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Morningstar | Ingersoll-Rand's Announced Acquisition of Precision Flow Systems Seems Like a Good Deal to Us

On Feb. 11, narrow-moat-rated Ingersoll-Rand announced its intention to acquire Precision Flow Systems, a leading manufacturer of fluid management systems, for $1.45 billion, funded via cash and debt. Ingersoll-Rand's management expects the deal to close in mid-2019 and for it to be accretive to EPS and cash flow return on invested capital during its first year under Ingersoll-Rand's ownership. The announced purchase price values PFS at approximately 3.6 times 2018 revenue of $400 million and 11 times Ingersoll-Rand's 2019 EBITDA expectations for the business, net of synergies. Based on what we view as sound strategic rationale behind the acquisition, as well as our cursory discounted cash flow analysis of stand-alone PFS, we think this is a good acquisition for Ingersoll-Rand. Because we expect the deal to close, we included PFS in our updated valuation model. The contribution of our projected PFS-related free cash flows net of the acquisition price added $2 per share to our fair value estimate, which now stands at $103 per share.

PFS designs and manufactures highly engineered products that are used across an eclectic mix of end markets, including water, food and beverage, pharmaceuticals, chemical, energy, and agriculture. Management expects most of PFS' end markets to grow at a mid-single-digit pace. About 50% of PFS revenue is generated from aftermarket and replacement sales. The mission-critical nature of PFS' products and its strong aftermarket mix explain the company's strong profitability, with EBITDA margins in the high 20s. Ingersoll-Rand has identified $20 million of EBITDA synergies, which based on our math, could push PFS EBITDA margins above 30% if achieved.

While PFS' growth and profitability prospects are attractive, in our view, the acquisition also makes strategic sense as it nicely complements Ingersoll-Rand's existing ARO-branded fluid management business and should result in cross-selling opportunities.

We were pleased with management's disclosures about PFS' financial contribution. To summarize, Ingersoll-Rand expects PFS to post GDP-plus level growth as most of its end markets are growing at a mid-single-digit pace. PFS generates EBITDA margins in the high 20s, and the firm's profitability is quite resilient thanks to its strong mix of aftermarket sales and the mission-critical nature of the products it sells. Ingersoll-Rand's management expects to achieve approximately $20 million of EBITDA synergies, which we think could take PFS EBITDA margins above 30%. PFS' annual capital expenditure requirements are approximately 1% of revenue, and free cash flow conversion is about 100% of net income.

Ingersoll-Rand intends to use both cash on hand and debt to fund the $1.45 billion acquisition. At the end of 2018, Ingersoll-Rand had $900 million of cash on the balance sheet, and before this announcement, management expected 2019 free cash flow of $1.6 billion. After considering Ingersoll-Rand's funding commitments for its dividend (approximately $500 million) share repurchases (management didn't withdraw its $500 million guidance), and the incremental free cash flow from PFS, we estimate that Ingersoll-Rand's cash balance could fall below $100 million by year-end 2019 without increasing its debt load. Because the company hasn't finished a year with less than $500 million of cash since 2006, we think the firm will take on at least an incremental $500 million of debt. Ingersoll-Rand has plenty of liquidity with an unused $2 billion commercial paper program and another $2 billion of untapped credit facilities.