tie the knot with the Industrial segment of Ingersoll-Rand.This looks like a win-win for both parties. Gardner Denver picks up scale and diversification, Ingersoll-Rand rids itself of a non-core segment.While the standalone climate business looks compelling, I think the Industrial piece of this business might have more upside.I've long been a big fan of spin-offs, particularly industrial ones: AdvanSix (ASIX), Versum Materials (VSM), Fortive (FTV) and others have been strongly profitable opportunities that we have taken advantage of over the past several years. Investing in these kinds of corporate events has become immensely popular in recent years, so much so that perhaps a lot of the easy alpha that they tend to generate has been taken out. Once plagued with indiscriminate selling as major funds and shareholders rebalanced, trading now tends to be orderly - particularly for those of a decent size.I've started buying into these types of special situations a little earlier than I used to. In my view, the upcoming tie-up between Gardner Denver (GDI) and the Industrial segment of Ingersoll-Rand (IR) provides a strong investment opportunity. While not a strict spin-off in the truest sense of the word, I think the deal is a clear opportunity where 1 + 1 makes something greater than 2. This checks all of my usual investment boxes: healthy margins, high free cash flow, a protectable moat, and a strong relative valuation story versus peers. As a bonus, leverage remains manageable and sales should remain relatively robust in a downturn versus other more cyclical industrial plays, checking a box that have not really used much in recent years: capital allocation into a more defense-oriented business model. My fair value target is $42.00/share, yielding 25% upside that will hopefully be uncorked over the next year leading into the spin-off.On April 30th, Gardner Denver and Ingersoll-Randannounced a partnership moveto try to unlock value on both of their balance sheets. Both have radically separate motivations for pursuing this deal. Riding high, Ingersoll-Rand has been a stand-out performer for several years and is trying to keep that momentum going, cutting a smaller business segment and putting cash in the bank for itself to drive investment elsewhere. Meanwhile, Gardner Denver,a KKR spin-off from 2017, had a very muted return back into the public equity markets. Despite solid bottom-line execution and cutting leverage in half since the initial public offering ("IPO"), the market has focused intently on its Energy business as a reason to keep a lid on the share price which caused management significant frustration.Unlikely parties can come together. Under the terms of the deal, Ingersoll-Rand will combine its Industrial segment with Gardner Denver in a Reverse Morris Trust transaction (meaning tax free), creating a juggernaut in what management is calling "flow creation" technology: air compression, vacuum, blower, and fluid products. These are boring yet great business lines. Believe it or not, margins are pretty healthy (expectations of 25% EBITDA margins inclusive of synergies) and annual capital expenditure needs are very small: low single digits per year as a percentage of revenue. Revenue growth, while not stellar, should come in incrementally ahead of GDP growth through the industrial and medical sales channels. This creates a recipe for consistent free cash flow generation which has long been a recipe for share price outperformance.

In keeping with company presentations, I will call this tie-up "IndustrialCo" going forward. Keep in mind that it will take on the Ingersoll-Rand name going forward with current CEO of Gardner Denver Vicente Reynal remaining in the top seat. The remaining Ingersoll-Rand business will become a pure-play climate solutions company focused on HVAC and transport refrigeration ("ClimateCo"). It will get a new name and a new stock ticker; Michael Lamach will continue to serve as Chairman and CEO at that company, no surprise given his roots in managing the Trane brand since 2008. To recap on the financial terms:This means there are technically two ways to play this transaction. Either you believe that ClimateCo will see significant value growth as a new pure-play option or that IndustrialCo might see higher valuations as it gains more scale and operational leverage. In general, I'm more interested in IndustrialCo (more on why later).To me, IndustrialCo is a great strategic fit when it comes to combined operations. While both have a dominant presence here in North America, Ingersoll-Rand has always been the better performer in Asia Pacific while Gardner Denver has a stronger foothold in Europe. Beyond some potential geographic benefits from sales team combinations, the product portfolio of each tends to bolster the weaker parts of the other where there is overlap.In total, IndustrialCo will see a doubling of its revenue, stronger end market diversification, a build-out of the complementary product portfolio and, best of all, leverage will remain essentially neutral. In particular, Gardner Denver, which currently has a meaningful Energy segment, will see that volatile business shrunk down in importance on a pro-forma basis, balanced out by the Compression Technologies and Fluid Management segments from Ingersoll-Rand. As seen below, Energy segment margins have been more than a little volatile for Gardner Denver, oscillating between the weakest and the strongest segment over the past several years. Revenue has been highly volatile as well, even accounting for seasonality. The market tends to not appreciate this kind of exposure.

Make no mistake, ClimateCo will also see substantial benefits. It becomes a pure play on climate control solutions in both residential and commercial settings with an excellent kicker business in transport refrigeration. As owners of the Trane brand, there is significant brand recognition and I would not be surprised to see a rename acknowledge this. Thermo King is also one of the leading brands in refrigerated transportation.Climate control products are a strong business that has seen healthy revenue growth and tends to be highly free cash flow generative. Large macro trends like urbanization, rising standards of living, and growth in prepared/fresh food transport are all large secular drivers. The company should have no problems throwing off mid-single-digit free cash flow at current valuations given the outlook above.Primary competitors/peer comps include Johnson Controls (JCI), Lennox International (LII), and Aaon (AAON), with the last two generating incrementally better margins and better leverage profiles. These three companies trade at 14.0x, 16.4x, and 23.5x respectively on EV/EBITDA for 2019. Aaon is a bit of an unusual case in that it is a small-cap, debt-free firm with no meaningful liabilities; Johnson Controls likely marks the cleanest comp. Is there a case for some incremental upside on the EBITDA multiple? I think so but likely no more than a turn, maybe a turn and a half. That's good enough for 15-20% upside using back of the napkin math. Constraining the multiple will be leverage which will spike to multi-year highs given that only a portion of the cash proceeds will get moved to debt reduction (share repurchases, deal cash cost, restructuring to eliminate costs will all drive other sources of cash use). The company looks a bit better on a net debt/EBITDA perspective today because of cash sitting on balance sheet that will be used to acquire the Precision Flow Systems business from Accudyne Industries.I think IndustrialCo looks to have the stronger value proposition from here, and while investors could get exposure to that value via holding Ingersoll-Rand (via the spin-off shares they will receive), I think it will most likely be better to go straight for the source and buy Gardner Denver today.

I spoke about the merits of these two businesses based on filling the gaps where the other has only a small presence - I think the above presentation slide drives that home. It's a compelling puzzle piece of the story. Also, I think it is important that investors remember that the Industrial business is just a fractional driver of the overall business of Ingersoll-Rand today. For most of recent history, this segment contributed only around 15% of overall company EBITDA. Given that, management focus has been elsewhere, driving value in the Climate Controls business. Most executive leadership has more experience in that area, and I think that shows in realized EBITDA margin between the two companies on an independent basis. While some aspects of the Ingersoll-Rand business (Power Tools, Small Electric Vehicles) likely carry lower realized EBITDA margin, in many ways, I think this is a function of a bit of neglect and there is some room to squeeze out improved margin:

Note that management cites 18% EBITDA margin for Ingersoll-Rand in its deal presentation, in large part due to thepending acquisition of Precision Flow Systems("PFS") for $1,450mm. This business has 32% EBITDA margin ($400mm in revenue, ~$131mm in EBITDA estimate) which was highly accretive to Ingersoll-Rand. Do keep in mind that this business, which focuses on positive displacement pumps, boosters, and mixers for fluids, is going to get added to the pro forma company.Pre-synergies, IndustrialCo believes it will generate around $1,400mm in EBITDA. This comes through roughly $700mm in contribution from Gardner Denver and $700mm in contribution from Ingersoll-Rand including what would have been full-year contribution from the PFS business. Keep in mind the above tables are segment level EBITDA - not consolidated - and there are some unallocated general and administrative ("G&A") costs which is what drives numbers lower.The target is $250mm in synergy savings. This is less than 4% of revenue and is a figure that should be broadly attainable. While some savings will come from manufacturing footprint consolidation and elimination of redundant G&A, most of it will come through shifts in the supply chain and procurement process. As a firm with larger negotiating power, IndustrialCo should be able to cut its input costs and also leverage a better distribution network for its products.Gardner Denver has limited manufacturing presence in AsiaPac; most of its manufacturing operations are in Europe and the Americas. Likewise, despite generating a lot of sales in China, most of its principal plant manufacturing facilities (90%) are located in the same regions as Gardner Denver. The PFS business appears to be a similar structure. While AsiaPac sales could very well be hit by export tariffs, this is 20% of the business - and likely lower margin business. Unlike other industrials that see damage both ways, such as Caterpillar (CAT) exporting products made in China and sold in the United States, that should not be an issue here. Comparatively to other international industrials, IndustrialCo should come out much better. While there is exposure to heavily cyclical industries (oil and gas drilling, industrials in general), the aftermarket parts business should provide a buffer.

Of note, this is one of my positions where I am (reticently) dipping my toe back into some meaningful European exposure when it comes to sales. Industrial production and overall demand growth has been very soft across the Atlantic, and I'm still a skeptic of that. With that said, leverage is very manageable here, roughly 2.3x EBITDA inclusive of the $1,900mm cash payout to ClimateCo. This should, given the free cash flow nature of the business (reconciliation in the Valuation section below) and likely synergy benefits come down quite quickly. Ratings agencies have been very positive on IndustrialCo. Moody's note the revenue increase, stronger end market diversification, and essentially unchanged leverage profile in a recent credit review. There is a long way to go for an investment grade credit rating, which will likely be predicated upon shifting some of the debt load away from the senior secured structure, but I expect management will attempt to make meaningful progress on the measure in advance of the 2024 maturity window.

IndustrialCo, at current market prices, should be a $17B company when it begins trading. While at first glance this does not look appealing from an EV/EBITDA perspective (12.2x EBITDA pre-synergies, 10.7x post), I think there is a little more value than there might appear at first glance.

Base case above is pre-synergies, bull case assumes full realization (likely a three-year endeavor). Using fairly reasonable assumptions, IndustrialCo is likely to generate roughly $830mm in free cash flow next year absent the one-time $450mm in expense necessary to fund the synergy capture. While less of a free cash flow story in 2020 given that, starting in 2021 this business will be throwing off 25% or more of the debt load as a percentage of cash. A lot of this is likely to be redeployed via acquisition or sent back to shareholder pockets.Competitors primarily include Colfax (CFX), Flowserve (FLS), IDEX Corporation (IEX), Thermo Fisher Scientific (TMO), and Atlas Copco (OTCPK:ATLKY). At 21% EBITDA margins, working up to 25%, IndustrialCo is going to comp more against the big large caps like IDEX Corporation or Thermo Fisher Scientific versus some of the smaller players that trade at lower multiples. Today, Thermo Fisher trades at 17.2x forward EV/EBITDA; IDEX Corporation at 15.3x. Flowserve, as a smaller player in many of the company's key markets, trades at 16.9x. Nearly all of these firms trade at lower free cash flow yields.There is significant room for multiple expansion. From the current 12.2x, every turn higher is worth $3.40/share based on pre-synergy EBITDA. I believe IDEX Corporation is a crystal clear comp, and at 15.3x multiple, there is room for shares to head higher into the $40s based on solid execution.I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.